Are we nearly there yet? Global markets are over 20% off their highs, and the past month has been particularly horrible.
Even the longstanding defensive (and supposedly diverse) strategy of having 60% of your assets in equities and 40% in bonds has been something of a disaster – 60/40 is heading for the worst year since 2008 (when a standard 60/40 portfolio fell 20%).
The only hiding place has been China.
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Sadly, this level of misery doesn’t mean there is no more misery to come: there may be a recession ahead.
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A recession will make things much more complicated
Bear markets don’t necessarily cause or come with recessions; the short, but nasty, bear markets of 1962, 1966, 1987 and 2018 did not, for example. But a recession can make a bear market very significantly worse – or, at the very least, longer.
Look at US bear markets since 1902 and you will see that those without a recession have lasted on average a mere 7.6 months. Those with a recession have lasted an average of 23.8 months – and that is with the generous inclusion of the super-short (one-month) bear market and state-enforced recession of 2020.
This makes sense, of course; bear markets are, in the main, reactions to overvaluation – a reversion to some kind of mean. If there is no recession – and hence no real change to the earnings part of the price/earnings (p/e) equation – a fall in prices to a level at which p/e ratios look OK can be quick and simple.
But add in a recession and all simplicity collapses: we can set prices when we have one moving part, but not when we have two. If you have been wondering why all market analysts are now obsessed with the possibility of a recession and how long it might last, this is why.
Are we at peak inflation yet?
Figuring out the answer is a matter of establishing first where inflation will go, and second how central bankers will react to where inflation has gone. Most analysts are looking to commodity prices – the supply crunch that has driven this year’s horrible consumer price index inflation numbers – for the answers.
Here there might be glimmers of good news. The oil price has turned down slightly and the copper price (one of the most watched in the market) has just hit a 16-month low (it is down 14% this year so far). Mining stocks are falling, too.
This suggests the tantalising possibility that we may be near peak inflation. If that is so, then it might not be that long until central banks can pull back from raising interest rates, today’s scary anti-Goldilocks environment (everything is either too hot or too cold) will evaporate and all will be well again.
If central banks get the balance right – unlikely, I admit – we could end up seeing exactly what everyone wants: a soft landing that comes with either no growth for a few quarters or a very mild recession. Job done.
Wages are inflation’s wild card
There is, however, an inflationary wild card here: wages. Listen to the news occasionally and you might conclude that real wages everywhere have been collapsing. But that is not quite right.
As market historian Russell Napier points out, by the end of April 2022, UK wages were 13.9% above their pre-Covid level. Consumer price inflation had risen only 9.2%.
In the past few months, inflation has hit new and nasty highs. But there is good reason to think that wages will catch up soon. The labour market in the UK remains very tight (as is the case in the US, where real wages are also up since the beginning of the pandemic). And while union membership in the UK has halved from its peak in 1979, it is rising again.
A summer of industrial action is already under way in the UK, as anyone hoping for an easy train ride to the first Glastonbury Festival in three years will know. And anyone planning to go on holiday over the summer will be increasingly worried, given that British Airways employees have just voted to strike.
There is, says Napier, “a bull market in the price of labour”. That is not necessarily bad news at all; in fact, you could see it as a welcome development: it makes a long, deep recession less likely.
Companies will still make more money
Note that even in the grim consumer confidence numbers released in the UK last week, purchasing intentions remained unchanged. And, given that central banks, the US Federal Reserve in particular, appear to be more focused on the wellbeing of the High Street than that of Wall Street at the moment, pay may be an inflation driver that worries them less than others.
Where wage growth might hurt, however, is in profit margins. Look at company earnings forecasts and you will see that not much misery has been priced in.
Current estimates suggest that UK companies will report earnings per share 4% above 2019 levels this year and that US and European companies will see earnings per share up 38% and 24% respectively, notes Simon French of Panmure Gordon.
A summer of strikes and real wage rises could turn that around pretty quickly, recession or no recession. We might be nearly there; it is just that our destination may not be the one we were expecting.
• This article was first published in the Financial Times
