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Despite some recent positive signs for the U.S. economy, the Wall Street consensus is holding out belief that a recession is lurking. A stubbornly strong labor market and services sector combined with resurgent housing data seem to suggest that the U.S. growth outlook is stable though perhaps not stellar. But with the Federal Reserve’s interest rate hikes working their way through and questions over how long the consumer can hold out against rising pressures, the economy is facing a number of dangers ahead that could cause at least a mild contraction. “Our most likely scenarios put the economy in a mild recession by the end of the year as consumers retrench and businesses slow hiring as surveys suggest,” wrote Jeffrey Roach, chief economist at LPL Financial, and Lawrence Gillum, the firm’s chief fixed income strategist, in a report for clients . The duo even compared the current situation to the climate in 2007, at the dawn of a financial crisis that paralyzed the global economy before lifting in early 2009. They see similarities in Fed positioning at a time when officials largely expected storm clouds in housing to pass and instead were worried about inflation that would hit around 5.5% in mid-2008. “Periods of economic regime shifts are difficult for policymakers to manage,” Roach and Gillum said. “This current environment could be eerily similar to early 2007, when the Fed held a tightening bias on rates as they believed the housing market was stabilizing, the economy would continue to expand, and inflation risks remained.” Still, LPL doesn’t see “another 2008” even though “investors should anticipate some volatility as the economic outlook remains cloudy.” From an investing standpoint, LPL backs a “neutral” allocation on style, with a bias toward international stocks, large caps over small and industrials as a sector pick along with communication and technology from technical factors. Data points improving Current indicators are providing conflicting signs on the potential for recession. Consumer confidence actually rose in June to its highest level since February, according to a widely watched University of Michigan survey. There also was good news in housing, as starts unexpectedly soared nearly 22% in May. Finally, the Atlanta Fed’s GDPNow tracker of incoming data is pointing to 1.9% growth in the second quarter, following a 1.3% annualized growth rate in the first quarter. Others on Wall Street, though, are cautious on stocks despite the fast start this year. Investment management giant BlackRock, for instance, sees significant economic risks from Fed policy and is advising clients to stay cautious. “Recession is foretold as central banks try to bring inflation back down to policy targets. It’s the opposite of past recessions: Rate cuts are not on the way to help support risk assets, in our view,” the firm, which manages $10 trillion for clients, said in a note this week. BlackRock focused on the upward revisions that Fed officials made to their economic outlook following last week’s policy meeting. “We think the Fed’s improved growth forecast ignores the sharp trade-off it faces: crush growth or live with inflation,” the firm’s strategists wrote. “We think the Fed and ECB appear to be underappreciating the existing damage from hikes. The Fed revised its growth forecast up based on historically low unemployment. The Fed may be relying on a job and growth relationship that has broken, in our view.” BlackRock also has a dim view on buying dips on domestic equities, saying it is underweight on the sector. “The new playbook calls for a continuous reassessment of how much of the economic damage being generated by central banks is in the price,” the strategists said. Obstacles for a soft landing Similarly, DBRS Morningstar, in an evaluation of the U.S. and Canadian economies, sent out a word of caution, particularly on sectors that get hit when the Fed raises rates. “Overall, we expect both economies to slow close to stall speed in the second half of 2023 as the lagged effects of monetary tightening are fully transmitted to the economy,” wrote Michael Heydt, senior vice president of global sovereign ratings at DBRS Morningstar. “This implies a cooldown in consumer spending, a deeper downturn in rate-sensitive sectors, or some combination of the two. Given this outlook, a recession is a clear possibility.” Fed Chairman Jerome Powell on Wednesday pushed back on the notion of a flagging economy, telling legislators on the House Financial Services Committee that growth is “very strong” and is “by far the strongest of many countries.” However, Wall Street persists in worries that the central bank will not be able to engineer its hoped-for soft landing. “The balance sheet of the consumer is deteriorating, manufacturing is contracting, cracks in the labor market are appearing, commercial real estate is imploding and banking stress remains,” wrote Megan Horneman, chief investment officer at Verdence Capital Advisors. She noted that previous hiking cycles generally don’t end without recessions. “Optimism around a soft landing [is] growing with the rally in equities and strong labor market,” Horneman said. “We believe the chance of a soft landing is unlikely.”
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