On the way

By Jim Allworth

U.S. recessions have always been associated with equity bear markets – not just for U.S. markets but for Canadian and other developed economy stock markets as well. But it’s worth pointing out the U.S. is not yet in recession. The official arbiter, National Bureau of Economic Research (NBER), needs to see “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” While no such decline has appeared yet, several factors suggest it may arrive in 2023:

1. History says so. The most historically reliable leading recession indicator – the position of short-term interest rates compared with that of long-term rates, also known as the “shape of the yield curve” – signaled back in July that a U.S. recession was on the way when the one-year Treasury yield rose above the yield on the 10-year note. Whenever such an “inversion” has occurred in the past a recession has eventually followed, usually about a year later.

The Conference Board’s Leading Economic Index – also sporting a “perfect” track record – fell below where it had been a year ago back in September. A recession has always followed such a signal, on average some two to three quarters later.

Most of the other leading indicators of recession we follow are still in positive territory but are sliding toward giving a negative signal for the U.S. economy in the coming months.

2. “Tight money” has arrived. With just two exceptions (the post-WWII downturn and the two-month-long 2020 pandemic recession) U.S. recessions have always been preceded by the arrival of tight money – i.e., prohibitively high interest rates accompanied by a growing reluctance of banks to lend.

The inversion of the yield curve in July, noted above, indicated credit conditions were heading in that restrictive direction. Certainly, interest rates have become prohibitively high for many borrowers as a result of the accelerated pace of tightening by central banks including the U.S. Federal Reserve (Fed) and Bank of Canada.

And loans are becoming harder to get too. The last three Senior Loan Officer Opinion Surveys (published every three months by the Fed) have shown that more and more U.S. banks are becoming choosier about who they lend to.

3. Consumer spending is waning. At some 70% of GDP the direction of U.S. consumer spending is all important. While there are still excess savings and wages are rising, high inflation has pushed real incomes below where they were a year ago. Despite that, real personal spending has continued to climb, although it appears to have weakened somewhat through the important holiday season.

A lot of future demand for goods was pulled forward into 2020 and 2021 as many services were not available due to pandemic shutdowns while consumer incomes remained high, boosted by government support programs, which have now mostly ended. Meanwhile, much of the pent-up demand for services such as travel and dining out was fulfilled in 2022, with spending on such services likely ease in 2023.

What it means for investors

Interest rates: We expect 2023 will be a year of trend transition with rates rising somewhat further in the first half before falling in the second.

Over the past 70 years, the Fed has usually stopped raising interest rates and begun cutting even before the recession started. Given today’s inflation concerns, both the Fed and the Bank of Canada have made a point of emphasizing the dangers of cutting rates too soon. Rate cutting is unlikely to begin, in our view, until there is some marked worsening in the economic data, most likely around midyear.

Stock markets: U.S. recessions have typically been associated with global equity bear markets. Media commentary over the past nine months has assumed that a bear market has already begun. That may or may not be the case. However, wherever the stock market is headed over the next several quarters it’s unlikely to go there in a straight line, in our opinion.

Starting a couple of weeks before the U.S. midterm elections, most major equity markets began a rally that appeared to have better underpinnings than any prior countertrend upswing in 2022.

So far, this move has been almost universally labeled as no more than a “bear market rally.” It may prove to be just that. However, several factors suggest that this advance could have legs into 2023. These include moderating inflation data, which could raise the possibility of an end to Fed rate hikes, and the fact that the S&P 500 has almost always delivered strong, positive returns for months following the U.S. midterms.

Whether any unfolding equity rally is something more than simply an upside interlude in a longer-term downtrend remains to be seen.

That said, our most reliable leading indicators indicate a recession arriving around midyear. Every U.S. recession has been associated with an equity bear market (not just in the U.S. but in every major equity market). As a result, we expect that any rally in equity prices in the coming weeks will, at some point, give way to another period of challenging share price performance (reflecting declining expectations for earnings and eroding confidence in the future that typically comes with a recession).

Putting it into perspective

A longer-term view reveals that the economy and businesses are constantly adapting to changing conditions. Sometimes that adaptation is painful. But if recessions are the painful periods, then they are typically very short. Over the 77 years since the end of WWII, the economy was in recession for a total of 12 years or about 15% of the time.

Making big portfolio asset allocation decisions based on the premise that the economy and already successful businesses are going to lose their ability to adapt, or that the challenging periods are going to last much longer than they have in the past, seems out of proportion to the historical record, in our opinion.

On the other hand, leaning more heavily toward quality and sustainable dividends and away from specific individual company risks that may come home to roost in a recession looks to us like a good approach as we enter 2023.

For a more detailed discussion of our outlook for financial markets, ask for a copy of our current issue of Global Insight.