The next bear market is coming, but it should be less fierce than the last downturn
Tai Hui says the global economy is showing decent momentum, and the US economy has become more stable. The next recession is more likely to resemble the mild ones of 1990 and 2001 than the 2008 monster
This month marks the 10th anniversary of the collapse of Lehman Brothers, the event that turned turmoil in the United States housing market into the global financial crisis. A decade on, people are naturally wondering how long it will be before the next equity bear market.
Investors are growing increasingly mindful of just when the US economic growth cycle will end. While the relationship between bear markets and recessions is not perfect, eight of the last 10 bear markets in the US were associated with recessions.
Given that the Hong Kong market is highly correlated with the US market, it would be difficult for the region to decouple from the US when the downturn comes. Since 1990, 73 per cent of the monthly returns for the S&P 500 and the Hang Seng Index have moved in the same direction, whether up or down. On a more positive note, market downturns are usually shorter than upturns.
Precisely predicting market downturns and recessions is notoriously difficult. Since the current US economic growth cycle is already the second longest on record, some investors think the end must be near. However, comparing the length of the cycle with the averages tells you little about the durability of the current cycle.
Financial conditions in the US remain accommodative. Real interest rates remain low by historical standards, and the real yield on the US 10-year Treasury, at 0.5 per cent, is well below the long-term average of 2 per cent. In six of the last eight US recessions, the real yield on the 10-year Treasury breached 2 per cent in the lead-up to an economic decline. The current interest rates are still favourable for debt servicing and should stay this way for the next 12-18 months.
Beyond the US, the global economy is showing decent momentum. The global manufacturing Purchasing Managers’ Index is still above 50, reflecting firm growth. Despite the political noise, the unemployment rate continues to fall in the European economy, consumption is solid and business investment is picking up.
China’s economy has softened on the back of Beijing’s effort to deleverage, but the authorities are prioritising selective stimulus measures to maintain growth around the official target in the face of trade worries. Global trade has weakened in the first half of 2018, with uncertainties from the US-China trade war yet to fully manifest themselves, but this should be partially mitigated by strong demand globally.
On the issue of recession, it needs to be said that, despite the past crisis, the US economy has actually been getting more stable over time. Better inventory management and more stable housing and services sectors in the US have all contributed to this trend. Banks are also better capitalised. This suggests the next recession is more likely to resemble the relatively mild recessions of 1990 and 2001 than the monster of 2008.
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Likewise, the next bear market should not be as ferocious as the last two. In the last two bear markets, the US stock market fell by an average of 50 per cent. However, in the previous nine recessions, the average stock market decline was just 24 per cent. This makes intuitive sense – the last stock market tumble came against a backdrop of the single biggest recession since the Great Depression, while the stock market entered the previous bear market with valuations that were a full 50 per cent higher than the average forward price-to-earnings ratio over the last 25 years.
If the next bear market is indeed serious but not catastrophic, then investors need prepare to weather the downturn prudently, instead of adopting an Armageddon strategy.
For investors in Hong Kong, the extra complication is the performance of the Chinese markets, which has been challenging this year due to the trade tensions, and the slowing growth momentum due to deleveraging.
Sentiment in China is also pessimistic. This may be undue, especially given the chance of the central government bringing in further stimulus measures. Nonetheless, it makes sense for local investors to reduce their exposure to Hong Kong equities.
Tai Hui is chief market strategist, Asia-Pacific, at J.P. Morgan Asset Management