Mike Wilson: The Increasing Risk of Recession

As price to earnings multiples fall and inflation continues to weigh on the economy, long term earnings estimates may still be too high as the risk of a recession rises.

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Welcome to Thoughts on the Market. I'm Mike Wilson, Chief Investment Officer and Chief U.S. Equity Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the latest trends in the financial marketplace. It's Tuesday, June 21st at 11 a.m. in New York. So let's get after it. 

Coming into the year, we had a very out of consensus view that valuations would fall at least 20% due to rising interest rates and tighter monetary policy from the Fed. We also believed earnings were at risk, given payback and demand, rising costs and inventory. With price to earnings multiples falling by 28% year to date, the de-rating process is no longer much of a call, nor is it out of consensus. Having said that, many others are still assuming much higher price to earnings multiples for year end S&P 500 price targets. In contrast, we have lowered our price to earnings targets even further as 10 year U.S. Treasury yields have exceeded our expectations to the upside. In short, the price to earnings multiple should still fall towards 14x, assuming Treasury yields and earnings estimates remain stable. Of course, these are big assumptions. 

At this point, a recession is no longer just a tail risk given the Fed's predicament with inflation. Indeed, this is the essence of our fire and ice narrative - the Fed having to tighten into a slowdown or worse. Our bear case for this year always assumed a recessionary outcome, but the odds were just 20%. Now they're closer to 35%, according to our economists. We would probably err a bit higher given our more negative view on the consumer and corporate profitability. From a market standpoint, this is just another reason why we think the equity risk premium could far exceed our fair value estimate of 370 basis points. Of course, the 10 year Treasury yield will not be static in a recession either, and would likely fall considerably if growth expectations plunge. For example, the equity risk premium exceeded 600 basis points during the last two recessions. We appreciate that the next recession is unlikely to be accompanied by a crisis like the housing bust in 2008, or a pandemic in 2020. Therefore, we're willing to accept a lower upside target of 500 basis points should a recession come to pass. 

Should the risk of recession increase to the point where it becomes the market's base case, it would also come alongside a much lower earnings per share forecast. In other words, a recession would imply a much lower trough for the S&P 500 of approximately 3000 rather than our base case of 3400 we've been using lately. 

As of Friday's close, our negative view is not nearly as fat of a pitch, with so much of the street now in our camp on both financial conditions and growth. Having said that, the upside is quite limited as well, making the near-term a bit of a gamble. Equity markets are very oversold, but they can stay oversold until market participants feel like the risk of recession has been extinguished or at least reduced considerably. We do not see that outcome in the near term. However, we can't rule it out either and appreciate that markets can be quite fickle in the short term on both the downside and the upside. What we can say with more certainty today versus a few months ago is that earnings estimates are too high, even in the event a recession is avoided. Our base case 3400 near-term downside target accounts for the kind of earnings risk we envision in the event a soft landing is accomplished. 

For us, the end game remains the same. We see a poor risk reward over the next 3 to 6 months, with recession risk rising in the face of very stubborn inflation readings. Valuations are closer to fair at this point, but hardly a bargain if earnings are likely to come down or a recession is coming. While investors have suffered quite a setback this year, we can't yet get bullish for more than just a bear market rally until recession arrives or the risk of one falls materially. At the stock level, we continue to favor late cycle defensives and companies with high operational efficiency. 

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