Recent signs of economic resilience have more and more investors giving credence to the "soft landing" narrative, a scenario in which the Federal Reserve successfully controls inflation without triggering a recession. This growing conviction in this rather rare outcome helped drive all three major US financial indices higher in 2023.
So far this year, leading companies Dow Jones Industrial Average rose 13% and set new all-time highs, the broad S&P 500 (^GSPC 0.75%) increased by 23%, and the technology sector Nasdaq Composite it shot up 42%.
However, analysts JPMorgan Chase and German bank, among other financial institutions, still see a recession as a distinct possibility in the next 12 to 18 months. They worry that the impact of higher interest rates has not yet fully spread to the economy, and that consumers have so far propped up the economy with outsized spending that is depleting savings and causing many to take on more debt. Some analysts argue that an economic recession is possible (or even likely) as these situations evolve.
A possible confirmation of analysts' fears can be seen in the bond market, which is sounding its most serious recession alarm in decades. Continue reading to learn more.
Treasury yield curve remains inverted
Treasury bond They are debt securities issued by the government that pay interest according to their maturity date. The interest rate that these bonds offer buyers is called the yield. When yields on Treasury bonds with different maturities (from three months to 30 years) are plotted, they form a line known as performance curve.
That line generally starts low for short-term bonds and slopes up for longer-term bonds under normal conditions. Bonds with longer maturities pay higher interest rates than bonds with shorter maturities to attract buyers. Investors I want more compensation by saving money for longer periods of time.
During periods of economic hardship, the Treasury yield curve can invert, where long-term bonds offer less yield than short-term bonds (something that has happened over the past two years). Aggressive interest rate increases aimed at curbing inflation sent recession fears on Wall Street, and investors hedged against the risk of an economic downturn by turning to long-term Treasury bonds.
Demand drives up bond prices and lowers yields. Therefore, demand for long-term Treasuries has driven down yields (relative to short-term Treasuries), causing the yield curve to start high and fall with longer-term bonds. term, thus reversing.
Yield curve inversion is bond market's most serious recession scare in decades
The spread between the 10-year Treasury and 3-month Treasury yields is a closely watched economic indicator. That part of the yield curve has inverted (the spread has become negative) before all eight recessions since 1968, with only one false positive in the mid-1960s, according to the Federal Reserve Bank of New York.
That part of the yield curve was inverted in October 2022 and remains inverted today. In the past, a recession has followed within two years, excluding the single false positive, meaning the yield curve indicates a high probability that the United States will fall into a recession in October 2024.
This alone is worrying, but the current situation is actually more significant. The spread between 10-year and 3-month Treasuries reached -1.89% in June 2023, marking its steepest reversal in more than 50 years. Since then, the spread has moderated, but the curve remains steeper today than it has been since 1980.
The following chart shows the spread between 10-year and 3-month Treasury bonds. The yield curve inverts when the spread is negative, and the inversion becomes steeper as the trend line moves deeper into negative territory. Gray shaded areas indicate recessions.
10-Year, 3-Month Treasury Yield Spread data for Y Charts.
In summary, the yield curve has consistently predicted recessions with remarkable accuracy over the past few decades. Yes, there was a false positive in the mid-1960s, but the spread was much less negative than today.
In fact, the current reversal is the most dire recession warning the bond market has sounded in over 50 years because the spread between 10-year Treasury and 3-month Treasury yields reached -1.89%. That hasn't happened in more than five decades.
To that end, if current investment is not followed by a recession, it would be historically unprecedented, according to the Federal Reserve Bank of St. Louis.
So, here's the big question: What could a recession mean for the stock market?
A recession could sink the stock market, but there is a silver lining
The US economy has suffered 10 recessions since the S&P 500 was created in 1957. For each recession, the S&P 500's maximum decline is detailed in the chart below.
|
Recession start date |
Maximum fall of the S&P 500 |
|---|---|
|
August 1957 |
(twenty-one%) |
|
April 1960 |
(14%) |
|
December 1969 |
(36%) |
|
November 1973 |
(48%) |
|
January 1980 |
(17%) |
|
July 1981 |
(27%) |
|
July 1990 |
(twenty%) |
|
March 2001 |
(37%) |
|
December 2007 |
(57%) |
|
February 2020 |
(3. 4%) |
|
Average |
(31%) |
Source: Truista. Note: Percentages have been rounded to the nearest whole number.
As shown above, history says that the S&P 500 would fall about 31% if the economy falls into a recession. For context, the index is currently 2% below its all-time high, so the implied drop is around 29%.
That said, the downturns have varied widely in severity, simply because each recession is the product of unique circumstances. Therefore, any future economic crisis could imply a much smaller (or much larger) decline in the S&P 500 than the historical average implies.
No forecasting tool is perfect. While historically rare, the Federal Reserve can actually engineer a soft landing that controls inflation without triggering a recession. But even if a recession were a guaranteed outcome, it would be wise to continue investing. Trying time the market (selling before the recession starts and buying again when it ends) will almost certainly backfire.
Historically, the S&P 500 has recovered four to five months before recessions end, generating an average return of 30% during that period, according to analysts at JPMorgan Chase. Investors who sit on the sidelines until economic data show the economy is recovering will miss out on those gains, likely leading to poor long-term performance.
Here's the silver lining of any recession: The S&P 500 has returned an average of about 10% annually since its inception despite suffering from economic downturns, bear markets, and corrections. There is no reason to expect a different result in the future. In that context, patient investors who buy and hold good stocks (or a S&P 500 Index Fund) will surely pay off well over time, whether or not a recession materializes in 2024.
