Stocks could drop 25% in recession as markets underestimate key risk

  • In an interview with Insider, SoFi’s head of investment strategy gave her stock market outlook.
  • Although 2023 is not a repeat of 2008, a downturn could see stocks fall more than 25%, Liz Young said.
  • “I can’t imagine a world in which we raise the fed funds rate by 475 basis points and then happily head into a new bull market.”

The Federal Reserve’s policy tightening campaign revealed significant risks in the banking systemand stocks could plunge later this year if a recession sets in, according to SoFi’s head of investment strategy Liz Young.

Over the past year, the Fed has raised interest rates by 1,700%, most recently hiking 25 basis points in March after the collapse of Silicon Valley Bank as well as an inflation reading in February which cooled in line with expectations.

“I can’t imagine a world in which we raise the fed funds rate by 475 basis points and then happily head into a new bull market,” Young told Insider.

Even before the banking turmoil hit, Young said she anticipated some form of stress emerging in the economy, given the amount of cash the Fed had drained and rising borrowing costs. The bank failures that followed marked a symptom of the Fed’s policy choices.

“I think we’re in a situation right now where we’ve plugged the short-term hole sufficiently, in the sense that depositors were covered,” Young said, adding that the contagion appears to have been contained. “I also have a hard time imagining a world where bank failures and corporate liquidity problems are good news.”

A recession could crush stocks

In Young’s view, tighter economic conditions this year could lead to lower equity valuation multiples, shrinking earnings and ultimately economic contraction.

Typically, if a recession is confirmed, the market falls by more than 30%. Last year, the S&P 500 fell about 25% from peak to trough, signaling a bear market but not quite recessionary territory, the strategist explained.

Meanwhile, Young pointed out, during the Great Financial Crisis 15 years ago, stocks plunged 58% from peak to trough.

“I don’t think this is a repeat of the financial crisis,” Young said. “However, I would expect it to be over 25%.”

Fragile trust

Before the wave of bank failures, a strong job market and falling inflation had boosted Americans’ confidence in the economy, Young said. But the snags of March have shaken this optimism.

“I think confidence is something that is a risk and is undervalued by the stock market right now,” she said. “Honestly, because consumer confidence is something that can change in an instant and consumers can change the way they spend money in a dime, when then there’s a disconnect between what that consumers can change and how quickly businesses can respond.”

Businesses, for example, stock shelves with items to sell to consumers and this essentially forecasts economic prospects up to a year in advance.

But consumers could change their minds with their buying habits on a daily or weekly basis, which means businesses could end up with the wrong inventory or too much inventory.

“That’s one of the biggest risks that would show up in corporate earnings,” Young said. “And I think corporate earnings estimates are still too high for 2023.”

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