Morgan Stanley sees ‘credible bear case’ for a US recession

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Morgan Stanley sees 'credible bear case' for a US recession


A grizzly bear and her cub

Jim Urquhart | Reuters

Interest rate cuts might come too late to save an economy that is dangerously close to slipping into recession, according to Morgan Stanley economists.

“For now, the path to the bear case of a U.S. recession is still narrow, but not unrealistic,” a team led by the firm’s chief U.S. economist, Ellen Zentner, told Morgan Stanley clients in a lengthy analysis that spells out the likelihood of negative growth within the next 12 months and what investors should do if that comes to pass.

Trade tensions that could lead to layoffs and a pullback from consumers are at the center of the recession case. Zentner said the current “credible bear case” probability is about 20%, but that could change quickly.

“If trade tensions escalate further, our economists see the direct impact of tariffs interacting with the indirect effects of tighter financial conditions and other spillovers, potentially leading consumers to retrench,” she wrote. “Corporates may start laying off workers and cutting capex as margins are hit further and uncertainty rises.”

The effects would be a “large demand shock” that would take growth from a projected 2.2% in 2019 to a negative 0.1% in 2020 — a shallow recession but nonetheless a substantial retreat for an economy that grew 2.9% in 2018.

From an investing standpoint, that could mean a significant hit to stocks, with the best bets being defensive sectors like health care and consumer staples, with autos and tech hardware the areas most likely to underperform, according to the analysis.

Other areas to avoid include cyclical stocks and high-yield bonds, though fixed income overall tends to outperform as a safe haven during a recession.

“Since recessions do not announce themselves when they arrive and markets are forward-looking, history suggests that investors should not wait for confirmation of a recession before getting more defensive in their asset allocation,” Zentner wrote.” Patience does not pay when it comes to recessions — an investor who rotates to bonds from equities only after a recession is confirmed by the [National Bureau of Economic Research] would have both felt the worst of equity underperformance and missed out on substantial positive bond returns leading up to the announcement date.”

In fact, Zentner said waiting until the NBER actually pronounces the economy in recession is a good time to start buying, as the market already will start pricing a recovery.

Waiting on the Fed

The Federal Reserve is expected next week to approve a rate cut of at least a quarter percentage point as “insurance” to stave off a slowdown caused by any number of factors, the trade tensions among them. Markets are still leaving open the possibility of a half-point cut, though chances for a more dramatic move signaling even deeper issues have diminished in the wake of speeches by several Fed officials.

Zentner said Fed policy easing could be negated by increasing pressure from tariffs that could pull both the U.S. and global economy into recession.

“If cuts are not enough to stave off recession, risk assets will not work — for example, US equities have been down between roughly 15% and 50% from their pre-recession peaks at the end of prior cycles, notwithstanding a Fed that is cutting,” Zentner wrote.

Clues for when the recession will start come from a variety of measures: Nonfarm payrolls, consumer strength, manufacturing and aggregate indicators of growth such as those the Conference Board publishers are reliable yardsticks, Zentner said.

Collectively, the data points are “just outside the danger zone,” she wrote, though “these series can deteriorate rapidly, and a continuation of current deceleration trends through the summer would materially increase the risk of recession.”

Morgan Stanley isn’t alone in its recession warning. The New York Fed, which gauges a recession chance by measuring the spread between government bond yields, estimates a 33% chance of a downturn coming in the next 12 months, the highest level since the Great Recession that ended in mid-2009.



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