Three scenarios that could kickstart a new bull market

As you’ve no doubt noticed, the world’s market commentators, brokers, and analysts have turned decidedly bearish. And they have good reason to be pessimistic. But this bear market will eventually end, to be followed by the next bull market. To my mind, there are three distinct economic scenarios that could kickstart the next upswing.

Someone once said all news is just young people doing old things for the first time. And there is certainly an element of surprise, alarm, and reaction to each data point or central bank utterance, in many of the headlines.

Headlines including, “A US recession appears all but inevitable”, “Don’t be fooled by low P/E ratios”, “Alarm bells are ringing with global markets in growing disarray” and “Shares vulnerable to more pain as recession fears intensify” represent merely a tiny sample from the banner pages of Australia’s major financial newspapers alone. Expand the search globally and we’d be here listing them for days.

What investors need is a game plan, and we’ve recently written extensively offering a framework to help navigate the inevitable vicissitudes that challenge investors from time to time.

So instead of reacting, how about we consider three possible and reasonable economic scenarios and their policy responses?

1. A serious recession

Scenario one is a serious recession following the Fed’s enthusiastic response to persistent, if not stubborn inflation. If the U.S. economy remains resilient and wage and price inflation continue to climb despite central bank tightening, the US Fed will be forced to tighten by more and for longer than the market currently expects.

I recently suggested the market might be in the final phase of its decline, marked by a third leg lower, and that central banks could be forced to recommence quantitative easing (QE) next year if not earlier, triggering a material rally in markets. But if the Fed is forced to lift rates even higher – for example to five percent – and keep rates high through 2023, the final phase of the bear market may linger a while. Bull markets don’t begin while central banks are still raising rates, and V-shaped bottoms are an exception.

The US economy would of course fall into a deeper recession, and earnings would collapse, at least for industrial non-financial companies. Markets cast their shadow before them and the market would bottom at a much lower level than might otherwise be expected as a deep recession becomes self-evident. The bottom would coincide with investors realising the Fed is forced to recommence QE or ease rates again.

2. A moderate recession

Scenario two is a more moderate recession brought about by the Fed rate hikes already accomplished. The lag effect. Initially, the economy remains resilient, as it has done to date, but evidence of economic damage becomes evident. Inflation begins to moderate, as bottlenecks ease and unemployment begins to rise. If disinflation then gains momentum, the U.S. Fed may be forced to reverse course sooner. The market bottoms at a higher level than scenario one.

3. A soft landing

The final scenario is the preferred outcome, and not-so-secret hope, of central bankers – the soft landing. Inflation eases rapidly and materially rising unemployment is avoided through a normalisation of job vacancies. The number of jobs available for each person unemployed eases back from 1.7 with a gentle easing in economic conditions. Under this scenario, the softening economy prompts the Fed to pause, and the Fed Funds rate peaks. Rates may then head lower again if required but may also remain at the paused rate through the remainder of 2023. Disinflation and a positive, albeit low, rate of growth sets the market up for a rally led by innovative growth companies.

While any of the above scenarios are plausible, so are several variations. What isn’t likely to change is the fact this bear market will eventually end, to be followed by a bull market. The only question will be from what level it begins and when. And that’s why the framework we’ve been advocating remains more important than any of the headlines, bearish or otherwise.