Should Investors Start to Prepare for Recession?

Investors have had to contend with a lot over the past six months: high and sustained inflation, an accelerated pivot toward tighter monetary policy, Russia’s invasion of Ukraine—and big drawdowns in both stocks and bonds related to these headwinds.

And while post-pandemic economic tailwinds and the resilience of corporate earnings have kept investors hoping that the Federal Reserve can engineer a “soft landing” for the economy and avoid imminent recession, we are less optimistic.

Morgan Stanley’s proprietary year-forward recession indicator is now indicating a 27% chance of a recession in the next 12 months, up from just 5% in March.

Here are three key reasons to take this warning seriously:

1. Inflation persists. Recently released inflation data showed year-over-year consumer price gains of 8.3% in April—down slightly from 8.5% in March, but still higher than consensus estimates of 8.1%. “Core” inflation, which excludes more-volatile food and energy items, rose 0.6% over the month, also above expectations. Drivers behind the rise were “sticky” items whose prices may remain stubbornly high, such as medical care and rents. The basic implication is that inflation is now broadening out, with the potential for it to stay higher for longer—historically, a scenario that keeps the Fed in policy-tightening mode. This likely portends additional rate hikes of a half-percentage point combined with aggressive balance-sheet reduction.


2. Price pressures may lead to “demand destruction,” in which higher prices eventually cause consumers to forgo purchases they would have otherwise made. Note that we’re seeing slowing demand in sectors that typically do well early in an economic cycle, such as housing and autos. On the supply side, inventory-rebuilding has been strong and may now start to slow. First-quarter gross domestic product (GDP) was surprisingly weighed down by a negative drag from a deceleration in private inventory investment. This means consumer demand may cool at a time when inventories have already been restocked, leading to an imbalance that could hurt businesses. In fact, the Morgan Stanley & Co. U.S. Economics team just cut its full-year GDP growth estimate by a full percentage point to 2.6%.


3. Commodity- and currency-market volatility complicates the global growth outlook. Turmoil in stock and bond markets has now spilled over into commodities and currencies, casting a shadow over global growth prospects and fueling uncertainty in still other markets. With commodity prices still relatively high, business and financial conditions are improving for emerging markets (EM) exporters while worsening for importers. These dynamics are exacerbated by a simultaneous strengthening of the U.S. dollar, which causes a squeeze for countries and businesses heavily leveraged to dollar-denominated debt. Shockwaves from these imbalances are increasingly reaching the broader credit market, with spreads on high-yield bonds, mortgage-backed securities and EM debt now widening—generally indicating risk aversion.

These developments mean conditions are ripening for a cyclical bear market, in which stocks and bonds need to get repriced to reflect an environment of more risk, less liquidity, higher rates and lower price multiples, as well as more-sober earnings expectations.

As a result, investors should keep an eye on inflation dynamics, which hold the key to policy decisions, consumer spending and corporate profits. As alarming as the daily volatility may be, we encourage investors to stay patient as the cyclical bear market completes its circuit, so to speak. Begin to look for opportunities where pain is intensifying, specifically in credit-linked asset classes.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 16, 2022, “Contemplating a ‘Landing.’” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.