US indices see their biggest drop in 2 years. But is recession imminent?

The precipitous drop in global indices yesterday has rattled many market watchers, with many fearing an imminent – if not already well-progressed – recession in the US. However, one leading global markets strategist believes recession remains “unlikely”, with the Fed ready and in a strong position to step in should conditions deteriorate.

While concerns over a fast-deteriorating US economy are likely to prove “overdone”, argues Seema Shah, chief global strategist at Principal Asset Management (PAM), a near-term market turnaround is also looking increasingly unlikely, given “the depth of the negative narrative”.

“A sustained market recovery needs a catalyst, or likely a combination of catalysts, including stabilisation of the Japanese yen, strong earnings numbers, and solid economic data releases,” she wrote. These conditions are unlikely to be met in the near term.

As it stands, the strength of household and corporate balance sheets implies recession is unlikely, Shah said. But weaknesses are undoubtedly building.

However, should the US economy follow the markets into retreat, the Federal Reserve (‘the Fed’) remains in good stead to “respond aggressively”, she added, with “plenty of room to cut rates and loosen financial conditions”.

Regardless of market movements, PAM’s longstanding forecast on US policy rates remains, Shah said: the Fed will continue to cut rates by 25bps in September and December, with another 25bps cut in November likelier now following yesterday’s big sell-off and unfavourable employment figures.

By end of trade on Monday, US time, the Dow Jones Industrial Average plunged 1,034 points, or 2.6%, while the S&P 500 and Nasdaq Composite declined by 3.0% and 3.4%, respectively.

Downbeat jobs data triggers market drop

Much of yesterday’s market sell-off was triggered by the “disappointing” US jobs data released late last week, with unemployment figures jumping from 4.1% to 4.3% as well as a consistent decline in payroll numbers recorded (showing only 114,000 jobs were created, well short of expectations of around 175,000 new jobs).

However, according to Shah, “markets were already floundering” before the release of this jobs data.

The frenetic market response – driven by “more than a tinge of panic”, Shah said – saw questions being raised over whether the US economy had already tipped into recession.

However, as Shah noted, one month of payroll data “does not make a trend”; as well, the July employment figure downturn may be a direct consequence of Hurricane Beryl, which devastated large parts of the US Gulf Coast.

This and other adverse weather phenomena resulted in “an unusually high number of non-agricultural workers reported not being at work”.

For Shah, US economic growth is clearly in a downshifting phase, while the labour market has been cooling for several months. Many companies, she notes, under the surface are “re-evaluating labour costs”.

“Recent surveys show that job openings have declined meaningfully, and smaller businesses have been pulling back on hiring plans,” with a “further weakening in labour demand” expected in the next data release.

On these figures, Shah said the market “is right to be concerned”.

However, whether these weaknesses in the US labour market tip over into widespread job losses will depend on the economy’s underlying strength.

“If household balance sheets are strong and company profit margins remain healthy, mass job layoffs and an income decline spiral should be avoided.”

While the strain on lower-income households is palpable, middle- and higher-income households – who represent around 60-70% of consumer spending – remain in good shape, Shah said.

As well, total US household net worth as a percentage of disposable income sits close to an all-time high.

On the small business front, while weaknesses are appearing, large business confidence remains very robust.

“Indeed, second quarter earnings so far have come in better than expected, with most companies beating expectations and earnings tracking to grow nearly 13%, above the pre-earnings season forecast of 8%.

“Broad corporate balance sheets are also in good shape— interest payments as a percentage of profits are at the lowest levels since 1957.”

Overall, Shah concluded, “while recession risk has been rising, strong household and corporate balance sheets should prevent the unfolding economic slowdown from mutating into a hard landing”.

Of note also is the Bank of Japan’s decision last week to raise interest rates for the first time in 17 years, has seen the yen rocket up 9% in value.

“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 US equities,” Shah wrote.

“As the yen strengthens, these trades unwind, contributing to US equity market weakness and increasing risk-off sentiment.

“[This] can create a self-reinforcing loop, whereby equity market weakness begets further yen strength, and so on.”