How Bad Could The Next Recession Be? - Morgan Stanley

• Wealth Management
• Jun 28, 2022

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If history is any guide, an inflation-triggered recession would be less severe than one caused by credit excesses. Get our latest portfolio insights here.

Lisa Shalett Chief Investment Officer, Wealth Management

The chances of a recession ticked higher last week, driven by the Federal Reserve’s latest rate hike and hawkish forward guidance.

The good news: If it does come to pass, a recession today is likely to be shallower and less damaging to corporate earnings than recent downturns. Here’s why.

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Inflation-Driven vs. Credit-Driven Recessions

Aside from the pandemic-induced 2020 recession, other recent recessions have been credit-driven, including the Great Financial Crisis of 2007-2008 and the dot-com bust of 2000-2001. In those cases, debt-related excesses built up in housing and internet infrastructure, and it took nearly a decade for the economy to absorb them.

By contrast, excess liquidity, not debt, is the most likely catalyst for a recession today. In this case, extreme levels of COVID-related fiscal and monetary stimulus pumped money into households and investment markets, contributing to inflation and driving speculation in financial assets.

The difference is important for investors. Historically, damage to corporate earnings tends to be more modest during inflation-driven recessions. For example, during the inflation-driven recessions of both 1982-1983, when the Fed raised its policy rate to 20%, and 1973-1974, when the rate reached 11%, S&P 500 profits fell 14% and 15%, respectively. This compares with profit declines of 57% during the Great Financial Crisis and 32% during the tech crash.

Fundamentals Are Stronger

Beyond historical trends, several economic factors point to a less severe recession, should one come to pass:

• The housing and auto industries are strong. Housing prices have been high and resilient, while inventories are tight and could fall even further with higher interest rates. For autos, production rates are below prior peaks due to semiconductor shortages. As supply chains clear, order backlogs could keep manufacturing activity uncharacteristically high for a recession.

• Labor-market dynamics remain robust. Not only is the labor market tight, as defined by unemployment rates, but it is also showing record-high ratios of new job openings to potential applicants. This suggests that, rather than laying off current employees, companies may first reduce their open job postings, potentially delaying the hit to unemployment.

• Balance sheets are in the best shape in decades across households, companies and the banking system.Moreover, catalysts for corporate capital spending appear strong, given current needs around energy infrastructure, automation and national defense that are not directly linked to the business cycle nor the Fed’s actions.

• Corporate revenues may be more durable. Today’s stock-index composition shows a growing share of earnings attributed to recurring revenue streams, as more companies build subscription- and fee-based models. 

In short, we are positive about the economy’s fundamentals and believe they can provide ballast in the event of a recession. Nonetheless, the bear-market bottom for stocks may still be 5%-10% away. Investors should remain patient and consider using tax-efficient rebalancing, including by harvesting losses, to neutralize their major overweight and underweight exposures. And, as we continue to emphasize, pursue maximum asset-class diversification.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 27, 2022, “Inflation-Driven Recessions are Different.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

Certain securities referred to in this material may not have been registered under the U.S. Securities Act of 1933, as amended, and, if not, may not be offered or sold absent an exemption therefrom.  Recipients are required to comply with any legal or contractual restrictions on their purchase, holding, and sale, exercise of rights or performance of obligations under any securities/instruments transaction.

The returns on a portfolio consisting primarily of environmental, social, and governance-aware investments (ESG) may be lower or higher than a portfolio that is more diversified or where decisions are based solely on investment considerations. Because ESG criteria exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. The companies identified and investment examples are for illustrative purposes only and should not be deemed a recommendation to purchase, hold or sell any securities or investment products. They are intended to demonstrate the approaches taken by managers who focus on ESG criteria in their investment strategy. There can be no guarantee that a client's account will be managed as described herein.

Disclosures

Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.  Past performance is not necessarily a guide to future performance.

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This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument.  That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter.  We have no obligation to tell you when information herein may change.  We make no representation or warranty with respect to the accuracy or completeness of this material.  Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein.

The securities/instruments discussed in this material may not be appropriate for all investors.  The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.  Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors.  Estimates of future performance are based on assumptions that may not be realized.  Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates.  Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events.  Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. 

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