How The Sell-Off Wave May Kill The Economic Expansion

A strong rally in stock prices on Friday is giving bullish investors renewed hopes of future gains, but other big daily advances recorded in recent months frequently have been followed by declines to new lows. Meanwhile, analysts at Bank of America Merrill Lynch warn that plunging stock prices, spikes in volatility, and evaporating liquidity in the securities markets may set off a general economic contraction. “We think this [volatility] can no longer be dismissed as noise on the grounds of illiquidity or machine trading alone,” BofAML writes in a recent report quoted by Barron's.

The S&P 500 Index (SPX) posted a 3.4% advance for the day on Jan. 4, but it remains in a correction, now 13.9% below the record high set in September 2018. If BofAML is correct, a vicious cycle may result, given that recessions tend to trigger bear markets, or worsen those that already are underway. The table below shows the longest recessions in the U.S. since 1929, from economic peak to trough.

Longest U.S. Recessions Since 1929

  • 43 months from Aug. 1929 to March 1933
  • 18 months from Dec. 2007 to June 2009
  • 16 months from Nov. 1973 to March 1975
  • 16 months from July 1981 to Nov. 1982

Source: National Bureau of Economic Research (NBER)

Significance For Investors

The first of the recessions listed above was the beginning of the Great Depression of the 1930s, and the Stock Market Crash of 1929 occurred in its early stages. The last recession above was punctuated by the financial crisis of 2008, and was accompanied by the most recent bear market for the S&P 500.

"We're going into a recession. I think it will be this coming year," is the opinion of David Rosenberg, chief economist and strategist at Toronto-based Gluskin Sheff + Associates, as he told CNBC. "We've got more than 80% chance of a recession just based on the fact that the Fed is tightening policy," he added. "This tightening of financial conditions that we've seen in the markets is going to end up having a cascading effect on the economy for the first few quarters if this year," he concluded.

High yield bonds rated CCC, a particularly risky segment of that market, are trading at distressed prices, Barron's notes, indicating that investors are fearful of defaults. Meanwhile, BofAML projects that the default rate on high yield debt will be 5.5% in 2019, up from 3.25% in 2018, Barron's adds. While they do not see a "full-blown [default] cycle" emerging just yet, BofAML analysts Oleg Melentyev and Eric Yu see this as one of several indicators that the credit cycle is peaking, and set for a contraction. Others include downgrades of BBB rated debt, weak loan covenants, tightening by the Federal Reserve, political tensions in the U.S. and Europe, and trade wars.

Personal consumption expenditures, also frequently called consumer spending, were 68% of U.S. GDP as of the third quarter of 2018, per the Federal Reserve Bank of St. Louis. While disposable personal income is the main driver of consumer spending, personal wealth is another key factor. A falling stock market can have a negative impact on the broader economy by depressing consumer spending, as well as by constraining the ability of corporations to raise new equity capital.

Looking Ahead

According to a model developed by Jonathan Wright, a professor of economics at Johns Hopkins University who has served as a special adviser to the Federal Reserve Board, the odds of a recession starting in the U.S. in 2019 is a mere 2.4%, per Seeking Alpha. However, a recent poll of chief financial officers (CFOs) of U.S.-based companies reveals that more than 80% of respondents expect a recession to begin by 2020, according to Money magazine.

Other noteworthy observers who believe that a recession is likely to begin sometime before the start of 2021 include, per the same story in Money magazine: billionaire hedge fund manager Ray Dalio, former Federal Reserve Chair Ben Bernanke, Mark Zandi, the chief economist at Moody's Analytics, the strategy and economics teams at JPMorgan and BlackRock, as well as economist Nouriel Roubini, who predicted the 2008 financial crisis.

The odds that a U.S. recession will begin by 2020 are 50%, in the opinion of former U.S. Treasury Secretary Lawrence Summers, per CNBC. The probability is 40% according to more than 100 economists surveyed by Reuters. Another Reuters poll of more than 500 fund managers, economists, currency analysts and equity strategists indicates a widespread belief that the U.S. economy is at or near a peak, and that a downturn is imminent.

Finally, note that the stock market crash of 1987 is the most recent example of a bear market that was not accompanied by a recession. The dotcom crash of 2000-2002 started while the U.S. economy was still in an expansion, and a recession developed subsequently. Meanwhile, the recession of 2007 to 2009, and the accompanying bear market, were partly set off by the subprime mortgage crisis of 2007, then worsened by the more widespread financial crisis of 2008.

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