At a meeting of the investment committee of a large UK endowment last week, I watched market presentations from several money managers, all of whom use well-established relationships between asset prices and macroeconomic indicators, among many other techniques.
I was struck by the fact that the majority of them made comments along the following lines. They regretted that there had been losses in their portfolios during October, which had been one of the most difficult calendar months in recent years. No surprises there.
They added that the October drawdowns in risk assets were probably a blip, rather than the start of an eviscerating bear market in equities and credit. The key reason for optimism was that there was no sign of a US recession on the horizon. The unspoken assumption was that, in the absence of a recession, a bear market was highly improbable.
Sometimes this argument is used in reverse. Many analysts assert (wrongly, in my opinion) that a recession is almost inevitable in 2020 because recessions “automatically” follow the inversion of the yield curve. They then conclude that a bear market will come along, like clockwork, a year or two ahead of the predicted economic downturn.
In fact, market projections that rely on any of these mechanistic connections between bear markets and recessions should be viewed with suspicion.
The above arguments only make sense if recessions can be forecast fairly accurately. But economists are very bad at predicting them more than a quarter or two in advance. Therefore, any market optimism to be gleaned from the argument that “there is no recession in the forecast” is on very thin ice.
Another problem is that even if we could forecast recessions, the link with equity bear markets is tenuous, particularly with regard to timing.
Everyone knows that equity prices, over the very long run — of several decades — tend to rise in line with dividends and therefore nominal gross domestic product. As a broad generalisation, these series are prone to share the same trend (that is, they are “co-integrated”). In fact, nominal GDP is said to be Warren Buffett’s favourite metric for valuing the US stock market.
However, there are very wide variations around these trends. Equities fluctuate over a decade or so much more than is justified by very long-run fundamentals. These medium-term swings seem to be triggered by extrapolation of more recent changes in GDP and also by large variations in risk premiums.
Some of the variations in risk premiums may well be due to shifts in perceived recession risks among investors. But it is a step too far to conclude that changes in real output growth (ie recessions), over shorter periods, will necessarily be related to changes in equity prices (ie bear markets).
Finally, any connection in timing that does appear in historic data (see box below) does not tell us very much about the direction of causation or the role of third factors:
This last possibility is probably what is happening at present. The gradual increase in interest rates by the US Federal Reserve has been enough to raise the value of the dollar, undermine confidence in emerging markets and tighten global monetary conditions. This has finally fed back into the US stock market, which had previously seemed immune from the proliferation of bad news from sources other than output growth in the American economy itself. This process may or may not end in recession, but it is certainly already causing “recovery fatigue” in most parts of the world economy.
In summary, it is quite clear that a period of global economic slowdown, accompanied by central bank tightening and overvalued markets, is under way. This may or may not be followed by a recession. On balance, I think it will not be, for what it is worth. But, recession or not, it could be more than enough to initiate a period of high volatility and low returns in equity markets, including possibly a bear market.
In the following graphs, bear markets are defined as 20 per cent declines over 12 months in equity prices. Recessions, as defined by Haver Analytics, are shaded in grey. Bear markets tend to start near the peak of 12-month growth rates in equity prices, and end near the low point for 12-month declines. However, the precise timing of bear markets and domestic recessions is obviously very debatable, so these graphs are only indicative.
In the US, most analysts agree that bear markets and domestic recessions have generally been fairly closely related, though the exact leads and lags between the two may differ considerably across cycles. Furthermore, there have been several bear markets, notably in 1987 and 1978, that have not been accompanied by recessions, and vice versa.
In other countries, the relationship does not look to be as close. For example, in Japan the data show only a limited connection, at least before 1990.The relationship has also been fairly loose in Germany. In fact, the timing of European bear markets tends to be affected by the behaviour of Wall Street, as much as by the onset of domestic eurozone recessions.
Finally, the UK stock market is highly exposed to global growth and commodity cycles, and to Wall Street, so the connection to domestic recessions is at best mixed.