A recession and yet the markets are going up?!

Since mid-October, we have seen a rebound in the major stock markets. Meanwhile, we see the global economy has got stuck in a recession at the same time. So why are investors bargain-hunting on the stock market right now? And why particularly riskier assets such as equities?

After earlier price falls of 20% and more, major Western stock markets such as the Dow Jones Industrials index in the US, or the STOXX Europe 600 index, have recently started to recover. What are we seeing? Risk appetite seems to be making a comeback among equity investors. They want to increase the amount of shares in their portfolios once again, mainly because they expect the profits of listed companies to shoot up. This means that they can look forward to higher dividends. Anyone who sees these rising share prices as being an indicator of a strong expansion of the global economy is, unfortunately, totally misreading the situation. At present, in fact, most of the macroeconomic indicators being published point to an (imminent) recession in the European and US economies. So why buy now? Investors appear to be looking ahead to 2023 and assuming that the recession news is already priced in. The disappointing economic indicators do also include a number of bright spots that are making investors eager to hit the buy button right now.

First of all, let’s take a look at the trend in global manufacturing confidence in the industrial sector. Published monthly, this is one of the most important indicators. And what does this show us? In October this year, it fell below the important 50-point level (49.4 at the end of October 2022). Below 50 points, it indicates a recession or contraction in global economic growth. Above 50 points, it indicates economic growth.

Figure 1 clearly shows that economic activity has been slowing down for some time. And it has recently reached the recession range (= below 50 points). If investors only looked at this chart, shares would be the last thing they would think of buying. But let's be clear, many argue that the imminent recession has already been priced in since the start of the year. Many cyclical stocks fell by 20%, 30% or more. With the recession now confirmed, investors are already looking at the future. Because that’s exactly what investors do: anticipate and always look 3 to 6 months ahead.

Figure 1: Trend in global manufacturing confidence in industry

Source: S&P Global, JPMorgan

What does their look into the future tell them?

Many see a sign that the worst is probably already behind us. This can be seen in Figure 2. It clearly shows that price pressure, or inflation, is easing. The sharp rise in inflation was the primary focus in the early part of this year, with long-term interest rates in Europe and the US pushed upwards, leading to a cooling off in the stock markets. Now we have also seen a downward price correction in the commodities market since the summer.

And that is cause for optimism. Because if companies can now pay less for their raw materials (= input prices in Figure 2), they will be less likely to increase their sales prices (= output prices in Figure 2). We therefore expect to see that inflation has peaked and will cool down over the next few months. As a result, the Western central banks will probably no longer be inclined to increase short-term interest rates so sharply. This hope of a breathing space for the economy in 2023 is precisely why investors are causing a stock market rally.

Figure 2: Trend in input and output prices in the industrial sector

Source: S&P Global, JPMorgan

Conclusion

There is a paradox afoot in the stock markets. While the global economy is heading into a recession, we see the stock markets rising. The reason for this is that equity investors are trying to look 3–6 months into the future. And that’s exactly what we’re seeing right now. The fear of recession was already factored into the prices at the start of the year, so what's next? Now investors are counting on a recovery in 2023, backed by cooling inflation and an expectation of less aggressive central banks. Only time will tell us if they were right.