What the rising likelihood of “growth scare,” according to Citigroup, means for the stock market

Recession worries are affecting stocks, according to Citigroup.

A “mild recession in 2023” could see the S&P 500 index fall about 20% from its high of about 4,600 in late March, analysts at Citigroup said in a research note on Monday. Amid “a more severe macro growth fear,” the index could register a loss of around 30% as the Federal Reserve continues to tighten monetary policy in an already flagging economy to stave off persistently high inflation, the report shows.

“Recession risks are more limited in 2022 but rise significantly in mid to late 2023,” Citi analysts said. “Equities markets have already started pricing this in, but we expect the impact to be felt primarily in the first half of next year,” they wrote.

Related: Goldman Sachs sees some risk that the US economy will stumble and fall into recession in the next 24 months

The S&P 500 SPX, -0.02%, was down around 4,385 on Monday afternoon as the company’s first-quarter earnings season gets into full swing this week. So far this year, the U.S. stock benchmark is down around 8%, FactSet data shows.

S&P 500 earnings would take a 10% “slump” in 2023 under Citi’s “baseline recession” scenario, with the index falling about 20% to about 3,650, according to the research report. Deeper recessions have resulted in an average 15% drop in earnings per share, the report shows.

Read: Recession fears and the stock market – is it too late to defend yourself?

“Investor nervousness in the early stages of recession usually results in multiple downgrades in the 2-3 round range,” the analysts wrote, referring to a decline in the S&P 500’s price-to-earnings multiple , when Fed policy stance deviates from macroeconomic growth backdrop,” meaning the central bank continues to tighten monetary policy while “growth weighs negatively,” Citi analysts said. “This could take another 1-2 turns in the S&P 500 price-to-earnings multiple,” they wrote.

The Fed has tightened policy, raising interest rates while planning to shrink its balance sheet as it aims to cool the economy to ease high US inflation

Traditionally defensive sectors such as Utilities, SP500EW.55, -0.30% Consumer Staples, Real Estate, Communication Services and Health Care SP500EW.35, -1.30%,
become attractive to investors worried about a recession because their returns are “less cyclical,” says the report.

But those sectors make up just 35% to 40% of the S&P 500 index, analysts said. “There isn’t enough market cap in defensive sectors to build a recession-resistant portfolio.”

In a “mild recessionary scenario, growth could also prove defensive, which would make technology relatively attractive,” they said. “However, a deeper pullback with further rate hikes is likely to put pressure on higher multiple groups, implying quality overlay” in cyclical areas such as materials, financials SP500EW.40, +0.27%,
“and even Industrial SP500EW.20, -0.39%,
make sense,” say the analysts.

Growth stock RLG, -0.14% has lagged significantly behind value stock RLV, -0.12% this year amid concerns about rising interest rates, according to FactSet data.

In recent weeks, investors have often asked analysts at Citi how paper and packaging stocks would fare in a recession or “sharp market correction,” according to the report. “Our analysis suggests that packaging is a relatively safe place for investors,” they said, “much better than paper.”

In their report, Citi analysts believe that “Equities markets began to more meaningfully price the likelihood of a recession for the year around the late March highs as inversions in the US yield curve and expectations of an eventual Fed policy cut emerged futures markets made their way into Fed funds.” At that point, “the S&P 500 was trading around 4600,” they said.

Read: ‘Calamity’ can come, stock market constellation similar to 1999: Jeffrey Gundlach

A closely watched portion of the Treasury market’s yield curve had briefly inverted during trading late last month and closed in inversion in early April, meaning 2-year yields surged above 10-year Treasury notes.

According to Dow Jones Market Data, the last time 2-year and 10-year Treasury note yields inverted was in 2019. An inversion of this part of the Treasury market yield curve has historically preceded a recession, though typically by a year or longer before an economic contraction.

Read: The US Treasury yield curve risks a reversal relatively early after the start of the Fed’s tightening cycle, Deutsche Bank warns

See also: Why an inverted yield curve is a bad tool for stock market timing

That part of the yield curve is no longer inverted, however, as the yield on 10-year Treasury note TMUBMUSD10Y, 2.861%, trades at 2.86% Monday afternoon, higher than the yield on 2-year Treasury note TMUBMUSD02Y, 2.468% of around 2 .47%, FactSet data shows, latest review.

The probability of a recession within the next year is 20%, up from 9% at the end of February, according to the Citi report.

“Investors see rising odds of macro growth fears over the next 12 to 18 months,” Citi analysts said. “Compared to previous recessions,” they expect the stock markets’ reaction to be “earlier on both the inbound and outbound journey.”

All three major US stock benchmarks are down this year, including the S&P 500, the Dow Jones Industrial Average DJIA, -0.11% and the Nasdaq Composite. The tech-heavy Nasdaq COMP has seen its sharpest drop of -0.14% in 2022, down around 15% based on Monday afternoon’s trading amid concerns that rising rates are hurting valuations of high-flying, high-growth companies are shares in particular.