Why the Stock Market May Ignore Recession Risks Until It Sees ‘the Whites of Its Eyes’

Stocks see growth. Economic forecasters see recession. (CHARLY TRIBALLEAU / AFP via Getty Images)

Stocks are back at all-time highs, artificial-intelligence investments are funneling billions into projects around the world, corporate earnings are growing, and new tech listings are flying off the shelves.

That doesn’t exactly sound like recession, does it?

The labor market is slowing, however. Consumers are tightening their belts, and inflation is moving in the wrong direction. Corporate leaders, meanwhile, are unable to pin down President Donald Trump’s tariff strategy, which has expanded from addressing trade imbalances to exacting political retribution and supporting global peacekeeping.

That all has left business investment limping into the back half of the year. And market experts are starting to recalculate their odds of recession.

Even so, that hasn’t dented investor sentiment.

Paolo Schiavone, a macro trader at Goldman Sachs, said in a client note last week that the market “can’t look far enough” ahead in assessing the mounting risks. “This is why it will ignore the recession risk,” which the bank pegs at around 30%.

Peter Berezin, chief global strategist and co-head of research at BCA Research, agrees, adding in a note published last week that while he pegs the odds of recession over the next year at 60%, markets aren’t likely to react “until the ‘whites of the recession’s eyes’ are more clearly visible.”

Government data are flashing warning signs. The weaker-than-expected July jobs report and major downward revisions to previous months were certainly worthy of focus. The Commerce Department’s robust reading of second-quarter gross domestic product, estimated to have grown by 3%, was also tempered by the fact that the run-rate for the first half of the year is about half the pace of a year ago.

The Institute for Supply Management’s benchmark activity surveys for both the manufacturing and services sectors, which are highly correlated to GDP growth, underwhelmed investors last month. Sub indexes inside the reports also showed soaring input prices and tepid hiring plans.

None of the data have been weak enough to derail the stock rally, which has lifted the S&P 500 more than 27% since its early April lows.

John Higgins, chief markets economist at Capital Economics, ran a test that compares the ratio of cyclical and defensive stocks and economic activity readings from the Institute for Supply Management since 1999.

Historically, the two have been tightly correlated, matching weakness and growth in the world’s biggest economy. But that relationship has effectively broken down over the past three years.

“The upshot is that investors in the stock market don’t seem to be remotely concerned about the economy,” Higgins said. “One interpretation is that they are being complacent. Another is that the economic outlook is better than the ISM surveys suggest.”

Another potential reason: The launch of ChatGPT and the surge in artificial intelligence investments distorted performance through outsize gains for megacap tech stocks.

“The AI boom has been more important than any macro issue, at least as far as the stock market is concerned,” said Berezin at BCA Research.

Still, beside the huge sums allocated to data center construction over the next five years, which could reach $7 trillion by some estimates, he isn’t convinced that AI will save the economy from recession.

“Overall tech-related manufacturing construction has been shrinking since last September,” Berezin said. “Although it is possible that some of this spending will be re-shored back to the U.S., it will take a while for that to happen.”

Meanwhile, the “whites of the recession’s eyes” might get a lot more visible. The Bureau of Labor Statistics, whose commissioner was fired by president Trump, will publish July inflation data on Tuesday. The Commerce Department will follow with retail sales figures on Friday.

Federal Reserve Chairman Jerome Powell will deliver a keynote address to the central bank’s annual symposium in Jackson Hole, Wyo., on Aug. 21, and the BLS will release what is likely to be a crucial August jobs report on Sept. 5.

Weak numbers will likely cement the case for rate cuts when the Fed wraps up it two-day meeting on Sept. 17. If so, the long-awaited easing might be the final signal of an economy in contraction.

Write to Martin Baccardax at martin.baccardax@barrons.com