By: Nexa Financial Group
It has arguably been the most anticipated and predicted economic recession in U.S. history. It has many of the classic trappings leading up to the event including aggressively tightening central bank, inverted yield curve, contracting manufacturing activity, declining leading economic index, and tightening bank lending standards just to name a few. The only twist is that the actual recession that everyone including my dog has been bracing for remains elusive to date. So, what should investors expect from financial markets once (if?) this recession finally comes to pass?
Medicine taken. A bear market in stocks typically accompanies an economic recession. Why? Because a slowdown in economic activity usually leads to a slowing if not outright decline in revenue and earnings growth. And since earnings and related cash flows help form the basis of how we value stocks (the “E” in the P/E ratio), a decline in earnings in an environment where economic times are tough results in investors being less willing to pay in price for stocks (the “P” in the P/E ratio). Hence the accompanying stock bear market, which some define as a peak-to-trough decline in the S&P 500 of more than -20%.
Does this mean that we should anticipate stocks falling by -20% or more in the months ahead once (if?) the recession finally arrives? Not necessarily for the following reasons.
Bear already unleashed? It is first important to note that economic recessions and stock bear markets typically do not happen simultaneously. While it is not unprecedented for stocks to fall into a bear market either at the same time or after the start of a recession, typically stocks will descend into bear territory in advance of an economic slowdown. This is because investors are forward looking, meaning that they are not buying stocks necessarily for what is taking place today but in anticipation of what they expect will be taking place in the future.
In this context, it is important to consider where we have already been over the last 18 months. The U.S. stock market peaked in January 2022 and subsequently declined by more than -32% on an inflation adjusted basis from peak-to-trough through October 2022. Such a decline is consistent with the bear markets we have seen associated with economic recessions over the past century.
Put simply, we may have already experienced the adjustment in stock prices and passed through the bear market associated with any pending recession ahead. The fact that the S&P 500 has rallied more than +20% since last October and recently broke decisively above its ultra long-term 400-day moving average are constructive signs in this regard.
Mild recession already endured? Another point worth considering is that the economic recession may have already unofficially happened, but it may have been so mild that we simply just missed it. Consider that the bear market in stocks began at the very beginning of the first quarter of 2022. Reflecting on the economic data, it is worth pointing out that we had two consecutive quarters of negative GDP growth at the same time in 2022 Q1 and 2022 Q2. Now, I recognize that several qualifying factors suggest that these negative GDP readings should be taken with a block of salt and help explain why an actual recession was not declared at the time. Nonetheless, it still fits the simple textbook definition of an economic recession – two consecutive quarters of negative GDP growth. Even if we dismiss the phantom recession notion, it’s not like economic growth was booming in 2022 H1 given the scorching case of inflation and the Russian invasion of Ukraine weighing heavily at the time.
Still looming threat. So, we’re already coming out a bear market, and it’s even possible that we’ve already had the economic recession to go along with it but blinked and missed it. Regardless, it still does not take away from the fact that the threat of an economic recession still lingers ahead. After all, several of the forward-looking economic data are still signaling such an outcome. Maybe it will end up being a repeat of the recessions in 1980 and again in 1982. Only time will tell, but what should investors reasonably brace for if a recession ahead finally comes to pass?
First, if we operate under the assumption that the stock market is a forward-looking indicator, today’s market is not acting like one that is on the brink of descending into a bear market. To the contrary, we are seeing several tailwinds gathering behind stocks. This includes the technical breakout above the 400-day moving average cited above and still steadily falling inflation. It also includes corporate earnings that have started to grow again – after three consecutive quarters of negative quarterly growth on a year-over-year basis, GAAP earnings just rose by more than +5% in Q1 versus the year ago period and are set to rise by as much as +10% in Q2. Still declining inflation is also giving a healthy boost to corporate profit margins, which is also a plus.
Also, selected market signals are also supporting a more constructive outlook not only for stocks but also the broader economy. While employment is understandably regarded as a lagging indicator, it still cannot be ignored that the labor market remains tight with little sign of stress outside of the “quiet quitters” fading into the history books. Perhaps more importantly, high yield spreads, or the additional yield premium over comparably dated U.S. Treasuries paid to investors for taking on the risk of owning lower quality bonds, including the CCC and lower rated space in particular have for months been narrowing, not widening like they historically have done leading into recessions. This coupled with the fact that the price of Bitcoin, the quintessential speculators instrument today, is once back above $30,000 suggest that the markets remain more than sanguine about taking on potentially uncompensated risk.
Bottom line. These are just a few readings that support the notion that barring a renewed rise in inflation (really bad, cannot be ruled out) or the outbreak of a full-blown banking crisis (bad, but potentially less likely than the inflation outbreak), if we do see the onset of an economic recession in the months ahead, it is likely to be relatively mild versus past recessions. Moreover, given the fact that we are still making our way back from a -30% real decline in stocks over the past 18 months, the associated impact on stocks is also likely to be muted.
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Disclosure: Investment advice offered through Great Valley Advisor Group (GVA), a Registered Investment Advisor. I am solely an investment advisor representative of Great Valley Advisor Group, and not affiliated with LPL Financial. Any opinions or views expressed by me are not those of LPL Financial. This is not intended to be used as tax or legal advice. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Please consult a tax or legal professional for specific information and advice.