You may have heard the saying “the economy is not the stock market,” which speaks to the differences between a bear market and a recession. While there is no single agreed upon definition of a bear market, it is accepted that a bear market is declared when a particular index drops by more than 20% from its peak.This contrasts to a recession, which involves consecutive quarterly declines in GDP. Though bear markets often accompany a recession, we’ve seen some occasions in the US where bear markets didn’t accompany recessions — in the 1940s, twice in the 1960s and then again in the 1980s. The S&P 500, a broad market index tracking the largest US companies, entered bear market territory declining 24% Jan. 3, 2022 from its closing price on June 16, 2022. Fortunately, markets can generate positive returns, even in an economic downturn. The TSX Composite Index is currently an example of this and has been one of the best performing indices compared to its peers.

Another important distinction is that stock markets tend to be forward looking and their prices indicate expectations of the future, including potential recessions. Because there is a buyer for every seller in a market, the collective views — optimistic or pessimistic — of many forecasts for individual companies are reflected in stock prices in real time. 

Looking at recent stock market performance, it’s clear that investors have concerns about the future economic prospects amid a high inflationary environment and rising rates. The silver lining is that many economic indicators have held up quite well including consumer spending, employment, and savings, while others, such as persistent inflation, stagnating corporate earnings, and rising inventory levels, are less optimistic.

Are we in a recession?

First off, there isn’t one definition of a recession. A commonly accepted thought is that a country is in a recession when it has two consecutive quarters of negative economic growth as measured by real GDP.¹ GDP is the value of all finished goods and services produced within a country’s borders during a specific time period. It encompasses consumer and government spending, investments and net exports (less imports). This information is tracked monthly, quarterly and annually to provide a sense of a country’s economic strength. 

 When dealing with global recessions, economists track larger GDP countries such as the United States, China, Japan and Germany, to name a few. In a globalized world, these major economies have complex interdependencies, and should not be looked at in isolation and each would have its own baseline as to what is considered normal. For example, the trade relationship between Canada and the United States positions the two countries to have a significant impact on each other, and given the size of the US economy relative to Canada, when the US goes into recession, it will inevitably impact Canada. As one saying goes, when the US sneezes, Canada catches a cold. One last consideration as we ponder what comes next in Canada and the US is the major difference between the two economies. Canada’s economy is much more heavily weighted to oil production relative to its overall economy. This could stand to support the Canadian economy further should the strength in oil prices continue. 

Inflation and interest rates

Whether it’s higher prices we pay to fill our vehicles at the pump or our carts at the grocery store, we’ve all recently witnessed firsthand how inflation can put a dent in our wallets. Central banks typically have a dual policy mandate of controlling both inflation and unemployment levels. Given the historically low unemployment levels, the current priority has shifted to reigning in high inflation. Increasing interest rates is one of the tools used by central banks to reduce inflationary pressures as increased borrowing costs can help reduce demand for goods and services, which may lead to lower prices — or lower inflation. Canada’s central banks, the Bank of Canada recently increased its benchmark interest rate by 0.5% to 1.5% on June 1, 2022 which was fully expected by market participants given the persistently elevated inflation levels. Many other central banks, including the US Federal Reserve, have also been aggressively raising interest rates while also signaling clear expectations for further increases. As recently as June 15, 2022, the US further increased its federal funds rate by 0.75% to 1.65% compared to Canada’s current rate of 1.5%.   

Central banks have a delicate balancing act to perform when considering interest rate increases. The goal is to raise rates enough to reduce demand so that inflation cools, but not to the point of causing a recession and increasing unemployment (sometimes referred to as a soft landing). This can be particularly tricky as interest rate changes may take a while to achieve their desired effects. Furthermore, residual supply chain issues from the pandemic and high commodity prices from geopolitical events have contributed to inflation and may be less responsive to rate increases. 

Historically, increasing interest rates too quickly has been a tipping point for past recessions as doing so impacts consumer spending and other metrics used in the calculation of GDP. For example, higher rates may impact consumer demand by increasing the costs of borrowing (such as higher mortgage payments), which may lead to less disposable income for other goods and services. The same concept applies for businesses, which may reconsider borrowing to facilitate major purchases such as a new piece of equipment. In anticipation of a recession and potentially poorer job security, consumers may also hold on to more savings in order to pay for essentials, which can further reduce consumer spending. Overall, it is evident how a decision like changing interest rates can feed into the performance of an economy and trigger a recession. 

Unemployment

Employment levels have historically had a strong relationship with economic output. In other words, when more people are working, there is generally more output. There is also a known relationship between inflation, unemployment and company profitability. For example, companies may need to increase wages paid to their employees amidst a tighter job market, which can put pressure on their margins. When the economy starts to decline and consumers are purchasing less, companies may result in laying off workers to control costs. In addition, higher input costs such as those resulting from supply-chain issues and increased energy prices can further pressure a company’s profitability if they are not able to adjust prices sufficiently to the end consumer.

Conclusion

At the time of writing this article, Canada and the United States have not entered recession territory but many have already felt the impact of negative market performance on their portfolios as the commonly accepted bear market threshold of 20% has been breached. GDP is an informative metric used to define a recession but it’s important to recognize that market participants and economists alike keep a close pulse on other metrics when making economic forecasts. There is a complex relationship between many data points, which ultimately contribute to a country's level of economic growth.

That said, there are areas of concern weighing on investors and financial markets. At the forefront are inflationary concerns and the rapid rise in interest rates to combat inflation. The combination of rising costs and increased borrowing costs are having an impact on consumers and their purchasing decisions. 

Understandably, a bear market makes investors nervous, but trying to time the bottom of the market is something that even the most seasoned professionals avoid. The chart above lends some perspective on historic market performance during economic downturns. While there is no guarantee of positive returns following a downturn in the market, we do notice a fairly consistent trend of strong market performance the year following a decisively negative downturn. One of the worst market crashes, the financial crisis of 2008, is an example of how a longer-term perspective can pay off for investors. If one had purchased the S&P 500 Index at its peak, prior to the financial crisis market crash, you would still be up over 140% representing an average annual return of over 9%. 

As always, these investment decisions should be made after careful consideration and a constructive discussion with your financial advisor.