Stockmarkets are wobbling. Data emerging from the US has spooked investors, who now believe the US Federal Reserve may have dropped the ball on interest rates. It has been a big reaction to an apparently small data point, but are they right? Had markets become too complacent about the inevitability of a soft landing?
The immediate trigger for the sell-off was news that the US had added just 114,000 jobs in July. Consensus forecasts had pointed to 175,000 jobs created. This sparked a panic that the Federal Reserve had been too slow in cutting interest rates, and a slowdown in the economy was now a possibility.
Preston Caldwell, chief US economist at Morningstar, says: “Make no mistake, it is bearish news.” He says that the increase in the unemployment rate to 4.3% in July is the biggest concern. “This triggers the “Sahm Rule”: the observation that the US economy had always entered a recession if the unemployment rate (using a three-month moving average) experiences a trough-to-peak increase of 0.5 percentage points within a 12 month period. Unemployment has averaged 4.1% in the past three months, up 0.5 percentage points from August 2023.”
Rates on hold
The Federal Reserve had only just announced its decision on interest rates for August. It maintained rates at 5.25%-5.50%, but Fed Chair Jerome Powell said the central bank may reduce interest rate cuts in September, if the economic conditions were right, with inflation still falling. He said: “We’ve made no decisions about future meetings and that includes the September meeting. We’re getting closer to the point at which we’ll reduce our policy rate, but we’re not quite at that point yet.”
The narrative built up by markets was that the Federal Reserve had dropped the ball. It had not been quick enough to cut rates and now recessionary pressures were building. The US market was hit hardest, particularly the Nasdaq, which was already struggling to digest some lacklustre earnings data from the large technology companies. The Nasdaq is now in ‘correction’ territory, having dropped more than 10% from its high on 11 July. Elsewhere, the impact has been more muted. The FTSE 100 is down just 1.3% this week, while the S&P 500 is down 2.1% (source: MarketWatch, to 2 August 2024).
The immediate reaction from financial markets looks overblown. Employment data is volatile, and significant gaps between expectations and reported data are not unusual. However, there is a wider concern that investors may have gone too far in assuming a soft landing for the US economy is inevitable. Salman Ahmed, global head of macro and strategic asset allocation at Fidelity, outlines the problem for many asset allocators: “We are still comfortable with our assumptions to the end of 2024. But if you ask me whether these probabilities will hold into 2025, my answer would be no. At that point, we will need to start thinking about a cyclical recession a bit more seriously. I’m not saying it will be the dominant scenario, but what happens in 2025 will depend on what happens on the political outcome in the US.”
The high levels of US debt remain a key source of fragility. In June, 76% of income tax revenues were spent on debt repayment. Neither side of the political divide appears inclined to tackle the yawning gap between revenues and spending.
Ahmed says leading indicators suggest that the cycle is losing steam, adding: “There is still positive growth, but the momentum is negative.” The main drag has been global trade and commodities. Even though business surveys have been positive, there is a deceleration in the strength of growth. He believes the readings on services inflation in the latter part of 2024 will be very important, particularly the strength of the US consumer.
Financial market fragility
Andy Warwick, co-portfolio manager of the BNY Mellon Real Return fund, says a cloudier economic picture could destabilise financial markets. He adds: “As market participants continue to debate the likelihood of a more significant economic slowdown, they will be evaluating the legacy of the build-up in government debt and stubborn inflation levels, as well as the potential impact of political change. We think this trio of influences will continue to cause volatility in markets in the second half of 2024 and beyond.
He believes a ‘soft landing’ is within reach, but only if central banks are quick to take the top off their high cash rates. Caldwell agrees: “It’s time for the Fed to cut the federal-funds rate. The data quality issues make our picture of the economy somewhat murky. But there’s enough risk to call for substantially cutting rates now. Rate cuts in each of the final three meetings this year, beginning in September, is the base case if the unemployment rate does not fall back.”
Warwick says the balance of risks are now in favour of a cut: “The odds of a downturn becoming more severe and developing into a proper hard landing are higher than the possibility of world economic growth reaccelerating and pushing inflation (and then interest rates) to new highs. On balance, the soft-landing scenario still appears most likely, but it has previously proved a difficult act for central bankers to pull off.”
The current sell-off appears a little petulant, but there is a serious point behind it. It is tough to get the timing right on rate cuts, and the Federal Reserve is looking increasingly slow to the party. This should make a decisive case for a rate cut in September.
