#106 – What are the consequences for investors with a recession?

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#106 – What are the consequences for investors with a recession?

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Recession – In this article you’ll find:

  • What investors can expect with a recession?
  • When can we see trend change in the stock market?
  • Why is not easy for the FED to get back the inflation to 2%?
  • When a new bull market arrive?

Here you can find other articles:

  1. The Deeper The Recession, The Deeper The Earnings Decline Will Be. Even in China?
  2. 2023? Implications For Profits And Equity Markets
  3. How Will Be The Future’s Hotels?

ENJOY THE ARTICLE

Introduction

After so many years of tech dominance, UBS Asset Management ask if investors will finally find an appreciation for other types of equities?

Will equities have to look a little like bonds to be attractive? Could dividend yields be back?

Time will tell, but what is certain is that these types of rotations in the equity markets can create wonderful alpha opportunities, particularly where the institutional mix of shareholders is low

The arrival of a recession would have consequences for investors. U.S. recessions have typically been associated with global equity bear markets.

So RBC wealth management team believe any equity market rally over the next few weeks or months will, at some point, give way to another period of falling share prices reflecting declining expectations for earnings and the eroding confidence in the future that typically comes with a period of economic retrenchment.

Yet investors should keep in mind that the stock market has always turned higher well before the recession ends, usually three to five months before.

Moreover, recessions typically are short-lived and already successful companies should have the ability to adapt to new circumstances.

Looking at the chart above, the 13 U.S. recessions since 1945 are barely visible on the nominal GDP line, while operating earnings per share always have ultimately recovered.

The Fed vs. the US labor market

Recession

To best understand US economic dynamics, it is necessary to break down the US labor market into lower and higher income cohorts.

This is happening in large part because higher income workers still have a lot of excess savings, which they are ready and more than willing to spend in the service sector.

While high earners have a lower marginal propensity to consume (that is, they spend a smaller percentage of their income compared to lower earners), they also account for the lion’s share of total consumption.

Corporate earnings

    Recession

Several leading indicators, including short-term interest rates being higher than long-term rates, point to a recession.

Moreover, interest rates are now prohibitively high while banks are increasingly reluctant to lend.

RBC wealth management expect rates will rise somewhat further in the first half of 2023 before falling in the second.

Is recession a real possibility?

While a recession is a very real possibility, investors may be surprised by the resilience of the global economy – even with such a sharp tightening in financial conditions.

The labor market will certainly cool, but healthy household balance sheets should continue to support spending in the services sector.

 When can we see a new bull market

Recession

Bull markets are typically born when investors ignore good news, but the fear of missing out (FOMO) seems alive and well.

This suggests there is more pain to go before markets are really investible again. It feels like more stuff needs to break.

Warren Buffett colorfully mused that it is only as the tide goes out that you find out who has been swimming naked.

Today’s tide is the rapid rise in interest rates to combat inflation.

What next for central bank policy?

Central banks in many areas, including the US, Eurozone and the UK, are likely to face a very stark choice as 2023 progresses.

Either keeping to a path of deflation (effectively tipping their economies into recession to help tackle inflation), or accept devaluation (effectively accepting inflation running at higher levels than they target, for longer).

But as recession looms, that may become a tough line to stick to.

Central Bank policy rates vs forecast peak

Recession

Cyclical factors will probably help stem the tide of inflation in coming months, but structural factors will also play a part and these could turn out to be much more sticky.

Central bank policy making has always been subject to change over time.

Policymaking was forward-looking, preemptive and generally model-based.

U.S. reserve balances are dwindling

Recession

As the Federal Reserve continues its balance sheet reduction program, excess reserve balances within the U.S. banking system are dwindling.

While the central bank’s aggressive rate hiking cycle has captured the majority of headlines, it is the movement in excess reserves within the U.S. banking system that appears to have impacted the direction of markets thus far this cycle.

 After ballooning in 2020 and 2021, excess bank reserves peaked at $4.3 trillion back in early December 2021 and have fallen steadily throughout this year, to $3.2 trillion today.

When we plot these excess reserve numbers against the S&P 500, on a one-week lag, we can see that correlation between the two is very strong – nearly 0.86 since the beginning of April 2020.

Given the strong correlation, and the fact that the Fed’s balance sheet projections indicate the reduction program should continue for the foreseeable future.

RBC wealth management believe this relationship is worth keeping an eye on over the next several months and quarters, as it could represent a headwind for the equity market.

Join the conversation with your own take on these topics in the comments below.

About the Author

Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics.

In doing so he shares with you the most interesting charts and comments.

Disclosure

This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. 

It has been prepared for informational purposes only. 

Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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