The share market is forward looking they say, it is a pretty good predictor of the future economic activity. Why is that the case you might ask?
Well, there are thousands of profit-seeking and well researched investors and economists investing daily in the market with real money. Their collective opinion of the future economic conditions is reflected in the direction of the share market movements in the short term.
On that basis, the share market, so far, is down roughly -13% from its peak about a year ago and it is telling us that the economic conditions have turned for the worse. The market is not always right though, particularly when it tries to second guess the future economic manoeuvres of the central bankers and politicians. We don’t have to look far back for the evidence of the market’s miscalculation of the economic outlook when during the first breakout of the Covid-19 pandemic in 2020 saw the share market sell off nearly -35% only to recover just as quickly when it was clear the central bankers and governments were going to prop-up the economy in unprecedented ways.
What was the lesson learned? Expect central banks and politicians (let’s call them collectively as feds for the purposes of this article) to come out swinging if the economy does enter a serious recession. Each recession brings with it unique set of challenges but there is pretty strong evidence between Global Financial Crisis of 2008 and Covid-19 pandemic crisis of 2020, each very unique and unprecedented in their challenges, that the government & central banks end up responding to economic crisis with equally unique policies. Is this simply a blind faith in the Feds’ ability to rescue the economy in case the worst happens? Not really, feds can get it wrong but it is equally unlikely that the feds will just sit through a deep recession and shun immense public pressure to respond in significant ways. That being said, the feds may have greater appetite to sit through an economic slowdown or even a mild recession for the rest of this year so long as it serves to bring down inflation, which is the public enemy number one right now!
So, will there be a mild recession? The share market decline of approximately -13% so far is not indicating a recession but just much slower economic growth. While we do believe that the chance of a prolonged and deep recession is low as feds are your insurance against that scenario, it is worthwhile revisiting what a recession is.
In official economic language a recession is when there have been two consecutive quarterly declines in economic growth as measured by the Gross Domestic Product (GDP). It is just a fancy way of saying that the country has been producing less and less stuff for six months at least. Obviously when the economy produces less, there is less income earned nationally, and less requirement of resources by businesses e.g. labour, thus higher unemployment. For comparison, the last major recession we had in Australia lasted for over 12 months between 1990-1991. During that recession unemployment rose above 10%. The recession came in response to the unwinding of the asset price boom in Australia during the 1980s, the international recession of the early 1990s, and high interest rates, which were necessary to help reduce Australia’s high inflation rate at the time.
Yes, we also had an official recession during the Covid-19 pandemic in 2020 when Australia’s GDP contracted for two consecutive quarters ending March 2020 and June 2020 and in subsequent quarters the GDP bounced back hard. You may not strictly consider that to be a serious recession, although a lot of businesses and individuals did suffer extraordinary hardship at the time.
While the economy tends to grow over decades it never grows in a straight line, the economic journey over the long term is very much punctuated by ups & downs of business cycles. In business up-cycles people are growing their businesses, making money on the stock market, buying cars & houses, and feeling lucky. Sounds like the past ten years! But when the cycle turns down, the business activity and income fall across the nation. During this time companies are getting smaller, revenues & profits fall, workers are losing their jobs, and families are tightening their belts, and everyone is stressing out. That’s a recession.
The central bank’s role is to smooth out the extreme highs and lows of the business cycles by raising or lowering interest rates.
What are some warning signals of a recession? Overall, the warning signals so far in this slow down, we would say, are flashing amber light as opposed to an all-out red light. The real question is will we go from amber to red, or will there be amber conditions for the foreseeable future, will the amber conditions turn back to green, or will amber turn to red soon?
Based on the main data indicators we will share below we would conclude for now that the amber conditions are likely to continue for the foreseeable future i.e. a case of a muddle through economic condition (which are also referred to as stagflation i.e. stagnant growth and higher inflation).
The main indicators to watch are as follows:
Firstly, a couple of positive indicators. The below chart (see top of next page) is illustrating current operating conditions in Australia’s manufacturing industry. Overall conditions are still positive and manufacturing businesses were still growing in May.