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The stock market is falling because investors fear recession more than inflation

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A stock market paradox, in which bad news about the economy is seen as good news for stocks, may have played itself out. If so, investors should expect bad news to be bad news for stocks heading into the new year – and there could be a lot.

But first, why would good news be bad news? Investors spent 2022 largely focused on the Federal Reserve and its rapid series of large rate hikes aimed at controlling inflation. Economic news pointing to slower growth and less fuel for inflation could serve to lift equities on the idea that the Fed might start to slow the pace or even start accepting future rate cuts.

On the other hand, good news about the economy can be bad news for stocks.

So what changed? Last week saw a softer-than-expected November consumer price index reading. While it’s still very hot, with prices rising more than 7% year-on-year, investors are increasingly confident that inflation likely reached an approximately four-decade high above 9% in June.

To see: Why November’s CPI data is seen as a ‘game changer’ for financial markets

But the Federal Reserve and other major central banks have indicated they intend to keep raising rates, albeit at a slower pace, through 2023 and likely to keep them higher longer than investors expected. This is fueling fears that a recession is becoming more likely.

Meanwhile, markets are behaving as if the worst of inflation fears are in the rearview mirror, with recession fears now looming on the horizon, said Jim Baird, chief investment officer at Plante Moran Financial Advisors.

That sentiment was reinforced by manufacturing data on Wednesday and a weaker-than-expected retail sales reading on Thursday, Baird said in a telephone interview.

Markets “are likely going back to a period where bad news is bad news, not because rates are raising 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.

Sadly, while Tepper’s prescient call was for a “win/win scenario”. the “reverse Tepper trade” is shaping up to be a lose/lose proposition, Lerner said in a Friday note.

Tepper’s argument was that the economy would improve, 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 will weaken, controlling inflation but also hurting corporate profits and challenging asset prices, Lerner said. Or, instead, the economy remains strong, along with inflation, as the Fed and other central banks continue to tighten policy and challenge asset prices.

“In both cases, there is a potential headwind for investors. To be fair, there is a third path, where inflation drops and the economy avoids recession, the so-called soft landing. It’s possible,” Lerner wrote, but noted that the path to a smooth landing seems increasingly narrow.

Recession jitters were on display Thursday when November retail sales showed a 0.6% drop, beating forecasts for a 0.3% decline and the biggest drop in nearly a year. In addition, the Philadelphia Fed Manufacturing Index rose but remained in negative territory, disappointing expectations, while the New York Fed’s Empire State Index fell.

Stocks, which posted moderate losses after the Fed raised interest rates by half a percentage point the day before, fell sharply. Equities extended their slide on Friday, with the S&P 500 SPX,
posting a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
fell 1.7% and the Nasdaq Composite COMP,
fell 2.7%.

To read: Still a bear market: S&P 500 crash signals stocks never reached ‘escape velocity’

“As we move into 2023, economic data will become more influential on equities because the data will give us the answer to a very important question: how bad will the economic downturn be? This is the key issue as we start the new year, because with the Fed on relative policy ‘autopilot’ (higher to start in 2023), the key now is growth and the potential damage from slowing growth,” he said. Tom Essaye, founder of Sevens Report Research, in a Friday note.

recession clock

No one can say with complete certainty that a recession will hit in 2023, but there seems to be no doubt that corporate earnings will come under pressure, and that will be a key driver for markets, said Baird of Plante Moran. And that means earnings have the potential to be a significant source of volatility in the coming year.

“If in 2022 the story was inflation and interest, for 2023 it will be profit and the risk of recession”, he said.

It is no longer an environment that favors high-growth, high-risk stocks, while cyclical factors may be adjusting well for value-oriented stocks and small caps, he said.

Truist’s Lerner said that until the weight of evidence changes, “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 slope, and sees “better opportunities below the market surface” such as the S&P 500 of equal weight, a proxy for the average stock.

Highlights of the economic calendar for the week ahead include a revision of third-quarter gross domestic product on Thursday, along with the November index of leading economic indicators. On Friday, consumer and personal spending data for November, including the Fed’s preferred inflation gauge, will be released.