Feedback from stock and credit markets could make US recession more likely says Morningstar

24th February 2016

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Fears of a recession in the US and the impact on stock markets are in danger of creating a feedback loop that actually makes a recession more likely says analyst Morningstar.

Currently Morningstar says the likelihood of a recession is around 20-25% in many models but equity and credit markets are signalling a greater risk.

Andy Brunner, Investment Strategist at Morningstar, says: “In the early part of the year, investors became increasingly concerned about slowing developed economy growth that only served to heighten fears that signs of financial market distress, particularly in the financial sector, might carry a darker message.

“Investors’ primary concerns are centred on the prospects of a US recession, yet the degree of equity market decline, and particularly credit spread widening, is indicative of a far greater likelihood than currently implied by recession risk models; most currently indicate a 20-25% probability of US recession within 12 months.

“The longer the financial market turmoil persists, however, the greater the danger of a recession becoming a self-fulfilling prophecy as capital market concerns drain consumer and business confidence.”

Brunner says that the current period of economic uncertainty is also being exacerbated by concerns about the potency of central bank policy. Indeed, adverse impacts from negative interest rates, along with growing fears of US recession, have moved concerns on from just China / EM and oil prices and drawn the financial sector into the firing line. The next phase of monetary policy, should a recession appear likely, has already been mapped out by the ECB and BOJ, potentially further undermining financial sector profitability.”

“With concerns focused on financials, the largest listed global sector, the impact of the current loss of confidence is magnified in main indices.  Financials accounting for 20% of the developed world index, hence, should financials fall by 20%, the buying of defensives, such as utilities and telecoms, would need to be huge to counterbalance this decline as the latter accounts for just 7% of the index combined. Consequently these defensive sectors would need to rise by some 60% to offset the negative impact of financials on the index.

Brunner says investors should focus on assets that are undervalued rather than expecting a broader rally.

“With equities oversold there is the possibility of a significant rally but we would encourage investors to focus instead on identifying assets that are fundamentally undervalued  While capital markets remain  volatile, investors are likely to require greater incentives to fully re-engage in equity markets.

“Overall we favour a neutral position in equities and believe the best long term opportunities are to be found in Europe, Japan and parts of EM. But, it is worth remembering that in the short term each of these markets tends to be correlated to global growth and the US market.”

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