Global Equities
Episode 1 - Recession watch
Matt Reynolds
Equity Investment Director

Is Australia heading towards its first recession in more than three decades? With the US now in a technical recession, Investment Director Matt Reynolds considers what this means for Australian investors, and discusses how lessons from past recessions might influence portfolio management during this time of uncertainty.

Matt Reynolds is an investment director at Capital Group. He has 25 years of industry experience and has been with Capital Group for four years. Prior to joining Capital, Matt worked as head of Australian equities at Colonial First State Global Asset Management. He holds a bachelor's degree in economics from The University of Sydney. He also holds the Chartered Financial Analyst® designation. Matt is based in Sydney.

Hi, I am Matt Reynolds and this is Capital Ideas, your connection with the minds and insights helping to shape the world of investments.

Writer Leo Tolstoy delivered a quote at the start of his 1878 book, Anna Karenina, that said, ‘all happy families resemble one another but each unhappy family is unhappy in its own way’ and I think the same can be applied to recessions, and probably bull markets. With recessions, every recession seems unhappy in its own way, in that there are often unique aspects to every recession. Reflecting on the press commentary that most everyone thinks that the US will move into recession in the near future, today's podcast digs into why this one actually may be inevitable and what it can mean for your global equity investments and what you can do about it.

So, let's kick off and I'll start with one piece of good news that the US is not technically in recession right now. The old rule of thumb about recessions being two negative quarters of GDP growth in a row is still valid and we saw that with the June quarter statistics but, in the US, calling a recession is more nuanced. There is a body called the National Bureau of Economic Research that is responsible for actually calling whether the US is in a recession or not. They do this by looking at a range of economic indicators, not just GDP.

I mentioned uniquely unhappy at the start and when we look back at past recessions, they've occurred for many different reasons but, typically, they're the result of economic imbalances that ultimately need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market and was considered a very severe recession, while the 2001 contraction was caused by an asset bubble in technology stocks and was quite mild. This time around, the COVID 19 pandemic and, crucially, the fiscal and monetary responses to the pandemic have created large distortions in the economy and markets. From chronic labor shortages to broken supply chains and importantly, prices increasing rapidly, somewhat feeding off themselves and also possibly being driven by opportunistic companies taking advantage of broad-based price increases. All these as a consequence, have led to a broadening out to inflation to all parts of the economy. These price increases now seem to be transitioning into a wage price spiral, dreaded by central banks the world over. With inflation seemingly becoming stickier and more persistent, one could argue that really the only way for the US Federal Reserve to stop the perpetuation of a wage price spiral is to create slack in the economy, slack in the currently very tight labor market. This likely means a need to broadly reduce the level of economic activity and induce a decline in this activity, which itself is the very definition of a recession.

In my mind, it has been this fast transition from price increases in isolated parts of the economy to increasing wages across the breadth of the economy. That seems to make a recession inevitable, and the Federal Reserve is on a resolute path to deal with it. In fact, almost all parts and all modeling lead to recession to reduce the inflation in past.

So now comes the question of what this means in terms of the numbers. Looking back over the past 70 years, the average US recession has lasted about 10 months and resulted in in the GDP decline of around two and a half percent. Capital Group economist Jared Franz suggests that this one, if current trends persist, may be worse than average but possibly still less severe than the great recession from December 2007 through to June 2009. Let's also put the two and a half percent into context versus the expansions that often lead into recessions.

One should consider that, in contrast, expansions in GDP are much more happy experiences. The average expansion period increases economic output by almost 25%. That is in contrast to the average recession decline of two and a half percent. As well, expansions have lasted much longer on average –  as 69 months versus the recession average length of time of 10 months. I also mentioned almost in terms of the paths that lead to recession, and there is actually one positive scenario to reflect upon. That is one where the supply issues that we saw coming out of COVID ease substantially and this easing also flows into the labour market. There is a labor market supply response if you like. Now, I think the probability of this scenario falls each time we see a new wage agreement being struck but it is important to surface it and consider that it may actually be part of the way forward.

Okay, so what does all this mean for your global equity investments? Well, the next couple of quarters could still be tough sledding for equities. A lot of this really depends on your own timeframe. The average 10 months recession can feel like a lifetime when you are in one and affected by the downturn. Looking longer term, though, and across the whole expansion, recession expansion type valley, the overall effect on equity returns can be positive over the full length of a contraction, since some of the strongest stock market rallies have occurred during the late stages of a recession. So, if these cyclical turning points are, say, the book ends, what do you do right now? Well, I think it has been like a passenger on a plane in turbulence, very uncomfortable and at times alarming, but the pilots are doing their job, they have navigated turbulence before. They know how to maneuver the plane and so what they are looking for is new market leaders emerging as some of the equity stars of the pandemic year struggle. They are looking for sectors and companies that show the best fundamentals for resilience through this part of the cycle. These ones have pricing power, steady demand and an economic moat and an ability to fund their own growth. They are looking at sectors that have been resilient in prior recessions, such as the consumer staples sector, the healthcare sector, utilities, and telecommunication services. These sectors when we look back in time have outpaced markets more often during declines. And they are looking at companies with high and rising dividends streams, as well as those with real or tangible assets that can generate cash.

In conclusion, bear markets eventually end and ultimately economy will write itself and growth will return. A longer-term time horizon may be required, though, and this downturn is likely to generate lots of new areas of market leadership for our portfolio managers to invest in. And these areas can drive future investment results. In closing, we are always trying to get better.

If you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at Capital Ideas Podcast Australia. This is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.


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