Here comes the pain
On the 31st of July US Federal Reserve (“Fed”) Chair Jerome Powell stated that if the economy continues on its current path a cut to the bank’s key rate “could be on the table” at the policymakers’ next meeting in September. The following day, US markets rallied in response to the positive news. As we set about writing this month Market Synopsis, we had initially argued that we believed that investors were getting ahead of themselves in this rally. However, our dissent proved unnecessary. Just two days later, on the 2nd of August, a weak US jobs report led to the Nasdaq making an about face and falling a cumulative 5.8% in the two trading days since.
Now that market participants are coming to terms with the possibility that a soft landing may not be the base case, many are calling for the Fed to cut rates by as much as 50bps, up from the usual 25bps. However, what investors are still misunderstanding is that a Fed rate cut, even a more aggressive one, does not immediately guarantee the avoidance of a recession. Over the past 40 years, when the Fed has cut rates, a recession has still followed shortly thereafter, as depicted by the vertical grey bars in Figure 1 below.
Figure 1 – It does not take long for recessions to follow rate cuts
Despite the Fed historically cutting rates pre-emptively, a recession still follows due to the lag that exists between rate changes and an actual change in economic activity. This occurs because as rates fall, the interest rate consumers experience may still be higher than what they experienced previously. For example, as new homebuyers take on mortgages in late 2024, assuming some rate cuts have occurred, the interest rate paid will still be higher than what they may have experienced had they initiated the mortgage in 2020 when rates were close to zero. As a result, the average mortgage rate that homeowners pay will keep rising. The same applies to the average interest rate on business loans as companies roll over existing loans that they took out at favourable rates during the pandemic – see Figure 2.
Figure 2 – The average mortgage rate paid by US homeowners will rise even if the Fed cuts rates
The second mistake that, we believe, market participants have been making for a while now is assuming that a soft landing is the most probable outcome despite the rising US unemployment rate. Starting in Mid-2023, US unemployment has steadily risen from the lows of 3.4% to 4.3% now. While the current 4.3% level is not in itself an issue, it is what will follow that is a cause for concern. For a soft landing to occur, unemployment would need to stabilise at the present levels and then continue to move sideways. However, in all periods post-World War II, US unemployment has proven to be a highly mean-reverting series, typically rapidly rising once an upwards trend has begun. In fact, over this look-back period, once unemployment increases more than one-third of a percent a recession has always followed – see Figure 3. To date US unemployment has risen 0.9% from its lows.
Figure 3 – A highly mean-reverting series
Will a Trump presidency help keep the economy out of a recession?
Some market commentators have surmised that a Trump presidency, in which he plans to further cut taxes, could boost aggregate demand and allow the US to avoid a recession. However, Trump’s “all tariffs policy” which aims to fully replace income taxes with tariffs of 10% on all imports and 60% on goods from China could, in fact, have the opposite effect.
If Trump wins the election his administration will probably choose to permanently extend the personal income tax cuts that were passed under the 2017 Tax Cuts and Jobs Act, which are set to expire at the end of 2025. While further incremental tax cuts for the middle class are possible, higher tariffs are likely to offset any benefit. In fact, 90% of federal income taxes are paid by the top 25% of income earners. In contrast, tariffs disproportionately hurt lower-income households. Thus, even if higher tariff revenue is entirely recycled into income tax cuts, the net effect on aggregate demand will be negative.
Moreover, as Republicans have sought to do in the past, they will look to cut spending on certain social welfare programs such as Medicaid, food stamps and housing assistance. This, too, would negatively impact aggregate demand.
At present, the Biden administration is already operating an extremely stimulative fiscal policy. The Congressional Budget Office expects the federal government budget deficit to average 7% of GDP in 2024, an exceptionally large number for an economy that is still close to full employment – see Figure 4.
Figure 4 – An exceptionally large government deficit given the US is not yet in a recession
The bottom line? Fiscal policy is more likely than not to tighten next year.
A guide to calling recessionary bottoms
Given that we expect a recession to emerge towards the end of 2024, or even early 2025, we thought it may be interesting to take it one step further and search for early indicators that may assist investors in calling the bottom of an equity market sell-off.
In doing so, multiple post-World War II recessions have been reviewed to identify the most consistently successful indicators in signalling the end of a recessionary bear market. Due to the varying nature of recessions, many of these indicators, cannot on their own be relied on. However, when they are used together, they become a powerful tool for an investor.
The review has yielded the following conclusions:
In almost all the recessions analysed, unemployment increased during the official months of the recession, and typically only peaked shortly after the recession was over. Thus, the investor looking for signs of a turnaround should ensure that the unemployment rate has increased at least 2%, and that unemployment has moved above estimates of the non-accelerating inflation rate of unemployment (“NAIRU”). If unemployment is above these levels, it should indicate that the recession is well underway and may be nearing completion. However, on its own this lagging indicator is not enough to call the bottom in equity markets.
In many recessions, the yield curve has been a good indicator of both an upcoming recession and a potential recovery. Once significant central bank interest rate cuts have occurred, the yield curve should steepen materially, signalling that a recovery could be underway. Figure 5 depicts this relationship, where only once interest rates have been cut, will unemployment begin its decline.
Figure 5 – A significant reduction in the Fed funds rate can indicate a recovery in equity markets
If balance sheets are under pressure during a recession, such as those of Chinese and US property investors of late, assessing high-yield corporate bond spreads becomes an important tool to estimate the start and end of a recession. High-yield corporate bond spreads did an excellent job of leading the equity market in the 2008-09 recession. For example, when spreads are peaking, it typically signals the imminent end of recession and thus a bottom in equity markets.
Finally, investors should watch for signs of a significant improvement in the momentum of key economic indicators, such as the ISM manufacturing index and the ISM new order momentum index. When these indices begin to make a recovery and head upwards one can infer that a recession may end shortly.
Investment takeaways
With the Nasdaq falling 5.8% over the last two trading sessions and the Nikkei 225 falling 12.4% yesterday – the biggest rout for Japanese shares since Black Monday in 1987 – we have gotten a taste of what is perhaps to come when markets succumb to a recessionary reality. We trust that the guide on identifying a bottom in recessionary market selloffs is something that can serve investors well and be referred back to when other market participants are in the depths of despair. As an investor, widespread fear can be used to your advantage as investment sage Warren Buffet so succinctly put: “Be fearful when others are greedy. Be greedy when others are fearful.”
If you are interested in finding out more about how cognisance of the macroeconomic backdrop impacts our investment decision making process, connect with Integrity Asset Management and let us help you navigate your investing journey.
For more information on this synopsis or to discuss solutions provided by Integrity Asset Management, please contact us at:
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E-mail: nic@integrityam.co.za / herman@integrityam.co.za
Source: Bloomberg, 31 July 2024