Calls for a recession in 2023 are now deafening, with not only many economists and experts projecting one, but lots of data and other economic indicators are telling investors to expect one as well.
The interesting thing is that a recession may not be so bad for the market, especially when you think about the tech sector, which struggled immensely in 2022. That's because a recession might further slow the high consumer prices that have come with some of the highest levels of inflation seen in about four decades.
It also might prompt the Federal Reserve to cut interest rates if the agency feels the economy slows too much and needs to be stimulated. This would create more of a risk-on environment for stocks, especially in the tech sector. But the market may be getting ahead of itself here, which could end poorly for tech stocks. Here's why.
The market is already thinking rate cut
The Nasdaq Composite, a proxy for the tech sector, has already rallied about 9% in 2023, largely because data has suggested that inflation is slowing, which would enable the Fed to end its aggressive rate-hiking campaign sooner than later. What's more, there have been several indicators showing the market is expecting a recession.
The first is the inversion between the yields on the two-year and 10-year U.S. Treasury bills, which is the most inverted this part of the yield curve has been in many years. This has always been considered a flashing sign of a recession.
2-Year Treasury Rate data by YCharts.
Additionally, according to CME Group's FedWatch tool, which uses futures pricing data to see how investors are betting on the trajectory of the Fed's benchmark lending rate, the bulk of market participants expect the federal funds rate to top out inside a range of 4.75% and 5% this year. But toward the end of the year, investors are betting the federal funds rate lands somewhere between 4.25% and 4.75%, implying one or maybe even two rate cuts.
It's not a guarantee
While the likely scenario seems to be some kind of mild recession this year, if there's one thing we've learned from markets over the last several years, it's to expect the unexpected.
Currently, the labor market is still incredibly strong, with unemployment at just 3.5%, and the Fed has said that to win its war with inflation, it really needs to see cracks in the labor market, which is a lagging indicator. The intense rate hikes the Fed did last year could certainly strike hard and fast as they start to work their way through the economy, but the labor market is also dealing with a different dynamic.
"Demographic shifts and aging populations mean countries like the U.S. will experience an ongoing shortage of workers and hiring will remain challenging for years," Svenja Gudell, chief economist at Indeed, said recently. "Without sustained immigration or a focus on attracting workers on the sidelines of the labor force, these countries simply won't have enough workers to fill long-term demand for years to come."
Bloomberg also recently pointed out that while the tech and manufacturing sectors are struggling, the construction and factory sectors are still quite healthy. Conflicting data has made predicting a recession difficult.
Why this could be a problem
The recent rally in the tech sector seems to be predicated on investors' beliefs that a recession will strike this year, forcing the Fed to cut rates, which will create a risk-on environment.
But the labor market may not crack as much as people think, or the Fed could very well engineer a soft landing in which unemployment rises modestly and inflation subsides, which may lead to rates remaining elevated this year. This could explain why a lot of analysts expect one more big dip in the market in the first half of 2023 before climbing out of a hole in the second half of the year.
Now, I still think a mild recession is probably the base case, but investors should be prepared for a range of scenarios. Currently, the market is pricing in rate cuts, so if they don't materialize, then there may be another big dip in the market.
