Caught in an economic wave or just a ripple? – Global markets are falling – Seema Shah

Global markets have been rocked by a series of sharp blows over the past few days, but mostly centered around concerns about the health of the U.S. economy. We continue to think the strength of household and corporate balance sheets means a recession is unlikely, but risks are mounting. If economic data continues to worsen, the Fed is well-positioned to respond aggressively — but we still forecast the Fed will cut rates by 25bps in September and December — with another 25bp cut in November added to the mix.

Unfortunately for markets, the negative narrative suggests that a combination of solid economic data, earnings data and reassuring comments from the Federal Reserve may be needed to calm nerves.

Latest Economic Data and Market Reaction

Markets were already wobbly, but a disappointing July US jobs report largely led to a sharp sell-off on Friday. As a reminder, US nonfarm payrolls slowed to +114k m/m (vs. expectations of 175k), down from -29k m/m prior. Private sector payrolls rose just +97k m/m. The unemployment rate rose from 4.1% to 4.3%.

Markets reacted to the data with dismay (and a bit of panic), with many analysts wondering whether the US economy was already in a recession and even considering the possibility of an emergency interest rate cut by the Federal Reserve during its meeting.

The price movement in the broad market also looks very dramatic

The S&P 500 fell 4.2% at the start of today’s US session, while the Nasdaq also fell 5.4%, joining the Magnificent 7 in correction territory. This decidedly risk-off tone has driven yields lower, with the US 10-year Treasury yield falling below 3.8% and down more than 30 basis points since last week’s FOMC meeting (at the time of writing), and the 2-year yield down a point from almost 60 basis points in the past few days. The 2s10s yield curve spread — a classic recession indicator — has widened sharply and is flirting with disversion for the first time since July 2022.

The US price moves come amid significant overnight volatility in Asia, where there was a broad sell-off in Japanese markets: the yen continued to rally against the dollar, while the TOPIX and Nikkei indices fell 12%, with the latter shedding more than 20% from its July peak.

How bad was the July jobs report?

Before COVID, an increase of 150,000 in the number of workers would be considered consistent with a very strong economy, a number between 100,000 and 150,000 would be consistent with a slowing economy, a number between 75,000 and 100,000 would start to give a sense of the direction of the economy, and a number below 50,000 would be cause for serious concern. On this basis, a continued decline in job growth in the coming months from July’s print of 114,000 would be a serious cause for concern, and as such the market is perhaps justified in its response. However, there are two complicating factors in the current environment:

This is just one month of data, and payrolls can typically fluctuate. It’s worth noting that the April 2024 payroll number initially came in at 165,000, then was revised down to 108,000, before rising to 216,000 the following month. Without stating the obvious, one month doesn’t make a trend, so next month’s employment report will be very important.
Economists are trying to determine how much of the slowdown in U.S. employment in July was caused by Hurricane Beryl. An unusually large number of nonfarm payroll workers reported being off work due to the weather and/or being temporarily laid off. At the same time, a reduction in weekly work hours would also be consistent with weather conditions. Interestingly, the San Francisco Fed recently released a paper suggesting that the weather could boost employment by 15,000 to 30,000 in July.

However, several parts of last Friday’s report do point to a fundamental decline. For example, a narrowing of job creation in the sector, which is not usually consistent with bad weather, and an increase in the number of workers moving from employment to unemployment. In addition, the BLS noted that Hurricane Beryl had no significant impact on unemployment (this is a bit odd, and analysts have a hard time explaining it).

Markets reacted not only to a disappointing payroll report but also to a rise in the unemployment rate, which triggered Sahm’s rule. The rule indicates a recession if the three-month average unemployment rate rises by 0.5% over a 12-month period. However, this particular recession signal may be weaker than it seems.

Sahm’s rule typically applies when unemployment rises due to layoffs. In this case, the rise is mostly due to labor force growth, not job losses, so it doesn’t necessarily signal a recession. Claudia Sahm, the rule’s creator, says: “Sahm’s rule rightly signals caution about a cooling labor market, but its impact is exaggerated by the shift from pandemic-induced labor shortages to increased immigration.”

Take a deep breath and take a step back

Given the uncertainty surrounding the latest jobs report, it’s important to look at the totality of the data (to borrow Jay Powell’s words). It’s still early, but the Atlanta Fed’s GDPnow estimate suggests third-quarter GDP is now at 2.5%. However, last week’s weaker-than-expected ISM Manufacturing report (46.8 vs. expectations of 48.8) and initial jobless claims rising to their highest level in almost a year are concerning.

Economic growth in the U.S. has been slowing significantly, and the labor market has been cooling for several months. While the labor market has appeared to be in good shape on the surface (average three-month wage gain of 170,000), beneath the surface, companies have been reassessing labor costs. Recent surveys show that the number of job openings has fallen significantly, and smaller companies are pulling back on hiring plans. As we noted in our latest Global Market Perspectives report, “labor market surveys suggest that further weakness in labor demand should be reflected in the data soon, likely leading to a modest increase in jobless claims and unemployment.”

So yes, the market has a right to worry. But whether labor market weakness translates into widespread job losses depends on the underlying strength of the economy. If household balance sheets are strong and corporate profit margins remain healthy, mass layoffs and a downward spiral in earnings should be avoided.

So far, there have been clear signs of stress among lower-income households. But middle- and upper-income households, which account for about 60% to 70% of consumer spending, remain in good shape. Combined with gains from exposure to housing and stocks, household balance sheets have remained broadly strong. Total U.S. household net worth as a percentage of disposable income is near a record high.

Similarly, while small businesses are showing signs of weakness, confidence among large businesses remains very strong. Indeed, second-quarter earnings have so far been better than expected, with most companies beating expectations and profits rising almost 13%, above the preseason forecast of 8%. Broad corporate balance sheets are also in good shape, with interest payments on profits at their lowest level since 1957.

The risk of recession is rising, and strong household and corporate balance sheets should prevent the economic slowdown from turning into a hard landing.

And then there’s everything else…

In addition to weak employment data, markets reacted to a confluence of other events.

Bank of Japan: The BOJ last week raised interest rates by more than expected and announced a plan to halve its gross monthly bond purchases over the next few years — a more hawkish plan than investors had anticipated. That has helped the yen gain 9% since early August. While the yen was widely expected to rise, the speed of the rally has surprised many.
The currency shift has made the yen less attractive for carry trades, where investors borrow yen at near-zero interest rates to invest in higher-yielding assets like U.S. stocks. As the yen strengthens, these trades unwind, contributing to weakness in the U.S. stock market and rising risk-averse sentiment. It’s worth noting that this can create a self-reinforcing loop, where equity market weakness causes further yen strength, and so on.
Large technology companies: Coming into this earnings season, there were already concerns that Big Tech would disappoint. In fact, six of the Magnificent 7 disappointed markets. The news that Warren Buffett’s Berkshire Hathway decided to reduce its stake in Apple by almost 50% in Q2 didn’t help. But the structural strengths of these companies (strong liquidity, high quality, innovation, productivity boosters) suggest that investors are looking for the right opportunity to re-enter the market.
Near East: Recent events in the region have increased the risk of a full-blown conflict. While the impact on oil prices has not been as significant, the risk of a major war has inevitably increased risk aversion.

Federal Reserve

Markets have moved from pricing in 50bps of easing this year to more than 125bps. That would imply another 50bps cut in September and November, and a 25bps cut in December. Some analysts have even suggested that an emergency mid-meeting rate cut is warranted. That seems like a panic reaction—mid-meeting cuts have typically only happened in financial crises. Chicago Fed President Goolsbee (one of the more dovish voices on the FOMC) spoke Friday evening and noted that the jobs report is one data point, and he reminded us that there will be a lot of information between now and the next meeting that “will determine the amount or if any action is taken.”

Our view of Fed easing is less aggressive than the market is pricing in. While the weakness of the July jobs report and market sentiment support adding another rate cut to the mix, the Fed would need to see additional evidence of elevated recession risks before moving to another 50 basis point cut.

We expect 25bps rate cuts in September, November, and December (our original forecast was for cuts in September and December only). However, if the August jobs report confirms July’s weakness and additional economic data shows a similar cooling, a 50bps cut in September will become our benchmark.

Importantly, in a worst-case scenario in which the economic slowdown turns into a recession, the Federal Reserve has ample room to cut interest rates and ease financial conditions.

Market prospects

Fears of economic weakness will likely prove to be exaggerated, but the depth of the negative narrative now suggests that a market recovery is unlikely anytime soon. A sustained market recovery will require a catalyst, or likely a combination of catalysts, including a stabilizing Japanese yen, strong financial results, and a solid economic environment.

Core Asset Management