Despite many of us feeling as though we are in recession¹ — high inflation, rising interest rates and stock market declines certainly haven’t helped to support optimism — there continues to be considerable debate about whether a full-blown recession is imminent. There is, however, widespread agreement that we have entered a period of economic slowdown. This is largely due to the actions taken by the central banks in aggressively raising interest rates to manage inflation.
How Do Rising Rates Affect Economies and the Markets?
Today, demand has exceeded supply for many goods and services, which has led to inflation — the increase in prices over time. This all stems from actions taken during the pandemic, including the economic shutdowns, which created supply chain problems, as well as unprecedented stimulus. Raising interest rates encourages saving and discourages borrowing by making it more expensive, which in turn helps to reduce spending and demand. While decreased demand can ease inflation, it also slows the economy, which can impact the profitability of businesses and lead to unemployment. Rising rates also increase the cost for companies to borrow money, along with the cost of holding debt. Sometimes companies pass these costs along to consumers. However, if they cannot, it may impact earnings. Valuations may also go down because the future value of cashflows is lower when a higher discount rate is used. For fixed income markets, there is an inverse relationship between interest rates and bond prices: as interest rates rise, bond prices generally fall. This is why both stock and bond markets have struggled in 2022 as the central banks have raised rates.
Is a “Soft Landing” Possible?
Renowned economist John Kenneth Galbraith once said, “The only function of economic forecasting is to make astrology look respectable.” Although said somewhat in jest, the point is to suggest that nobody knows with certainty how the economy will react in the near term. Economic slowdowns will occur from time to time; after all, economies, like the financial markets, are cyclical. However, recessions can be quite different in their length and intensity. Consider also that this current economic period is not typical. We have never lived through a period in which economies were shut down and then supported by mass amounts of stimulus, leading to high inflation and prompting aggressive rate hikes. At the time of writing, labour markets and productivity continue to be stable, so some believe that we may avoid a full-blown recession and achieve a soft landing.
How Do Markets Perform During a Recession?
While there is a continuing narrative in the media that suggests gloom for equity markets during recessionary times, a variety of studies indicate otherwise. A recent article published on Forbes online suggests that the S&P 500 rose an average of one percent across all recessionary periods since 1945. “This is because markets usually top out before the start of recessions and bottom out before their conclusion.”²
Indeed, the markets can often begin their climb when economic conditions are at their worst. Looking back at the last seven U.S. recessions reminds us that the S&P 500 Index has, just as often as not, started its climb during the depths of a recession (see chart). After all, equity markets are often forward-looking in nature.
S&P 500 Index Returns During Recession and One & Three Years After Its End
Sources: NBER, Returns 2.0 ; https://awealthofcommonsense.com/2022/06/timing-a-recession-vs-timing-the-stock-market/
As such, the potential for economies to enter into recession should never be a reason to consider curtailing investment programs. The stock market and the economy don’t always move the same way at the same time, and predicting how and when stock markets react to recessions is difficult, if not impossible…perhaps good food for thought for when a recession eventually does take place.
