Andrew Sheets: The Complexities of Market Risk

While the risk of economic contraction has lessened in a few regions, is the story of recession and market risk being oversimplified?

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, February 10th at 2 p.m. in London. 

Markets have been fixated on the question of whether the U.S. and Europe will enter recession this year. With Europe benefiting from a fall in energy prices and the U.S. adding half a million jobs in January, it's tempting to think that recession risk is now lower and by extension, the risk to markets has passed. But the story may be more complicated. 

Near term, the risk of an economic contraction or recession has fallen. Europe has seen the largest swings here, where much lower energy prices, a result of a mild winter and plentiful supply from the United States, is leading to both less inflation and better growth, the proverbial 2-for-1 deal. 

Recession risk has also fallen a bit in the U.S., where our economists tracking estimate for U.S. GDP has been moving modestly higher. 

For markets, however, we fear that this story is getting oversimplified, to a recession is bad and no recession is good. At one level yes, avoiding a recession is definitely preferable. But markets often care most about the rate of change. It remains likely that U.S. growth will decelerate meaningfully this year, even in a scenario where a recession is avoided. 

For one, the idea that the U.S. avoids recession but still sees a meaningful slowdown in growth is the current forecast from Morgan Stanley's economists. And that's also the signal that we're getting from our market indicators. We classify an environment where leading economic data is strong but starting to soften as 'downturn'. That phase tends to see below average returns for stocks relative to bonds over the ensuing 6 to 12 months. We entered that phase recently. 

Of course, the U.S. economy has been defying predictions of a slowdown for many months now, and it could still have a few surprises up its sleeve. For now, however, we think favoring bonds over stocks is still consistent with our forecast for slowing growth, even if a recession is avoided. 

In Europe, we think the biggest beneficiary of lower energy prices and better growth prospects is the euro. What we think the euro performs well broadly, we think it does especially well versus the British pound, where economic challenges remain greater and our economists do forecast a recession this year. 

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