What to expect in a recession

Several major global indices fell into bear market territories in the past weeks. Investor behavior has shifted from ‘buy the dip’ during the pandemic to ‘sell the rally’, fearing of a potential recession. A wave of layoffs has swept across businesses, especially in the tech sector in the United States (U.S.) in the first half of 2022. The University of Michigan Consumer Sentiment Index fell sharply to a record low of 50.2 in June of 2022, well below market forecasts of 58, mostly attributable to the soaring inflation, which is at a 40-year high.

To combat the inflation, the Federal Reserve (Fed) has accelerated the pace of its interest rate hike, lifting interest rates by 75 basis points in June. This represents the third hike in 2022, and the largest since 1994. Historically, recessions start a median of 25 months after the Fed begins a tightening cycle, although there have been three cases (in 1963, 1994, and 2015) when a recession did not follow.

The best scenario for the markets would be a so-called soft landing, where the Fed could bring inflation under control without causing a recession. An ideal outcome would be similar to 1994, when the Fed hiked interest rates seven times in 13 months, almost doubling the rate from 3.05% to 6.05%, while avoiding a recession. However, the annual inflation was only 2.7% in 1994, while the latest inflation rate accelerated to 8.6% in May of this year. The unemployment rate was also higher in 1994, at 5.5%, versus 3.6% in May 2022, indicating a tighter labour market and higher labour cost today. These factors suggest it will be more challenging for the central bank to tame the inflation this time around. It is more likely than not that we are going to have a recession as early as next year, as predicted by leading economists.

How long does a recession last?

Based on data provided by the National Bureau of Economic Research, since 1945, the U.S. has experienced 13 recessions, including the short one in 2020. The average length of a growing economy is 5.3 years, and the average recession lasts for 10 months. A full economic cycle is around 6.3 years.

What about the stock market? In the same time period, the S&P 500 experienced 11 bear markets, six of which were accompanied by a recession, according to data compiled by Invesco. Bear markets on average have taken about one year to go from peak to trough, and 2.3 years to return to break-even. The S&P 500 index plunged an average of 33% during bear markets in that period, with the biggest decline occurring between 2007 and 2009, when the S&P 500 dropped 56%.

What does small cap do historically in bear markets or recessions?

History indicates that small caps tend to outperform larger caps after a bear market, and small caps have outperformed large coming out of nine of the last 10 recessions since World War II, according to the Jefferies Equity Research report published on April 8, 2020, JEF’s SMID-Cap Strategy – Thoughts & Observations.

Small cap vs. inflation

Small caps have historically outperformed and have shown better pricing power during most of the previous high inflation regimes, including the early 1960s, and the 1970s. Margins of small cap companies have declined less than large caps when inflation goes up, and in some cases, small cap margins go up with inflation, according to the BofA report by Jill Carey Hall, Small cap primer: the big guide to small stocks, published on May 31, 2022. Companies we invest in at Global Alpha are leaders in their niche markets, which gives them the pricing power to pass on higher costs to clients, hence maintain a healthy margin in an inflationary environment. 

Small cap vs. high interest rates

Two types of companies are most likely to suffer from higher interest rates. From the valuation perspective, expensive stocks are more likely to get hurt; from the operation point of view, heavily leveraged companies are likely to suffer. The valuation of small caps looks particularly attractive today, as small caps were expensive vs. large leading into almost every other Fed tightening cycle since the 1980s. Today, small caps trade at discount to large caps, as noted in the BofA’s report, Small cap primer: the big guide to small stocks. Companies we invest in at Global Alpha are high-quality companies trading at reasonable prices. Approximately one third of the companies in our portfolios have a net cash position.

Expansion and recession are a natural part of the economic cycle. It is important to be diversified, and stick to quality names that benefit from secular trends. It is during the down markets that more investment opportunities will emerge. The Global Alpha team has identified many great companies that are trading at attractive valuations, and we will introduce these names in future commentaries.