A Timeless Lesson From Italy’s Recession

“Stocks are a leading indicator of the economy” is one of those basic truths that investors always accept until push comes to shove. It is one thing to believe this in an academic sense. It is another to accept it when economic data hit the doldrums—especially if a recession materializes. So we thought Italy’s recession, which became official three weeks ago, would be a handy way to reiterate this timeless maxim—a reminder that waiting for economic data to confirm an upturn is a common investor error.  

Exhibit 1 shows the MSCI Italy Index in euros, to remove currency conversion skew, since 2018 began. Note how it peaked a few weeks before GDP did and bottomed about a month before the recession became official.

Exhibit 1: Italian Stocks Moved Before GDP

Source: FactSet, as of 2/21/2019. MSCI Italy Index returns with net dividends in EUR, 12/29/2017 – 2/22/2019. Indexed to 100 at 12/29/2017. Istat initially announced Q3 GDP on 10/30/2018 and Q4 GDP on 1/31/2019.

Stocks are efficient. They don’t wait for official evidence of economic developments before they start discounting them in current prices. Rather, they reflect all investors’ expectations, observations and fears in real time. In Italy’s case, investors started seeing the potential for a new government to stir credit-market volatility—impacting borrowing costs and business investment—well before those developments became apparent. Seven-plus months later, with those credit-market disruptions fading, investors seemed to start pricing in the resumption of business as usual and unleashing of pent-up demand. Time will tell if those intuitions are correct, but pricing in the gap between expectations and reality is part of markets’ normal ebb and flow.

Markets’ forward-looking nature explains why stocks typically resume rising before a recession ends. The US’s last bear market ended on March 9, 2009, but GDP continued contracting through June 30, and it would be a few months more before economic data started confirming a nascent recovery.^[i] The eurozone’s last recession ended at the end of Q1 2013. But eurozone stocks began rising in earnest after retesting their bear market low in early June 2012.^[ii]

By the time economic data confirm a recession, there is likely little investors can do about it. That is the bad news. The good news? Simply sitting tight, if you have already survived the downside, ensures you are positioned for that sharp bounce that typically precedes the recession’s official end. Just remember to always think like markets and look forward, not backward.