Stalled rally

Is more market pain in store ahead of a recession?

The S&P 500 Index has been in retreat after hitting a recent high at the end of July. But why? There are several reasons that U.S. stock indexes (and others globally) have fallen in August. For starters, many of them were on a tear heading into the month, and having already climbed almost 20% since the beginning of the year, they were susceptible to profit-taking by investors. Moreover, late summer is a notoriously slow time for markets, and once the most recent earnings season ended, there really wasn’t a catalyst to push stocks any higher.

Still, the bigger question for investors should be whether this current weakness is a temporary blip on the road to further gains or something that persists for longer. In our opinion, either outcome is a possibility, but it’s the risk of the latter that some investors may not be fully appreciating.

The debate about a hard or soft landing

This is especially true of the camp that wants to believe the U.S. Federal Reserve and other central banks can navigate a soft landing (or “no landing” as some people are calling it) and keep the economy afloat despite their ongoing campaign to quash inflation with higher interest rates. Remember, this isn’t what most investors thought when central banks embarked on their current tightening cycle 17 months ago. In fact, there’s rarely been an instance over the past 50 years when rate hikes didn’t cause a recession.

So, what’s changed? The resilience of the economy, mostly. If anything supports the soft-landing argument, it’s that unemployment has barely budged in the face of higher interest rates and remains near historical lows in countries like the United States and Canada. Yet, this may be dangerous thinking because it doesn’t fully consider the lag effect that tighter monetary policy has on economic activity. By some estimates, it can take 18 months or longer for interest rates to have an impact, and the variability of these lags can be significant, according to a recent paper by the U.S. Federal Reserve Bank of St. Louis that quotes Nobel Prize-winning economist Milton Friedman.

Based on that time frame, it’s no wonder the economy has held up even as interest rates climb and inflation falls. But it’s also not surprising that some of the more recent economic data have finally started to weaken. For instance, here in Canada, signs of a slowdown are clear in areas like housing and manufacturing, as well as consumer spending.

Granted, that doesn’t mean a recession is now assured, but it should give investors hoping for a soft landing some pause. After all, if the global economy weakens more significantly from here, the losses accumulated so far this month may only be the start of a more serious pullback.

More market pain ahead?

How severe could the market correction be if the economy is going into recession? Some will argue that last year’s 25% decline in the S&P 500 Index is as low as markets will go in this current rate-hiking cycle, but history suggests equity markets could suffer another significant drop from today’s levels, with the greatest pain likely to be felt by investors in the lead-up to and early stages of the recession. Indeed, while stocks usually rebound well before the end of a recession, it’s also rare for them to bottom before the beginning of one takes hold.

Of course, what ends up happening to stock markets in the event of a recession will largely depend on the response of central banks. The Fed, for instance, has in the past been quick to cut rates at the first signs of an economic contraction, but this time may be different if inflation continues to fall short of its 2% target or worse, starts climbing higher again. In this scenario, instead of lowering rates, the Fed is likely to stand pat for a period, but it’s also conceivable that it would raise rates to keep inflation at bay, regardless of whether such a move undermines the strength of the economy even further.

Ultimately, equity markets remain precarious despite the rally so far this year. The potential for losses may only grow if economic activity continues to wane and central banks can’t stick the landing without a hard thud.

Kevin McCreadie is Chief Executive Officer and Chief Investment Officer at AGF Management Ltd. He is a regular contributor to AGF Perspectives.

Notes and Disclaimer

© 2023 by AGF Ltd. This article first appeared in AGF Perspectives. Reprinted with permission.

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