Recession is an emotive word in the investment industry. Like the bogeyman, an imaginary monster used to frighten children, the word ‘recession’ is used to frighten investors.
Recessions are however a natural part of investing. For anyone investing over a multi-decade period there should be an expectation that many will occur. Some excellent analysis from Capital Group, a US investment manager, shows that since 1950, the US has seen 11 of them, depending on how they are measured. On average they last about 10 months, whereas the expansionary periods last 69 months on average.
Put another way, on average, for each 79-month period we are in recession 12.6% of the time and seeing growth for the remaining 87.4%. Historically it has made much more sense to plan for expansion rather than recession when investing.
Also interesting is their work on when markets peak and trough around recessions. As forward-looking indicators and discounting mechanisms, equity markets peak around 10 months before the economic cycle peaks. Equally they begin to rally before the recession ends, usually a bit quicker than 10 months.
This is what makes embedding recessions into investment decision making so hard. Recessions are rare and happen much less frequently than we fear they do. But even if you can predict them, you must be able to predict them before markets do, as these move ahead of the economic cycle. In our experience, by the time investors realise a recession is occurring it can be too late, as market prices have already moved to the point where it can often make more sense to be buying than selling.
The US S&P 500 equity market peaked on 31 December 2021 and nearly reclaimed that peak in July this year. Since that peak, it has fallen nearly 14% suggesting, amongst other things, a more cautious view of the economy going forward but perhaps not a recession yet.
Each quarter we receive an update from the companies we own, which gives us more information on how they are performing. These updates are like photographs, a moment in time depiction of what is happening, from which current and future events can be inferred. Some of these inferences will be correct, and some won’t.
The results season we are going through now has been particularly bumpy. There has been an unusual number of companies downgrading profit expectations for this year. Here are a few things they are telling us:
- The fall in the value of real estate in the US is starting to impact both the quantity and price of credit there. In simple terms, banks are lending less and at a higher price as they are worried about losses on loans previously made, and the value of assets they may lend against in the future. This is a classic credit cycle which will be relevant in thinking about the future strength of this economy.
- China remains disappointing economically. This has been a theme all year. Since China unlocked from Covid late in 2022 there has been the expectation of a rapid bounce back in economic activity which hasn’t materialised. In part this is due to a lack of confidence after three years of lockdown, particularly from consumers, but it also reflects problems in the property market which have yet to be fully resolved. Those companies expecting an improving Chinese economy have been disappointed.
- The rising cost of debt is impacting the economy in many and varied ways. For consumers it is making debt-funded large purchases much less attractive. Mortgage rates are above 8% in the US, and car loans above 10%. It also makes the cost of servicing existing debt higher, reducing expenditure in other areas. For small companies, which often pay higher rates and have less long-term funding, interest rates on their borrowings have gone from low single-digit to low double-digit rates in many cases.
- Certain trends, such as AI and infrastructure investment remain strong. Underneath the economic uncertainty and cyclicality there continues to be a lot of progress, the pace of which is not slowing. This is symptomatic of the opaque macro situation versus the clear micro, which we have written about previously.
It could be that the increased number of companies downgrading future expectations is symptomatic of a turn in the economy and a future recession. There were similar concerns a year ago, which didn’t prove to be correct. In coming to such a conclusion though, the probability of a recession over time must be borne in mind as well as noting that the US economy grew at 4.9% in the third quarter. There are mixed messages out there now and keeping an open mind is important.
There is a saying in investing that the big money is made in the big moves. This is another way of saying when there is a dominant trend which lasts over multiple years this is when investors tend to make the most money.
The 2010s were a big move in which big money was made, as growth stocks and innovation were supercharged by falling interest rates. The big move in the 2000s was in emerging markets in China, after it was admitted to the World Trade Organisation. In the 1990s the big move was in technology with the creation of the internet. Finding the next big move is something worth spending time on, and what markets are struggling with now.
Through the course of this year, defensive stocks have not proven to be very defensive, as many of them depend on high levels of debt (utilities) or are seeing their business models threatened (consumer staples). Growth stocks have also struggled as continued higher interest rates eat away at their valuations. Finally cyclical stocks have struggled due to increased concerns over the economic outlook. If defensive, growth and cyclical stocks are all struggling together it doesn’t leave much left and gives an indication as to why it is hard to find the big move and gather performance.
Where could the big move come from? If we had to guess then as emerging markets found their feet in the 2000s after the technology led 1990s, there are credible reasons as to why they could do well again in the next decade. Emerging markets is of course a broad term, covering Latin America, Asia, and Africa, but what is common is these economies, overall, do not have the inflation and fiscal deficit issues of the US, UK and Europe. This, combined with higher levels of economic growth, may see them outperform their more developed peers. They are also generally cheaper and less well owned.
Of course, no one has privileged access to the future and many other scenarios could occur. We believe we have an investment process which can evolve into the future whatever it may be, supported by some very clear trends which are favourable to sustainable investing. When the next big move comes, we will be ready.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.