Wall Street Not Looking For 2020 Recession — But This Could Cause One

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The base case on Wall Street is for no recession in 2020, but a little-talked-about chain of events in the economy could cause a recession sooner than many observers expect.

Currently, most strategists and economists see a roughly 20% to 30% chance of a recession by the end of 2020. Many experts’ base cases are for 1% to 1.8% GDP growth in the year. The S&P 500 has risen 24% year-to-date, powered partly by low interest rates

Sure this hasn’t been a classic risk-on market, with money flowing away from safe treasury bonds. The need for stimulus and subsequently lower rates has driven capital flows into treasurys, pushing yields lower, accompanying the stock gains. And strategists are looking for gains on the S&P 500 for the next year of 5% to 7%, still putting the bond market to shame.

But the Wells Fargo Investment Institute cited a risk that could easily kickstart negative growth, in turn posing a clear risk to stocks.

“The likelihood of a U.S. recession depends upon whether (or how quickly) weak manufacturing cracks the economic expansion’s foundation in job and wage growth and associated consumer confidence,” wrote a team of strategists at Wells Fargo.

The bank isn’t looking for a recession in 2020 in its base case, but it takes note of the “aging [economic] cycle.”

Simply put, with weak manufacturing activity comes less business investment. When companies invest less, they hire less. This hasn’t yet shown up in the job market, but if the trend continues, it almost certainly will. If workers are laid off and lower demand for workers sharply pressures wages, consumer spend would weaken.

Consumer spend is roughly 70% of U.S. output and has trended at around just above 2% growth in 2019. Should consumer spending contract, a recession would be almost certain.

Meanwhile, the ISM manufacturing index read 48.1 for November, missing economists’ expectations of 49.4 and falling below October's reading of 48.3. (Below 50 indicates contraction.) Manufacturing activity has contracted since August and capital expenditures have slowed materially. Wells Fargo certainly doesn’t want to see the trend continue — or worsen.

As for consumer confidence, negative headlines around the economy would lower consumers’ willingness to spend.

So should the U.S. economy fall into recession sooner than expected, the stock market would be particularly vulnerable. Not only is the market up considerably for 2019, but it’s pricing in bullish economic outcomes for 2020. The average forward one-year earnings multiple on the S&P 500 is more than 17, above the 10-year average of about 16.4.

“According to market pricing, political tail risks seem to have disappeared,” wrote strategists at Unigestion, which has more than $20 billion under management, partly referring to the U.S.-China trade war. “The mispricing of political risk is a clear change in our narrative and will limit our overweight in growth-oriented assets."

Most on Wall Street say stock gains in 2020 are likely to come not from multiple expansion but from earnings growth. And while earnings are expected to grow at roughly 8% in 2020, it’s very possible that "earnings growth expectations gets cut by 5 percentage points,” Lindsey Bell, chief investment strategist at Ally Invest, told TheStreet.

She noted that earnings estimates can often be too optimistic to start a new year and that trade remains a huge risk.

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