How might bad news for the economy be good news for the stock market?

In the past few weeks, you have probably heard or read a lot about a possible recession, or further potential declines in the stock market. Yet, we have seen stock markets try to rebound right as it sounds like the economy could be about to slow down or go into a recession. Is this just another “bear market rally”, or could this be indicating a possible turn in the markets?

The Possibility of a Recession is Likely Priced into the Markets Already

Unfortunately, it is easy to see a scenario where we see the rapidly rising cost of nearly everything, along with spiking interest rates, trigger a recession and a further decline in the stock market. However, we need to keep in mind the stock market is a forward-looking economic indicator, meaning it usually reacts to what is expected to happen in the economy 6-12 months from now.  The TSX is already down around 10%, the DOW and S+P 500 are both down approximately 20%, and the NASDAQ had been down roughly 35% so far this year. While stock markets have been declining, corporate earnings have actually grown slightly, and actual economic data (aside from inflation) has not been bad enough to justify such a large drop in the markets. It is quite possible the US is already in a mild recession, and their stock markets have already declined to reflect this. It was not too hard to predict the record-high price of gas would slow the economy down on its own, and rising interest rates would slow the economy down even further, so the possibility of a recession shouldn’t be too surprising and is likely priced into the markets already.

So, what does this have to do with bad economic news potentially being good for the stock market?

Well, the prevailing narrative for this year has been multi-decade highs in inflation requiring interest rates to be raised aggressively to try to fight that inflation, consequently causing the stock markets to decline (due to stock valuations being reduced). If we start to see signs that inflation is peaking or that the economy is slowing, it should mean that central banks won’t need to raise interest rates as much as previously expected, which would likely be positive for the stock market.

Are we starting to see signs that inflation could be in the process of peaking?

There is a long way to go for it to meaningfully come down, but there are a few important things that are starting to move in the right direction. After rising for more than two years, the price of oil has finally dropped by a sizeable amount, and over the course of a few weeks. This could just be a correction in the oil bull market, or $120-$130 per barrel could be the ceiling in the price of oil. The rising price of gas, and specifically diesel, has been a direct result of oil prices heading higher, and has been feeding into inflation as it raises production and shipping costs of many of the goods we purchase. If the price of oil can stay below $120 per barrel and gradually decline over the longer term, it would likely make a significant impact in bringing inflation down.

Another major component of inflation is housing costs, and we are starting to see data that both house prices and the number of home sales have started to decline in the past few months. With interest rates set to rise further from here, it is likely this trend will continue and we will see housing prices start to comeback down to a more reasonable level, bringing inflation lower with it.

The pandemic was a major source of supply chain problems, as it caused product shortages and rapidly rising prices, which helped to fuel inflation. As most countries around world lift Covid restrictions and move away from “lockdowns”, this should help to normalize supply chains and inventory levels, which should also reduce inflationary pressures.

Even the mere prospect of a recession is starting to manifest in commodity prices, as the prices of natural gas, wheat, corn, cotton, and copper have all moved sharply lower in recent weeks over fears of a growth slowdown. The effect of these various price declines won’t show up in inflation readings for a few months, but they certainly hint that inflation numbers could start to move lower before too long.

On one hand, we can see the pathway for inflation to cool down over the next 6-12months. On the other hand, some recent data is revealing some slowing down of the economy is already underway. If inflation starts to decline, and/or economic data starts to show the economy slowing down significantly, central banks probably won’t need to raise interest rates by as much as currently expected, and that could be a catalyst for the markets to start recovering.

Don't Wait to Invest Based on Only Hearing Good News and Positive Outlooks

I am not attempting to call the market bottom or the peak of inflation, as we could still see the price of oil break above $120 per barrel and push inflation even higher and the stock market even lower. However, there are some reasons for optimism that we have hit “peak bad news”, and the markets could put in a bottom and start to recover if news is not as bad as expected going forward. I recently heard a quote (from Howard Marks) about being a skeptic that seemed appropriate for the current environment we are in. He said “In good times, skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. People have a hard time doing that.”.

If you wait until you are only hearing good news and positive outlooks to invest, chances are the markets will have already rebounded by then, and you will have missed out on a good opportunity to make some money as the markets recover. We will probably continue to see volatility in the markets and gloomy headlines in the media for at least the next few months, but remember the famous sayings that “bull markets are born on pessimism” and “stocks markets climb a wall of worry”. There may just be a silver lining in all those clouds.

- DennisRubeniuk, Investment Advisor

Dennis Rubeniuk is an Investment Advisor atEndeavour Wealth Management with iA Private Wealth Inc, an award-winning officeas recognized by the Carson Group. Together with his partners he provides comprehensivewealth management planning for business owners, professionals and individualfamilies.

This information has been prepared by DennisRubeniuk who is an Investment Advisor (Mutual Funds) for iA Private Wealth Inc.and does not necessarily reflect the opinion of iA Private Wealth. Theinformation contained in this newsletter comes from sources we believereliable, but we cannot guarantee its accuracy or reliability. The opinionsexpressed are based on an analysis and interpretation dating from the date ofpublication and are subject to change without notice. Furthermore, they do notconstitute an offer or solicitation to buy or sell any of the securitiesmentioned. The information contained herein may not apply to all types ofinvestors. The Investment Advisor can open accounts only in the provinces inwhich they are registered.