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What came first, the bear market or the recession?


Despite the evidence of history, investors persist in looking at economic data as their guide to investment returns. The mistaken logic is to believe that if the economy is on the up, investment returns must surely follow. Quite the reverse is usually true and often market weakness predicts a recession.

Since the 1950’s the US has experienced ten recessions, and nine bear markets and almost all have overlapped, however it is generally the bear market that come before the recession. As can be seen in the graph below, there has been a bear market in the S&P 500 directly prior to five of the last seven US recessions.  The questions that spring to mind are why, and can we learn anything from this observation?


Wealth effect on spending

Household wealth is a key determinant of spending.  As the value of your assets climb, you feel wealthier and spend a little more.  With around 70% of US GDP is derived from consumer spending, the impact of the wealth effect can be critical.  Conversely, a fall in asset prices will have the reverse effect.  This chart from the OBR that highlights how as net wealth contracts, there is a spike in saving.  The implicit reduction in consumption can easily translate into a contraction in GDP and tip the economy into a recession.

Household (spending - Income)

Source: OBR

Growth in household net wealth is of course positive for an economy so long as it remains in proportion to growth in GDP, meaning it is organic and sustainable.  When it grows faster than GDP this has historically led to a bubble in asset prices and a subsequent sell-off. Over the last decade we have seen US household net worth relative to GDP climb to worryingly high levels, far higher than during the Dot Com bubble, and the 2007 US housing bubble.  This time household net worth has risen higher as Quantitative Easing has driven money into investment asset markets creating (as intended) a surge of consumer demand.

Seeking Alpha

Source: Seeking Alpha (July 2018)

The danger of a correction now looks material, not least as the Federal Reserve is tightening monetary policy, raising rates and significantly reducing its balance sheet. The past shows that when household net worth is peaking the Fed is usually hiking rates.

Household net worth

Can we trust the FED?

Central bankers are tasked to control inflation but also to promote growth. Conventionally, as inflation rises, central banks will raise interest rates to slow down aggregate demand by increasing the cost of borrowing.  The ability of central bankers to manage complex economies in this way is limited and the Fed has had little success in both controlling inflation and maintaining growth at the same time.  Indeed, a jump in the Fed Funds rate preceded every recession since the 1950’s.

Can we trust the FED

Christmas 2019: What will the charts show?

As we come to the end of the year, we can point to a number of signals which suggest bumps in the road ahead.  The economic handbrake of interest rate increases has been pulled hard in the US. This began in the context of a strong US economy, with no sign of recession in the near future.  However historically high net household wealth relative to GDP is a clear warning sign. Over the last two months we have seen how rate rises exposed the vulnerability of asset prices.  The US yield curve is close to inverting – another potential indicator of impending recession.  The fact that long term rates are below short term interest rates means the bond market believes the Fed will be required, at some point in the future, to drop rates to stimulate an economy in recession.

10 year treasury

Whatever the other drivers for market views, the excessive growth of household net worth, at a rate faster than the growth in the overall economy, can be a tinder box for an investment asset sell off, one with the real potential to push robust economies into recession. Holders of well diversified portfolios will of course take comfort from the fact that this is the time in the cycle that their cash and bonds come into play, and the time that the renewal in economic activity, in those businesses which issue equities, will begin. Change will always create opportunity.




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