Is Wall Street Underestimating the Chances of a Recession in 2020?

It was not long ago that investors were consumed with fears of a coming U.S. recession, spooked by an inverted Treasury yield curve, estimates of declining corporate profits, and waning business investment due to the trade war with China.

The nadir for market sentiment was Oct. 1, when the Institute for Supply Management’s (ISM) survey of manufacturers showed the sector contracted in September at its fastest pace since the Great Recession of 2008, while the growth of the services sector also slowed at a worrying pace.

Since early October, however, sentiment has made a surprising recovery, fueled by easy Federal Reserve monetary policy, better-than-expected third-quarter corporate earnings, and global economic data that many say has bottomed out and is poised to rebound. Questions remain though as to whether the market is are getting ahead of itself and are now ignoring lingering signs that a recession may still be on its way next year, analysts say.

“The disconnect between the economic data and what is discounted in the S&P 500 continues to grow,” wrote Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, in a Monday note to clients. “The consensus view [is that] deterioration in economic indicators bottomed in September,” she added. “Since then however, the data have not been encouraging.”

Since Oct. 1 the S&P 500 index SPX+0.22%  has gained 6.6%, the Dow Jones Industrial AverageDJIA+0.2%  has risen 5.6% and the Nasdaq Composite index COMP+0.18%  has advanced 9.3%.

Shalett pointed to a contraction in US industrial production in October, a disappointing reading of the New York Fed regional manufacturing survey, and Morgan Stanley’s estimate that the Institute for Supply Management’s (ISM) estimate of manufacturing activity in November will show further negative growth, as reasons for concern.

“The bulls dismiss the manufacturing recession as old news that doesn’t matter,” Shalett wrote.
“However, we believe that they are ignoring that not only is the data deteriorating, but that it is surprising to the downside—a combo that the market has historically not liked,” adding that the Citi U.S. Economic Surprise index fell below zero in the second half of November, indicating that economic data has largely been surprising to the downside.

On the other hand, bulls can take solace in Markit’s survey of manufacturing health which surprised to the upside in November and showed the sector growing, according to Tom Essaye, president of the Sevens Report, in a Monday note. But Essaye also pointed to a potentially worrying sign out of last week’s data: first-time claims for jobless benefits remained at a five-month high in the week ended Nov. 16.

“Considering that recession fears are based on a slowdown in manufacturing and business spending bleeding into the labor market and, ultimately, the consumer, it’s notable that claims are rising,” he warned.

Meanwhile, Essaye added, the yield curve, or the spread between yields on government bonds of differing maturities, continues to flatten, a sign that fixed-income investors are potentially concerned about future economic growth.

“Since last week, the yield curve has broken its multi-month uptrend and begun to compress, relatively rapidly, amid trade war developments,” he wrote, adding that the difference between the yield on the 10-year U.S. Treasury note BX:TMUBMUSD10Y+0.49%  and the 2-year U.S. Treasury noteBX:TMUBMUSD02Y+0.5%  has fallen to a six-week low. “Looking ahead, the fact that the trend line has broken is not a bearish game changer in and of itself, but it is a notable warning sign.”

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