What history suggests about the economic recession and stock market returns.
On Thursday, July 28, 2022, the US economy technically entered a recession. The US economy contracted for a second consecutive quarter. Gross domestic product (GDP) fell at an annualized rate of 0.9% after falling 1.6% in the first three months of the year. The most common definition of recession requires a country’s GDP to contract in two successive quarters.
The reason for such a drop in economic activity is the monetary tightening carried out by the US Fed to curb inflation in the economy. The US Fed has raised the Federal Funds Rate (FFR) by 150 basis points in the past two meetings. This aggressive policy was adopted to contain inflation, which was at its highest for forty years. The FFR is the interest rate at which commercial banks in the United States borrow from each other overnight.
The US inflation rate was over 9% last month and the US Fed’s target inflation rate is 2%, which means a gap of 7 percentage points. Historically, whenever the Fed has attempted to lower inflation by more than 2 percentage points, the United States has experienced a recession.
Impact on Indian economy
In a globally interconnected world, we cannot remain immune to what is happening in other parts of the world. The impact of the slowdown on the world’s largest economy will have a negative impact on the Indian economy, especially on the trade relationship between India and the United States. The United States overtook China to become India’s top trading partner in the 2021-22 financial year. Two-way trade between India and the United States stood at $119.42 billion, or 11.5% of India’s total trade. Among India’s top 10 trading partners, the United States is the only country with which India has a positive trade balance. Therefore, a slowdown in the United States could have a greater impact on the Indian economy.
Silver lining of the global recession
Those who focus more on US economic data and Eurozone data are not very encouraging. Eurozone trade activity contracted unexpectedly this month (in July 2022). Its Purchasing Managers’ Index (PMI), an indicator of overall economic health, fell to 49.4 in July from 52.0 in June. A reading below 50 signifies contraction and above 50 signifies expansion. This contraction was driven by an accelerating decline in manufacturing activities coupled with a virtual halt in growth in the services sector.
Although the fundamentals of the Indian economy remain solid in terms of corporate debt, foreign exchange reserves and other macro-economic indicators, the relentless rise in the price of crude oil should not be overlooked. India is heavily dependent on imports for its energy needs, as it imports more than 80% of its crude oil consumption, which could affect its current account deficit.
But the good news is that if the world’s major economies go into recession, we could see a drop in crude oil prices. It has already fallen from 134 dollars a barrel a few months ago to 100 dollars a barrel for fear of recession. There was an earlier impact as well when we saw crude oil prices soar on fears of a recession. During the Great Financial Crisis (GFC) of 2008-09, brent crude oil crashed from a high of $147 per barrel to near $35 per barrel. More recently, during the Covid-19 pandemic, the unthinkable happened and the price of oil turned negative. Therefore, if a global slowdown were to occur, oil prices would surely take a hit, which would be very positive for India.