The next bear market to hit global investors should be relatively mild one – assuming the eventual US recession plays out as strategists at Legal & General Investment Management expect. 
A bear market is commonly defined as a sell-off in which asset prices fall by 20 per cent or more from their recent high point as sentiment collapses and investors flee the market en masse.
With many expecting the US economy – the world’s largest – to enter recession in the near future, there is much speculation about whether a bear market would follow.
Lars Kreckel, global equity strategist at LGIM, said: “If you know only one rule of thumb for equities, it should be that recessions trigger bear markets.
“Of the past 14 recessions, 11 were accompanied by a bear market. Another two were preceded by significant drawdowns just under the arbitrary 20 per cent cut-off for a bear market. That is an almost perfect track record.”
Bear markets and recessions
Source: LGIM, Bloomberg
Why do recessions cause bear markets? The strategist notes that investors do not really care about the nominal GDP figure that is being reported but rather the fact that economic recessions go hand in hand with recessions in earnings.
Indeed, every economic recession since the 1960s has come with an earnings recession. Falling GDP means that companies sell fewer items and companies are more likely to try to sell their goods and services at a cheaper price, leading to negative revenue growth.
When all of this is combined with a large proportion of the cost base being fixed (because of sticky wage levels, the cost of factories and other facilities, etc), then a relatively moderate fall in revenues can turn into a more severe decline in profits. This is what spooks investors.
Economic recessions and earnings recessions
Source: LGIM, Bloomberg
“When translating economic growth into earnings growth, a few things in particular matter,” Kreckel said.
“Taking into account where companies in the equity index generate their revenues is more important than global GDP, so we calculate sales-weighted GDP. The level of sales-weighted GDP growth is obviously important for earnings growth, but just as important is the change in sales-weighted GDP growth. How quickly is growth falling?”
The strategist pointed to research by Tim Drayson, head of economics at LGIM, who argued that the next US recession is “likely to be mild” if it occurs relatively soon and does not come with any policy errors.
The asset management house currently sees the probability of the US entering recession over the next 12 months at around 30 per cent, which is the most elevated risk it has forecast since the current expansion began.
But Drayson suggested there are several reasons why the next US recession will be a mild one: “The length of the expansion, now in its 11th year, does not mean the US requires a deep recession to purge excesses and reduce overheating. Despite low unemployment, the output gap appears around zero and inflation is well under control. So any downturn should quickly create economic slack and allow policy to focus on supporting growth.
“Cyclical parts of the economy – such as housing, autos, and business investment – do not appear overstretched. Indeed, in the case of housing, the current level of residential investment is typical of that seen at the start of the economic cycle. In other words, it is hard to crash if you have not got off the runway.
“In addition, household-sector balance sheets appear in particularly good shape. Debt has fallen and debt-servicing costs are historically low. The savings rate appears relatively high compared with household wealth (though savings data can be prone to substantial revision). So households could probably tolerate some declines in asset prices without having to raise savings from current levels.
“Furthermore, if there is a recession, the banks seem much better capitalised and less exposed to defaults, so they should not amplify the downturn by restricting credit to worthy borrowers. The Senior Loan Officer Survey should be a good indicator to check for a credit crunch.”
Because of this, Kreckel said that a mild recession in the US would likely result in “an unusually mild earnings recession”.
Sales-weighted GDP growth would dip but remain in positive territory while the actual slowdown of growth should be much less severe than in previous recessions, as the economy lacked a real ‘boom’ before the recession.
LGIM’s macro earnings model suggests that US profits would drop by less than 20 per cent in a mild recession, which would not even register in the top-20 such episodes on record.
As well as the peak-to-trough earnings decline, other factors that could indicate the severity of a bear market include:
* Valuations (bear markets that start with higher price-to-earnings ratios tend to suffer greater drawdowns)
* ‘Hidden’ corporate vulnerability (such as what was seen in 2001 with the huge goodwill write-downs that came after the M&A binge)
* The shape of the expected post-recession recovery (expectations of a V-shaped rebound after a cyclical downturn require a smaller discount than expectations of a longer-lasting or structural slowdown resulting in a U or L-shaped economic recovery)
“The good news is that on most of the above counts the current equity market looks ‘OK’. The current price-to-earnings ratio is close to the historical average of bull-market peaks in the US, and lower in most other regions. Furthermore, we have not had a wave of corporate excess that tends to build up hidden vulnerabilities,” Kreckel concluded.
“So, while there is no such thing as a painless bear market, for the time being we seem to be missing many of the ingredients that would turn a normal bear market into an extreme one like 2001 and 2008. A 20 per cent drawdown would qualify as a bear market and would be roughly consistent with the recession scenario painted.”