The two phrases investors don’t want to hear are “bear markets” and “recessions”. Unfortunately, they’ve been hearing them a lot lately.
US internet search interest
Before we get to why, let’s get the definitions out of the way.
Three Ps in a pod
A recession is sometimes defined as two consecutive quarters of economic contractions (falling GDP) but the better way of thinking about it is the three Ps: a decline in economic activity that is pronounced, pervasive and persistent. In other words, economic activity declines meaningfully for several months over a broad front (not just one or two sectors). Recessions are typically associated with rising unemployment and bankruptcies. Since both workers and firms lose pricing power – competition for work and customers becomes fierce – inflation also typically declines.
The notable exception was the1970s when inflation stayed high despite successive recessions – hence the term stagflation. Importantly, asset prices also usually fall in recessions.
A bear market is typically defined as a peak-to-trough decline of 20% in broad equity prices, but this too is a somewhat unhelpful definition since a 19.5% fall is not less painful than a 20.5% decline. Moreover, a quick decline followed by a rapid bounce back leaves little long-term damage to portfolios. Despite last week’s rally, the US S&P 500 and the MSCI All Country World Index were 17% down from their respective peaks.
A more useful definition of a bear market would also apply the three Ps.
Investors should be concerned about a deep decline over most sectors that takes months, if not years, to recover from. This can cause real damage to long-term wealth depending on when it takes place in an investor’s lifetime.
A bear market early in your career is not a bad thing. Indeed, if you keep saving and aren’t scared off by the experience, you get to buy cheap equities and hold them for decades.
However, a bear market late in life can cause serious damage, especially if you are required to sell shares at big discounts to draw retirement income. Therefore, it’s important to have other assets in your portfolio to cushion against in such a scenario.
Equity market volatility is common, and corrections happen often. However, major bear markets in global equities happen less frequently and have historically coincided with recessions in the US. The US is still the biggest economy on earth, but its financial markets are even more important. The adage “if the US sneezes the rest of the world catches a cold” is still very much true.
Recessions and bear markets coincide because company profits tend to fall when the economy contracts and investors price this in. There are also several feedback loops between financial markets and the real economy. For instance, banks become more risk averse and not only pull in loans to companies and households, but also pull back on margin loans to traders who then must sell. People lose their jobs and have to live on savings, and this involves selling some of their equity holdings.
As equity values fall, people see their accumulated wealth decline and they might feel less inclined to spend. Less spending by one person means less income for another.
It seems particularly strange to be talking about a recession in the US when its economy has been booming. Its biggest problem has been a shortage of workers, not a shortage of jobs. There are a record two vacancies for every unemployed person.
Job openings and unemployed persons
Source: Refinitiv Datastream
In one sense, we are always a day closer to the next recession since the economy moves in cycles. In the US, recessions occurred on average every five or so years before the 1980s but less frequently thereafter. This became known as the Great Moderation, with economic growth, inflation and interest rate cycles becoming more subdued. But there were still recessions in 1990, 2001, 2007-09 (The Great Recession) and of course the brief lockdown-induced recession of 2020.
Echoing Tolstoy’s comment about unhappy families, each recession is unhappy in its own way. But there are similarities in the underlying causes of each recession, with the exception perhaps of the 2020 Covid slump. There is normally a policy tightening in response to a build-up of some big imbalance such as too much debt or too much inflation. Sometimes, as in 1980 and 1982, the recession was arguably deliberately caused by the Federal Reserve to kill inflation. Other times the recessions are accidentally caused by over-tightening, a policy mistake in other words. Spikes in the oil price also often precede recessions (notably in 1973, 1979, 1990 and 2008).
On the one paw
So what is the likelihood of a recession in the US?
Economists are often teased for saying “on the one hand and on the other hand…”. But this is one of those cases where there are conflicting pieces of evidence.
Arguing against a recession, consumers have lots of excess savings. By some estimates, total savings levels jumped during the pandemic to more than $2 trillion over and above what US households would normally have. This provides a substantial buffer should things go wrong, though of course not all households have such savings. Aggregates and averages can hide a lot. Household debt has not increased much in the past decade. Consumers are currently spending a near-historic low share of income on interest payments. Jobs are plentiful and unemployment is low, but then it is always low before a recession starts. Business debt is also not a problem, and companies have already committed to substantial capex spending in the year ahead.
Higher mortgage rates should slow the red-hot housing market – indeed it must, since housing is the key channel through which the Fed can influence the economy – but this is unlikely to cause a recession as in 2008. There has been no equivalent increase in dodgy borrowing as there was in the run-up to the 2008 subprime crisis.
But on the other hand, there are two big forces that can tip the economy into recession: inflation and interest rates.
Real incomes have fallen sharply as inflation has increased at the individual level. Total income growth still exceeds inflation since job growth is so strong. But should job growth slow and inflation remain sticky, total household income growth will fall in real terms. Since 70% of US GDP is consumer spending, this is likely to be recessionary.
As for interest rates, the Fed will keep hiking until there is “clear and convincing evidence” (in the words of Jerome Powell) that inflation is on the way down. Once inflation is entrenched, a recession might be needed to bring it down. In other words, by hiking interest rates, a central bank hopes to lower consumer demand by increasing interest burden.
So far, despite the fanfare, the Federal Reserve has only increased its policy rate to 1%. However, effective interest rates have already increased substantially. Bond yields have moved up sharply in anticipation of the Fed. Most borrowers, whether corporates or households, pay a spread on top of these base yields. These spreads have also increased, a double dose of tightening. On top of that, the dollar has also strengthened. Overall financial conditions have therefore tightened notably even if the Fed has only hiked twice.
US interest rates %
Source: Refinitiv Datastream
It would be ironic if the Fed causes a recession given how hard it tried to steer the US economy through the pandemic, but circumstances have changed dramatically. Inflation at 6.3% according to its preferred measure (4.9% excluding food and energy) is simply too high. Getting it down is a priority, even if it results in a recession.
How far it must go down is debatable. The Fed has a 2% inflation target, but arguably it can take its foot off the brakes if 3% inflation was in sight and the economy showed signs of weakness. But if the inflation outlook is 4% or above, it is likely to keep up the pressure even if the economy slides and recession risk rises. Therefore, how inflation evolves remains key.
Balancing the for and against arguments, it still seems as if a recession can be avoided in the next year, but the risks have increased and unless we get some good news on the inflation front soon, it will continue increasing.
US equity prices in 2022
Source: Refinitiv Datastream
The next question is what is priced in already?
Equities have clearly sold off sharply so far this year. However, much of this reflects the impact of higher interest rates pulling down price: earnings multiples. Notably, the more expensive and interest-rate sensitive growth stocks have fallen much more than cheaper value shares. Indeed, growth shares meet the standard definition of a bear market, while value shares have barely budged.
Overall earnings expectations remain relatively robust, though these have been revised down modestly. A substantial economic slowdown or recession will pull these expectations way down. More volatility ahead is a distinct possibility.
The bond market seems to be becoming more sensitive to an economic slowdown. While long yields have shot up this year, they’ve pulled back a bit in the past two weeks. Shorter-dated yields will continue marching higher in lockstep with the Fed’s plans. When they move above long bond yields, this is known as a yield curve inversion, and this has been a useful recession predictor in the past. An inversion reflects expectations that short-term rates will rise and tip the economy over the edge, before eventually falling.
Can you bear it?
Clearly there is still considerable uncertainty over the outlook for the US and global economies. By extension, the same applies to equities and other financial markets. However, markets are already pricing in a lot of bad news and sentiment is already quite bearish.
Bear markets can be damaging to your wealth, but the impact depends greatly on your response.
Selling after the market has fallen means locking in losses and denying your portfolio the ability to rebound. When the markets rebound comes, it has historically been extremely rapid. Importantly, the turning point for markets usually occurs well before the economy turns. In fact, things will still look quite gloomy on the ground, but markets look ahead.
The recovery from the 2020 crash illustrates this: the market turned extremely quickly even though the virus still raged and economies were still locked down. But investors realised that the worst-case scenarios would come to pass and collectively decided that too much bad news was priced in.
For this reason, it is important to retain an equity exposure appropriate to your long-term investment horizon and financial goals.
If this all sounds too gloomy, remember too that bear markets can provide once in a generation buying opportunities that enhance long-term wealth. Somewhat counterintuitively, there is usually an inverse relationship between past and future returns. That is because the valuation of any investment – whether it is cheap or expensive relative to the cash flows it can be expected to produce – is a major determinant of the return it will deliver.
The more the market falls, dragging down past returns, the cheaper it becomes, lifting prospective returns.
Hopefully this makes unpleasant market volatility a bit more bearable.
Izak Odendaal is investment strategist at Old Mutual Wealth