Is a recession already priced into ASX 200 shares?

What's next for the market is anyone's guess…

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Key points

  • There's plenty of chatter about how Australia will fare in a global economic downturn
  • The question then becomes if investors have priced in a recession, or if there's still strong optimism dictating markets
  • Meanwhile, ASX 200 shares have posted a comeback today with all sectors in the green

With equity markets in turmoil this year, most investors are questioning when – and at what mark – we'll find a bottom in the broad ASX 200 indices.

It's been a difficult year for just about all sectors in 2022. Indices tracking the performance of each ASX sector are all down, except for utilities and energy.

The once high-flying tech and information tech domains have been punished the most.

For instance, the S&P/ASX 200 Information Technology index (ASX: XIJ) has slipped around 35% into the red this year to date, and is trailing all other sectors over the past 12 months as well.

Zooming out, there's a total of eight Global Industry Classification Standard (GICS) sectors down in the past year, while just three have punched up into the green.

But there's plenty more room to run with the broad market now trading back more or less in line with its pre-pandemic levels, as seen below.

TradingView Chart

What does this tell us about ASX 200 shares?

Chief to the investment debate is the Reserve Bank of Australia (RBA)'s decision to lift policy rates in order to combat surging inflation.

It has done so at a rapid pace, with a series of hikes earlier in the year sending an impulse throughout financial markets and the economy.

The subsequent increase in yields on long-dated government bonds – often a proxy for risk in the market – shot to multi-year highs, compressing the valuations of generously priced ASX 200 shares.

At the time of writing, the yield on the 10-year Australian government note is sitting at 3.9%, just off 4.15% in June – its highest mark in years.

As seen in the chart below, the yield on the Australian 10-year and US Treasury 10-year notes have been a leading indicator for ASX 200 shares in 2022.

As yields have spiked, share prices have de-rated downwards in an inverse relationship.

TradingView Chart

This is due to the relationship between asset valuations and the yields on these government bonds – the higher the interest rate, the lower the valuation.

The spike in both policy rates by the RBA and yields on government bonds also signals tough times ahead for investors and the real economy.

Striking the right balance

Right now, central banks have a balancing act to perform in order to reduce inflation and maintain a respectable level of economic growth.

Chances are that a successful landing of both issues is quite unlikely, as history has shown.

Typically, there's a slowdown in economic growth as the intervention by central banks tends to slow aggregate demand. Especially with efforts from the US Federal Reserve in trying to cool the US economy.

However, Australia has fared well in previous global recessions, and both job and economic growth numbers are currently strong.

The review of last month's consumer price index (CPI) data for Australia showed a 20 basis point month-on-month decline in inflation to 6.8%. Previously, it was 7% in July.

What's next?

The question then turns to what the RBA might do next, and if it sees the current level of policy rates as acceptable in achieving its inflation mandate.

Markets have priced in a high chance the RBA will deliver another 50 basis point increase to the cash rate when it meets for its monthly sit-down next week.

This could, in turn, spell further jumps in government bond yields and further dampen the price evolution for ASX 200 shares when looking ahead.

Moreover, with so many external headwinds yet to be clarified, including tension in Europe, issues in the global supply of key industrial materials and ongoing financial market instability, it's unwise to say investors have fully priced in a recession.

There's still too much unknown, and the market takes pride in assigning value based on past history and forward expectations.

Meanwhile, in today's session, all sectors are up and running and have posted gains at the time of writing.

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