A recession in the US will crash stock markets! What to do before that happens

stock market recession

We are all aware that central banks around the world have been hiking interest rates to reduce inflation back to normal levels. The US economy, and particularly the labour market, have been more resilient than most expected. This means the US central bank might have to hike interest rates higher than in other jurisdictions to tame inflation. A consequence of this is that it will probably send the US economy into recession. And if history repeats itself, stock markets will fall.

If this scenario plays out, what actions should you take now?  

There are three economic scenarios

Share markets have been wrestling with three possible economic scenarios as follows:

  • Hard landing: this means that the Federal Reserve’s interest rate hikes achieve their aim of curtailing inflation but at the cost of sending the US economy into recession.    
  • Soft landing: this is a Goldilocks scenario where the Federal Reserve hikes rates just enough to cool inflation, but not too high that it causes a recession (or it is able to cut rates in time to avoid a recession).
  • No landing: it is possible that the US economy continues to be resilient, and inflation remains stubbornly high which means the Federal Reserve must hike rates higher for longer.

US labour market is stubbornly robust

The problem that the US central bank has (that the RBA doesn’t) is wage inflation is high at 4.6% over the year ended 28 February 2023. If it cannot cool the labour market and stop incomes rising, it probably won’t be able to return inflation to normal levels. The US labour market is proving to be very robust and although there are some signs that it is starting to slow, data is somewhat mixed.

As reported late last week, the US unemployment rate did rise in February from 3.4% to 3.6% p.a., not because there were fewer jobs but because the participation rate increased (i.e., more people are attracted to return to the labour market and look for jobs). This helped the three-month annualised wage inflation rate slow to 3.6% (compared to the 12-month reading at 4.6%), so there are signs that wage growth is slowing.

This is the most important issue that markets are watching. If we see more data that confirms wage inflation is slowing, a soft-landing scenario might be considered more likely.

The other noteworthy difference in the US (compared to Australia) is that most mortgages (home loans) are fixed for 30 years, so it takes longer for higher (variable) interest rates to cool consumer demand. 

What happens to equity markets in a recession?

Most analysts would agree that the US stock market has not priced in a recession. Equity valuations are still relatively high by historical standards with the S&P 500 price-earnings ratio trading at circa 20 times compared to the long-term average of 16.

Share market valuations have not yet adjusted to reflect higher interest rates. Given you can earn more than 6% p.a. on very safe assets such as investment-grade bonds issued by the big 4 banks, riskier asset classes (like shares) must provide much higher returns to compensate you for the higher risk you take. This is called the Equity Risk Premium. Most investors would expect to earn 5% to 5.5% over the risk-free rate (usually the 10-year government bond rate is used as a proxy for the risk-free rate). Given the Australian government bond rate is circa 3.5% p.a., investors need to earn 9.5%-10.0% p.a. for shares to be attractive investments. Based on Research Affiliates model, 10-year future US equity returns are likely to range between 3.1% and 7.9% p.a. That is not enough to compensate you for the risk. So, prices must fall to make shares more attractive, or so the theory goes.

My point is that if the US economy does go into a recession, it is doing so with relatively elevated share market valuations, which increases the likelihood that the share market will fall in value.

The chart below highlights all the past US recessions as determined by the NBER in grey bars and the S&P 500. The point to note is that the stock market has always fallen in value after each recession began and bottomed out (red cross) before the recession has ended. Therefore, if the US is heading into a recession and history repeats itself, the US market is likely fall in the near term.

The Australian economy is in very good shape and the RBA hinted last week that it will soon pause hiking rates. As such, most commentators predict that Australia will avoid a recession (again). However, the US is the largest developed economy in the world (15 times larger than Australia), so if it slows, it will affect the rest of the world and our stock market is likely to suffer too.   

This time could be different

Of course, a soft-landing scenario is entirely possible too. It is true that this time is different. Higher inflation has been artificially caused by the pandemic. For example, initially, when people were first locked up, they received government support (pandemic payments), enjoyed very low interest rates, and over-spent on buying goods. Since reopening, everyone has been over spending on services (leisure and travel) due to the pent-up demand resulting from being locked up for 2 years. It is possible all this will rewind soon (like goods demand has), and inflation will normalise.

Obviously, the market thinks this is the most likely scenario. But the market is not always right.

What to do?

If you believe that we are heading for a hard landing, what should you do?

Of course, you could reduce the amount that you have invested in shares and reinvest these monies in defensive (safer) assets such as bonds or even cash. But there’s an overwhelming amount of evidence that confirms that would be a big mistake for two reasons.

Firstly, the US might avoid a recession and the share market might not fall. The truth is no one knows. No one has developed a reliable method for predicting what markets will do in the short term.

Secondly, underinvesting is dangerous, because you will almost certainly miss the recovery (days with the highest return) and your long-term returns will suffer tremendously, as illustrated by the chart below. Missing the best 30 days in the market between 2003 and 2022 results in a return of only 0.8% p.a., whereas you would have generated a return of 9.8% p.a. if you had have stayed fully invested. The best and worst days tend to occur within the same two-week period.

I came across this article from 1995. It calculates that an investor that invests $10k per year on the most expensive day of the year (i.e., terrible timing because stocks weren’t cheap) still accumulated a return of 7.9% p.a. over a 16-year period. Investing on a more regular basis (e.g., monthly) spreads your timing risk. But this analysis proves that in the long run, timing will have little impact on returns.

A client recently brought this article to my attention – the theme is that you are better off investing all your money into the market in one lump sum rather than investing it progressively over time. By the way, regarding lump sum investing, I prefer the middle ground i.e., not investing it in one lump sum but investing it in tranches over many months (depending on amount and proportion of wealth already invested).

Here’s some Australian market data – the theme is the same i.e., stay invested.

Adjust investment methodology

Whilst you should stay invested, you might want to adjust the index methodologies you use. For example, here are some common themes incorporated in client investment portfolios.

Firstly, we have increased the allocation to value index methodologies. This means we have invested in indexes that exclude companies that appear to be overvalued. If we invest in businesses that are already relatively cheap, then arguably, they will fall by less than the broad market. I explained this last month here.

Secondly, we allocated a portion of client portfolios into quality factor investments because high quality companies tend to outperform in recessionary times.

Thirdly, because of these allocations, we have been underweight in traditional market cap indexing, as I think this index provides less protection from a potential recession.

I should make it clear that there are multiple reasons for these allocations – a potential hard landing scenario is only one.

Remain focused on medium to long term

Other than the steps above (which we have been implementing over the past couple of years – they are not recent changes), we are simply going to stay laser focused on the long term and not get distracted by any shorter-term volatility. Our goal is to maximise average returns over the next 5, 10 and 15+ years – not to worry about what returns might be over the next year or so.