The stock market is tumbling as investors fear recession more than inflation

A stock market paradox, in which bad news about the economy is seen as good news for stocks, may be running its course. If so, investors should expect bad news to be bad news for stocks heading into the new year – and there could be plenty of that.

But first, why should good news be bad news? Investors in 2022 have largely focused on the Federal Reserve and its rapid series of major rate hikes to bring inflation under control. Economic news pointing to slower growth and less fuel for inflation could serve to lift stocks with the idea that the Fed could begin to slow the pace or even cherish future rate cuts.

Conversely, good news for the economy can be bad news for stocks.

So what has changed? Last week saw a softer than expected consumer price index in November. While it’s still mighty hot, with prices rising more than 7% year over year, investors are increasingly confident that June inflation likely peaked at about four decades above 9%.

To see: Why November’s CPI data is seen as a game-changer for financial markets

But the Federal Reserve and other major central banks have indicated they plan to continue raising interest rates, albeit at a slower pace, into 2023 and likely to keep them high for longer than investors expected. This fuels fears that a recession is becoming more likely.

Meanwhile, markets are behaving as if the worst of inflation fears are in the rearview mirror, with recession fears now looming on the horizon, said Jim Baird, chief investment officer of Plante Moran Financial Advisors.

That sentiment was bolstered by manufacturing data Wednesday and weaker-than-expected retail sales on Thursday, Baird said in a telephone interview.

Markets are likely to go back to a period where bad news is bad news, not because interest rates will worry investors, but because earnings growth will falter,” Baird said.

A ‘Reverse Tepper Trade’

Keith Lerner, co-chief investment officer at Truist, argued that a mirror image may be forming of the backdrop that came to be known as the “Tepper trade,” inspired by hedge fund titan David Tepper in September 2010.

Unfortunately, Tepper’s prescient call was a win/win scenario. the “tepper reverse trade” is developing as a lose-lose proposition, Lerner said in a Friday note.

Tepper’s argument was that the economy would get better, which would be positive for stocks and asset prices. Or the economy would weaken, with the Fed stepping in to support the market, which would also be positive for asset prices.

The current set-up is one in which the economy will weaken, tame inflation, but also erode corporate earnings and test asset prices, Lerner said. Or, instead, the economy remains strong along with inflation as the Fed and other central banks continue to tighten policy and make asset prices challenging.

“In both cases, there is potential headwind for investors. To be fair, there is a third path, where inflation falls and the economy avoids a recession, the so-called soft landing. It’s possible,” Lerner wrote, but noted that the path to a soft landing seems increasingly narrow.

Recession jitters were apparent on Thursday, as retail sales fell 0.6% in November, beating forecasts for a 0.3% fall and the biggest drop in nearly a year. The Philadelphia Fed’s manufacturing index also rose but remained negative, beating expectations, while the New York Fed’s Empire State index fell.

Equities, which had suffered moderate losses after the Fed hiked interest rates by half a percentage point the day before, plummeted. Stocks continued their decline Friday, with the S&P 500 SPX,
with a weekly loss of 2.1%, while the Dow Jones Industrial Average DJIA,
lost 1.7% and the Nasdaq Composite COMP,
decreased by 2.7%.

Read: Still a bear market: S&P 500 slump indicates stocks never reached ‘escape velocity’

“As we approach 2023, economic data will have more influence on stocks because the data will give us the answer to a very important question: how bad will the economic slowdown get? That’s the key question at the start of the new year, because with the Fed on relative ‘autopilot’ policies (more hikes through early 2023), the key now is growth and the potential damage from a slowdown,” said Tom Essaye, founder of Sevens Report Research, in a Friday note.

Recession watch

No one can say with absolute certainty that a recession will happen in 2023, but there is no doubt that corporate earnings will come under pressure, and that will be a major driver for markets, according to Plante Moran’s Baird. And that means earnings could be a major source of volatility in the coming year.

“If in 2022 the story was inflation and tariffs, then in 2023 it will be earnings and recession risk,” he said.

It is no longer an environment favorable to high-risk, high-growth stocks, while cyclical factors could favor value-oriented stocks and small caps, he said.

Truist’s Lerner said that until the weight of the evidence shifts, “we maintain our overweight position in fixed income, focusing on high-quality bonds, and a relative underweight position in equities.”

Within equities, Truist favors the US, a value tilt, and sees “better opportunities below the surface of the market,” such as the equal-weighted S&P 500, a measure of stock average.

Highlights from the economic calendar for the week ahead include a revised outlook on third-quarter gross domestic product on Thursday, along with the November index of leading economic indicators. On Friday, November 11, personal consumption and spending data, including the inflation gauge desired by the Fed, will be released.