Recession concerns are making their way into stocks, according to Citigroup.
A “mild recession in 2023” could lead to a drop of around 20% for the S&P 500 index from its late-March high of around 4,600, Citigroup analysts said in a research report on Monday. Under “a more severe macro growth scare,” the index could see a reduction of around 30% as the Federal Reserve continues to tighten monetary policy in an already weakening economy to stave off persistently high inflation, the report shows. report.
“Recession risks are more limited in 2022, but increase significantly in mid-to-late 2023,” Citi analysts said. “Equity markets have already begun to price in this, but we expect the fallout to be felt primarily” in the first half of next year, they wrote.
The S&P 500SPX
it was dipping Monday afternoon to around 4,385 as corporate earnings season for the first quarter gets into full swing this week. So far this year, the US stock benchmark is down about 8%, data from FactSet shows.
S&P 500 earnings would take a 10% “hit” in 2023 under Citi’s “base recession scenario,” with the index falling about 20% to around 3,650, according to the research report. The most severe recessions have resulted in an average 15% decline in earnings per share, the report shows.
“Investor nervousness in the early stages of a recession typically leads to a multiple draw in the 2-3 gyration range,” the analysts wrote, referring to a drop in the S&P 500’s price-earnings ratio. The real concern occurs when the Fed’s policy trajectory deviates from the macro growth context,” meaning the central bank continues to tighten monetary policy while “growth reflects negatively,” Citi analysts said. “This could take another 1-2 turns for the S&P 500 P/E ratio,” they wrote.
The Fed has been tightening its policy by raising interest rates while also planning to reduce its balance sheet as it aims to cool down the economy to reduce high inflation in the US.
Traditionally defensive sectors, such as utilities, XX:SP500EW
Consumer Staples, Real Estate, Communication Services, and Healthcare XX:SP500EW,
become attractive to investors worried about a recession, as its earnings are “less sensitive to economic activity,” according to the report.
But these sectors comprise only 35% to 40% of the S&P 500 Index, analysts said. “There is not enough market capitalization in defensive sectors to build a recession-resistant portfolio.”
In a “mild recession scenario, growth may also turn defensive, making technology relatively attractive,” they said. “However, a deeper pullback with more rate hikes likely to put pressure on multiple groups higher, meaning quality overlap” in cyclical areas like materials, financials XX:SP500EW,
“and even industrial XX:SP500EW,
should make sense,” according to analysts.
Amid concerns about rising interest rates, RLG growth shares
RLV value stocks have been lagging
this year by a wide margin, according to data from FactSet.
In recent weeks, investors have often asked Citi analysts how paper and packaging stocks would perform in a recession or “sharp market correction,” according to the report. “Our analysis suggests that packaging is a relatively safe place for investors,” they said, “much better than paper.”
In their report, Citi analysts assumed that “equity markets began to more significantly price in the likelihood of an off-year recession around the late-March highs as yield curve inversions appeared. US futures markets”. At the time, “the S&P 500 was trading around 4,600,” they said.
A closely watched portion of the Treasury market’s yield curve briefly inverted during trading late last month and closed in reverse. in early Aprilmeaning that 2-year yields rose above those on the 10-year Treasury note.
The last time 2-year and 10-year Treasury yields were inverted was in 2019, according to Dow Jones Market Data. Historically, an inversion of that part of the Treasury market’s yield curve has preceded a recession, though usually a year or more before an economic contraction.
However, that part of the yield curve is no longer inverted, with the yield on the 10-year Treasury note BX:TMUBMUSD10Y
trading at 2.86% on Monday afternoon, putting it above the yield on the 2-year Treasury note BX:TMUBMUSD02Y
about 2.47%, FactSet data shows, at last revision.
The probability of a recession within the next year is 20%, up from 9% at the end of February, according to the Citi report.
“Investors see increased odds of a macroeconomic growth scare in the next 12 to 18 months,” Citi analysts said. “Relative to previous recessions,” they expect the stock market’s response “to be earlier in both entry and exit.”
All three major US stock market benchmarks have tanked this year, including the S&P 500, the Dow Jones Industrial Average DJIA
and the Nasdaq Composite. The tech-heavy Nasdaq COMP
has seen the steepest drop yet in 2022, down around 15% based on Monday afternoon trading, amid concerns that rising rates will hurt valuations of high-growth stocks and high flying in particular.