Market Outlook: Is a Recession Coming? Or Is It Already Here?

TG: Following the professionals is going to be an investor's best option in these choppy markets. The view of many professional money managers, analysts, and economists is that the macro fundamentals are changing in magnitude, not necessarily in direction. Investors may want to be rather tactical and selective in how they consider equities and fixed income exposures in their portfolio.

Investors continue to face a highly challenged macro backdrop. Inflation pressures, the ongoing Russia-Ukraine war, and recession fears are driving negative sentiment. Markets and rates have struggled to price in the growth/policy trade-off, swinging from recession fears and a less aggressive Fed to inflation fears and a more aggressive Fed.

While May brought a measure of stability with positive equity returns and lower rates, continued inflationary pressures in June increased pessimism and hawkish Fed expectations, leading to large drawdowns in equities and higher rates. Inflation is unlikely to show signs of peaking for another couple of months, which is likely to keep rates volatile and prevent equity markets from recovering.

That said, looking forward a couple of months, it's expected that the demand collapse that's already well underway and higher retail inventories could bring inflation relief. This, combined with slowing growth and tightening financial conditions, suggests the Fed may have to slow the pace of rate hiking later in the year. This would provide some support to both equity and fixed income returns.

Equities have struggled to find appropriate levels given macro risks and a lack of visibility around Ukraine and supply-driven inflation pressures. Entering the quarter, equities were underpricing risks. Now they're pricing the odds of a recession as a given. This, along with the outlook for growth, means investors might not have to be as defensive in the near-term.

Investors may want to consider tactical adjustments that make sense in a slower growth, tighter policy backdrop . This includes a higher dividend allocation, higher quality, and a larger underweight to Europe, where aggressive monetary policy is just starting to take hold and inflation is worse.

The demand destruction (a permanent shift in customer behavior fueled by high prices and low supply) was delayed by consumers flush with cash. But it's now taking hold and will result in falling core inflation in coming months. While rates are expected to remain volatile, a medium-term thesis is that the Fed will not get to where the market is currently pricing rates by year-end. It's anticipated the result may better returns for fixed income investors in the back half of the year. This is driven by higher yield carry and some rate relief by year-end (or at least no more rate increases).

TG: A handful of prominent forecasters cut estimates for second-quarter gross domestic growth. This shows they believe we're in a technical recession even while other economists foresee a return to growth.

The nation's economy was off by about 1.6% for the first quarter of 2022, then 0.9% for the second quarter. That technically qualifies this stretch as a recession since negative GDP growth was sustained across two straight quarters, although that isn't an official definition.

And storm clouds continue to circle. The Wall Street Journal found several economists significantly raised their odds of a recession in the next 12 months to just under 50%. Economist and subprime mortgage crisis bell-ringer Nouriel Roubini was even less optimistic, predicting a full-blown recession by year's end. And in a column for Bloomberg, former New York Federal Reserve President Bill Dudley estimated a recession was “inevitable within the next 12 to 18 months.”

All that said, many economists are still unconvinced the U.S. will fall into recession—at least not immediately. Analysts at S&P Global Ratings said the economy has enough momentum to avoid a recession this year, but warned “what's around the bend next year is the bigger worry.” The economists put the odds of a recession in 2023 at 40%. One week earlier, Morgan Stanley put the chances at 35%.

Whether or not analysts decide to call it a ”recession,” a slow growth environment seems likely. Investors will have to be flexible with their portfolios and look for opportunities in the equity and fixed income areas that benefit from these types of market environments.