Morgan Stanley
  • Wealth Management
  • Jun 28, 2022

How Bad Could the Next Recession Be?

If history is any guide, an inflation-triggered recession would be less severe than one caused by credit excesses.

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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:

  • 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.

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