Key Points

• Equity prices continue to face downward pressure and markets appear to be pricing in a 50/50 chance of a U.S. recession. We believe a recession is unlikely.

• Investor caution is warranted and we may witness additional downside, but we expect stock prices should trend higher over the coming months.

Equity prices fell again last week, with the S&P 500 Index dropping 2.6% despite a significant bounce on Friday.1 Investors continued to focus on downside risks and fears of slowing growth. Rising concerns over central banks adopting zero or negative interest rate policies also detracted from market sentiment, drove confidence lower and resulted in a sharp sell-off in banking sector stocks.1


The Negative Feedback Loop Will Take Time to Unwind

Financial markets appear to be caught in a series of intertwined and self-reinforcing negative spirals. Falling oil is dragging down inflation and economic growth expectations. As a result, general market sentiment sours and equity prices decline as financial conditions tighten. Given this backdrop, corporate management teams grow more cautious and actual economic activity slows. At the same time, consumers appear to be saving rather than spending their proceeds from the “energy dividend.”

Fears over the prospects of a recession are rising. We do not believe a recession is likely, but we acknowledge that it will take time for financial markets to stabilize and better data to emerge. Unfortunately, this means confusion and turmoil could be the order of the day for several more weeks or even months.


Weekly Top Themes

1. The consumer sector of the economy remains solid. For the last several years, it seemed like the business sector was upbeat while consumer-related areas of the economy struggled. The tables may be turning. Retail sales were stronger than expected in January,2 while income levels and consumer sentiment seem to be improving.

2. Ongoing financial turmoil may slow jobs growth, but any setback should be modest. Initial unemployment claims fell 16,000 to 269,000 for the week ended February 6.3 This suggests labor market fundamentals remain in decent shape and should be able to withstand downward pressure.

3. The Federal Reserve must choose whether to focus on economic or financial signals. January’s jobs report showed that wages are rising just as financial conditions have been turning increasingly ugly.3 This puts the Fed in a tough spot, as it needs to balance the fact that the expansion is continuing with mounting investor fears.

4. Zero or negative rate policies may provide short-term relief but could bring long-term problems. In our view, the longer countries keep their interest rate levels artificially low, the more likely financial distortions will occur.

We Believe Equities Are in an Extended Bottoming Process

There are clear risks ahead. Slowing growth in China and commodity price weakness have long been concerns, and investors are now grappling with monetary policy confusion. Ultimately, we think improvements in economic data and stabilizing oil prices are necessary to improve sentiment. In the U.S., it may make sense to stimulate growth via fiscal policy measures since economic growth remains relatively slow. However, such a development seems unlikely since voters and politicians appear biased toward austerity.

It seems we are either at the forefront of a recession or investors are overreacting to the negatives. At its current level of around 1,860, the S&P 500 appears to be pricing in a 50% probability of a recession. If a recession does ensue, we think the index could drop to around the 1,600 range in the coming months. If the economic picture brightens (as we expect it will), the S&P 500 would be more likely to climb back to around 2,000.

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