Thursday, April 13, 2023
Yesterday, the Federal Reserve (Fed) released the minutes from its March 21-22 Federal Open Market Committee (FOMC) meeting. In the section summarizing staff projections, to the surprise of some, the staff explicitly forecasted a recession:
“Given their assessment of the potential economic effects of the recent banking-sector developments, the staff’s projection at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.”
Three important things to keep in mind with this:
- A projection is only a base case scenario. The consensus base case for Bloomberg-surveyed economists has also been that a recession is more likely than not in the next year for some time, so the call by the Fed’s staff should be no surprise.
- Having a recession as a base case is by no means saying it is a “lock.”
- The staff play an important role in supporting policymakers, but they are not the policymakers themselves.
As for Fed policymakers, they have been more careful about how they talk about the likelihood of a recession. But without saying it directly, even their projections imply a recession may be more likely than not over the rest of the year. FOMC participants’ median forecasts for 2023 economic growth and changes in the unemployment rate, last updated in March, both remain consistent with a recession in the second half of the year (although the dot plot is not).
With recession risks getting more attention in the wake of the FOMC minutes’ release, today we highlight some important characteristics of market behavior around recessions and some unusual features of the current market if a recession were to be on the horizon. Most of these points can be seen in the table below, which summarizes some key historical S&P 500 behavior around recessions.
- As has been widely reported, S&P 500 lows have always occurred after the start of a recession, going back to 1937. This has led to rising concerns that the increased likelihood of a recession is also increasing the risk of a new bear market low.
- But it’s important to keep in mind that recession declines are not always all that steep. We have seen a bias toward reporting only the size of recession declines during bear markets, but this is deceptive, even if we’re already in a bear market. Typical market behavior during recessions needs to include ALL recessions. The median decline in the price index of the S&P 500 during recessions has been 23.9%.
- The current 25.4% maximum decline of the bear market to date from the January 3, 2022 all-time high is already greater than the median decline for all recessions in our study.
- If we get a recession in the second half of the year, the S&P 500 would have peaked earlier compared to the start of the recession than for any recession in the lookback period. It has been 465 days since the last S&P 500 Index all-time price high on January 3, 2022. By the start of the second half of the year, it will have been 544 days. No other recession has seen the index peak more than 400 days before the recession began.
- Combining the two points above, if we have a recession at this point it would have been the most anticipated recession going back to 1937, by a solid margin, primarily from the perspective of the time since the last peak but reasonably also based on the price decline. That’s not surprising given the primary cause of this recession, were it to occur, would likely be the Fed’s well telegraphed efforts to control inflation. From that perspective, getting a new S&P 500 low, even if we were to have a recession, would be more surprising than expected.
- If we used the rough (but inaccurate) definition of a recession as two consecutive quarters of economic contraction and stipulate, for argument’s sake, that we had a recession in the first half of 2022, the bear market would have looked entirely consistent with history. February 2022 would probably have been called the peak of the expansion, putting the start of the first full recessionary month at March 1, 2022. The market low on October 12, 2022 would have taken place 225 days after the start of the recession, which would already be a little longer than average, but entirely within the realm of normal. And the S&P 500 decline would be almost exactly the same as the median for a recession. In other words, you could view last year’s declines as a typical recessionary bear market.
We are wisely often warned that the most dangerous words in the industry are “this time it’s different.” In the current context, that phrase has often been used to caution a recession would likely come with a new market low. The problem with this argument is that this time has already been different. Saying we may not hit a new bear market low, even if we get a (mild) recession, is simply paying attention to those differences.
The risk of a new bear market low certainly increases if we get a recession and economic uncertainty remains elevated. But for now, our Asset Allocation Committee’s base case is that well telegraphed recession risk has already been meaningfully priced into markets and market participants may look past a mild recession as inflation continues to fall. We have recently reduced our recommended equity overweight on the combination of market gains and increasing risk, but still remain overweight overall.
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