Mike Dolan

LONDON, (Reuters) – Investors may be tempted to believe they have a rough year ahead. But it’s not clear that investors are prepared for a recession.

There are many reasons why benchmark stock indices have fallen by 15-20% this year. These include rising interest rates in order to control soaring inflation rates after the pandemic. The rates were also raised because of a Ukraine-related shock, which has also smashed household incomes.

Add to that the geopolitical risk of China’s “zero COVID”, its growth-reducing lockdowns and persistent supply-chain issues, and you see more clouds. A Northern summer may help ease energy shortages, but Europe has little information about the future if Russian gas supplies cease.

So it’s no surprise that many areas of the globe are just riding the waves of a post pandemic recovery wave, but economists have warned of a worldwide recession.

The key policy issue is whether the U.S. Federal Reserve or other central banks will decide to raise monetary policy into “restrictive”, which slows economic growth to lower inflation, or whether it will just be enough to allow for more “neutral” rates to keep the economy growing. They are currently 150 basis points above the “neutral” rate.

It doesn’t look like a lot of activity in the near future.

David Malpass (World Bank President) was worried about the future of global production. He stated that it was difficult to predict how the world would avoid another recession on Wednesday.

Washington’s Institute for International Finance reduced its global growth forecast by half to 2.3% for the year. It also stated “global recessive risk is high”.

These commercial banks include Deutsche Bank (ETR: Wells Fargo (NYSE:) Now, the U.S. will experience a recession sometime in the next twelve-18 months. Many houses also see Europe this year.

Surprises in economic data are becoming more sour. The U.S. indexes and China’s indexes have been rolling over and they now look worse than when the Omicron variant was first released six months ago. With world oil prices almost 50% higher than their last Autumn, and 10-year-dollar borrowing rates nearly 3% above November, this is a new trend.

Rising mortgage rates and rising materials costs are starting to cause problems in the U.S. housing sector.

On many levels, it is clear that the dramatic drop in stock price is not unfounded. The only problem is whether or not.

Graphic: Econ Surprise Indexes turn back negative – https://fingfx.thomsonreuters.com/gfx/mkt/byprjdergpe/One.PNG

Graphic: World stocks forward PE valuations – https://fingfx.thomsonreuters.com/gfx/mkt/klvykobdgvg/Four.PNG

LEG ALTER LOWER

It is easy to forget that technology stocks sensitive to interest rates are taking the majority of the damage and have fallen 25% over the past year.

Standard valuations which consider prices as a percentage of 12-month future earnings reveal plunges of between 25-30% in Europe, the United States, and Europe since January. They might indicate a bargain or 2.

However, despite the fact that many subscription-based and tech-based companies are exposed to China and chips shortages (or even energy rationing in Europe), there has been no or very little downgrade of total 12-month forward earnings or full-year 2023 forecasts.

Even though Wall St stock prices have declined in price since 2000’s dot.com bubble burst, they still exceed 30-year averages. This is only a fraction of what they were at the time of the pandemic. Although the situation is somewhat better in Europe it’s not great.

The most concerning aspect of the current valuations is unfazed earnings predictions.

After all the recent shocks, interest rate increases and volatility since January 1, the total full-year earnings growth predictions for have actually increased more than a percentage points and the 2023 projections barely moved below 10%.

If recession fears become reality, many fear that there is a heavy shoe in the market. Are stocks likely to become even more costly if earnings are reduced in the next months or through the second quarter earnings season?

“The question here is whether the equity markets will continue to discount our earnings cuts or require that companies formally reduce their guidance. Morgan Stanley (NYSE:)’s strategists mused this month, adding “bear market rallies” are likely but another 15-20% leg lower for the S&P500 is then likely.

However, this is still an uncommon view.

JPMorgan (NYSE 🙂 still believes the risk-reward ratio is positive for equities over the medium term. The team points to a bottoming China, Fed loosening, and a peaking US dollar as reasons for believing the worst is over.

Many asset managers like Blackrock (NYSE) believe the soft landing is possible. However, they prefer to keep equities neutral as it unfolds.

DWS Chief Investor Officer Stefan Kreuzkamp is optimistic about stocks in spite of the shocking start to this year.

But he adds a fairly basic get-out clause — “the precondition that risks do not escalate – no recession in the United States and Europe – and that the U.S. central bank manages to contain inflation without curtailing economic growth too much.”

This may prove to be a long wait.

Graphic: Earnings forecasts for 2022 and 2023 in Europe and US – https://fingfx.thomsonreuters.com/gfx/mkt/egvbkwqakpq/Three.PNG

Graphic: Forward PEs for US and Europe – https://fingfx.thomsonreuters.com/gfx/mkt/lbpgndzoqvq/Two.PNG

The editor-at-large of finance and markets for Reuters News is the author. All views and opinions expressed in this article are the author’s.

By Mike Dolan. Twitter: (NYSE:): @reutersMikeD. Charts created by Danilo Masoni, editing by David Evans