Equities have not priced in an impending recession. That could increase the risk of recession fears next year, says Goldman Sachs.

Tightening financial conditions keep recession risk high, but financial markets have not priced in an imminent recession as valuations of risky assets are still well above recessionary levels, strategists at Goldman Sachs said.

A team of strategists led by Christian Mueller-Glissmann, head of asset allocation research, is forecasting a 39% chance of a slowdown in the US economy in 2023, but following recent recovery rallies in stock markets, they believe that risky assets at only one price level have an 11% chance of an imminent recession, increasing the risk of further recession fears next year. (See diagram below.)

SOURCE: DATASTREAM, HAVER ANALYTICS, WORLDSCOPE, GOLDMAN SACHS GLOBAL INVESTMENT RESEARCH

Hopes that the US Federal Reserve might back off its aggressive rate hike policy have propelled US stocks higher over the past two months as inflation finally shows signs of cooling. The S&P 500 SPX, -1.47%, gained 6.1% in November, while the Dow Jones Industrial Average DJIA, -0.32%, posted a 9.3% monthly rally and the Nasdaq Composite COMP, -1.48%, up 2.3% is Dow Jones market data.

Goldman strategists see a low equity risk premium amid heightened recession risk and uncertainty about the growth/inflation mix. A low premium usually indicates that investing in shares offers little compensation to investors for taking on the higher risk of investing.

“Slow growth and volatility coupled with relatively high valuations keep the risk of stock downside high,” the strategists wrote in a note Monday. “In addition to market stress indicators, financial stability concerns have also increased.”

Also read: The stock market could see “fireworks” by the end of the year as headwinds have “turned around,” says Fundstrat’s Tom Lee

Mueller-Glissmann and his team suggest investors remain “defensive over the next three months,” meaning investing more money and credit while neutralizing commodities and underweight bonds and equities.

“In the near term, bonds and duration may continue to be a source of risk rather than safety in portfolios as investors still need to reevaluate a ‘higher for longer’ interest rate regime,” strategists said. “We see the potential for bonds to become less positively correlated with equities and offer more diversification benefits later in 2023 — but until central banks stop hiking and inflation normalizes further, they likely won’t be a reliable buffer for risky assets.”

James Bullard, President of the St. Louis Fed, said in a MarketWatch interview Monday that he advocates more aggressive rate hikes to curb inflation, adding that rates may need to stay elevated into 2024.

Meanwhile, New York Fed President John Williams said in a virtual event that further tightening was needed to cool inflation, which remains “way too high”.

Market Watch Live: Stocks lose ground as protests in China rock markets

US stocks fell on Monday as protests over China’s zero-COVID policy weighed on markets and pushed oil and industrial metals prices lower. The S&P 500 lost 1.4%, the Dow 1.3% and the Nasdaq 1.5%.