Investor anxiety has shifted from inflation fears to recession worries. The level of bearishness from investors and analysts is the highest in recent memory, with a large majority thinking that we’re already in a global recession, or about to enter one.  Every recent discussion around the stock market has ended with the same proclamation: “I’ll wait for the next pullback before buying, the world is entering a recession, if not already in one.” To top it all off, the US just announced that 2Q GDP was negative, causing a ‘technical recession’ of two negative GDP quarters in a row.

When there’s weakness in markets and economies around the world, the key difference between a shallow bear market (average -20-25%, which we have already seen) vs. a deep bear market (more than -35% fall) is whether the US enters recession, given its position as the world’s largest economy and largest exporter of capital.  US recessions cause a shortage of dollars around the world, aggravating the economic contraction in emerging markets, causing deeper equity bear markets.

So, is the technical recession a sign that there’s more downside in equities? The correct definition of a recession is not two consecutive quarters of negative GDP; it is a more complicated, and more subjective, decision made by the National Bureau of Economic Research (NBER). The problem for investors is that NBER takes its time to announce the start and end of recessions as it assesses many variables.  This analysis gives a more accurate call on the US economy, where a recession is called when there’s a broad decline in economic activity, but is of little use to investors, as NBER recession proclamations are made long after the fact, making them useless as a timing tool.

Analysts who say the US economy is already in a recession should re-read the preceding paragraph. There has never been a recession when the job market is as strong as it is now. Broad declines in economic activity occur when consumers significantly reduce spending, and the primary cause for such an event is loss of employment. 

What about investor sentiment, which has been cited as a significant factor contributing to recessions? At the end of each year, BusinessWeek used to run a roundtable of Wall Street economists’ forecasts for the coming year. The practice was discontinued as the forecasts were consistently and widely off the mark, sometimes comically so. Chief economists of major banks did not want their wrong forecasts in black and white for all to see.

In 2007 (at market peak pre-Great Financial Crisis) and 2020 (pre-COVID) over 70% of economists and fund managers said that a recession was unlikely. After equity markets fell ~40% in both cases, close to 90% of respondents reversed their view and said recession was ‘likely or already here’, but by then markets were bottoming. If the BusinessWeek annual roundtable was still being held, at the end of last year economists would likely have been uniformly bullish, following 2021’s stellar year where every asset class gained in value.  

Instead what we got was the worst first half performance in bonds since 1865, and the second worst for a century (the worst was in the 1930s Great Depression).  The combination of weak equity and bond markets has resulted in the worst start for a traditional 60% equity / 40% bond portfolio in history.

And predictably, investor sentiment has taken a beating, with predictions of a global recession flooding investor inboxes. Europe is likely already in recession, caused by high energy prices and years of misguided ESG policies by politicians, but the chorus for recession has now extended to the US. 

The current downturn is very different from the ones experienced in the last two decades. The “Great Moderation”, where inflation was low, manufacturing was outsourced to developing economies, and services grew, resulted in economies that were less cyclical, with lower macro volatility.  This stability is over, and the resulting higher volatility in economic data will be a primary feature of the global economy for the next 10 years.

Investors who grapple with the question of whether the mid-June equity lows were the bottom in the current bear market need to make an accurate assessment on a US recession. Given the fact that equity bear markets have never ended before a recession began, if we are to see a recession like so many are predicting, we are left with three possibilities:

1. The recession has already begun and markets bottomed in June – extremely unlikely, the job market is so strong that there hasn’t been any significant slowdown in economic activity up to now
2. Recession hasn’t started, so we will see a new low in the future
3. There is no recession in the US (soft landing), and this is a non-recessionary bear with markets likely having bottomed in June

Investor surveys scoff at the soft landing outcome, pointing to the Fed’s abysmal track record in achieving this, where rate tightening cycles have usually continued till something breaks. There is no doubt that the global economy is slowing down. But a recession requires a significant weakening in the jobs market. 

Instead the US economy is still producing over 300,000 jobs a month. The broadest measure of unemployment, the U-6 labour utilisation, which includes the underemployed and discouraged job-seekers, is at an all-time low. US recessions have never started when the job market is this strong. 

In addition balance sheets for both consumers and businesses are healthy, the banking system is solid, and there are no clear bubbles with excessive leverage (many bubbles have already popped, such as NFTs, crypto, and the most speculative COVID-beneficiary tech stocks).

Amongst the recession calls have been many calls for a sharp drop in corporate earnings. And yet after Q2, corporate earnings have been resilient. In aggregate the total stock market’s earnings did not drop compared to last year. Despite this, global growth optimism has plunged to an all-time low, even worse than in 2008. The number of investors that expect profits to deteriorate is at an all-time high, worse than any previous recession.

This year’s first half equity performance has been the second-worst in the last century.  In the other four cases, the terrible starts to the first half have been followed by second half rebounds every time, with three out of those four cases being double digit returns, even though equities still ended the year negative. Out of the four cases two were in a US recession, and two were not.

The risk of a US recession in the future is still present as the economy slows; but the data as of now does not point to a recession. The biggest two risks to the bullish outlook is that something breaks: either the Fed follows in Volcker’s footsteps and over-tightens into a slower economy, or China breaks due to its continuing fallout from the implosion of its real estate sector.  

Remember the post-COVID recession where investors were confused about the ‘disconnect’ between the stock market’s gains and the weak economy from government lockdowns? Even after this year’s downturn equities are significantly higher than anytime around the initial COVID lockdowns. Investors who got out fearing the global pandemic missed out on the significant recovery, which is why average investors should stay invested rather than trying to time markets. 

If you insist on trying to time markets, remember that if there was no volatility and the fear it causes investors every time there’s a significant pullback in equities, everyone would be Warren Buffet rich. You get paid for taking risk and you get paid for other investors’ behavioural mistakes. Instead of being influenced by all the talk about recessions and further downside, keep a close watch for a deteriorating labour market and actual deteriorating corporate earnings, not just the forecasts of deterioration.  If these economic indicators do not worsen significantly to cause an outright recession, history points to the probabilities for the second half being more in the camp of the bulls.