Stock markets have been wobbling for weeks over the rising risk of possible recessions for the US and eurozone economies, with this week bringing some crucial new data that could fill in some blanks.
Based on hard data received so far, the risk of a US recession has now risen further to 96%, according to UBS, surging from a probability of 11% in April to 89% in May.
For Europe there is a 30% probability, according to the Swiss bank's data modelling.
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Examining the market implications, the UBS economics team, led by Arend Kapteyn, issued a note to clients this week that examined the four recession scenarios they see as most likely and compare their depth and duration to other recessions.
Scenario 1: a consumer-led recession
Under the first "shallow recession" scenario, the pent-up pandemic demand for services and savings drawdowns dissipates, and "consumption aligns with negative real disposable income growth", with GDP contracting for six-to-eight months and shifts 0.5-0.7% lower in both the US/Eurozone.
In such recessions in the past, the S&P 500 index typically has seen an average drawdown of around 11%, and the market typically bottomed within four months of the start of the recession, the economists said.
In the event of a recession the US Federal Reserve is seen cutting the federal funds rate back to zero, "we see US equities benefitting disproportionately more than other regions in 2023" with the S&P 500 ending 2023 higher at 4,500 in this scenario than in the baseline scenario of 4,400 (and current levels around 3,800).
"Lack of a significant policy change from the ECB implies Stoxx 600 does not enjoy the same liquidity tailwind."
Scenario 2: the Fed and ECB overtighten
In the second scenario, the worst outcome for the S&P 500 in all the scenarios modelled, both Fed and European Central Bank tighten 100 basis points more than the market is currently pricing, which is seen as having a "somewhat larger" impact on US growth, with GDP shifts 1.5 percentage points lower, with unemployment back up to 5.8% by the end of next year (from 3.6% now).
Even after a 30% derating, Shiller’s CAPE for the S&P 500 would still be at 28.7 times, compared to an average of 23 ahead of deep recessions and 14 ahead of shallow ones.
"Policy overtightening can lead to a significant further derating", the economists say, which, along with earnings downside should cause the S&P 500 to slip to 3,100 by the first quarter of 2023 before recovering to 3,900 by the end of 2023.
In this scenario, the European Stoxx 600 index follows a similar profile, hitting bottom at 330 in early 2023 before recovering to 410 by the year end.
Scenario 3a: voluntary gas rationing in Europe
In this scenario, Europe starts to pre-emptively ration energy to fill gas storage, which essentially leads to a more extreme version of the consumer-led recession with higher inflation.
GDP would be expected to drop 1.6 percentage points lower and inflation 2.5 percentage points higher by mid 2023.
While the S&P 500 makes a modest recovery to the end of 2022 and 4350 by the end of 2023, Europe’s poor mix of growth and inflation is seen causing a further 15% decline in the Stoxx 600 to 350 at the end of 2022 and 430 a year later.
Scenario 3b: Russia cuts all gas deliveries to Europe
If Russia stops all gas supply to Europe, removing what has been 6% of total European energy consumption, the UBS team would we expect a 4-percentage-point drop in GDP.
"Already elevated stagflationary pressures in Europe worsen considerably, making this the most adverse scenario for Stoxx 600, pulling it lower by more than 20% between now and 325 at year end."
Earnings would slip more than 15% and valuation multiples also contract to below 12 times, with the Stoxx finishing 2023 at 400, modestly below current levels.
"The S&P 500 is unable to ignore this recession and gets pulled lower towards 3500 before swiftly recovering in 2023."
The euro would slip sharply towards US$0.90, German bund yields to zero, and BTP spreads (the difference between German and Italian 10-year government bond yields] rise to just under 400 bps towards end 2022 before each makes a modest recovery in 2023.