The “astonishing” recovery from the Covid crisis could soon give way to a significant stocks market correction – if history is anything to go by, according to research by Bank of America. 
Although the global economy took a massive hit in 2020 as many countries locked down to tackle the coronavirus pandemic, growth and inflation have jumped in recent months as the vaccine rollout allowed them to re-open.
The recovery in the stock market has been even more impressive. Since the market peaked in mid-February 2020, global equities have posted a total return of 20% (in sterling terms) – and that’s including the 25% drawdown in the initial sell-off.
Since the market bottomed-out at the end of March 2020, the MSCI AC World index has climbed 60% on the back of massive amounts of fiscal and monetary stimulus.
Performance of indices since 19 Feb 2020
Source: FE Analytics
A paper by Bank of America analysts labelled the rebound in both economic activity and risk assets over the past year as “astonishing”. They noted that risk assets have already rallied to a point that it took two years to reach in previous recoveries, on both absolute and risk-adjusted bases.
However, they warned that past recoveries have always been followed by a large drawdown in stocks and other risk assets.
“While trading has been choppy at times and we've seen idiosyncratic corrections and rotations across growth, value and re-opening trades, we have yet to see a sustained drawdown and correction across risk assets,” they said.
“However, looking over the past 90 years, we find that every economic recovery has run into a substantial drawdown at some point in the first two years following troughs in US GDP, with the S&P 500 falling an average of 18-20%, and only one episode below 10%. Given this regularity in recovery dynamics, is history bound to repeat?”
Size of largest drawdown in S&P 500 in first 2 years following recovery in US GDP
Source: BofA Global Research, Bloomberg
In the first quarter of 2021, the US economy posted annualised GDP growth of 6.4% while the Chinese economy was up 18.3%. Bank of America expects global growth to remain strong in the near term as countries continue to open up and areas like Europe catch up.
However, it argued that “peak growth may well be behind” as the re-opening and base effects start to fade, policy stimulus eases and the recovery normalises in pace.
“With the spread of the Delta variant keeping Asia locked down, additional US stimulus significantly damped and a slowing and more restrictive China, the global growth machine may not have enough fuel for a second wind,” they added.
In addition, while many believe that recent high inflation will prove transitory, the risk remains that central banks could be forced to tighten policy if prices continue to rise to fast for too long. Given that ultra-loose policy has fuelled much of risk assets’ gains, this would be a major headwind for the market.
Bank of America’s analysts continued: “Given the risk of being past peak growth, rising inflation, impending central bank tapering and the spread of the Delta variant weighing on the economic recovery, is the new bull market heading towards a correction?
“In every episode outside of 1991, the S&P 500 experienced a drawdown of at least 10% within the first two years of the recovery, with full and post-war averages of 20% and 18%, respectively.”
There seems to be a wide variance in the timing of these drawdowns – the one in 2001 came almost immediately after the recession while it took 15 months to appear after the end of the 1953-1954 recession.
The average time to the start of a drawdown is seven months, which the current recovery has passed.
Max S&P 500 drawdown size vs length of max drawdowns in first 2 years following recovery in US GDP
Source: BofA Global Research, Bloomberg
The length of the major post recovery drawdowns also ranges widely – from less than a month to more than 1.5 years – with an average of 8.6 months. The chart above illustrates how the longest drawdowns tend to be the largest.
Bank of America conceded that predicting the start or length of any drawdown is “an impossible exercise” but did further analysis to determine if investing at a medium-term top can still be fruitful over the following two years.
Cumulative returns in two years following start of largest drawdown following recovery in US GDP
Source: BofA Global Research, Bloomberg
“The S&P 500 runs into average drawdowns of 20% in the first two years of recoveries, but risk assets still ended up ahead,” the research said.
“We find that equities generally tended to still post mildly positive risk-adjusted returns, outside of 1980 and 2002 for MSCI World and S&P 500 indices respectively, with averages of around 0.4.
“Looking at cumulative returns, equities were still able to push higher by an average of 8-9% despite facing 17.5% drawdowns.”