U.S. economic trends have worsened over the past few months, and we recently updated our base case to a moderate recession (from a mild recession). Our view is that the steepest contraction will occur later this year and that the recession could last through mid-2023. We expect an economic recovery to begin in the second half of 2023. In the near term, we expect the Federal Reserve (Fed) to continue tightening monetary policy, which likely will weigh on consumer and business spending in the coming quarters. We see borrowing costs rising, credit availability diminishing, and the possibility of higher unemployment. Businesses are cutting capital spending plans and announcing hiring freezes in anticipation of falling demand.
Our macro forecasts have a direct impact on our equity targets. We expect slowing revenue growth and higher costs to squeeze margins in the coming quarters, likely leading to an earnings recession over the next 12 months. We are seeing margins compress in the Consumer Discretionary and Consumer Staples sectors due to higher input costs and in the Information Technology sector due to higher labor costs. Energy is one of the few sectors where margins are expanding. Overall, we expect corporate earnings to decline this year, but to rebound late in 2023 as the economy emerges from recession. We expect equity markets to be volatile through the remainder of 2022. However, we forecast significant upside through year-end 2023 as the recovery takes hold in the second half and into 2024.
Historically, equity markets have been mixed prior to official recessions, but tend to bottom before the economic contraction ends. Likewise, equity markets also lead earnings, historically bottoming well before profits trough. The following table illustrates how equity market movements and economic recessions overlap, but are not always aligned. Bear markets (down greater than 20%) often coincide with recessions, but generally have not occurred within a recession. The exception is during the Great Financial Crisis — an event that we believe is not comparable to our 2022 – 2023 forecasted recession. Even more compelling is the equity market performance after recessions, where returns have generally been positive the majority of the time.
S&P 500 Index price return around and during recessions
Sources: Bloomberg and Wells Fargo Investment Institute. August 4, 2022.
In our view, during late cycle and early recessionary periods, investors should consider moving up in quality (we prefer U.S. Large and Mid Cap Equities over Small Cap Equities) and reducing cyclical exposure in favor of defensive sectors. Earlier this year, we reduced risk and cyclicality in the portfolios with a focus on quality. This included downgrades to U.S. Small Cap Equities and Emerging Market Equities at the asset class level and downgrades to Consumer Discretionary, Industrials, and Financials at the sector level. In addition, we have added to defensive positions by upgrading Consumer Staples, Health Care, and Utilities.
We are currently favorable on the Energy, Health Care, and Information Technology sectors. We believe improving fundamentals and tight oil supply will support Energy sector prices. We expect the sector to lead earnings growth in the coming quarters and, while prices have rallied, valuations remain relatively inexpensive versus history and the S&P 500 Index. The Health Care sector fits nicely into our quality theme with relatively low leverage and high return on equity. Also, its defensive characteristics should continue to serve it well during market volatility and as the economy slows (it has outperformed the S&P 500 Index in each of the past seven U.S. recessions). Information Technology is one of the highest-quality sectors in the S&P 500 Index, ranking high in quality metrics such as earnings stability, return on equity, and low debt levels. Heading into a recession, we believe investors likely will gravitate toward consistently growing, high-quality companies that can be less sensitive to cyclical slowdowns.
We believe that a defensive posture is still an appropriate strategy in this late cycle and early recessionary period. Risks to the downside remain as the economic data worsens, the Fed continues to tighten monetary policy, and earnings expectations recede. However, given that the equity market is likely to anticipate the recovery before the recession ends, we will look to tactically add risk as opportunities present themselves.