Recession risk: 'We’re in for a tough battle' with inflation, strategist says

Edison Group Director of Research Neil Shah joins Yahoo Finance Live to discuss the state of the stock market, inflation, recessionary risks, and the outlook for investors.

Video transcript

BRAD SMITH: Back over to our recession watch, and as inflation continues to rise, our next guest says that there is uncertainty of how deep a recession we are facing to try and subdue inflation. We welcome in Neil Shah, Edison Group Director of Research.

And Neil, particularly here, we were having the conversation earlier this morning with Aaron Brown of PIMCO around how deep and protracted a recession might be. The same question to you. What type of recession might we be looking at, mild or more severe than perhaps is already priced in?

NEIL SHAH: So I think it really comes down to how stubborn do you think inflation is going to be. And the message that is coming through, certainly from the Federal Reserve, is that they will work to quell inflation over and above being concerned about growth.

Now, we have been looking at what is driving the inflation and supply chain shocks. And I think that the concern, I guess, would be that if you don't start to see moderating growth and those inflation expectations coming down, it's going to stick around. So I think we're in for a tough battle. I genuinely don't know. And I think that's one of the problems of the market right now, which is that it's digesting information one step at a time and processing that.

And the way we tend to look at the market is we're in a sort of four-stage process. Number one is that the expectation of rising rates is now starting to be baked into the market. We're at stage two, which is how deep a recession are we going to see?

I do buy the arguments that the consumer, the US consumer in particular, remains healthier than in previous cycles and that that should mean that it's a shallow recession. But if rates continue to rise more steeply, et cetera, that remains a concern.

The step three would be, in September, I think that the outlook statements are going to come into focus as companies come to report. And there is this expectation of profits downgrades. And then I think you're at that point where you see a bottom of the market and, effectively, people starting to participate and buying equities again.

BRIAN SOZZI: Neil, for in stage two of this four-stage process you mentioned, how much downside risk is left in the S&P 500?

NEIL SHAH: Well, valuations have moderated. So I mean, if you look at NASDAQ, if you look at even some of the crypto indexes, the bubble element seems to have eroded away. But there is still acute sensitivity to earnings misses to the tune of--

This is typically when we're looking at companies managing those expectations as going to be key because if there is an earnings miss, you tend to see those stocks being punished quite hard. But I think we're at that point where there feels to me like there's maybe 5% to 10% risk in the market or downside risk in the market before you'll start to see people starting to participate.

I mean, I talked to a number of asset managers. And their view is, a lot of them are sort of building cash right now because the expectation is in September or October, you're going to start to see that capitulation. And then you will start to see some participation in the market.

BRAD SMITH: To what extent, though, are you expecting earnings revisions to start to come fast and furious?

NEIL SHAH: Well, I mean, I do think that the consumer is going to start tightening. You're starting to see elements of that. And your previous guest mentioned the fact that you are seeing signs of it but that they will come back.

I think that in September, we're still going to be in that cycle of the consumers are going to be managing budgets. And people are returning back from the holiday period, planning for the months ahead, et cetera. And I think there's going to be some caution.

So I expect that there is going to be some downward revision to earnings still coming through in September, October. And then I think you're probably going to see the market react to that. And then my sense is you'll find a bottom.

BRIAN SOZZI: Yeah, if we get a bad miss on headline payrolls later this week, how do you think the market reacts?

NEIL SHAH: Well, I mean, the tight labor market is contributing to the inflation concerns. So I think the market is going to be looking at it's a little bit torn. So if there's no sign of the labor market easing, et cetera, there's concerns that you're going to see a rate tightening cycle. However, it's a really bad miss, et cetera. It's a sign that downturn's coming.

Then I think you're tipping yourself into that sort of stage two, that there is a deeper recession coming. And I think the market will react badly to that.

BRAD SMITH: For as long as we had been discussing, it seemed like weeks, there were economists that were kind of tossing around this idea that, amid higher inflation, amid higher energy prices and the number of job openings that are out there with, perhaps, the number of people as well that are still sitting on the sidelines that are yet to still come back into the workforce, that that would push people back in. But have we seen that start to show up in the data at all? And if we do see a more kind of drawn out recessionary period, how much of that job openings and turnover even, kind of the Great Resignation-- does it suck the wind out of a Great Resignation? And does it push people back into the job markets and the labor force participation?

NEIL SHAH: So I think that-- I mean, we see it from the corporates we write research on that recruitment is a challenge for a lot of them. And you hear the headlines around that in the airline sector and other areas where it is particularly difficult to recruit. What are you going to do to tempt people back into the workforce?

Remove, effectively, some of the security blanket. I think that will start to compel some people back into the workforce. I don't think that's a healthy solution. My sense is that there is a balancing act to work our way through here. And hopefully moderate rate increases, a modest downturn in activity sees us through. And then I think that's my sense of where I hope we will get to. And I still think that there is some modest downgrades coming through in profit expectations.