Numerous commentators – including Bank of England Governor Mervyn King – have expressed surprise at the resilience of equity markets given the significant risk of a global “hard” landing. My attempt at an explanation goes as follows.

As I have noted before, G7 industrial output growth peaked at an annual 4.5% in September 2006, marking the start of the current economic downswing. 12 prior downswings in G7 industrial growth can be identified over the last 40 years. Six were associated with US recessions, as defined by the National Bureau of Economic Research – “hard” landings. The remaining six can be termed “soft”.

Unsurprisingly, global equity markets tend to perform well in soft landings and badly in hard landings. I calculated an index of average performance starting from the cyclical peak in G7 industrial growth for each of the two groups. I then superimposed these averages on the current cycle – see chart.

Global equities have so far followed the historical soft landing path closely. Does this imply that markets are irrationally ignoring the significant risk of a hard landing? Not necessarily. If the current downswing does indeed turn out to be soft, the historical average would suggest a further rise in equities of 20% from closing November levels by the end of 2008. If a hard landing transpires, a fall of 13% is indicated. The resilience of equities may therefore partly reflect market participants’ assessment that the potential gain in a favourable economic scenario exceeds the loss in the event of a US recession / hard landing.

Based on recent economic evidence, it seems reasonable to assign 60% / 40% probabilities to soft / hard landings at present. Using the historical averages shown in the chart, this would imply a probability-weighted price change between November’s close and the end of 2008 of +7% (i.e., 0.6*20 - 0.4*13). Adding on dividends gives an expected return of 9%. This compares favourably with cash rates and likely bond performance.

Equity markets will clearly weaken if the probability of a hard landing increases further but current price levels are defensible based on the latest economic indicators.