Morgan Stanley
  • Wealth Management
  • Oct 7, 2019

One Step Closer to Recession

As U.S. economic fundamentals weaken and uncertainty rises, cracks in the case for market resilience are starting to appear.

Lisa Shalett Chief Investment Officer, Wealth Management

The S&P 500’s robust 20% gain so far this year belies softening U.S. economic fundamentals and market weakness in non-U.S. equities, as well as U.S. small caps, cyclicals and value stocks. Large-cap U.S. growth stocks, which dominate the broader benchmark index for U.S. equities, account for the bulk of the gains.

Confidence in U.S. large-cap growth stocks rests on two key pillars: a belief that policies around trade and interest rates will be a net benefit for U.S. companies and faith in the strength of U.S. consumer spending, despite lackluster global trade, business spending and manufacturing.

Now, cracks in those pillars are starting to show. Below are three recent developments that make me think the odds of recession are growing:

  • The slowdown in manufacturing activity seems to be spreading to services industries. We learned in early September that the Institute for Supply Management’s manufacturing index had fallen to the lowest level in more than a decade. Only 17% of industries showed growth. Investors may shrug this off, arguing that the manufacturing sector—though it makes up about 40% of the S&P 500’s market capitalization and profits—is no longer a significant part of the overall U.S. economy, which is dominated by service industries. However, the ISM services sector index also declined in September to the lowest level in five years, a drop that was twice as steep as what economists had forecast.

  • Consumer confidence seems to be flagging, and vulnerability in the labor market is emerging. I’ve written recently about why U.S. consumers are essential for market health. The Conference Board reading on consumer confidence in future expectations in September registered sharp declines, in part because of a drop in survey respondents noting that jobs are plentiful. The labor market is usually the key to consumer confidence remaining healthy. The September non-farm payrolls report showed 136,000 new jobs created, less than expected and with slower wage gains.

  • More Fed rate cuts are likely, but will they work? Markets are pricing in as many as three more interest rate cuts this year as the Federal Reserve aims to stimulate the economy by encouraging more borrowing and spending. Some stock investors continue to cheer that path. However, rapid Fed rate cuts often precede corporate profit weakness. Even more worrisome, if rates get low enough, the effect could be to encourage more saving and less spending among consumers—the opposite of stimulus. 

To me, this all adds up to growing odds of recession, but investors need not fear the “R” word. While large-cap U.S. growth stocks may be somewhat vulnerable since valuations seem high, a potential recession might not be severe or have that big an impact on the broader stock market since many sectors and regions have already discounted it. My advice is for investors to stay patient and keep their portfolios defensively positioned and broadly diversified.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

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