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We are all aware that central banks around the world have been hiking interest rates to reduce inflation back to normal levels. The US economy, and particularly the labour market, have been more resilient than most expected. This means the US central bank might have to hike interest rates higher than in other jurisdictions to tame inflation. A consequence of this is that it will probably send the US economy into recession. And if history repeats itself, stock markets will fall. 

If this scenario plays out, what actions should you take now?  

There are three economic scenarios

Share markets have been wrestling with three possible economic scenarios as follows: 

§  Hard landing: this means that the Federal Reserve’s interest rate hikes achieve their aim of curtailing inflation but at the cost of sending the US economy into recession.    

§  Soft landing: this is a Goldilocks scenario where the Federal Reserve hikes rates just enough to cool inflation, but not too high that it causes a recession (or it is able to cut rates in time to avoid a recession). 

§  No landing: it is possible that the US economy continues to be resilient, and inflation remains stubbornly high which means the Federal Reserve must hike rates higher for longer.

US labour market is stubbornly robust 

The problem that the US central bank has (that the RBA doesn’t) is wage inflation is high at 4.6% over the year ended 28 February 2023. If it cannot cool the labour market and stop incomes rising, it probably won’t be able to return inflation to normal levels. The US labour market is proving to be very robust and although there are some signs that it is starting to slow, data is somewhat mixed. 

As reported late last week, the US unemployment rate did rise in February from 3.4% to 3.6% p.a., not because there were fewer jobs but because the participation rate increased (i.e., more people are attracted to return to the labour market and look for jobs). This helped the three-month annualised wage inflation rate slow to 3.6% (compared to the 12-month reading at 4.6%), so there are signs that wage growth is slowing. 

This is the most important issue that markets are watching. If we see more data that confirms wage inflation is slowing, a soft-landing scenario might be considered more likely. 

The other noteworthy difference in the US (compared to Australia) is that most mortgages (home loans) are fixed for 30 years, so it takes longer for higher (variable) interest rates to cool consumer demand.  

What happens to equity markets in a recession?

Most analysts would agree that the US stock market has not priced in a recession. Equity valuations are still relatively high by historical standards with the S&P 500 price-earnings ratio trading at circa 20 times compared to the long-term average of 16. 

Share market valuations have not yet adjusted to reflect higher interest rates. Given you can earn more than 6% p.a. on very safe assets such as investment-grade bonds issued by the big 4 banks, riskier asset classes (like shares) must provide much higher returns to compensate you for the higher risk you take. This is called the Equity Risk Premium. Most investors would expect to earn 5% to 5.5% over the risk-free rate (usually the 10-year government bond rate is used as a proxy for the risk-free rate). Given the Australian government bond rate is circa 3.5% p.a., investors need to earn 9.5%-10.0% p.a. for shares to be attractive investments. Based on Research Affiliates model, 10-year future US equity returns are likely to range between 3.1% and 7.9% p.a. That is not enough to compensate you for the risk. So, prices must

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