The hottest debate on Wall Street right now is whether or not the US economy will enter a
in the months ahead.
Consumer spending — the driving force behind about two-thirds of the economy — is starting to slow down as the highest inflation rate in four decades hits budgets and the
hikes interest rates to cool demand.
Whether or not either factor hits the economy hard enough to drag GDP into the negative for two consecutive quarters remains to be seen. But as financial conditions tighten, the odds of a recession coming to fruition grow.
For Jon Wolfenbarger, the founder of Bullandearprofits.com and a former Allianz Global Investors securities analyst, the writing is already on the wall that a recession is coming. In a recent commentary, he laid out several reasons he sees the expansion ending.
The first is that real personal income has dipped negative year-over-year, which has historically only happened during recessions. Recessions are highlighted in the gray areas below.
Second, yields on the 10-year and 2-year Treasury notes inverted in April. Yields on 10-year Treasury notes are usually higher than those on short duration bonds. When yields on notes like the 2-year surpass the 10-year, it signals low confidence in the economy in the near-term. Yield curve inversions like this have preceded every recession since the 1950s.
The curve remains flat, Wolfenbarger pointed out, and could invert again soon.
Third, the spread between junk corporate bonds — or bonds issued by firms at the highest risk of defaulting on their debt — and Treasury bonds, which are viewed as risk-free, continues to rise, even as Treasury bond yields surge. This means investors are starting to sell riskier bonds at a higher pace as they become concerned with tightening financial conditions.
Copper pricesa leading recession indicator, has also fallen substantially in recent months, Wolfenbarger highlighted.
And then there’s sentiment. consumer sentimentaccording to the University of Michigan’s poll, is at its lowest level since it started in the early 1980s. CEO confidenceaccording to the Conference Board’s survey, is also at its lowest level since the start of the pandemic.
Finally, the Fed’s Brave-Butters-Kelley index’s leading recession indicator (shown in red), has fallen below the -1 level (the index combines 500 economic indicators). This is associated with heightened recession probability in the following 10 months, according to the Fed. Wolfenbarger said this has correctly predicted recessions 86% of the time.
All of this amounts to more trouble ahead for stocks, Wolfenbarger said. He said he expects the S&P 500 to fall around 60%, or more, from its January peak. It’s already down 21%.
One reason he’s calling for such a steep drop is because valuations remain extended above historical norms by many measures. He also said many investors haven’t sold positions yet because they’ve repeatedly believed a bottom could be in. But with his call for a recession ahead, the outlook for stocks is likely to get worse, and this will lead to more selling, he said.
“A lot of people are just not understanding what’s going on,” Wolfenbarger told Insider on Friday. “I think there’s a lot more downside to go. Once people start to realize that we are in a recession, it could be a really ugly recession.”
Wolfenbarger said the sell-off will go into next year before bottoming out.
The bigger picture
Wolfenbarger’s call for a recession ahead is becoming more common as inflation remains above 8% and the Fed tightens aggressively (they raised interest rates by 75 basis points in June, the largest amount since 1994).
The Fed itself has begun to acknowledge the growing risk. Fed Chair Jerome Powell said in June that it would be “very challenging” to achieve a soft landing — or raise rates and not trigger a downturn — and a June Fed paper found a 50% chance of a recession in the next year.
Goldman Sachs also recently raised their recession probability over the next 12 months to 30%. Morgan Stanley says that chance is 35%. Citi sees a 40% chance of a recession unfolds before 2023.
Still, while risks are rising, many banks don’t see a recession as their base case.
As far as Wolfenbarger’s bold call for a 60% drop, he finds company in names like Michael Burry (the hedge fund manager featured in the film “The Big Short”), Jeremy Grantham, Ray Dalio, and others.
The most bearish Wall Street strategists, meanwhile, remain a little less bearish than Wolfenbarger. Many in recent weeks — like Bank of America’s Savita Subramanian, Morgan Stanley’s Mike Wilson, and Societe Generale’s Solomon Tadesse — have said the S&P 500 would find a bottom around the 3,000-3,100 range. The index currently sits at 3,820.
There is also a chorus of more bullish strategists, who think a bottom could be in soon as the Fed may be able to back off if inflation cools.
“While the S&P 500 has likely entered a ‘secular
,’ the process is not linear — and we see a relief rally led by Cyclical Growth (mostly Technology) to 4,150 for the S&P 500 (+10%) in summer 2022 as oil prices fall and the market looks ahead to a possible Fed rate pause at their December 2022 meeting,” said Stifel’s Barry Bannister in a June 24 note to clients.
Interest rates have already risen substantially, and demand is starting to fall. If inflation begins to come down, the Fed may be able to back off, and stocks could begin to rally. But things could also get a lot worse as the economy continues to digest tightening policy. If they do, as Wolfenbarger is warning, stocks could have a lot further to fall.