Key Points

- The sharp market sell-off has triggered fears of a pending U.S. recession, but we believe such concerns are overwrought.

- Fundamental conditions remain relatively solid outside of slowing Chinese growth and the collapse in oil prices.

- It will likely take some time, but we believe investor sentiment should recover over the coming months.

Equity markets remained in free fall last week, with the S&P 500 Index dropping another 2.2%.1 Mixed economic data, a renewed collapse in oil prices, financial turmoil in China and worries over credit conditions and corporate earnings prompted fears that the U.S. economy may be heading for recession. This put additional downward pressure on equity markets and other risk assets.

Weekly Top Themes

We believe the odds of a recession are lower than what equity markets are forecasting. The S&P 500 is off 7.9% for the year and is close to 10% below its high from late 2015.1 Following what proved to be a mediocre period for equities last year, the drastic decline has some believing the U.S. is on the cusp of a recession. It looks to us as if stocks are pricing in a 50% chance of a recession; we think the odds are actually closer to 25%.

Corporate earnings remain under pressure. Fourth quarter results are expected to show a 6% decline, which would result in profits contracting for three consecutive quarters for the first time since 2009.2 Analysts are also forecasting a modest decline for the first quarter.2
Falling oil prices should help the U.S. economy but could cause some short-term pain. Lower energy costs are long-term positives for consumers and businesses and should be a positive for trade. In the near-term, however, the sharp collapse is causing credit issues, hurting earnings and sparking deflationary fears.

Fundamentals Are Stronger Than What Markets Reflect

The sharp market downturn appears to have turned what has long been concern over weak economic growth into more dire forecasts of an end to the bull market and the onset of a recession. Investor sentiment has imploded in the face of worries over the fragility of the economy, a slowdown in U.S. and Chinese manufacturing, confusing signals from Chinese policymakers and another collapse in oil prices.

Importantly, however, the negative turn in sentiment is not due to a significant fundamental shift in economic data or a policy mistake. In our view, most fundamental conditions remain steady. The U.S. economy is growing slowly and wages are accelerating while broader inflation remains contained. Federal Reserve policy is still easy and the European Central Bank, Bank of Japan and People’s Bank of China are all in easing cycles. Outside of the equity downturn, other financial assets are not showing severe dislocations. Non-energy fixed income credit sectors are relatively stable, and government bond yields have not dropped by as much as would be expected if the economy were severely worsening. The main fundamental changes we have seen are the economic downturn in China, the drop in the value of the yuan and the corresponding free fall in oil. Falling oil prices by themselves, however, do not indicate an imminent recession. Rather, they reflect excessive supplies around the world. Nor do we believe China is headed for a hard landing. Growth is slowing but remains positive.

The challenge for investors in this environment is to decide whether to turn defensive on a short-term basis to guard against further downturns, or remain patient on the expectations that panic conditions will ease once investors realize a recession is not in the cards. We believe the latter strategy would be more prudent. In many ways, the current scenario reminds us of the market turmoil in 2010 through 2012 when periodic crises resulted in a series of sharp sell-offs and subsequent rallies in risk assets.

So what will it take for markets to break out of the current downdraft? For one, we think we need firmer economic data from China and evidence that policymakers can manage the country’s financial conditions. Additionally, we probably need to see signs that both U.S. and Chinese manufacturing levels are recovering, so we will keep a keen eye on purchasing manager indices. Finally, stabilizing oil prices would go a long way toward improving investor sentiment.