The economic outlook may not be as bad as the market fears. Here's where investors should be looking

Published Sat, May 14 20228:36 AM EDTUpdated Sat, May 14 20228:40 AM EDT

Inflation is soaring, the stock market is tumbling and consumers are worrying more and more about their future. None of that is good, but it's probably time to tap the brakes a little on worries that everything is crashing down. Fears of a recession are definitely on the rise, particularly after the U.S. already has had one quarter of negative economic growth after Q1 GDP fell 1.4%. All it needs is one more to send the economy into the rule-of-thumb definition of a recession. But the labor market is alive and well. Companies are filling on average more than half a million open positions a month in 2022, wages are rising — albeit not as fast as the cost of living — and companies are still making money at a healthy clip, registering a 9.1% profit gain in the first quarter, according to FactSet estimates. It's still, though, the inflation problem that has markets bedeviled the most. The good news is once that starts to decelerate, it could increase both investor and consumer confidence. The bad news is that could take a while, as in years. That's in part because there are multiple factors influencing c lose to the fastest price growth in more than 40 years . There are the residual effects of massive fiscal and monetary stimulus, supply chain backlogs related to the pandemic, and the associated risks from the war in Ukraine . "On the economic front, you've got to keep asking yourself the question of if there is a realistic chance of recession in the United States. To me, the answer is 'no,'" said Jim Paulsen, chief investment strategist at The Leuthold Group. "All of those separate fears are one fear. It's all tied to inflation, that is the key here." Whether 8.3% inflation, and the accompanying Federal Reserve interest rate hikes to tamp it down, is enough to bring the economy to its knees is a matter of intense debate now. Most Wall Street economists are raising their expectations for recession, with Goldman Sachs predicting about a 1-in-3 chance and Deutsche Bank, on the other hand, foreseeing a steep period of negative growth starting late in 2023. A reliable barometer the New York Fed uses that compares 10-year to 3-month Treasury yields indicated just a 3.7% recession probability as of the end of April. Ed Hyman, chairman of Evercore ISI, said recently he thinks inflation has peaked, and hedge fund titan David Tepper at Appaloosa Management recently told CNBC he is taking off his short position on the Nasdaq, whose constituents are most susceptible to higher interest rates. The persistence of inflation, though, is scaring investors enough to send the tech-focused Nasdaq well into a bear market and the S & P 500 and Dow Jones Industrial Average not far behind. "The market is all about technicals and trying to find a bottom. We need to see capitulation but there are those technicals that keep breaking," Paulsen said. Paulsen sees a better fundamental picture than the technicals indicate, primarily because of the strength of the household and corporate balance sheets. He also is in the camp, along with JPMorgan strategist Marko Kolanovic and others, in seeing inflation as having peaked in March. Household debt rose consistently last year, topping off with an 8% increase in the fourth quarter to bring the total to nearly $16 trillion . However, as a share of disposable income, it's only about 9.4%, lower by half a percentage point than it was prior to the pandemic, according to Federal Reserve data. Corporate debt compared to GDP also is less than it was pre-Covid. Paulsen said investors should focus on the longer-term strength and invest accordingly. He points to frontier markets, emerging markets excluding China and the all-country index excluding the U.S. MSCI as places that could outperform the S & P 500. One way to play frontier markets is through the iShares MSCI Frontier and Select EM ETF . One ex-China play is through the Columbia EM Core ex-China ETF. Trying to thread the needle ... Finding both safety and outperformance is a tough chore with the crosscurrents the market is facing. The approach from Scott Knapp, chief market strategist at CUNA Mutual Group, tries to thread that needle by betting on a better future while dealing with the realities of the present. In Knapp's baseline "hard-landing" scenario, the Fed has to tighten aggressively to pull inflation down to its 2% target and in the process stunts growth and inflicts more pain on the market. However, he makes room for a nonnegligible probability that inflation might react more quickly to the interest rate hikes and require less Fed tightening. "The change in [inflation] expectations causes a rally in markets that probably will happen before people know it. A rally like that will get less respect than most rallies," he said in describing the latter scenario. "People won't believe it until it's in their rearview mirror." As such, Knapp recommends a portfolio in which investors take on more duration risk, something counterintuitive to an inflation scenario. At the same time, investors should keep a solid commodity allocation but not overweight. "Investors need to think like options traders, rather than relying on forecasts that are unreliable," he said. "We need to evaluate the probabilities and invest accordingly across the spectrum, while still holding hedges against left-tail events. That's what options traders do, and they are not relying on trying to predict the future." '...With a pair of boxing gloves' Those whose business it is to look into the future see a potentially dour picture. The Fed is trying to tame inflation without crushing the growth, and history suggests that it's a difficult though not impossible job. Consumers aren't convinced it can happen: Friday's widely watched confidence survey from the University of Michigan hit a 10-year low, with buying conditions for long-lasting goods hitting their lowest reading in history dating back to 1978. Inflation expectations for the next year remained mired at 5.4% and at 3% for the next five to 10 years, both levels well above where the Fed feels comfortable. "They're attempting to thread the needle with a pair of boxing gloves," said Joseph Brusuelas, U.S. chief economist at RSM. "We're in a very difficult situation here, where if they engineer a slowdown to 1% [GDP growth] they're going to cause a growth recession while they're declaring victory. That's a difficult picture here." Indeed, reverberations are being felt in multiple parts of the economy. The Cass Freight Index for April showed a decline of 0.6% in April volumes after increasing 0.5% in March, and the accompanying narrative with the survey wasn't encouraging. "After a nearly two-year cycle of surging freight volumes, the freight cycle has downshifted with a thud," the report said. "The prospect of freight recession is now considerable, as substitution from goods back to services spending picks up pace, and as inflation slows overall spending, particularly via higher fuel prices and by pressing up interest rates." Brusuelas also pins the chance of recession over the next 12 months as about 33%, with the situation in Ukraine and Covid lockdowns in China as wildcards. Interestingly, Deutsche Bank, which has the most downbeat forecast on the Street , praised Fed Chairman Jerome Powell and his fellow central bankers for pursuing the right path on inflation, even with the consequences "He and his [Federal Open Market Committee] colleagues know that based on the painful experience of the 1970s and early 1980s, the sooner the inflation problem is dealt with, the smaller the cost in doing so will be, and the sooner the economy will return to a more desirable growth path," the bank said in a note for clients. "The road ahead will not be an easy one, but the Fed is on the right one."

Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, U.S., May 13, 2022.

Brendan Mcdermid | Reuters