Stocks dive, again. Does Wall Street foresee a recession?

Why We Wrote This

After several strong years, stock markets look rattled as 2018 draws to a close. A mix of factors signal a heightened risk of a slowdown, but an outright recession is far from certain.

Brendan McDermid/Reuters
A trader works on the floor at the New York Stock Exchange Dec. 4, 2018.

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Investors panic. Stocks down another 500 points. Is Wall Street trying to tell us something? Typically, a hard fall in share prices comes during or a few months before a recession. So far, US stock indexes like the Standard & Poor’s 500 are down a little over 10 percent from their record highs set a few months ago. Among traders, that’s a “correction” but hardly the 20 percent decline that would signal a full-on bear market and give a clearer warning of possible recession. The concerns are real: Interest rates are rising, making it more expensive for businesses to borrow, while the fiscal stimulus from US tax cuts is wearing off. The trade-war atmosphere between the US and China doesn’t help. Some global markets, including China’s and Germany’s, are already in bear-market terrain (see chart). But several forecasters say a slowing economy does not mean outright recession. Says Michael Klein, an economist at Tufts University: “There are lots of things that could happen that could help the economy keep going.”

The big downdrafts in US and global stock markets have spooked investors and raised a question: Is something suddenly going very wrong for the economy?

There are real reasons for concern: Central banks have been raising interest rates, making it more expensive for businesses to borrow. Finance experts say the fiscal stimulus from US tax cuts is wearing off. And despite a pause for negotiation, a trade-war atmosphere between the US and China shows no signs of resolution.

But some perspective is in order: Stocks always reflect a mix of factors on investors’ collective radar, and it’s quite common for some turbulence to occur in Wall Street even when no recession is on the way for Main Street.

So far US stock indexes like the Standard & Poor’s 500 are in “correction” territory.  That means stock prices are down more than 10 percent from their all-time highs set a few months ago, but still far from the 20 percent declines that would signal a full-on bear market and give a clearer warning of possible recession.

What’s clear is that investors are recalibrating their expectations, and taking into greater account that US-China trade relations could sour for an extended time. Less clear is whether a downturn for the overall US or global economy is on the horizon.

“There are a number of things pointing toward potential softness in the economy. One shouldn't be sanguine about what's going on,” says Michael Klein, an economist at Tufts University’s Fletcher School. “[But] there are lots of things that could happen that could help the economy keep going.”

Monday was another bad day for world markets, with the S&P 500 falling about 2 percent.

View from abroad

Although the US market is so far down 13 percent from its peak, some global markets including China’s and Germany’s are already in bear-market terrain.

SOURCE: Yahoo Finance (with S&P data), National Bureau of Economic Research, Federal Reserve Bank of St. Louis
Jacob Turcotte/Staff

This comes after the International Monetary Fund and others have scaled down their growth forecasts for the world economy. Still, it often takes a significant shock, not just some bumps in the road, to tip an economy from growth to contraction.

“It's really hard to predict turning points in a market or the economy,” says Dr. Klein. 

That’s one reason why many economic forecasters and stock-market strategists remain cautiously optimistic.

A report by forecasters at Oxford Economics last week asserted that a “not too hot, not too cold” Goldilocks environment is still prevailing in the US. “While core retail sales momentum picked up in November and jobless claims fell back near their 49-year low, consumer prices showed that inflationary pressure remain tame.”

And many financial advisers say that, for investors with a long-term horizon like saving for retirement, it’s safer to remain invested in stocks than to panic amid the current volatility. Investment firm Vanguard, for example, sees the prospect of modest but positive stock-market returns in 2019 and for the decade ahead, in the range of 3 to 5 percent for US stocks and a bit higher for global stocks.

Still, slowdowns in economic momentum, at the very least, give the economy less cushion against adverse shocks.

In a note to clients over the weekend, Neil Shearing of Capital Economics said “we expect the global economy to slow next year, and by more than most currently anticipate.” The firm, with offices worldwide including in London and Toronto, sees global economic growth slowing from a 3.7 percent pace in 2018 to around 3.3 percent in 2019 and less than 3 percent in 2020.

“That might not sound very dramatic but, if we’re right, global growth in 2020 would be the third weakest of any year since 2000,” Mr. Shearing wrote. And in the US, the firm sees growth falling from 2.9 percent this year to 2.2 percent next year and a scant 1.2 percent in 2020.

More volatility ahead?

With both forward momentum and challenges, this is the kind of economic climate where markets could remain volatile for a while, up one day and down the next. Will the US-China settle their differences or not? Will the Federal Reserve manage a “soft landing” for the US economy – boosting short-term interest rates enough to keep inflation at bay, while managing to avoid hitting the brakes too hard?

These questions are top of mind, with trade concerns clearly weighing on global markets and with Fed policymakers expected to boost its short-term interest rate for banks once again, at a meeting Wednesday.

In emerging markets, the problem is not just that China has been struggling to maintain economic momentum. It’s also that other nations face tighter financial conditions as boosts in US interest rates ripple overseas. But some forecasters are optimistic that the emerging markets will weather that storm, as the Fed may be reaching the end of its tightening cycle on US interest rates by mid-2019.

The Fed under Chairman Jerome Powell is certainly watching market signals such as the bond “yield curve,” which can be a barometer of trouble when short-term rates (influenced more by the Fed) rise higher than long-term rates (guided more by investors’ sentiments about the outlook).  

“The Fed is always careful,” says Klein at Tufts in Medford, Mass. “[But] to some extent it's going to be outside the ability of the Fed to micromanage the economy.”

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