So much for the summer lull. Stock markets are in turmoil and bond yields have fallen significantly as fears about a U.S. recession have taken hold.
1. Is the U.S. heading for recession?
While economists use two successive quarters of falling GDP as short-hand for recession, true recessions start when “reflexivity” in the jobs market kicks in: weaker demand leads to less hiring and more firing, which feeds back into weaker demand, creating a vicious cycle that is only broken with government policy support. This is why labour market data is critical to assessing recession risks, and why there has been such an extreme reaction to the July’s U.S. Employment Report released on Friday.
It wasn’t just that payrolls missed consensus expectations – rising by 114,000 vs 175,000 expected – it was that the unemployment rate rose to a three-year high of 4.3%, triggering the Sahm Rule: an indicator which signals the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. The July reading was 0.53%.
“The rise in the unemployment rate has so far been driven by an expansion in the labour force rather than a fall in employment…”
But, some perspective is needed. The rise in the unemployment rate has so far been driven by an expansion in the labour force rather than a fall in employment (the same can be said in Canada, where unemployment has increased, not by layoffs of existing workers, but by new entrants into the labour force). This marks a difference from previous cycles. Other data points paint a picture of a labour market that is cooling, but not collapsing. Data also released last week showed that, while job openings in the U.S. held steady at close to a three-year low in June, there has been no increase in layoffs. Furthermore, the modest decline in average weekly hours worked seen in July’s Employment Report does not scream “recession”.
Piecing all of this together, the probability of a ‘Goldilocks’ outcome – in which GDP growth remains above 1.5% q/q annualised and core PCE inflation drops to 2.5% or below – is likely slightly lower. Likewise, the risk of a recession/hard landing has increased. In reviewing the macro economic data and scenario analyses, the risk of a recession/hard landing has increased, but there is probably something like a one-in-four chance of this happening. Big questions that flow from here are whether the dislocation in financial markets seen over the past week feeds off itself and creates a vicious cycle that feeds back into the real economy and how the Federal Reserve responds. Which brings us to our second question.
2. How will the Fed respond?
“As I noted earlier, while the respective probabilities of a hard and soft landing in the U.S. are converging, our analysis still suggests that the latter is the most likely outcome.”
We have argued in our earlier commentaries that the Fed should have started cutting rates in the second quarter, and I’ve noted before that, by waiting for core inflation to return to target, central banks more generally risk keeping policy too tight for too long (since inflation is a lagging indicator). July’s Employment Report suggests that these risks may be starting to crystallize. With that said, while the report was bad it wasn’t that bad. As I noted earlier, while the respective probabilities of a hard and soft landing in the U.S. are converging, our analysis still suggests that the latter is the most likely outcome.
Given all this, our sense is that the Fed will now cut by 25bps at each of its three remaining meetings this year. It would take one of two developments to trigger a larger 50bps cut. The first is a market dislocation that deepens and starts to threaten systemically important institutions and/or broader financial stability. The extent to which this will happen is inherently unknowable. But it’s worth keeping in mind that a rapid appreciation of the yen, and the subsequent unwinding of carry trades, have played a role in previous periods of acute market stress, including the collapse of the hedge fund LTCM in 1998.
The second is if markets continue to price in a 50bps cut in September (and beyond) and policymakers judge that not delivering it would do more harm than good for financial markets. The fact that the inflation genie appears to now be back in the bottle means the Fed has more leeway in this regard. This is not true of all central banks, and that brings us to our third question.
3. How will other central banks respond?
Many central banks are still trying to calibrate policy in an uncomfortable environment of weak growth and stubbornly high inflation. This is particularly true of the European Central Bank (“ECB”), where euro-zone GDP increased by a solid if unspectacular 0.3% q/q, however, inflation data released over the past week showed that inflation edged up from 2.5% y/y in June to 2.6% in July, and services inflation continued to hover around 4%. The latter is of particular concern since it more closely reflects domestically driven price pressures. This has given ammunition to a vocal set of hawks on the ECB’s Governing Council.
As things stand, our sense is that doubts over the outlook for the U.S. economy, combined with a softening in euro-zone business surveys in recent months, will mean that policymakers opt to lower interest rates by another 25bps to 3.5% at its September meeting. The same is likely to be true for other countries; where previously a decision may have been finely balanced, now central banks will err on the side of looser policy.
Putting it all together
“Market sentiment will drive volatility and prices wildly over the short term, but ultimately the fundamentals will overcome those base emotions.”
Corrado Tiralongo
Vice President, Asset Allocation & Chief Investment Officer
Canada Life Investment Management
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