March 2008

With the risk of a US recession increasing, equities are at risk of further declines in the near term, but we expect a rally in the second half of the year.

Since the start of this year, the chances of the US entering a recession have risen significantly. In December’s issue of Investment Perspective, we warned that things would look pretty bleak at this stage, but even so we have been surprised by how bad some of the recent economic news has been. As a result, we need to consider what may happen to financial markets in the event of a recession.

Crucially, not all recessions are alike, and their differences can have a significant impact on the outlook for the various types of assets. So, the key question is what form any recession may take.

Broadly, recessions come in two types: V-shaped (or Martini glass), where an abrupt slowing of the economy is followed by a strong recovery; and a shallower but broader shape,often referred to as a soup plate, with a longer but gentler slowdown and a similarly gradual recovery.

The V-shape is typical of US recessions when businesses – faced with overcapacity and rising interest rates – cut back dramatically on investment and lay off workers, resulting in a sharp fall in economic output.

Then, as conditions improve, they invest in equipment and hiring, prompting a strong recovery. In these cases, risk assets – such as equities, corporate bonds and real-estate investment trusts (REITs) – tend to rally three or four months before the recovery begins, as investors anticipate the pick up.

The more drawn-out, soup-plate recessions tend to occur when consumers are worse hit than businesses. As a large proportion of consumer spending is on essentials such as food, housing and health care – spending that can’t easily be put off – these recessions tend to be shallower. For investors, the problem is that the longer a recession lasts, the greater the decline in stock markets tends to be.

In general, recessions caused by banking crises are of the soup-plate variety, as consumer spending is affected by restricted bank lending. And, clearly, the current slowdown has been caused by a banking crisis. Nevertheless, we think it may prove less protracted than most similar episodes. That’s mainly down to the speedy response of the US authorities.  

INVESTMENT REVIEW
•The economic outlook has worsened considerably so far this year, and the risk of recession in the US has grown.

The Fed rides to the rescue

In a recent paper analysing past banking crises*, Carmen Reinhart and Kenneth Rogoff argue that one of the keys to the length and extent of any such recession is how quickly and decisively the authorities respond.

Encouragingly, their response has so far been pretty impressive. The Federal Reserve (Fed) in particular has reacted dynamically. It has cut interest rates aggressively so far this year, placing more emphasis on protecting economic growth than on concerns that inflation may be taking off. In our view, they are right to have done so, as inflation is likely to slow of its own accord over the coming year.

The US authorities’ response has been pretty impressive.

Meanwhile, Congress has swiftly passed a fiscal package to stimulate growth. The package has been specifically targeted at lower income households, who are considered most likely to spend their rebates. That should provide a boost to growth, particularly in the second half of this year.

In addition, the dollar’s recent weakness has led to a surge in US exports that is going some way to offsetting the slowdown in consumer spending. With the dollar unlikely to appreciate strongly for some time, we think exports should continue to support growth throughout this year.

In many ways, these are positive developments, allowing some of the long-term imbalances in the global economy – notably, the over-reliance on US consumer spending – to correct.

The equity market has not fully priced in a recession.

For all these reasons, we think the shape of any recession could well be more of a Martini glass than a soup plate. But, whether it is a recession of either shape or just a severe downturn, we foresee further potential downside in the near term for equity markets.

For one thing, the market has not fully priced in a recession. In the average recession, the market falls by 25% from the peak to the low point. At present, the market has fallen only 15%, so past experience would suggest that it could have further to go. Secondly, this could still become a soup-plate recession, and equity markets will probably experience further volatility as concerns over that outcome ebb and flow.

So we expect recent turmoil in markets for risk assets to continue for some time yet. Encouragingly, however, valuations – particularly for equities – are low. In fact, global equities are currently trading on their lowest trailing priceearnings ratio since 1990.

Hence, when the rebound comes, we would expect it to be strong and sustainable. And, if we are right and the downturn and subsequent recovery is more of a Martini glass shape than a soup plate, then that rally could start around the middle of the year.