It happens very slowly and then all of a sudden. The positive narrative in investment markets seems to have been upended in the space of a week. Since the start of August, nervousness has become rife. In the US unemployment is rising, stocks are falling, and bond yields are well below short-term interest rates. These are all the usual harbingers of recession.
However, detailed analysis suggests that while recession risk has risen (Goldman Sachs raised its probability of US recession from 15% to 25%), the US isn’t in one now. The distinction is crucial because it means it isn’t too late to avoid a downturn. It depends on the Fed, and on the moods of investors, consumers, and employers. The Fed is very likely to cut rates in September.
Two events have driven the recession talk. The first is the stock-market selloff, which wasn’t only triggered by news of the US economy, but by the Bank of Japan’s (BoJ) decision to tighten monetary policy (taking rates from 0% to 0.25%).
The second event came a few days later when it was reported that the US unemployment rate had jumped from 4.1% to 4.3% in July, triggering the Sahm Rule (a rule of thumb that, simplified, says once the unemployment rate rises 0.5% from its low in the previous 12 months, the US is in recession). But the US is not in a recession now – at least not when calculated by the usual methodologies.
What about the sharp correction on the stock market, which as I write is around 8% lower than a week ago?
Recessions are usually preceded by share market corrections, although not every stock slump has been followed by recession. The reasons for a weaker market matter. Sometimes overleveraged market participants dump stocks for reasons having nothing to do with the economy. The Bank of Japan’s rate increase caused a sharp rise in the yen, forcing a wave of selling by investors who had bet heavily on it staying low (reversing the “yen carry trade”).
Whether such deleveraging leads to recession depends on whether the financial system also starts to crack, as it did in 2008 at the start of the GFC. Of that, there’s little evidence of this. Treasury bond yields have declined, but they would have fallen even more sharply if panicked investors were flocking to safety.
It would be worrisome if corporates were forecasting weaker profits and sales ahead. There are some examples, but that hasn’t been the general trend across Wall Street. 413 of the S&P 500 have reported with 78% beating earnings expectations. Earnings growth is now 10.5% on average vs 9% expected for the entire S&P 500.
So, the key question, is the US about to go into a recession? In our view, it remains unlikely. The soft-landing scenario is still the base case, especially now that warning shots have been fired across the Fed’s bow. The likelihood of a Fed cut in September just became almost a certainty.
Source: FT
