There’s a clear chance the world is heading into recession, as higher interest rates put pressure on mortgage holders and debt-laden companies. That’s bad news for the economy. But the stock market is not the economy.

No-one wants a recession. But they want inflation even less.

If a recession is the price of getting on top of inflation – well, that’s a price central bankers think should be paid.

So:

– What does this mean for investment markets?

– Surely an economic contraction is bad for our wealth?

– And what is really going to drive markets from here?

It’s true that over the long run, growth in the economy should correlate to growth in investment markets.  But looking at the immediate economic environment is an unreliable way to judge which way markets are going to perform.

Here are three reasons why.

1. Markets anticipate the economy

Investments are valued based on the benefits investors think they will receive in the future.  You’ve heard the adage: past performance is not a guide to future returns.

The economy is measured quite differently: the statistic that matters is the growth in recent quarters, or years.

So don’t be put off by talk of recession. The stock market tends to find the bottom long before the end of a recession – or even before one starts. Economists have been forecasting “the most anticipated downturn ever” for months now: investors have had a long time to bake that value into asset prices.

2. The bond market is where the real action is

The bond market is around 50% bigger than the stock market.  And it can make a real difference to your returns.

Of course, there are the bonds you own through your own investments – say in your pension as you approach retirement.

But there’s also the money that moves in and our of bonds and into the stock market, affecting demand and valuations.  For example, a report this year estimated the UK pensions industry has overseen a massive outflow of money (around €450 billion) out of stock markets into bonds over the last quarter-century. What happens in the bond market matters.

In 2023-24, the bond market has real potential to drive investor returns, as interest rates plateau and are then cut.  This will help unwind the major falls seen last year in bond markets.

3. The stock market isn’t for everyone

If you only paid attention to those companies listed on stock markets, you could be forgiven for thinking the world is made up of tech firms, pharma companies, and banks. There’s a whole world of economic activity out there which never looks to the stock market.

Firstly, there’s the public sector: the millions employed in schools, hospitals, public services and so forth, usually paid out of taxation.

There are also many businesses that don’t need to raise finance in the public market.  Most law and accountancy firms, services businesses, and owner-managed businesses, not to mention some very large private businesses are not listed.  Mars, the chocolate bar-to-Pedigree dog food manufacturer had sales of $45 billion last year, for instance.

Interest rates are the key to growth from here

That the stock market is not the economy is true more than ever in the conditions of 2023.  Why?  Because interest rates will have such a powerful role in determining the direction of markets from here.

Inflation and rising rates are the root cause of poor market performance over the last 18 months, and reversing them is the key to recovery.

There’s no doubt that inflation has taken longer to fall than governments and central bankers expected (although there’s decent evidence the rate of inflation is falling now).

The onset of recession – while never pleasant in the real world – would play a major role in reducing demand, and so reducing price inflation. In turn, that would likely prompt interest rate reductions which will help support valuations of many listed assets as well as bonds over the next economic cycle.