Banks Are Warning of a Recession but Stocks Are Rising

For all the recession talk in corporate boardrooms, Wall Street doesn't seem to be too concerned.

So far this year, the S&P 500 is up 4.6% after entering into a bear market in 2022 while the tech-weighted Nasdaq Composite, which dropped 32.4% last year, has gained 8.5%.

The fact that recent stock leadership has been in cyclical names suggests that investors feel comfortable investing in growth-oriented names even if economic conditions aren't entirely favorable. Even more, it means that investors are embracing the notion that after nearly three years of economic stimulus and accompanying inflation, that the Federal Reserve may be able to engineer something resembling a soft economic landing.

"The market has taken the side that whatever the landing is, it won't be a hard one," Ed Yardeni, president of Yardeni Research, told Barron's.

That sentiment comes despite a confusing time for market watchers whether it be labor news or other economic data.

On the jobs front, each day it seems there's news of some major company —whether it be Microsoft (MSFT), Amazon.com (AMZN), Alphabet (GOOGL), or Spotify Technology (SPOT)—laying off a significant portion of its workforce. Not to mention big banks such as Goldman Sachs Group (GS) and Morgan Stanley (MS) also reducing headcount. But while no one wants to be in the camp of being let go from their job, the layoffs also need to be put in context. Many of these firms over-hired during the pandemic and are now getting their workforces closer to pre-pandemic levels.

Meanwhile, investors took pause earlier this month when bank executives warned on quarterly earnings calls of the potential recession. But again, more nuance is needed here. JPMorgan Chase (JPM) and Citigroup (C) executives both used the term "mild" when describing a possible recession, with both expecting that the unemployment level could hit 5%. That is not much higher than the Fed's own unemployment forecast, which shows the jobless rate climbing to 4.6% by the end of this year and staying there through 2024.

Unemployment at 4.6% is more than a full percentage point above the current 3.5% rate, and also likely just above what the Fed sees as the so-called natural rate, representing a "strong labor market," Fed Chair Jerome Powell said in a December press conference.

What's more, while the banks are adding to their reserves for soured loans, the reserve builds are modest. In the fourth quarter of 2022, JPMorgan, Citigroup, Bank of America (BAC), and Wells Fargo (WFC) added a collective $2.8 billion to their reserves . Compare that to the reserve builds at the onset of the coronavirus pandemic when each of these banks added at least $4 billion to their reserves in the second quarter of 2020. The banks may now be preparing for a downturn but they aren't bracing for catastrophe.

Few on Wall Street expect 2023 to be an easy one in markets. Yardeni expects to see a "rolling recession" across industries that can spell trouble for a few industries at a time without turning into a "full-blown" recession.

But forward-looking investors who had expected a severe recession during 2022's bear market are now more bullish on 2023 and 2024.