Drawdowns, corrections, and the risk of recession
Among the most common questions I receive in most years is, “When is the drawdown coming?”? For what it’s worth, rounding out the top five this year are: “How should I position my portfolio based on the likely election outcome?” (Elections don’t matter to markets.) “How concerned are you about US debt?” (I’m not.) “When will markets broaden out?” (Likely when policy eases and growth reaccelerates.) “Who will win the election?” (I don’t know).
The answer to whether a drawdown (a decline of less than 10%) is coming has always been an easy one.?Sure. Drawdowns are always coming. Since the early 1980s, there has been a greater than 5% drawdown in the S&P 500 Index in every year but two (1995 and 2017). (1)? Even in this year, which had felt relatively benevolent until the past few days, the S&P 500 Index experienced a 5% drawdown in April before climbing to an all-time high in the middle of July. (2)? For all the excitement around the current drawdown, the broad market is still less than 6% from its all-time high (3), although companies that are disappointing on earnings have fared worse.
On the other hand, corrections (declines of greater than 10%) happen less frequently.? Corrections typically don’t just emerge out of nowhere.? Often, they’re the result of policy uncertainty and/or surprising weakness in economic activity.? The market has currently gone since Nov. 2, 2023, without an official correction, representing a 188-day period of a resilient economy and declining inflation. (4) We appear to potentially now be on the brink of that next 10% decline as the economy weakens (see Friday’s jobs report (5)) and the Federal Reserve passed on lowering interest rates at the July meeting.
S&P 500 Index: Number of days and total return since the last 10% decline
How ominous is it? Admittedly, US growth is below trend and deteriorating, which would suggest taking a defensive approach. However, we would expect the weakness to be short lived as the Federal Reserve eases policy to reinvigorate economic activity. Historically, markets tended to perform well in easing cycles that were not associated with recessions. (6)
Fortunately, we do not see glaring signs that a recession is imminent. For one, there does not appear to be significant excess in the economy (7). Two, corporate borrowing costs relative to the risk-free rate remain below recession levels. (8) Three, the banks do not appear to be tightening lending standards significantly. (9) If the end of the cycle is not imminent, then any near-term drawdown or correction would likely prove to be a short-term deviation on a longer-term advance.
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Last few days data out of the US has changed the investment outlook and scenario overnight. Markets are approaching panic mode as many economic factors converge, supporting a drift away from risk assets. Investors are dropping stocks like rocks and opting for safety of Treasuries and Swiss francs. Stocks sank after US Non Farm Payrolls (NFP) grew by just 114,000 last month, a slowing from 179,000 jobs added in June and below the 185,000 expected by economists polled by Dow Jones, while the unemployment rate rose to 4.3%, the highest since October 2021. This heightened fears the labor market was deteriorating and potentially making the US economy vulnerable to a #recession. The 10-year Treasury yield fell to its lowest since December as investors fear the Fed made a mistake this week by keeping interest rates at elevated levels. Traders are increasing bets that the Fed will start easing policy in September with a big 50 bps rate cut. Interest rate futures contracts now reflect about a 70% chance seen of a 0.5% rate cut next month. Fed could use this powerful tool at it's disposal to cut rates in an "out of meeting" policy decision if necessary to stimulate the economy and prevent a recession. Yes, so a recession looks unlikely.