Market Synopsis – July 2024

Market Synopsis – July 2024

Jul 2, 2024 | 0 comments

We have reached the kink

We have discussed and used the kinked Phillips curve framework to interpret the direction of the US economy and financial markets since the start of the pandemic. For example, in 2023, the kinked Phillips curve indicated that “immaculate disinflation” would unfold, which is exactly what happened. Now, in 2024, the very same framework is forecasting that the consensus soft-landing narrative is wrong, and instead a recession will start later this year or in early 2025.

Before we get into why, a quick refresher on the kinked Phillips curve. The framework proposes that there is a non-linear relationship between inflation and unemployment – see Figure 1. Meaning that when unemployment is high, businesses can hire workers without raising wages. However, once full employment is achieved, the only way that firms can grow their staff is by poaching workers from other firms by offering higher wages. This can lead to higher wages on aggregate and higher prices, in short, inflation.

Figure 1 – The non-linear relationship between inflation and unemployment

In post-war US history, aggregate labour demand has exceeded supply just twice: In the late 1960s and during the Covid-19 pandemic as seen Figure 2. Both episodes led an explosive rise in inflation. Despite the higher Federal Reserve (“Fed”) funds rate the US managed to avoid a recession in 2022 and 2023 because labour demand exceeded labour supply, so any weakening in labour demand led to lower wage growth and falling job openings rather than rising unemployment – see Figure 2. In other words, “immaculate disinflation”.

Figure 2 – The labour demand-supply gap

However, as of April 2024 the official job openings rate has fallen from a peak of 7.4% in March 2022 to just 4.8%. Fed Governor Waller recently noted that a drop in job openings below 4.5% has historically coincided with an increase in the unemployment rate. Two years ago, workers who lost their jobs could simply and quickly find new work. Now, as Figure 3 depicts, that has become increasingly difficult.

Figure 3 – Its proving harder to find new work after losing your job

It’s not just Figure 3 that highlights the ongoing softening in labour demand. A myriad of indicators in Figure 4 such as the hiring rate, quits rate, posted wages, and business surveys point to the same trend.

Figure 4 – Labour markets continue to loosen

Phase transition

Another common question we receive is “Why a recession now?”. Much like how a glass of warm water placed in a freezer will steadily decline in temperature and eventually freeze over. So, to will an economy under tight monetary conditions. Eventually freezing into a recession. But before freezing, the economy cools, which can be evidenced by the presently falling inflation and wage growth.

The analogy to freezing water helps explain why recessions often start seemingly out of nowhere. For example, the Great Recession began in December 2007 despite real GDP expanding 2.5% in the fourth quarter of that year. However, while the GDP may have been expanding, home prices were declining, and large books of subprime mortgage loans were defaulting. As 2008 wore on, the weakening economy put further strain on banks, which correspondingly cut back on lending, creating an even weaker economy, and ever higher non-performing loans. A vicious cycle developed, culminating in the Global Financial Crisis.

While we do not expect anything as dramatic this time around. We do still expect several feedback loops to emerge later this year that will cause the economy to weaken significantly. Rising unemployment will prompt consumers to precautionarily raise their savings from the currently low savings rate of just 3.6%, half of what it was in 2019. Unlike in 2022, US households’ excess savings are now depleted – see Figure 5.

household savings

Figure 5 – Households have run out of excess savings

In addition, the ability of households to borrow to supplement their depleted savings will also be challenging given the current consumer delinquency rates. Both credit card and auto loan delinquency rates are back to 2010 levels, a period in which the unemployment rate averaged 9.6% – see Figure 6. As a result, banks have tightened their lending standards and further increased the interest rates charged on consumer loans.

delinquency, lending standards

Figure 6 – Negative outlook for consumer loan growth

With little accumulated savings to draw on and constrained credit availability, many households will have to reign in their spending. Decreased spending will lead to less hiring. Rising unemployment will curb income growth, which will lead to even less spending and further unemployment.

The Fed won’t stop the coming recession

Will the Fed rate cuts to prevent a recession? We do not think so.

The Fed will likely remain reluctant to cut rates aggressively given the lack of overwhelming evidence of an imminent recession developing in their eyes, and the continued fear of a second wave of inflation.

As Figure 7 illustrates, the level of consumer prices is now slightly above where it would have been if inflation had averaged 2% since the Global Financial Crisis. The Fed was lucky that inflation was consistently below target going into the pandemic. However, allowing another overshoot could un-anchor long-term inflation expectations.


Figure 7 – A second wave of inflation could un-anchor long-term inflation expectations

Second, effective monetary policy will likely continue to tighten even after the Fed starts cutting rates.

Why? Because what really matters for the economy is not the Fed funds rate, but the actual interest rate that households and businesses are paying. As Figure 8 depicts, these two rates can differ as the actual interest rate paid can lag the Feds funds rate. For example, even if rates on new mortgages decline, the average mortgage rate will still rise as more new homebuyers are forced to take on high-rate mortgages than what they previously had.

The process will also apply to businesses that will need to roll over loans they took out at favourable rates during the pandemic.

The rising average interest rate will trigger more defaults, and further pain for the banking system. Banks will respond through slower credit formation, sapping growth.

mortgage rate, effective rate

Figure 8 – The average mortgage rate paid by US homeowners will rise even if the Fed cuts rates

Investment takeaways

Historically, equity markets have peaked six months before the onset of a recession. Given that we expect that the US economy will fall into a recession by the end of 2024, we believe equities could begin to swoon in the near term. Once the recession is officially underway, shares typically trough ten months later.

While rising recession risks are bad for equities, they are typically considered good for bonds. As such, we believe that cash and high-quality long-duration government bonds should provide the protection investors will be looking for.

If you interested in finding out more about how cognisance of the macroeconomic backdrop helps our clients invest, 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:

Tel: (021) 671 2112
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Source: Bloomberg, 28 June 2024