Stocks Still Face Challenges Despite the Absence of a Recession

Stocks still face challenges despite the absence of a recession by wsjrenewal wsj print edition subscription

Stocks Still Face Challenges – Visualize a world without an economic downturn. It’s effortless if you attempt it. However, envisaging a straightforward future for the stock market is significantly more challenging.

Concerns about an impending recession in the U.S. have been persistent, but the fact remains that the economy continues to expand and the labor market remains robust. Despite the struggles of major tech firms and the recent failures of several banks, including Silicon Valley Bank, Signature Bank, and First Republic, there has been no significant impact on the overall economic growth yet.

Federal Reserve Chairman Jerome Powell said in a press conference after the central bank’s decision to increase rates on Wednesday that he thinks it’s more probable to avoid a recession than to experience one.

Long-term yields are below the Fed’s target range

Long-term yields are below the Fed's target range

How could this scenario unfold? The issues faced by small and mid-sized banks must be managed, and the upcoming dispute between House Republicans and the White House over the debt ceiling must be settled. In general, employment expansion should slow down without a significant increase in unemployment, with inflation reaching the Fed’s preferred range and the economy continuing to grow.

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Thus far, things seem to be going well. According to the latest report from the Labor Department, the economy added 253,000 jobs in the previous month, indicating that employment is still growing solidly, even though the labor market has slowed down. Inflation, while still high, has started to decline. Household balance sheets are healthy, as individuals’ savings accumulated during the early stages of the pandemic serve as a cushion against difficult times. Some companies that profited from the pandemic, such as large tech companies and those in the manufacturing, transportation, and sales industries, are seeing a decline in demand, but many in the service industry seem to be thriving as people return to pre-pandemic activities.

If a recession is avoided, the service industry could continue to make up for the decline in the goods sector, returning consumer spending to 2019 levels. If this were to occur suddenly, service spending would increase by 3.8% compared to the first quarter, while spending on goods would decrease by 7.6%.

Anticipating a slow growth in the demand for goods compared to the overall economy could negatively impact the stock market since most of the companies in it are focused on goods. Manufacturing and retail alone contributed about half of the S&P 500’s sales last year, according to FactSet, even though these industries made up less than a quarter of total private sector sales in the US, as measured by gross output from the Commerce Department.

Additionally, in this situation, the need for workers in service-related industries would maintain steady wage growth compared to a recession, making it challenging for companies that focus on goods to reduce labor expenses, ultimately causing a squeeze on profit margins.

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Should a recession be avoided, the Federal Reserve would not need to significantly reduce interest rates. In such a case, long-term interest rates would likely remain at their current level or even rise. On Wednesday, the central bank raised its target for overnight rates to 5% to 5.25%. Meanwhile, the yield on the 10-year Treasury, which reflects investors’ assessment of average overnight rates over the next decade, is below 3.5%. If long-term rates increase, investors may be incentivized to shift their investments from stocks to bonds.

Everyone would wish for Mr. Powell’s forecast to come true and for the United States to steer clear of a recession. Nonetheless, stocks might still face a challenge even if a recession is avoided.

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