A recession is coming by year-end and stocks will struggle amid elevated risk of an 'unknown unknown,' JPMorgan says

• Despite a surging stock market, the economy is still on track to enter a recession within the next nine months, according to JPMorgan.
• The bank said a teetering economy puts the stock market at risk for a sell-off in the second half of the year.
• "The risk of another unknown unknown resurfacing appears high," JPMorgan said.

The stock market rally that sent the S&P 500 surging about 14% in the first half of the year is likely to fizzle out over the second half as the economy inches closer to a recession, according to JPMorgan.

The bank said in a Thursday note that unless the Federal Reserve starts cutting interest rates, a recession could arrive sometime between the end of this year and the first quarter of 2024.

Not helping the situation is the fact that stock market valuations have surged in recent months, which sets the S&P 500 for pain if JPMorgan's expectation of a recession materializes.

"Absent preemptive Fed easing, we expect a more challenging macro backdrop for stocks in 2H with softening consumer trends at a time when equities have re-rated sharply," JPMorgan chief global equity strategist Durbravko Lakos-Bujas said.

Prospects for rate cuts dimmed further this week as Federal Reserve Chairman Jerome Powell reiterated in Capitol Hill testimony that more hikes are possible later in the year.

Also weakening JPMorgan's outlook for stocks in the second half of the year is the fact that investor positioning in equities has surged amid growing "recession fatigue," as numerous warnings have come and gone without a downturn materializing yet. And that's evidenced by a recent spike in investment sentiment indicators and a sharp decline in the CBOE Volatility Index.

The CNN Fear & Greed Index is in "Extreme Greed" territory, and the AAII Investor Sentiment survey saw its highest bullish reading since 2021, right before the stock market entered a painful bear market.

"We see unattractive risk-reward for equities and increasing investor complacency ahead of our expectation that the business cycle will further decelerate in 2H with an onset of a recession likely in 4Q23/1Q24," Lakos-Bujas said.

JPMorgan's view that a potential recession is imminent is driven by a weakening consumer, the expectation that accumulated excess savings from the COVID-19 pandemic will be fully depleted by October, and that fiscal tailwinds are fading as student loan repayments restart in September.

And there's always the potential for a surprise black swan-type event that could disrupt markets and send stock prices lower, akin to the regional banking crisis earlier this year or the onset of the COVID-19 pandemic in 2020.

"The risk of another unknown unknown resurfacing appears high," Lakos-Bujas said, pointing to the potential lagged effects of the Fed's aggressive interest rate hikes and balance sheet reduction over the past year. "There is risk that liquidity and credit conditions tighten in coming months."