Recession talk seems to be everywhere, and it's not just pundits: 28 of the 48 economists recently surveyed by the National Association for Business Economics expect a recession in the U.S. this year. While the U.S. economy added more than half a million jobs in January, news of huge layoffs at large companies have been making headlines lately, a clear signal that many businesses are expecting a tougher operating backdrop this year. And executives' comments in recent quarterly conference calls and investor presentations also seem to reinforce the notion.
It may be hard to imagine that a recession could actually be good for the market. The "Great Recession" started in December 2007 and lasted through June 2009, and as the chart below shows, it was a very tough stretch for stocks.
Recessions typically correspond with a significant reduction in corporate earnings, which in turn puts substantial pressure on stock valuations. But no two recessions are exactly alike.
Each recession is different
To put the difference between the Great Recession and today's situation in perspective, the Federal Reserve responded to the challenging economic backdrop in 2008 by reducing its short-term interest rates to virtually zero for the first time in history. This time, the Fed has been raising rates at a brisk pace even though the economy is seemingly on the brink of recession. The reason? Dangerously high levels of inflation.
Many economists and stock market analysts have speculated that the Fed has been aiming, or at least willing, to artificially induce a recession in order to stave off potentially devastating currency devaluation. If forced to choose between dramatic inflation and a recession, the latter is probably the better outcome for investors.
Image source: Getty Images.
Why rising interest rates are bad for stocks
Rising rates make it more expensive for companies to borrow money, fund existing operations, and pay for new growth initiatives. They also drive higher yields for bonds and other fixed-rate investments, which typically means that stocks are offering less appealing risk-reward profiles on a relative basis.
By some estimates, large institutional investment firms account for more than 70% of total trading volume and overall stock holdings. With many of these institutions aiming to hit annual return targets, stocks face strong selling pressures as access to capital becomes more expensive and fixed-income investments become more attractive.
Rates are now at their highest levels since 2007, and the rising interest rate environment has been one of the main reasons why the market has struggled over the last year.
Data source: Federal Reserve.
Notably, the 25-basis point increase that the Fed delivered with its Feb. 1 meeting was the lowest interest rate hike since March 2022, and the more dovish approach from the central banking authority corresponded with bullish momentum for the market across the first three weeks of the month. But a new round of data signaled that inflation isn't under control yet.
Published on Feb. 25, the latest personal consumption price index data arrived showing that inflation had risen 0.6% on a sequential basis and 4.7% year over year. Unfortunately, this came in significantly hotter than economists and market analysts had anticipated and triggered another round of sell-offs for the broader market.
A recession wouldn't necessarily mean that the inflation situation has been remedied to the Fed's or the market's satisfaction. But a mild recession could tamp down on inflation, reduce the need for subsequent rate hikes, and actually pave the way for stronger overall stock market performance.
Slowing inflation and interest rate hikes could lift the market
Because of their higher risk profiles and other factors, valuations for growth stocks tend to be hit hard by rising interest rates. Growth stocks have also come to comprise a historically high percentage of the S&P 500 index by weight, to say nothing of the even more growth-oriented Nasdaq Composite index. The table below outlines the 10 largest components of the S&P 500 by weight and this year's stock performance.
| Company | Sector | Stock Performance YTD |
|---|---|---|
| 1. Apple | Information Technology | 12.3% |
| 2. Microsoft Corporation | Information Technology | 4.7% |
| 3. Amazon.com Inc. | Consumer Discretionary | 9.7% |
| 4. NVIDIA Corporation | Information Technology | 59.5% |
| 5. Berkshire Hathaway Class B | Financials | -0.4% |
| 6. Alphabet Class A | Communication Services | 4.3% |
| 7. Tesla Inc | Consumer Discretionary | 55% |
| 8. Alphabet Inc. Class C | Communication Services | 4% |
| 9. ExxonMobil Corporation | Energy | 1% |
| 10. UnitedHealth Group Incorporated | Healthcare | -9.9% |
Data source: S&P Global; Slickcharts, YCharts. YTD stock performance as of market close on March 2.
Of these components, Apple, Microsoft, Amazon, Nvidia, Tesla, and Alphabet could all reasonably be classified as "growth stocks." Partially driven by slower rate hikes from the Fed, all of these stocks are already outperforming the 3.7% year-to-date gain for the S&P 500 index -- in addition to also playing outsized roles in lifting the index's level.
Even with layoffs and other cost-cutting initiatives, a recession would likely pressure earnings for these companies. But it could prove to be a welcome trade-off for investors if a recession curbs the inflation problem and results in more dovish Fed policy.
What comes next?
It's possible that a recession will be needed to get the inflation situation under control. But that doesn't mean investors should panic, and it's also possible that a recession could correspond with, or otherwise set the stage for, more bullish stock market conditions.
There's an incredible array of factors that go into shaping performance for the stock market and broader economy. As such, predicting what will happen with the market in the near term is virtually impossible to do with a meaningful degree of consistency, and the best thing investors can do is continue to focus on owning strong companies with reasonable valuations that have what it takes to deliver wins over the long term.
