The “latent” risk of a traditional US recession replaced the financial markets’ fear of an imminent downturn in the first half of the year

Financial markets’ first-half fear of an impending US recession is being replaced by a new storyline: one involving what a Goldman Sachs strategist calls a “latent” risk of an economic downturn over the next 12 months and a maybe not so hard landing as central banks continue to hike rates to curb inflation near 40-year highs.

At Goldman Sachs Group Inc. GS, +0.22%,
Researchers put the market implied risk of a US recession beginning within a year at an annual high of 37% on Thursday. And while the threat of stagflation hasn’t entirely disappeared, it could look more like “quasi-stagflation” or an environment of “stagflation tendencies,” said Christian Mueller-Glissmann, a managing director and London-based head of asset allocation for Goldman Sachs.

Sources: Haver Analytics, Datastream, Worldscope, Bloomberg, Goldman Sachs Global Investment Research

Underlying the recent rethink is the notion that the US economy may be better equipped to handle higher interest rates than previously thought. This shift in sentiment is most evident in US stocks, which have rebounded from their mid-June lows and even posted modest gains on Thursday despite dissenting comments from Fed officials on interest rates. The shift contrasts with the pessimism that prevailed in the first half.

Goldman Sach’s conclusions came as US stock and bond markets slipped into a wait-and-see mode for much of Thursday, even after Federal Reserve officials made fresh remarks about possible paths forward for interest rates. Treasuries are in “an environment of indecision” as “investors shelve political fears in favor of side positions until there is great clarity on how the employment and inflation landscape will evolve in August,” said rates strategists at BMO Capital Markets, Ian Lyngen and Ben Jeffery.

Read: The Fed doesn’t want to “overdo” rate hikes, says San Francisco President Daly, and the Fed’s Bullard says he’s inclined to support a 0.75 percentage point hike in September

“In the first half of the year, markets were really worried about the risks of an impending recession as central banks battle this incredibly high inflation. That risk has gone down,” Mueller-Glissmann told MarketWatch by phone. “The problem is that this traditional recession can still unfold if central banks tighten policy, yield curves flatten and growth conditions deteriorate for a few quarters.”

“A traditional recession takes time to build up,” and in such a scenario “you can expect earnings expectations to turn more negative,” he said. “This latent risk is the same or higher than before over the next six to 12 months. Our baseline view is that a recession is likely to be fairly soft in most economies; the only place it would be lower is Europe. But that doesn’t change the view that one of the steepest rate hike cycles on record is likely to hurt profits and that markets need to reassess risk.”

On Thursday, Dow Industrials DJIA, +0.06%,
the S&P 500 SPX (+0.23%) and the Nasdaq Composite COMP (+0.21%) rose 13.8%, 16.8% and 21.8%, respectively, from their mid-June lows. The S&P 500 and Nasdaq ended the day up 0.2% each, while the Dow Industrials was up less than 0.1%.

In FX markets, pricing for major currencies like the dollar is still “tightly anchored” with stagflation and recession as the most likely outcomes, and the dollar is being traded as an “excellent” hedge against the risk of high inflation and slower growth, Mark said McCormick, global head of FX strategy at TD Securities in Toronto.

These risks “are not fully priced into the dollar yet,” and people are still long the dollar because “at the same time, deteriorating growth in Europe and Asia are strong forces for the dollar to react to,” he said. Given ICE US Dollar Index DXY up around 13% year-to-date, +0.87%,
The greenback “is not priced in for a soft landing, it’s priced in for a contraction in the global economy, and the question is how much the US is contributing to that weakness.”

“If things get better over the next six months – China recovers, Europe produces fiscal stimulus – and 2023 looks much better, given its stagflation characteristics, the dollar will look very expensive heading into a potentially better world .” McCormick said.