As an economic slowdown weighs on earnings, corporations are reviving the “trust the process” slogan made popular by the Philadelphia 76ers in the post-Iverson era.
Markets, for their part, have already started pricing in risks of a recession, with the S&P 500 and Nasdaq falling into bear markets this year — down 20% and 32% year to date, respectively — while the Dow has fallen more than 9%.
“The market goes first, so the market has cracked this year,” Liz Young, head of investment strategy at SoFi, told Yahoo finance Live (video above). “The market has shown us its pessimism. It’s shown us its reaction to the microenvironment.”
The market decline is largely contingent on the Federal Reserve’s aggressive raising of interest rates, and thereby slowing the economy, in the fact of decades-high inflation: Fed Chair Powell recently acknowledged the risk of tipping the economy into a recession but said that thinking about pausing interest rate hikes at this juncture would be “very premature.”
“Until we see consecutive months of inflation coming down in a meaningful way, I expect them to continue hiking and continue tightening,” Young said. “I think that they are quite comfortable with tightening maybe a bit too far, and then trying to sort of ask for forgiveness from markets later with the tools that they have to stimulate.”
In the meantime, Young suggested that investors watch for two other signs that the business cycle may be turning over.
A sweeping earnings contraction may be the next shoe to drop, according to Young. The market has not seen a wave of downward revisions in its earnings estimates since the onset of the coronavirus pandemic.
“I think the piece of it that hasn’t quite been priced in entirely is that earnings contraction,” she said.
In a Nov. 4 note, Goldman Sachs shrunk its earnings target for the S&P 500 for the rest of the year as well as through 2024. The bank now sees earnings for 2022 coming in at $224, down from $226. Furthermore, strategists at the firm revised their earnings expectations for 2023 down to $224 ($234 previously) and to $237 in 2024 (from $243).
Young added that if the U.S. were to fall into a recession, she would expect a 10% to 15% contraction in earnings. At the same time, she noted, earnings faltering would vary across sectors due to inflation.
“Goods inflation is likely to come down much more quickly and to a more manageable level than services inflation, which tends to be more sticky and includes things like rents, and businesses are also dealing with sticky wage inflation,” Young said. “So the sectors that are goods intensive and can benefit from goods inflation coming down and commodity prices coming down are likely to do better and maybe don’t take as big of an earnings hit.”
The U.S. unemployment rate is currently hovering near 50-year lows, and the Fed broadly sees an overheated labor market with demand for employees exceeding the supply of labor market participants.
But that could change as the Fed continues to raise rates.
“The last piece of the puzzle is that the economy falters, and you see real data in the economy, the labor market, inflation comes down, that things are actually contracting,” Young said.
The bright spot for investors would be that by the time the economic data stumbles, the stock market may already be in recovery mode as equities tend to bottom well before the conclusion of a recession.
According to historical data from JPMorgan, on average, the S&P 500 sees a bottom three months after the beginning of a recession and reaches a cyclical low 10 months before the end of a recession.
“A recession is pretty likely at this point — doesn’t mean it has to be bad, doesn’t mean it has to be armageddon,” Young said. “Recessions reset the business cycle, and that might be a positive in this environment.”
Bradley Smith is an anchor at Yahoo Finance. Follow him on Twitter @thebradsmith.