June 2019 Comments: Impact of Economic Recession on Stock & Bond Prices

Sam Ngooi Comments

During June, stock and bond prices in the US increased. Some of the likely reasons for these increases seemed to be contradictory, but all centered on the likelihood that an economic recession may be on the horizon. A recession refers to an economy that has two consecutive quarters of negative gross domestic product (GDP) growth.

In the current economic and market environment, the bond market is signaling an expectation of a recession with ten-year US Treasury yields falling below the short-term (3-month) yield. This is called an inverted yield curve, since most of the time longer maturity bonds come with higher yields to offset the price risk of holding longer maturity bonds when rates rise. As interest rates on the ten-year Treasury have fallen since last October, the prices of these bonds have increased, adding to the investment return of bonds. This good news is tempered by the fact that interest received from these bonds has declined. The other consequence of lower rates is that at some point in time these rates will go back up, and prices will decline even as interest received increases.

The bond market is also expecting some reduction in interest rates from the Federal Reserve, after nine quarter-point increases over the past few years.  These reductions are supposed to have the impact of stimulating economic growth, assuming a recession is coming.  The Fed has taken the position that it will watch the progress of the economy to see if and when an interest rate decrease is warranted.

Other government action that can stimulate the economy would be to increase government spending and/or lower taxes. While these actions can have the negative effects of adding even more to the budget deficit and increasing inflation, they will likely be used if needed in an election year featuring President Trump running in part on his economic record.

But if a slowdown in the economy is good for bond prices, it would seem to be a negative for stock prices, because an economic slowdown presumably means more unemployment, less business activity, and falling profits, which are the main determinant of future stock prices. The current Price Earnings ratio (P/E) for the S&P 500, using twelve-month trailing reported earnings, is 22 (source: multiple.com S&P 500 pe ratio). Note that the 22 P/E is considerably higher than the long-term average P/E of 15, but this has been the case for several years now. If future earnings (the “E” in P/E) are likely to decline, stock prices would appear vulnerable. But we also know that many factors affect stock prices, and it’s possible that easing trade conflicts, a compliant Fed, and a supportive federal government can avoid and/or minimize a recession and thereby keep stock prices from declining.

None of this information comes as a surprise to the investment community, so it is up to investors to decide whether to stay the course and see whether a recession does occur, and if so how significant the decline in economic growth proves to be. The alternative is to try and time the market impact from a potential recession, by selling ahead of it and then buying back in when it ends.  As our clients know, we advocate the long term, stay-the-course approach, since timing markets is extremely difficult, if not impossible, and client allocations have already taken into account the potential for declines in stock prices.