Europe’s Stock Slump a Sign Recession Trade is in Full Swing

This week’s dizzying stock-market swings have made one thing clear for stock investors: the recession trade has arrived.

(Bloomberg) — This week’s dizzying stock-market swings have made one thing clear for stock investors: the recession trade has arrived.

Traders are quickly shifting their bets from last year’s focus on inflation to the risks posed by an economic slowdown. That was evident once again on Friday after a renewed bout of volatility gripped equity markets around the globe, capping a volatile week after the financial sector was rocked by fears that more US and European banks could be headed for trouble as interest rates continue to rise globally.

The S&P 500 slumped as much as 1% Friday before erasing the loss, while a slide in bank shares drove Europe’s main Stoxx 600 benchmark down 1.4%. The selloff in recent weeks in the financial sector is rippling out from banks across other sectors, as investors reposition portfolios for the risk of a hard landing in the US and Europe.

“The trade has totally flipped from inflation to recession angst. So when it comes to the banks, investors are selling first and asking questions later,” said Eric Diton, president and managing director of the Wealth Alliance. “But the extreme negativity is encouraging. That’s what’s needed for stocks to bottom. With US tech stocks holding up still despite bank stress, perhaps a lot of this bad news was already baked in.”

Read more: Deutsche Bank Slumps in Resurgence of European Bank Worries

Investors are relying on incoming economic data and eyeballing historical trends for clues on where to invest heading into a downturn. Those that tend to peak late in economic cycles, like materials producers and industrial companies, usually perform strongly in the six months ahead of a recession, according to data compiled by Ned Davis. The same goes for consumer-staples and health-care stocks, both of which advanced Friday.

At the same time, stocks from rate-sensitive industries like financials, real estate, and growth-oriented technology tend to lag during that period.

Of course, even if there’s a recession, it’s the length that really matters for stock investors. The depth of peak-to-trough real GDP declines isn’t historically correlated to the severity of moves in equity markets, according to Gina Martin Adams, chief equity strategist at Bloomberg Intelligence. But shorter recessions have led to more rapid rebounds.

What’s more, banks are often in the frontline when recession threatens, as they are the channel through which credit flows into the economy. The recent turmoil has renewed the likelihood the European economy will tip into recession, a scenario that had been all but priced out earlier this year.

Forecasters surveyed by Bloomberg are predicting that the US economy will contract in the second and third quarters of this year followed by a return to growth in the final three months of 2023 and early next year.

“Sooner or later this had to happen. Interest rates hikes will hurt the economy and we are seeing the first signs in the financial sector,” said Alfonso Benito, chief investment officer at Dunas Capital. “Banks could start reducing their lending business and that will translate to companies’ activities. That could be the starting point for recession.”

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There are signs money managers are avoiding companies with high levels of leverage and equity volatility. And they are ditching shares which screen highly for dividends and buybacks. That’s a clear sign investors expect companies to preserve cash rather than return it to shareholders.

Alongside banks, other growth-sensitive sectors dropped on Friday with energy, autos and miners among the worst performers. Commercial real estate also slumped. Investors dashed instead for stocks perceived as more resilient to economic downturns, including those of food, pharmaceutical and telecommunications companies. 

“Cyclical sectors are in the downward spiral as they are closest to the banking sector and would suffer from second and third round effects,” Comdirect Bank strategist Andreas Lipkow said.

(updates throughout on US stocks)

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