A top strategist explains how stocks could sink more than 25% in a recession - and warns markets are underestimating a key risk 'that can change on a dime'
In an interview with Insider, SoFi's head of investment strategy gave her stock market outlook.
While 2023 won't be a repeat of 2008, a downturn could see stocks dive more than 25% from their January high, said Liz Young.
"I cannot imagine a world in which we raise the Fed funds rate 475 basis points and then trot off merrily into a new bull market."
The Federal Reserve's policy-tightening campaign has revealed significant risks in the banking system, and stocks could dive later this year if a recession sets in, according to SoFi's head of investment strategy, Liz Young.
Over the last year, the Fed has hiked interest rates by 1,700%, most recently making a 25-basis-point hike in March following the collapse of Silicon Valley Bank as well as a February inflation reading that cooled in line with expectations.
"I cannot imagine a world in which we raise the fed funds rate 475 basis points and then trot off merrily into a new bull market," Young told Insider.
Even before the bank turmoil hit, Young said she had anticipated some form of stress to show up in the economy, given the amount of liquidity that the had Fed drained and the increase in borrowing costs. The ensuing bank failures marked a symptom of the Fed's policy choices.
"I think we're in a situation right now where we plugged the hole that was discovered sufficiently for the near-term, in the sense that depositors were covered," Young said, adding that the contagion appears to have been contained. "I also am hard pressed to imagine a world where bank failures and corporate liquidity issues are good news."
A recession could crush stocks
In Young's view, tighter economic conditions this year could result in lower valuation multiples for stocks, an earnings contraction, and finally an economic contraction.
Typically, if a recession is confirmed, the market falls more than 30%. Last year, the S&P 500 fell roughly 25% from peak to trough, which signaled a bear market but not quite recession territory, the strategist explained.
Meanwhile, Young pointed out, during the Great Financial Crisis 15 years ago, stocks plunged 58% from peak to trough.
"I do not think that this is a repeat of the financial crisis," Young said. "However, I would expect that it would get beyond 25% [lower from this cycle's high reached in January]."
Before the spate of bank failures, a strong labor market and cooling inflation had bolstered Americans' confidence in the economy, Young said. But March's snags rattled that optimism.
"I think confidence is something that's a risk and is underappreciated by the stock market right now," she said. "Frankly, because consumer confidence is something that can change on a dime and consumers can change the way they spend money on a dime, whereas there's a mismatch then between what consumers can change and how quickly companies can respond."
Companies, for example, stock shelves with items to sell to consumers and that essentially forecasts an economic outlook as far as a year ahead of time.
But consumers could change their mind with buying habits on a daily or weekly basis — meaning corporations could get caught with the wrong inventory or too much inventory.
"That's one of the bigger risks which would manifest itself in corporate earnings," Young said. "And I do think that corporate earnings estimates are still too high for 2023."
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