Investing in the shadow of a recession

It's come to this: Even fairly bullish outlooks about the stock and bond markets are beginning to assume that there will be some kind of a recession.

The question is what kind - shallow or deep, a full-bore recession or a milder downturn. While steeply rising interest rates are making a slowdown in economic growth all but inevitable, there are many possible varieties of recession, and they suggest different market outcomes.

Deep recessions are horrible experiences for most people, including investors. If you are living off your holdings, with no margin for error, you need safe, fixed-income assets. But if you are lucky enough to have a long horizon, of a decade or more, the best approach may be to keep buying and holding stocks and bonds, even if conditions worsen.

Taking a recession into account

The quasi-official National Bureau of Economic Research defines a recession as "a significant decline in economic activity that is spread across the economy and that lasts more than a few months".

A classic, deep recession would throw millions of people out of work. But the US unemployment rate, at 3.5 per cent, is as low as it's been in 50 years. This doesn't look like a traditional recession, at least not so far.

Yet it's easy to see why a recession in the US has come to seem so likely that Bloomberg has put the odds of one occurring in the next year at 100 per cent. Inflation, and the efforts of the Federal Reserve and other central banks to combat it, are at the heart of the problem. Until inflation comes down, the Fed says it will keep raising rates. That will slow the economy.

So it is especially important to make sure you have put aside enough money to pay the bills. Once you are ready to invest, a wide range of academics recommend low-cost stocks and bonds in index funds that mirror the entire market.

Investing is forward-looking. There are a number of ways to interpret current trends that provide a fairly positive outlook for investing, depending on the type of slowdown that may be coming and on your horizon as an investor. None are certain, but these narratives are spreading in the markets and, if only for that reason, they are worth considering.

Rolling recessions

Spiking interest rates are beginning to hurt a vast array of consumers, businesses and financial assets. Add Russia's war in Ukraine, the lingering pandemic and heightened tensions between the US and China, and you have quite a bad picture.

As Liz Ann Sonders and Kevin Gordon, investment strategists at Charles Schwab, put it in a note to investors: "Several segments of the economy are experiencing their own recessions, including housing and segments of the goods side of the economy."

Edward Yardeni, an independent Wall Street economist, says that in addition to housing, the auto, semiconductor, personal computer and retail sectors have been going through what he calls "rolling recessions". Much of this is already abating, he says, adding that it's entirely possible that the slowdowns underway won't be deep enough or pervasive enough to become a classic recession.

In this essentially benign view, corporate earnings growth is almost certain to decline, stocks will remain volatile and inflation will remain well above 2 per cent. But the situation will improve fairly soon. There will still be rough moments in the markets in the months ahead, but the prospects for the next year or so would be quite positive.

Already in recession?

Compared with some alternatives, it might even be a good thing if we were already in a recession.

Here's the logic, from Ned Davis Research, an independent markets research firm, which accepts the consensus wisdom that a recession sometime within the next year is probable.

In an interview, Ed Clissold, the firm's chief US strategist, pointed out that the stock market typically rebounds after mid-term elections, but that a recession in 2023 would probably smother a post-election bounce.

Therefore, he said, the "most bullish scenario I've come up with, given these assumptions, would be that we are in a recession already, or will be very soon, and that it ends in early 2023."

That timing is theoretically possible, although Clissold isn't counting on it. The National Bureau of Economic Research doesn't declare a recession until long after the downturn has started, and often, not until it has ended. We could well be in one now.

If that were the case, as signs of damage to the economy become evident, the Fed will be expected to stop raising interest rates. That, in turn, could set off rallies in both stocks and bonds.

A classic recession

If we are already in a recession, however, it is a very mild one. And for it to end happily, this scenario assumes that inflation will soon drop sharply, enabling the Fed to cut interest rates instead of continuing to raise them.

The latest inflation readings haven't been cooperating. And a mild recession that fails to squelch high inflation would not be welcome in the bond market.

If a recession of some kind is going to take place, as seems likely, it won't help anyone if it's not severe enough to return the economy to low inflation, said Stephen M Kane, a top investment executive at TCW, an asset management company in Los Angeles.

"I'm afraid it's best to get the pain over and done with now, and get inflation under control quickly," he said. Sadly, he added, "People may have to be put out of work for that to happen."

Perversely, a severe downturn would be bullish for bonds, which have lost value this year as yields have risen. They would benefit from falling interest rates and a flight to safer assets.

In a major recession, companies would post losses and the stock market would suffer. But if the downturn were fairly brief, and an economic recovery came soon, stocks could rally even before bond yields started falling.

The long view

Eventually, in any of these narratives, inflation would recede and the Fed would start to lower rates.

We don't know which, if any, of these outcomes is most likely. And because no one has been able to reliably identify major shifts in economic cycles in real time, a bull market in stocks could begin at an unlikely moment. You don't want to miss out on rallies, and if you can't predict when one will occur, you may want to hold stock even when the market is falling.

The numbers are impressive. Since 1928, the first month of a bull market has, on average, produced a 15.2 per cent gain; for the first three months, the gain has been 31.6 per cent, Bespoke Investment Group said. Stock surges have often begun when the outlook was bleak.

Fundamentally, maintaining a bullish view assumes that history will be a useful guide, that the markets will recover and that their long-term trajectory will be upward. It assumes that pain now will lead to better prospects down the road.

There is no guarantee that this will happen, but I wouldn't bet against it. NYTIMES



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