Is it different this time?

North American equity markets whipsawed during the month of August. The initial leg down was driven by an interest rate increase in Japan which led to an unwind of ‘Yen Carry Trade’ , together with increasing fears of a potential recession around the corner fueled by a few weak economic data prints early in the month. ISM Manufacturing PMI (Purchasing Manager’s Index) at +46.8 for July (reported in August) was weaker than +48.5 in June (reported in July) and the expected +48.8. Non-Farm Payrolls were also lower than expected (later revised further downwards). However, equity markets were quick to recover during the second half of the month on the back of benign inflation readings in the United States, still supportive economic data, and dovish messages from the US Federal Reserve Chair, Jerome Powell, at the annual Jackson Hole event. On the other hand, the fixed income markets benefited as the expectations of policy rate cuts continued to build. Investors also speculated if a 50 basis points cut is more appropriate during the September FOMC (Federal Open Market Committee) instead of a 25 basis points as labor market data continues to deteriorate.

Historically, August and September have had the reputation of being the seasonally weaker months for the North American equity market returns. Despite the recent market tremors, some investors have been questioning if it could be different this time as interest rate cuts in the United States are about to start. Afterall, markets have been fixated on the policy rates trajectory for long and the US Federal Reserve has very well telegraphed that it would be prudent to start the policy rate cut cycle from the FOMC meeting on 18 September. The Federal Reserve Chair has made it clear that the Central Banks’ focus has shifted to the health of labor market. This, along with the softening jobs data in the recent past has led the markets to bake in a full percentage policy rate cut by the end of this year, including a 25 basis-points cut in September, a 50 basis-points cut in November; and again a 25 basis-points cut in December. In the absence of a significant weakening in the economic data, we think the Federal Reserve will refrain from delivering more than a single cut (25 basis-points) in any meeting given its potential to send a wrong message (economy is weak or expected to be weak) to the markets.

Short-term volatility aside, we think another larger question on market participants’ minds is if it could be different this time and North America avoids a recession as the yield curve dis-inverts and the Central Banks embark on the rate cut cycle? Yield curve inversion has been regarded as an indicator of potential recession in the future and historically a recession has started shortly after yield curve has dis-inverted after inversion (see Figure 1). The US 2-year to 10-year segment of the yield curve dis-inverted on September 6th. Given that this occurrence also typically coincides with the weakness in the labor markets and the start of policy rate cuts by central banks shortly before a recession; the recent jitters witnessed in markets are not without a merit, in our view.

Figure 1: US 10-year yield over 2-year yield

October 1978- September 2024

Source: Bloomberg

That said, we note that the labour market is weakening from a very high level. The ratio of total job openings to unemployed looking for jobs has declined to 1.3x from its highs. Though the trajectory is worrisome, it is still at a level where it can be classified as becoming more normal after the distortion due to the pandemic (see figure 2). Corporations reported healthy revenue and earnings growth during the second calendar quarter earnings season and the outlook for twelve-month forward earnings has continued to improve. Above all, the Central banks now are in a relatively comfortable position to support the economy by reducing interest rates should a faster than expected deterioration in economic data come to fruition, in our opinion. As markets navigate through these questions, we think volatility is likely to continue with the ebb and flow of the economic data. Nevertheless, the balance of data keeps us constructive on the outlook through the end of this year for now.

Figure 2: Ratio of US total Job openings to unemployed looking for full time work

October 2014 to July 2024

Source: Bloomberg