Market Watch: How will stock market cope with recession?

Recessions are always bad news for the sharemarket.

But are we actually in a recession? Are we heading into one? And what are the clues market investors should look for in the coming months?

History suggests that the average decline for the S&P500 through a recession is about 30 per cent, Pie Funds CEO Mike Taylor told the Market Watch video show.

In a mild recession that might be more like 20-25 per cent, he said.

That's close to the fall we've already seen this year. The S&P500 was down about 23 per cent by mid-June.

Markets tended to be forward looking and take the hit at the front end of a recessionary cycle, Taylor said.

But what wasn't clear, in this strange pandemic economy, is to what extent we're already through the worst of the sell-off.

"If the recession were to turn nasty - if it started to look similar to 1987 or 2008 - then we could expect further and significant losses for equity markets."

Right now despite the US recording two quarters of economic contraction - the traditional bench-mark for recession - it all looks quite benign.

US jobs data surprised the market on Friday showing 528,000 jobs were added in July as the labour market returned to pre-pandemic levels.

"It's pretty hard to have a recession when you've got full employment in a tight labour market," Taylor says.

There were other buffers keeping the economy buoyant.

There had been a significant build-up of savings during the pandemic due to Government stimulus and people just not spending because they couldn't go out, Taylor said.

Despite the recent market dip, house prices were still up significantly since the start of the pandemic so many consumers now had a bigger asset base to draw on.

"So there's a number of factors to suggest we may not be in a recession despite everyone calling it," Taylor said.

However, there were also indicators that suggested we may still be headed for a recession - or at least a deeper downturn.

Key among those was interest rates, which have risen at a historically fast pace.

It often took several months for those rates to flow through to the real economy, Taylor said.

"It takes time for people to roll off their fixed rates. So it's not until those mortgages roll over and people moved from 3 to 6 per cent that they have to actually adjust their spending habits," he said.

"So I think that part of it is still to bite and it might be later in the year."

We had to be cautious right now because it was simply not clear which way the data was going to go.

Shipping costs have fallen sharply in recent weeks. Photo / AP

There had been some promising moves in the inflation fight with falls in oil, metals and food commodities as well as shipping costs.

Bond markets - often described as the smartest and most forward looking market - seemed to have determined that yields have peaked.

The US 10 year bond yields had dropped significantly - from 3.5 per cent in mid-June
to about 2.8 per cent right now.

"That's the bond market saying that interest peaked," Taylor said.

But it was just too early to make a call that the market had bottomed out, he said.

While we had the initial pain from the sharp rise in interest rates would likely be another wave as things started to bite in the real economy over the remainder of the year.

That meant a strong possibility of "a second iteration" of the market slump in the coming months.

For stockmarket investors employment data was now the key thing to be watching, Taylor said.

"If the unemployment rate was to rise by more than one per cent I think that would be quite negative for the economy and for stock prices."

- The Market Watch video show is produced in association with Pie Funds.