Stock-market investors are still wagering that the U.S. economy will avoid a recession even as the Federal Reserve and other central banks raise interest rates aggressively to get decades-high inflation under control. 

The S&P 500 Index initially dropped as much as 1.6% Wednesday after consumer prices in June surged by another four-decade high only to later pare the loss, with the index slipping 0.3% to about 3,806 by midday in New York. 

That’s put it down more than 20% this year. But to reach the point where investors are pricing in a U.S. economic downturn, the benchmark index would need to sink another 5.8% to 3,586, according to Bloomberg Intelligence. 

Despite Wednesday’s muted drop, investors say they are bracing for more pain ahead after U.S. stocks finished one of the worst half of the year in decades. Stubbornly high inflation is bolstering the odds that the Fed will raise interest rates by 75 basis points later this month and again in September, which some strategists fear may halt the nation’s economic expansion. 

They key question for investors is “how big a recession, if one occurs, should be expected,” Scott Knapp, chief market strategist at CUNA Mutual Group, wrote in a note. “Many have suggested a short, shallow one is likely because of the strength of the labor market and consumers. The probabilities are increasing that a steep one will be required to defeat inflation at these levels.”

Bank of America Corp. economists have joined Wells Fargo Investment Institute and Nomura Holdings Inc. in expecting a U.S. recession in 2022. BofA forecasts a “mild” downturn, saying services spending is slowing and hot inflation is spurring consumers to pull back.

Even so, the probability-weighted base case from BI’s model assumes that the S&P 500 is fairly valued around 4,100, or 8% above current levels, according to BI. That estimate is still 18% below the current aggregated bottom-up analyst consensus of 5,011.

Investors are now looking ahead to the official kick off of second-quarter earnings season Thursday, when JPMorgan Chase & Co. and other big banks begin to report results, to see whether profit growth can handle inflation and supply constraints. 

In the second quarter, S&P 500 earnings are expected to rise just 3.5% from a year ago, led by energy, industrials and materials, while financials and consumer discretionary are expected to post the largest declines, according to strategists at Bernstein. Excluding energy, the S&P 500’s growth would contract 5.3%, the firm said. 

This article was provided by Bloomberg News.

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