Markets Embrace Potential Recession as a Cure for Economic Ills

Markets Embrace Potential Recession as a Cure for Economic Ills

A recession might not only be a circumstance that financial markets can weather, but it could also be a remedy for some of the challenges currently troubling the U.S. economy, according to a Wall Street analysis. Nicholas Colas, co-founder of DataTrek Research, suggests that an economic downturn might address three obstacles to growth: decreased productivity, elevated inflation, and a hawkish Federal Reserve consistently increasing interest rates. Colas points out that all recessions since 1960 have rapidly reversed these issues, noting that a recession can be seen as a “feature, not a bug.”

Expectations of a Recession and Market Resilience

Many Wall Street economists and strategists predict an economic recession to occur later this year, due to various factors such as the Federal Reserve’s rate hikes to curb inflation and an anticipated credit crunch resulting from banking turmoil in early March. The Federal Reserve’s own economists also foresee a mild recession. Despite these economic warning signs, financial markets remain strong. The S&P 500 has gained over 7% in 2023, and the CBOE Volatility Index recently hit its lowest level since late 2021. If a recession does occur, markets appear to be betting on a brief contraction followed by a robust recovery.

Recessions in History: A Silver Lining?

Colas delves further into the history of recessions to support his argument, highlighting that they can have some positive effects. Firstly, during a recession, labor force productivity tends to rise as companies streamline operations and prioritize efficiency, ultimately increasing output and earnings. Colas explains that stocks generally bottom out before the economy reaches its lowest point during a recession, as markets recognize this dynamic.

Secondly, the Federal Reserve usually lowers interest rates in response to a recession. Currently, there is a discrepancy between market expectations and central bankers regarding interest rate directions. While both parties anticipate a final rate hike in May, traders predict that the Fed will begin cutting rates by year-end in response to a downturn. Policymakers, however, emphasize the need to combat inflation through tight monetary policies. Colas argues that markets are aware of this history and foresee a recession as the catalyst for the Fed to initiate the next easing cycle.

Lastly, a recession would suppress demand, thereby reducing the most persistent economic issue: inflation, which remains significantly above the Fed’s 2% target. Concurrently, a recession would improve labor force productivity, which was negative during the first half of 2022 before modestly recovering in the latter half of the year. Colas concludes that while other methods could achieve these necessary objectives, an economic contraction would be the fastest solution, which is why markets view a recession as a feature rather than a bug.


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