Sirens warning of economic recession?

In brief

• A rise in the U.S. unemployment rate in early August sparked recession fears, causing market corrections and a decline in bond yields. However, better economic data later helped U.S. equities recover.
• With inflation nearing target, the Federal Reserve (Fed) is shifting its focus to job market stability. Since early August, markets have moved to price in more rate cuts by the end of 2024.
• To weather through potential economic slowdowns, government bonds, investment-grade debt and defensive equities can help manage volatility, while cash equivalents may underperform in a falling yield environment.

Sirens are mythical creatures in Homer’s Odyssey that are part bird, part human. Their singing can hypnotize sailors to make their ships go off course and crash. The hero of the story, Odysseus, used beeswax to block his sailors’ ears so they would not fall under the Sirens’ spell.

In early August, a surprising rise in the U.S. unemployment rate sent shockwaves through the investment community, prompting fears of a potential recession. As investors reacted, we witnessed sharp corrections in global risk assets and a decline in government bond yields. However, by the end of the month, equity markets had recovered much of the lost ground. Are investors responding to mere noise, or do we face deeper economic concerns requiring a reassessment of our asset allocation?

A chain reaction from the weak job data

The rise in the unemployment rate from 4.1% to 4.3% in July came as a surprise. However, a closer look at the broader economic landscape reveals that the market may have overreacted to this single data point. The economy added 114,000 jobs in the same month, with job openings remaining robust and initial jobless claims still below recessionary levels.

That said, signs of slowing consumption are emerging. Retailers reported an increase in price sensitivity among consumers, and delinquencies on credit cards and auto loans are rising, particularly among low-income households. Overall, the momentum of the U.S. economy is shifting from “hot” to “warm.”

In reaction to the recession concerns, rich valuations and crowded positions in the market have led to a decline in bond yields and corrections in equities. In early August, the S&P 500 and NASDAQ 100 fell by 6% and 8%, respectively, while the 10-year U.S. Treasury yield dropped to 3.8%, matching late 2023 lows. The unwinding of the U.S. dollar-Japanese yen carry trade, exacerbated by the Bank of Japan's recent policy rate increase, further impacted Japanese equities and Asian tech exporters.

Fortunately, subsequent better economic data has alleviated some fears of recession. U.S. equities have recovered, even as Treasury yields remain low. 

Ready, set, cut

Even if the U.S. economy is on track for a soft landing, inflation is trending toward target, prompting the Fed to shift its focus from combating inflation to safeguarding the job market. This was a clear takeaway from Chair Jerome Powell’s Jackson Hole speech. Current futures market pricing indicates a 33% chance of a 50 basis points (bps) rate cut in September, with expectations for rates to decline by over 100 bps by the end of 2024.

Given the stable economic momentum, a modest 25 bps cut may be more appropriate, signaling that the Fed is not overreacting to weaker data.

Looking ahead, the Federal Open Market Committee’s (FOMC’s) dot plot from June projected a median policy rate of 4.25% by the end of 2025, significantly higher than the futures market’s current estimate of 3%. However, we anticipate meaningful downward revisions in the Fed's forecasts in its September meeting if inflation continues to stabilize.

Overall, the futures market seems reasonable in pricing the path to neutral over the next 12-18 months, although it may be overly aggressive at times. This raises questions about whether the U.S. Treasury market has fully accounted for the impending rate cut cycle. Still, investing in U.S. Treasuries offers income generation and downside protection as we navigate potential economic deceleration.

Let’s put a smile on that face

The U.S. dollar index has declined by 5% since its recent peak in late June, driven by expectations of lower interest rates, alongside long-standing factors like overvaluation and persistent fiscal deficits.

For the dollar to depreciate further, several conditions must be met: the global economy must avoid a sharp recession, and the U.S. must align its growth with that of other developed nations. This is often known as the “dollar smile” where the U.S. dollar (USD) strengthens when the U.S. economy outpaces other developed economies, leading to more inflows into USD assets, or for the global economy to run into a deep recession, raising demand for the USD as a safe haven currency.

Historically, a weaker dollar benefited international assets, including emerging market and Asian equities and fixed income. While stronger Asian currencies may challenge export competitiveness, high-tech sectors, such as semiconductors, often remain resilient. Additionally, a weaker dollar provides Asian and emerging market central banks with greater flexibility to cut rates, supporting their fixed income markets.

What does this all mean for investors?

Our core view of Fed cuts amid a U.S. economic soft landing has worked out well so far. With both fixed income and equities outperforming cash, the Fed’s intention to ease monetary policy becomes clearer. We continue to see a balanced stock-bond allocation as the optimum way to construct a portfolio.

Given the likelihood of softer growth in the U.S., investors should prepare for potential downside scenarios. Government bonds, investment-grade corporate debt and defensive equities can help balance the pursuit of returns with the need to manage volatility. While cash equivalents may seem like a safe hedge against recession, they often underperform government bonds and investment-grade debt, particularly as falling yields increase bond prices.

Global economy:

• In the U.S., inflation continues to moderate with the July headline consumer price index (CPI), core CPI and core personal consumption expenditures (PCE) all at a steady 0.2% month-over-month (m/m) growth, in line with consensus expectations. As the Fed has a dual mandate — maintaining price stability with a 2% inflation target and achieving full employment — focus has now shifted to the labor market’s health. Non-farm payrolls fell to 114k jobs in July, substantially below consensus estimates of 175k, while the unemployment rate also rose to 4.3%, triggering the Sahm Rule, a historically accurate recession predictor. These raised concerns about the U.S. economy's strength and increased expectations for aggressive rate cuts by the Fed. In Chair Jerome Powell’s speech at the Jackson Hole Symposium, it was acknowledged that “the time has come for policy to adjust,” signaling the start of the policy easing cycle in September and shifting discussions to the extent of upcoming rate cuts.
  (GTMA P. 22, 30, 31)
• July activity data in China remained subdued, reflecting persistent headwinds in its domestic economy. Loan growth slowed to 8.7% year-over-year (y/y) in July from 8.8%, as credit demand has stayed weak. Fixed asset investment (FAI) also saw a broad-based moderation, with easing growth in both manufacturing and infrastructure FAI, while real estate FAI remains in contraction. Industrial production softened to 5.1% y/y in July from 5.3%, led by construction-related sectors, while communication and other electronics are still resilient. Retail sales saw a slight pickup in July from the previous month’s weakness, although ex-catering spending stayed modest. China’s imbalanced strength on the external front over the past year also appears to have peaked, as July exports slowed to 7.0% y/y from 8.6%, amid concerns of easing global manufacturing activities and echoing the end-July’s Politburo message to shift priority to boosting domestic consumption.
  (GTMA P. 6, 7, 12)

Equities:

• August was a tumultuous month for equities with the VIX hitting as high as 38 on Aug 5, before falling back to below 20. Despite the volatility, stocks mostly ended higher than the start of the month. The MSCI AC World was up 2.4%. Within consumer sectors, consumer staples outperformed with 3.8% return, while consumer discretionary was flat. Energy also lost 1.8% due to falling energy prices. Regionally, ASEAN was the bright spot, outperforming with 7.1% monthly returns, versus 2.5% and 1.4% returns for developed markets and emerging markets, respectively.
  (GTMA P. 34, 40)
• In the U.S., large caps outperformed, with the S&P 500 returning 2.3%, while the Russell 2000 lost 1.6%. Within the S&P 500, there was a major rotation out of growth and technology stocks in early August when recession fears took hold, and the Japanese yen (JPY) carry trade unwound. The Magnificent 7 no longer led the rally but detracted from the S&P 500’s total returns by as much as 0.75% in August.
  (GTMA P. 53)
• In Asia, TOPIX caught market attention by tumbling 12% on August 5 (largest drop since 1987 Black Monday), before recovering most of the losses and ending the month down 2.9%. The rotation out of tech stocks dragged Taiwan and Korea markets down, with local indices returning 0.3% and -3.5%, respectively. The CSI 300 underperformed with -3.5% given further growth concerns, but southbound flows lifted the offshore market, Hang Seng Index, to return a substantial 3.7%. Prospects of a September rate cut from the Fed pushed ASEAN markets higher, with several reaching fresh highs. Indonesia’s Jakarta Composite Index stood out, returning 5.7% in the month.
  (GTMA P. 40)

Fixed income:

• The weak labor market data and growth concerns pushed markets to expect more aggressive Fed rate cuts, pushing Treasury yields lower. The U.S. 10Y Treasury yield started the month above 4% but fell to below 3.8% intramonth, ending the month 14 bps down at 3.9%. European yields were stable, with 10Y bund yields down 3 bps and gilts ending the month flat. Asian 10Y yields fell more dramatically, with Indonesia falling 27 bps, Singapore down 18 bps and Australia down 15 bps.
  (GTMA P. 56, 60)
• The fall in yields was also reflected in credit markets, with global investment-grade and high yield bonds’ yield-to-worst falling 15 bps and 29 bps, respectively. As a result, the Bloomberg Global Aggregate Index posted a 2.4% return, driven by flight to quality, fall in yields and solid corporate fundamentals.
  (GTMA P. 56, 59)

Other assets:

• The pullback in rates prompted the USD to weaken 2.3%. The JPY and euro rose 3.3% and 2.3%, respectively, while several Asian currencies strengthened even more, such as the Malaysia ringgit, up 6.3%, and the Indonesian rupiah, up 5.2%.
  (GTMA P. 69, 70)
• The soft economic data from early August also caused crude oil prices to drop. WTI crude oil fell 7% from 79 USD to 73 USD, but tensions in the Middle East and slightly more positive economic data prevented prices from falling further.
  (GTMA P. 73)

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