Until the looming recession question is answered, volatility will remain elevated, and no clear market direction will be established.

Recession depends on two key components – inflation and employment. If inflation falls enough for the Fed to stop raising rates BEFORE employment strength is wiped out, then we may escape recession. If not, recession is all but guaranteed and the question becomes one of severity. The market is currently struggling with this uncertainty – will economic conditions affect earnings and growth potential? We have repeatedly written over the past year to expect a recession. Even with inflation falling, there is still a way to go towards the Fed’s 2% goal, and the Fed has been vocal in its willingness to overshoot. To date, employment has held up very well in the face of higher interest rates. People with money to spend keeps the economy growing. But that is also part of the problem – people keep spending and contributing to inflationary forces. Making the Fed’s job even more difficult, consumer spending has moved away from goods towards services. Goods inflation has come down markedly in the past 6 months, but services (restaurants, travel, sporting events, concerts, etc.) has continued to rise. It is much harder for the Fed to tamp down services inflation while people have jobs. Additionally, there is still $4 trillion of excess savings in consumers’ bank accounts, so they could continue spending for a while even with no job.

However, we do not expect a protracted and deep recession. The financial system is much more stable and liquid than a decade ago, corporate, and personal balance sheets are in very good shape, and employment demand is likely to remain (relatively) strong. Therefore, we are in the mild recession camp.

The market already suffered a meaningful decline in 2022. How much farther could the market decline should a mild recession occur? With valuations far lower than a year ago, the downside from here could be limited. Perhaps we have already seen the bottom for this cycle. However, the typical P/E ratio for a recessionary market is closer to 14-15 times earnings (we are currently at 18). Along with potentially weaker earnings, this implies we could move lower in the coming months. If earnings don’t dissolve meaningfully, we think 3,500-3,600 on the S&P 500 may be the bottom. That represents a roughly 10% decline from today’s levels.

The bottom line is to expect volatility to remain elevated at least until the Fed stops raising interest rates. Then the market can more easily assess future earnings prospects, and the stage should be set for a rebound in financial markets.

Enjoy today and tomorrow, and let us do the worrying!

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