As we approach year end, Wall Street firms are beginning to announce their economic and market “outlooks” for the year ahead. It’s a somewhat futile exercise: they all have the same information, economies and markets are notoriously difficult to predict, and there’s so much noise in the data that it’s impossible to know whether forecasters (and asset managers) are relying on skill or luck. Yet, despite this futility, we can’t seem to resist their siren song.
The value of such forecasts, at least in my view, isn’t precision—it’s about providing directional accuracy and context for what’s happening in the world, guidance for how to think about it, and suggestions for what, if anything, should be done in response. Equally important—perhaps most important—is to understand what shouldn’t be done: Never make investment decisions based solely on economic forecasts, especially those that claim a recession is coming.
As our team begins to put together Mercer Advisors’ 2023 Outlook, it’s no surprise that there’s near-unanimity among forecasters—self included—that the odds of a recession in 2023 are relatively high (say, north of 50%). While the panoply of current economic data is ambiguous at best, there’s an overriding sense among economists and market watchers that a recession is likely. The yield curve is inverted, new housing starts have decreased significantly, asset valuations and profit margins have declined, and there are early signs the labor market is beginning to cool. And, despite a barrage of historic rate hikes, the Fed clearly isn’t finished combating inflation and is expected to raise rates another 50 basis points in December—with one or two more smaller hikes expected in early 2023.
Exhibit A: Federal funds rate expectations.
Source: J.P. Morgan, “Guide to the Markets,” slide 34, December 1, 2022.
Market expectations are based off the respective Federal Funds Futures contracts for December expiry. *Long-run projections are the rates of growth, unemployment and inflation to which a policymaker expects the economy to converge over the next five to six years in absence of further shocks and under appropriate monetary policy.
To determine whether a recession is coming, we need to know what one looks like. The colloquial definition is two successive quarters of negative GDP growth. This definition isn’t the official one, however, because it can occasionally produce false positives due to complexity in how GDP is measured. Instead, a recession is determined officially by a committee of academic economists at the National Bureau of Economic Research (NBER) when it observes a “significant decline in economic activity that is spread across the economy and lasts more than a few months.” The committee looks at monthly changes in six key variables to determine whether the U.S. economy meets its definition of a sustained, broad-based decline. Among those, only one—real wholesale and retail sales—suggests we’re currently heading into a recession. The other five categories remain positive—for now.
Exhibit B: Variables for making recession determination by NBER; % change month-over-month.
Source: J.P. Morgan, “Guide to the Markets,” slide 20, December 1, 2022.
Heatmap shading reflects 10 years of data, with green and red reflecting a range of +/- 0.5 standard deviations from a baseline of 0% monthly growth.
The challenge with the NBER framework is that, given the relative opacity, ambiguity, and backward-looking nature of economic data, recessions are always identified after they’ve begun. Consider, for example, the global financial crisis of 2007–2009. While the recession began in December 2007, it wasn’t officially identified as such by NBER until 12 months later—in December 2008. Furthermore, while the recession ended in May 2009 (which we know only with the benefit of hindsight), it wasn’t announced by NBER until September 2010—16 months later.
Consequently, it’s impossible to trade on NBER’s official recession announcements. The reason is because markets are forward-facing institutions that incorporate new information in real time. Between December 2007 (when the recession began) and December 2008 (when it was announced), the S&P 500 declined 43.6%—an example that serves to highlight how markets always lead the economy and do not wait for official proclamations from NBER. If bad news is coming, markets quickly incorporate that information and subsequently decline. The reverse is also true – markets begin to recover long before good news is announced. For example, from December 2008 (when the recession was announced) and September 2010 (when it was declared over), the S&P 500 rallied 37.8%.1
Exhibit C: US Recession and Performance of S&P 500 Index During the Global Financial Crisis
(January 2007 – December 2010).
Source: Dimensional Fund Advisors, “Markets Don’t Wait for Official Announcements”.
Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment.
Consider the period of March–April 2020, the onset of the COVID-19 pandemic. During those chaotic months, all of NBER’s recession variables were blood red. Markets were scrambling for information about how the pandemic might impact them and the economy. None of it was good. If a looming recession was ever “obvious,” it was at that moment. During those two months, the economy declined at an annualized rate of 33% and entered a recession—but only for a brief time. In the following months, the economy expanded at an annualized rate of 34%—one of the greatest economic whipsaws in history. Notably, the S&P 500 hit bottom for the year on March 23—long before any official NBER determination of recession and, in fact, well before markets had much actionable information about the pandemic’s economic impacts. The index subsequently rallied 39.3% over the next 14 weeks.
Exhibit D: S&P 500 Index Return, March 23, 2020 – June 30, 2020.
Source: YCharts, Inc.
Past performance is no guarantee of future results. Investing risks include loss of principal and fluctuating value. Indices are not available for direct investment. Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment.
If a recession is indeed coming—as seems to be the prevailing consensus—it’s likely already reflected in stock prices (and indeed the prices of everything else that’s publicly traded). Market history suggests that by selling now, investors will miss out on the recovery. Rather than trying to time markets based on recession forecasts, we believe investors are better served by focusing on more-important determinants of investment success, including:
For more insights—and to better manage the investment year ahead—mark your calendar for January 25. Mercer Advisors will conduct its first webinar of 2023, with market updates and outlooks that can help you navigate through these uncertain times. Invitations will go out later this month, so keep an eye on your inbox.
