A recession could be 'deeper than expected' this year, says analyst—here's what it means for your money

If you follow financial headlines, you've likely seen "recession" cropping up enough times to believe the economy is already in one. By the traditional definition — two consecutive quarters of negative economic growth — the U.S. hasn't gotten there quite yet.

Then again, you never know you've had a recession until it's long past started, and about half of Americans think a recession has already struck, according to a recent survey from Morning Consult.

Yet despite recession fears, the S&P 500 has risen nearly 7% this year. That could be because a chorus of economists are predicting a relatively short and shallow recession — one that investors may have more or less "baked into" stock prices when they bid the S&P down 18% in 2022.

Some market watchers, though, believe portfolios could be in for a shock. David Rosenberg, a former economist at Merrill Lynch who now helms Rosenberg Research & Associates, called investors' combination of recession fears and market bullishness a case of "cognitive dissonance" in a recent interview with MarketWatch.

Raheel Siddiqui, senior research analyst at Neuberger Berman, told CNBC Make It a recession in 2023 "will be more severe than expected."

Here's why some experts are still bearish on the economy's prospects, and what it could mean for your portfolio if they're right.

Throughout 2022, the Federal Reserve aimed to fight inflation that was eating into Americans' finances. The central bank's solution was to embark on a series of interest rate hikes in an effort to slow down the economy and cool inflation.

The question now is whether the Fed's moves will be enough to dampen inflation without tipping the economy into a recession.

The prospect of pulling that off has been dubbed a "soft landing," and even if it doesn't happen, many economists believe a recession could be "soft-ish." That's because many of the hallmarks of traditional recessions aren't happening. Consumer spending, which makes up about 70% of the U.S. economy, is still strong, for instance. The labor market is strong, too, with a tiny unemployment rate of 3.4%.

"That's the case people are making," said Siddiqui. "Inflation is coming down, wages are doing fine, real incomes are turning positive."

Despite the relatively rosy view held by many economists, some analysts see trouble brewing underneath some of the headline statistics.

Inflation could be tougher to fight than expected

While many see cooling inflation as a sign that the Fed may soon be able to slow or even cease hiking interest rates, Siddiqui said headline inflation numbers don't tell the whole story.

Take inflation among services — as opposed to goods — which in January hit its highest level since 1982. There's no case in history, Siddiqui said, where services inflation came down before unemployment picked up. "That's just not how it works," he said. "First employment weakens, then services inflation."

In other words, the economy will have to endure some additional pain in the form of rising unemployment for inflation to subside. That could mean continued rate increases that could send the economy into a deeper recession than experts are expecting. "The Fed has a longer road than even the Fed is saying," Siddiqui said.

Corporate earnings could be in for a blow

Those with a rosier outlook for stocks might point out that despite economic uncertainty, the forecast for corporate earnings — a key driver of stock performance — is ultimately positive. Wall Street analysts expect companies in the S&P 500 to boost earnings by 1.5% in 2023, according to Refinitiv.

"In a plain-vanilla recession, earnings go down 20%. We've never had a recession where earnings were up at all," Rosenberg told MarketWatch, calling this year's forecasts a "glaring anomaly."

This could be partially because companies are using accounting methods incorporating "best-case scenarios that may never come to pass," Siddiqui said, at a frequency he hasn't seen in decades worth of data.

Investors tend to punish these sorts of "aggressive" accounting methods when companies report failures to meet earnings projections. And when economic downturns occur at the same time as deflation, you can expect a larger-than-normal drop in earnings, Siddiqui said.  

Income inequality must be taken into account

Much of the source of inflation comes from stimulative pandemic-era monetary policies that saw many Americans significantly increase their cash reserves — cash they've spent at a high rate since Covid restrictions began to ease, Siddiqui said.

The top 20% of wealthiest households, who fund their lifestyles through savings, are barely feeling the effect of rising rates, Siddiqui said. But the bottom half of earners, who rely on wages to support themselves, are feeling the crunch, having racked up record credit card and personal loan balances.

The bottom quarter of earners are likely to run out of excess savings this quarter, Siddiqui said, with wages not growing fast enough to keep up with consumer spending. That will likely hurt companies that rely on low-income people as customers, he said.

In other words, there are already two economies afoot, and one is hurting. "The top quartile is behaving like it's the roaring 20s. The bottom quartile is entering a recession," Siddiqui said.

A deep recession would mean a steep drawdown in stock prices in 2023, these analysts said. By Siddiqui's calculations, the S&P 500 — which currently sits at 4,079 — could hit 3,000 this year. Rosenberg predicts 2,900. That would mean a loss of 26% to 29%.

Financial pros caution against making wholesale changes to your portfolio in light of short-term market predictions. If you're convinced that a deep recession — and accompanying bear market — is imminent, focus on adding high-quality assets to your portfolio.

Bond investors, for instance, may want to ramp up exposure to funds that hold U.S. Treasurys, Rosenberg suggested, as Treasurys currently offer attractive yields, will rise in price should interest rates fall and have never faced a default scenario.

He suggested stock investors stick with high-quality firms with strong balance sheets and solid dividend payouts, since those firms typically hold up better during periods of economic turmoil.

Generally speaking, avoid taking undue risk, Siddiqui said. For the remainder of the year, "I would maintain a very risk-off portfolio — whatever that means for you."

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