Markets are forward looking

Bear in mind that financial markets are forward looking.

Markets have spent the past six months pricing in the possibility of a recession ahead. If a recession becomes a reality, markets will start to ask key questions of how long and how deep the contraction will be.

Assuming the contraction is short and shallow, risk assets may start to bottom out soon after a recession starts. Historically, there is a big range. Based on recent recession examples, the S&P 500 Index can take between one month to 19 months to bottom after a recession.

Focus on the long-term picture

One thing is clear looking at how the S&P 500 and MSCI World indices performed during recessions. Staying invested amid market volatility tends to pay off over the long term.

Stock market losses incurred upon a recession may seem extraordinarily large in the short-term. However, these periods tend to be brief when viewed from a longer-term perspective, as markets stage large rebounds from their bottom until the next recession (Figure 6).

As such, while there are periods of volatility and pain, the time-tested trend is one of rising stock markets over a multi-year and multi-decade horizon. Therefore, we always advise investors to adopt a long-term approach to investing, stay invested through volatility, buy on dips, invest in tranches during downturns, and most importantly, avoid timing the market.

With more clarity by mid-2023, investors could gradually seek out capital appreciation opportunities with greater confidence in the latter half of the year.

*Recovery off the low indicates the bottom from the past recession into next peak before the next recession.
Source: Bloomberg (30 November 2022)

Inflation needs to moderate

For a sustainable market recovery to happen, it is crucial that inflation eases further. When this happens, the squeeze on global household disposable incomes will abate. It will also mean that companies face less upward pressure on input and wage costs, allowing them to focus on expansion plans once again.

As such, investors should keep a close eye on both headline and core consumer price index (CPI) data, while staying mindful that central banks are acutely focusing on core CPI and wage trends.

Pause in monetary policy

A decline in core inflationary pressures will also allow global central banks to pause their rate hike cycles. A key reason behind 2022’s financial market tumble was aggressive central bank tightening to combat runaway inflation. If price pressures ease and central banks back away from rate hikes, one big headwind for financial assets will be removed.

In this scenario, we will see global bond yields peak and trend lower, while broad USD strength should also abate. For Asian risk assets, capital inflows may gather pace once the USD starts to weaken.

A peak in USD strength

From late September 2022, we have seen USD strength start to abate and enter a consolidation phase, even before the noticeable pullback that started in early November.

Indeed, the USD Index has now broken below the shorter-term trend line from early 2022, undermining the previously bullish picture (Figure 9).

Source: Bloomberg (30 November 2022)

The downturn was triggered by a weaker-than-expected US October CPI report, and helped by the Fed raising interest rates in smaller increments. This is a good signal, as a reversal of USD strength should boost stock market sentiment, as evidenced by the negative correlation between the USD and equities.

Figure 10: Correlation between the USD and S&P500 and MSCI World indices

A bottoming in economic activity

Another key trigger required is for economic activity to bottom out. Watch for higher frequency data such as Purchasing Managers’ Indices (PMI) and corporate guidance updates, followed by lagging indicators such as trade, employment data, and GDP reports.

Still, note that when economic data confirm a bottom, financial markets would already have rallied in anticipation, so these are more of confirmatory signals of a sustainable market rally, rather than leading indicators.

A bottoming in asset valuations

A definitive market recovery traditionally happens after investor capitulation, where fear takes centre stage and panic selling ensues without consideration for valuations. Once this capitulation is complete, the rationale is that there is no one left looking to sell; hence the market can find a bottom. This is difficult to call in real-time, and will only be apparent in hindsight a few weeks or months down the road.

What investors should focus on instead are historical valuation trends, such as forward price-to-earnings (P/E) ratios and price-to-book (P/B) ratios. A lower P/E ratio indicates better value. A P/B ratio below one indicates that a stock is trading for less than the value of its assets.

Source: Bloomberg (30 November 2022)