Is a recession still on the cards?

Amidst the surprisingly strong market performance, investors are questioning the possibility of a recession in the US, but history suggests caution is still warranted

Given how well risk assets have done in the first half of 2023 globally and the continued strength in the US economy and job market, many investors are questioning the idea that we will see a recession in the US towards the end of 2023, or the beginning of 2024. The common refrain is that price action and market behaviour do not seem to show any signs of trouble ahead. Most of the Wall Street banks have also now revised down their probability of a recession, and the idea of a soft landing seems to be the new accepted wisdom among many. Given this backdrop, Deutsche Bank came out with an interesting analysis, tracking how markets historically have behaved in the run-up to a recession in the US.

Their analysis was based on the premise that if you were six months from the start of a recession (assuming a recession were to begin at the end of 2023/beginning of 2024) how would you have expected the markets to behave, based on history, and are we following this playbook in the current cycle? Or are the markets in their behaviour implying that there is no recession threat?

First of all, it is true that risk assets have done surprisingly well in 2023 so far. The Nasdaq is up over 30 per cent, its best start to a year since 1983, coming off its worst start to a year ever in 2022. The S&P 500 is also up over 16 per cent for the year. All the major equity markets, be it the DAX, Nikkei or MSCI EM, are up 12-15 per cent for the year, as well as all the fixed-income markets. The only asset class in the red in 2023 is commodities and oil.

The breadth of positive returns this year is in stark contrast to 2022, when, absent commodities, all financial assets, bonds and equities were down more than 20 per cent.

The question investors need to ask is whether this is a new phase in the markets, a new bull run, and whether the declines of 2022 were sufficient for markets to adjust to a new era of higher rates. Can the 15 years of zero rates and surging liquidity be adjusted in one year?

Alternatively, when one looks at asset return from the beginning of 2022 (when rates began to move up), the picture is different — most financial assets are still in negative territory. The S&P 500 is still down 6-7 per cent, Nasdaq over 10 per cent, and the MSCI EM index by 15 per cent. All developed world fixed-income assets are down, with the worst performer being gilts, which have declined by almost 30 per cent since the beginning of 2022.

So, is this a bear market rally within the construct of markets having to adjust to structurally higher rates, or the beginning of a bull phase? Not at all clear. One cannot just look at the strong returns this year, these assets are still down from when the markets realised that the days of low rates are over.

On the question of how markets are behaving this year, compared to historical data in the run-up to a recession (assuming we were to get a recession by end 2023), the picture is mixed.

For equities, markets on average have historically been flat in the 12 months leading up to a recession, only starting to decline 2-3 months before the recession hits and 2-3 months into the recession. If we were to get a US recession hitting by the end 2023, markets have actually been much stronger than the norm this year. Instead of flat (historical pattern), they are up by double-digits. This could be due to the large declines in equities in 2022, thus they are flat on a 24 months basis. An alternative explanation is that looking at an equal-weighted S&P, markets are actually flattish this year. The equal-weighted S&P 500 is behaving much in line with the historical pattern of how equities trade before a recession. Thus the trading pattern of US equities this year does not by any means contradict the possibility of a recession by the end of the year.

When we look at bonds, the pattern is similar. Ten-year yields tend to rise going into a recession and we are seeing a similar move today. There is nothing in the price action of bonds that would contradict the possibility of a recession by the end of 2023.

Credit spreads have hardly widened this year, again consistent with past history. Spreads start widening only just before the recession hits and continue widening into the recession. The behaviour of the yield curve is also consistent with historical patterns, with a clear inversion signalling a high probability of a recession.

The bulls always point to the tight labour markets as the reason we cannot have a recession. While it is true that unemployment in the US is at ultra-low levels of 3.5 per cent, the fact is that even in past cycles, unemployment only starts rising once we are in the recession.

The real economy indicators, be it the Conference Board leading Index or the ISM Manufacturing Index, are already in recessionary territory, having dropped into contractionary readings much before the historical norm. The survey data on bank lending officers and their tightening of credit standards in the US also supports a significant weakening of the economy in the coming months.

The only data point that is counter to all the above is housing starts. Normally at this point in the cycle, if we are about six months away from a recession beginning, housing starts should be falling. They are, in fact, strengthening. The basic point in giving all this data is to point out that despite commentary to the contrary, the current strength in markets by no means precludes a recession beginning in the US within the coming six months. It is way too soon to sound the all clear on the recession front. If we do get the economic contraction eventually, markets and earnings will both decline. Earnings estimates in the US do not build in any contraction, while a typical recession sees a 20 per cent earnings downgrade. Given where valuations are today, they cannot sustain an earnings downgrade of any magnitude. We are also seeing real rates finally turning positive in the US only now, despite 500 basis points of tightening. As an example, the real Fed funds rate at 2 per cent today is at the highest it has been since the global financial crisis. It has just turned positive as inflation has cooled. The lagged impact of these rates going positive is still to be felt.

Whether the US finally goes into a recession is still unclear, but the impact of a recession on financial markets, even a mild one, were it to transpire, will be unambiguously negative. Just because equity markets in the US are up so much, it is by no means certain that we have avoided the recession and its negative consequences.

The writer is with Amansa Capital