A “Wile E. Coyote” moment
Last week the US Federal Reserve (“Fed”) cut rates by 50 bps, and market participants cheered in response. In fact, the market’s reaction was similar to January 2001 and September 2007, months that marked the start of two of the largest easing cycles this century. In both cases, the Fed surprised investors by cutting rates by 50 bps. Following which, the S&P 500 gained 5.0% on the day of the rate cut in 2001 and 2.9% in 2007.
Unfortunately, in both cases, equity markets declined significantly over the subsequent months as it became clearer that the US economy was entering a recession – see Figure 1. Although it was not obvious at the time, the Fed was behind the curve. We believe this time is unlikely to be different.
Figure 1 – Recessions often start after the Fed begins cutting rates
What could cause a US recession?
Recessions typically begin due to a decline in consumption growth. This can be the result of several factors, such as increased unemployment, slowing wage growth, depleted consumer savings, reduced access to credit or fiscal tightening.
Wages are the product of compensation-per-employee and the number of employees. At present, compensation-per-employee is falling as an increasing number of people, unable to find full time jobs, are being forced to work part time – see Figure 2. An increase in part time work instead of full-time employment inevitably leads to the average length of the workweek shrinking and wage growth slowing. As a result, we expect wage growth to fall over the coming quarters, which will curb consumer spending growth.
Figure 2 – More people are working part time, but not by choice
Reviewing US unemployment indicators
In last month’s Market Synopsis, we debated whether the Sahm rule had been triggered. Now though, US unemployment has risen enough to truly trigger the Sahm rule. However, this is not the only recession indicator flashing red. As can be seen in Figure 3 below, indicators such as BCA Research’s Mel rule (which aggregates state-level unemployment rates to generate a cleaner picture of the jobs market) has also breached critical levels which has historically only occurred prior to a US recession.
Figure 3 – The unemployment rate has breached several recession triggers
Of course, optimistic economic commentators argue that part of the reason unemployment has ticked up is because of new entrants and re-entrants joining the job market. However, these cohorts account for only two-fifths of the increase in the unemployment rate, with the rest of the increase in unemployed workers still the result of job losses.
In fact, relative to the size of the labour force, the number of people who are unemployed because they lost their job has risen by 0.21 percentage points from its 12-month low. While that may not sound like a lot, there has never been a scenario over the past 50 years where this metric has risen by more than 0.20 percentage points without a recession taking place.
Even individuals without the statistics at hand are noticing the cooling in the labour market. For example, the number of respondents in the Conference Board survey who think that jobs are plentiful has meaningfully declined, down from the 2019 average of 33.2% to just 12.6% now – see Figure 4. If that is not enough, the decline in the quits rate to below pre-pandemic levels provides further evidence of the extent to which consumer confidence in the US labour market has deteriorated.
Figure 4 – Evidence of a labour market slowdown is growing
One of the few contra signals to the above story, initial unemployment claims, is no longer rising. We believe a plausible reason is those that are losing their full-time jobs are turning to the gig economy and other part time jobs instead of filing for unemployment insurance. This theory is corroborated by the rising number of people working part time as seen in Figure 2. Of course, part time jobs are not an adequate replacement for a full-time employment and will still lead to slowing income growth, the negative economic impacts of which were discussed above.
The revised personal savings rate
Previous measures of the personal savings rate depicted a steady downward trend since the beginning of 2023. However, the Bureau of Economic Analysis (“BEA”) recently revised the data revealing an upward trend in the savings rate since its 2022 trough – see Figure 5. Encouragingly, this indicates that the personal savings rate is, in fact, not unsustainably low.
Therefore, as consumer income growth slows, they can decrease their savings rate and reallocate it to spend. In effect enabling the spending growth rate to outpace income growth. However, given the cooling labour market, consumers are unlikely to opt for this.
Figure 5 – Revised savings rate
In addition, the material personal savings built up during the pandemic, have allowed consumers to consume at rates higher than their incomes would normally allow. Unfortunately, those pandemic savings are now fully depleted as the San Francisco Fed recently confirmed. As a result, it is unlikely that households will be able to boost spending any further, and in turn consumption growth will decline in line with income growth.
China had no choice but to act
With housing starts now down 65% from their peak, the Chinese government had no choice but to act this week – see Figure 6. Housing completions do not look too bad, down just 11%, as property developers benefit from government financing providing them with the resources to finish previously stalled projects. However, once this pipeline of existing projects is depleted, the supply of finished housing will plunge much further than the current 11% decline.
Figure 6 – Housing completion could soon follow housing starts lower
Up until this week, the government’s response to sluggish domestic demand has been insufficient to reignite their economies growth. This is evident when reviewing Figure 7 below which depicts the combined credit and fiscal spending impulse, indicating that stimulus has continued to decline for more than a decade. In addition, this metric has also served as a great leading indicator of economic activity 9 months later. Therefore, to improve growth, the recently announced stimulus has been sorely needed.
Figure 7 – China must stimulate if they are to meet their growth targets
How effective will this stimulus be?
Against this backdrop, it is not surprising that the government had to act to defend its 5% growth target. However, we believe the measures announced this week, first by the PBOC on Tuesday, and then by the Politburo on Thursday, will do little to jumpstart long term growth and will probably only serve to bolster investor confidence in the near term.
Recent stimulus measures, like the PBOC continuing to cut reserve requirements and lowering interest rates, have had little effect on growth over the past few years – see Figure 8. This is largely because the Chinese economy has already fallen into a liquidity trap. Households and businesses do not want to borrow as they instead focus on paying back existing debt. As a result, lower rates are unlikely to drive credit growth and produce a meaningful business cycle recovery.
Figure 8 – PBOC easing has had little effect on growth
What China really needs is more consumption. Which the Chinese government is no doubt aware of. However, there seems to be a deep-seated resistance amongst the Chinese Communist Party to policies that could boost consumer spending on a large scale, as they are seen as emblematic of the excess and over-consumption prevalent in the West. Instead, the central government tends to channel funding into investment projects that are increasingly facing diminishing returns.
Given the widespread debt deflation pressures in the Chinese economy and depressed sentiment among households, businesses, and local government officials, it will probably take more than what has been announced to create a cyclical recovery in the mainland economy. Ultimately, China will have to adopt policies that boost consumer spending, probably in conjunction with efforts to boost their declining birth rate. However, for now we do not expect any major consumer-focused stimulus efforts.
As a result, the recent policy announcements will likely fuel a brief window of outperformance in Chinese equities. Especially given the depressed valuations that Chinese shares are trading on relative to developed and other emerging market equities.
Investment takeaways
The upwardly revised savings rate, combined with a larger than expected Fed rate cut have marginally decreased the probability of a recession. However, we do still believe that a recession is the most likely outcome for the global economy towards the end of 2024 or early 2025.
Meanwhile the stock market is currently experiencing a “Wile E. Coyote” moment. Like the coyote, the US economy has run off the cliff, but rather than noticing the canyon below and falling, investors are entranced by the shiny light of Fed easing.
Given that since the 1960s, US shares peak on average six months before the start of a recession we have adopted a defensive sector tilt in our equity portfolios. At the same time, the recent Chinese stimulus and global monetary easing have allowed us to remain overweight materials on a short-term horizon. An approach commonly referred to as the barbell strategy.
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.
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Source: Bloomberg, 30 September 2024