As a growing number of investment banks and company chiefs warn that the likelihood of a recession is increasing, analysts at Morgan Stanley are telling clients that the stock market—despite reeling from a steep selloff in recent weeks—has plenty of room to fall before hitting levels consistent with recession-era lows, which would be especially bad for cyclical industries like travel and hospitality.
Despite major stock indexes plunging more than 20% below recent highs, markets are still only down by about 60% of the average drawdown compared with previous recessions (which denote two consecutive quarters of negative GDP growth), Morgan Stanley analysts told clients in a Tuesday note.
As the Federal Reserve works to combat decades-high inflation with interest rate hikes that will likely stunt economic growth, a recession "is no longer just a tail risk," analysts led by Michael Wilson wrote, putting the odds of one over the next year at 35%, up from 20% in March.
They estimate the S&P 500 could plunge as much as 20% to 3,000 points, from current levels of 3,770, if the U.S. falls into recession, citing earnings that tend to fall an average of 14% during recessions—a marked turnaround from record profits and 25% growth last year.
“The bear market will not be over until recession arrives—or the risk of one is extinguished,” the analysts said, adding that market weakness will likely continue over the next three to six months in the face of "very stubborn" inflation readings.
With high prices deterring some consumer spending, Morgan Stanley says stocks tied to discretionary spending, like those in retail, hotels, restaurants and clothing, are at higher risk of a downturn, while those tied to the internet, payments and durable household goods (like appliances and computers) are less at risk.
The note comes the same day Tesla CEO Elon Musk said the U.S. economy will "more likely than not" face a recession in the near term, echoing concerns raised by several other top business leaders and financial institutions following last week's steeper-than-expected hike in key interest rates, which tend to deter spending by making borrowing more expensive.
Morgan Stanley's not alone in raising recession odds this week. In a note to clients Monday, Goldman Sachs' chief economist, Jan Hatzius, said the firm now sees "recession risk as higher and more front-loaded," given the Fed's more aggressive rate hike, putting the odds of a recession over the next two years at 48%, up from 35% previously. The investment bank estimates tighter financial conditions could drag down GDP as much as 2 percentage points over the next year.
Restaurants are most at risk of a pullback in spending, according to a Morgan Stanley survey of some 2,000 consumers. Roughly 75% of respondents said they’ll cut back on dining out over the next six months, while 60% said they'd do so on deliveries and takeout from restaurants. Though driving much of the inflationary gains, essential items like gas and groceries should see more resilient spending, with roughly 40% of consumers saying they'd cut back on either.
Major stock indexes plunged into bear market territory last week ahead of the Fed's largest interest rate hike in 28 years, and the gloomy sentiment has ushered in waves of layoffs among recently booming technology and real estate companies. "We don't believe the Fed can stop the issues that are causing inflation on the supply side without absolutely wrecking the economy, but at this point, it looks like they are resigned to the fact that it must be done," says Brett Ewing, chief market strategist of First Franklin Financial Services. Goldman Sachs has warned clients it expects another 75-basis-point hike in July.
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