A stock-market paradox, in which bad news about the economy is seen as good news for equities, may have run its course. If so, investors should expect bad news to be bad news for stocks heading into the new year — and there may be plenty of it.
But first, why would good news be bad news? Investors have spent 2022 largely focused on the Federal Reserve and its rapid series of large rate hikes aimed at bringing inflation to heel. Economic news pointing to slower growth and less fuel for inflation could serve to lift stocks on the idea that the Fed could begin to slow the pace or even begin entertaining future rate cuts.
Conversely, good news on the economy could be bad news for stocks.
So what’s changed? The past week saw a softer-than-expected November consumer-price index reading. While still running mighty hot, with prices rising more than 7% year over year, investors are increasingly confident that inflation likely peaked at a roughly four-decade high above 9% in June.
See: Why November’s CPI data are seen as a ‘game-changer’ for financial markets
But the Federal Reserve and other major central banks indicated they intend to keep raising rates, albeit at a slower pace, into 2023 and likely keep them elevated longer than investors had anticipated. That’s stoking fears that a recession is becoming more likely.
Meanwhile, markets are behaving as if the worst of the inflation scare is in the rearview mirror, with recession fears now looming on the horizon, said Jim Baird, chief investment officer of Plante Moran Financial Advisors.
That sentiment was reinforced by manufacturing data Wednesday and a weaker-than-expected retail sales reading on Thursday, Baird said, in a phone interview.
Markets are “probably headed back to a period where bad news is bad news not because rates will be driving concerns for investors, but because earnings growth will falter,” Baird said.
A ‘reverse Tepper trade’
Keith Lerner, co-chief investment officer at Truist, argued that a mirror image of the backdrop that produced what became known as the “Tepper trade,” inspired by hedge-fund titan David Tepper in September 2010, may be forming.
Unfortunately, while Tepper’s prescient call was for a “win/win scenario.” the “reverse Tepper trade” is shaping up as a lose/lose proposition, Lerner said, in a Friday note.
Tepper’s argument was that the economy was either going to get better, which would be positive for stocks and asset prices. Or, the economy would weaken, with the Fed stepping in to support the market, which would also be positive for asset prices.
The current setup is one in which the economy is going to weaken, taming inflation but also denting corporate profits and challenging asset prices, Lerner said. Or, instead, the economy remains strong, along with inflation, with the Fed and other central banks continuing to tighten policy, and challenging asset prices.
“In either case, there’s a potential headwind for investors. To be fair, there is a third path, where inflation comes down, and the economy avoids recession, the so-called soft landing. It’s possible,” Lerner wrote, but noted the path to a soft landing looks increasingly narrow.
Recession jitters were on display Thursday, when November retail sales showed a 0.6% fall, exceeding forecasts for a 0.3% decline and the biggest drop in almost a year. Also, the Philadelphia Fed’s manufacturing index rose, but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State index fell.
Stocks, which had posted moderate losses after the Fed a day earlier lifted interest rates by half a percentage point, tumbled sharply. Equities extended their decline Friday, with the S&P 500 SPX,
logging a 2.1% weekly loss, while the Dow Jones Industrial Average DJIA,
shed 1.7% and the Nasdaq Composite COMP,
Read: Still a bear market: S&P 500 slump signals stocks never reached ‘escape velocity’
“As we move into 2023, economic data will become more of an influence over stocks because the data will tell us the answer to a very important question: How bad will the economic slowdown get? That’s the key question as we begin the new year, because with the Fed on relative policy ‘auto pilot’ (more hikes to start 2023) the key now is growth, and the potential damage from slowing growth,” said Tom Essaye, founder of Sevens Report Research, in a Friday note.
No one can say with complete certainty that a recession will occur in 2023, but it seems there’s no question corporate earnings will come under pressure, and that will be a key driver for markets, said Plante Moran’s Baird. And that means earnings have the potential to be a significant source of volatility in the year ahead.
“If in 2022 the story was inflation and rates, for 2023 it’s going to be earnings and recession risk,” he said.
It’s no longer an environment that favors high-growth, high-risk equities, while cyclical factors could be setting up nicely for value-oriented stocks and small caps, he said.
Truist’s Lerner said that until the weight of the evidence shifts, “we maintain our overweight in fixed income, where we are focused on high quality bonds, and a relative underweight in equities.”
Within equities, Truist favors the US, a value tilt, and sees “better opportunities below the market’s surface,” such as the equal-weighted S&P 500, a proxy for the average stock.
Highlights of the economic calendar for the week ahead include a revised look at third-quarter gross domestic product on Thursday, along with the November index of leading economic indicators. On Friday, November personal consumption and spending data, including the Fed’s preferred inflation gauge are set for release.