ABOUT THE AUTHOR
A member of Putnam's Fixed Income team since 2007, Onsel Gulbiten analyzes macroeconomic issues, including inflation, interest rates, and policy developments.
With a recession in the next 12 months likely, we consider how deep a downturn could be, as its severity could result in different policy responses.
- A mild recession does not necessarily mean a mild contraction in financial markets.
- The current imbalance between capital markets and the real economy is large enough to increase the odds that a recession could come with a large drop in financial markets.
- Imbalances could be corrected through a recession or persistent inflation over many years, or some combination of the two.
Recessions tend to correct excesses via drawdowns in the prices of risk assets. Market participants are penciling in a contraction, and the Federal Reserve's own economics staff is projecting a mild recession, where the unemployment rate could increase by 2.5% to 3%.
Every recession projection starts as a mild one, since beforehand, household and/or business balance sheets look relatively firm, and the need to rebalance seems small. Only after a downturn starts to unfold do asset values come down, while liabilities do not, and the underlying mismatches and imbalances come to the surface. If the need for retrenchment affects a wide range of sectors, a mild-looking recession might turn out severe. If rebalancing affects a narrow set of sectors, a recession might be mild. Today, the strong starting point of U.S. households also makes the likely approaching downturn look mild. Nonetheless, a large number of sectors seems likely to be affected, while the policy support might be more than the historical averages.
Imbalances result from elevated asset prices
A mild recession does not necessarily mean a mild contraction in financial markets, however. The U.S. has had various mild downturns that came with large drawdowns in financial markets. The degree of imbalance between capital markets and the real economy tends to determine the significance of drops in asset prices around recessions. In that respect, the odds of a large contraction in financial markets are high. Two factors in particular — elevated household wealth relative to incomes or GDP and excess business formation (which raised asset values with inflated return expectations and resulted in high demand for labor relative to its restricted supply) — are reflections of large imbalances in capital markets relative to the U.S. economy. The next recession is likely to correct these imbalances through business failures and defaults. Financial markets will have to price in declining profitability, higher probability of business failures, and rising defaults.
Market cycles changed under a market-friendly Fed
One can argue that financial markets have already priced in a mild contraction, as various U.S. equity indexes declined by around 15% from the highs attained at the end of 2021. It is true that, going back to 1970, a mild contraction in the U.S. equity markets has been about 15%. However, all post-1991 recessions, whether mild or severe, came with large drawdowns in asset markets. This is not a coincidence. A more market-friendly Fed policy first adapted — or perhaps first revealed — by Greenspan in the late 1990s changed the return characteristics of risk assets during an economic cycle. Larger gains early in the cycle were followed by larger losses late in the cycle; the so-called boom-and-bust cycle became the norm.
Figure 1. The current market drawdown has not yet matched past recession-related drawdowns
S&P 500 Index drawdowns
Sources: Putnam calculations using Bloomberg data.
A more market-friendly Fed policy also changed the timing of the peak in risk assets during a cycle. An extra central bank cushion lifted asset prices more than otherwise in early cycles. After the beginning of rate hikes, asset prices started to peak and then soon descended, especially if no other factor was supporting growth expectations. Before 1991, risk assets did not peak until it became clear that recession was unavoidable. In some cases, the peak came after the downturn was already underway.
As asset markets have become more driven by interest rates, they have reached peak levels at an earlier point in the cycle. This is not because Fed policy started to have a faster impact. Monetary policy has always worked with lags. Given this lag, corporate profitability — which matters to markets more than anything — can stay high for a period following Fed hikes. What changed with the market-friendly Fed policy — and caused markets to peak at an earlier point — was the discount rate. It was lowered too much early in the cycle. When monetary policy later began to reduce accommodation, the discount rate went up to levels more in line with the underlying economy, reducing asset values.
Consequently, the first phase of "financial tightenings" became more rate-driven as rates became a dominant factor determining returns. Only when the impact of the monetary tightening started to hit profitability and show in data did financial markets move to the second half of financial tightenings. Then, the market focus shifted to declining earnings and rising defaults. The larger part of the drawdowns happened during this period. Risk assets sharply came down even if interest rates turned supportive. This typically happened as a downturn approached.
Why the current downturn could worsen
In the current cycle, financial conditions started to tighten when the Fed signaled the beginning of rate hikes and quantitative tightening in late 2021. U.S. equity markets got the message and peaked soon after, at the end of 2021. The drop in equities since the end of 2021 has been mostly rate driven. The P/E multiples, which had brought risk assets down last year, turned supportive for risk assets as the market quickly priced in the end of a tightening cycle and the beginning of rate cuts, but the earnings side has not adjusted much.
The earnings side of the equation has not yet priced in a mild or deep recession. In a mild recession, earnings tend to decline by 15% to 20%.
Figure 2. The earnings drawdown is not yet as large as in previous recessions
S&P 500 Index forward earnings-per-share drawdowns around U.S. recessions
Source: Putnam calculations using Bloomberg data.
How policymakers might respond
Risk assets have corrected somewhat, but they seem to be waiting for more convincing signs of a recession to fully correct. Asset values and household wealth remain elevated with respect to the underlying economy. A full correction of household wealth relative to incomes might be very painful and highly intolerable for policymakers. A generous combination of fiscal and monetary policy could be announced, and a large correction could be avoided, but inflation would continue. Monetary policy might have to tighten quickly again, igniting another correction and a likely recession.
It is possible that a full correction would not happen all at once, but over a few downturns. Economic volatility might persist for a period while imbalances are sorted out. Policymakers could even react very quickly to signs of weakness in the labor market and take steps to avoid a recession. Then, imbalances might have to be corrected over time via inflation, which would gradually erode corporate margins but not earnings. Asset markets could remain trendless for years. A partial correction through inflation might be complete by the end of 2025, which is, coincidentally, the year many central banks project inflation will return to target. To fully correct current imbalances through inflation could take up to seven years.
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5/23
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