Recession Risks Roil Markets but Not Yet Alarming

Headlines 

1. Disappointing U.S. jobs data has raised concerns about a potential recession, affecting global markets. 
2. Abandonment of the yen carry trade has contributed significantly to market turbulence. 
3. Various economic indicators present a mixed picture of the global economic outlook.

Disappointing U.S. jobs data has shaken confidence in a soft landing for the world's largest economy, sending global equity markets tumbling and increasing expectations of interest rate cuts. The abandonment of a popular yen carry trade has played a significant role in the market selloff, complicating the message from asset prices regarding the economic outlook. The likelihood of a recession is uncertain, with Goldman Sachs (NYSE:GS) estimating a 25% chance of a U.S. recession and JPMorgan predicting a 35% chance by year-end. 

1. Data Puzzle

The U.S. unemployment rate jumped to a near three-year high of 4.3% in July, amid a significant slowdown in hiring. This increase has heightened recession fears by reaching a trigger point of the Sahm rule, which historically indicates a recession when the three-month rolling average unemployment rate rises half a percentage point above the low of the prior 12 months. 

Despite this, many economists believe the reaction to the data was overblown, given that the numbers may be skewed by immigration and Hurricane Beryl. Better-than-expected jobless claims data on Thursday also supported this view, sending financial stocks rallying. Payrolls are still growing. If you started to see payrolls turn negative, that would make me much more concerned that a genuine recession is starting, said Dario Perkins, managing director, global macro at consultancy TS Lombard. 

The U.S. economy grew 2.8% in the second quarter on an annualized basis, double the first quarter rate and on par with the pre-pandemic average. Services activity also points to growth continuing. However, beyond the United States, business activity indicators suggest faltering eurozone growth, while China's recovery remains fragile. Global economic data is delivering negative surprises at the highest rate since mid-2022, according to Citi's surprise index. 

2. Corporate Rout

MSCI's global stocks index is down more than 6% from July's record highs, while the U.S. S&P 500 has lost over 4% so far in August. Yet, analysts believe stocks, which are still up around 7% globally this year, are far from signaling a recession. 

Goldman Sachs estimates that every further 10% drop in U.S. equities would reduce growth over the next year by just under half a percentage point. Credit conditions could prove more important, analysts say. They note that although the risk premium corporate bonds pay over government bonds has widened in Europe and the United States, it was correcting from historically tight levels and moves were not yet pronounced enough to suggest recession risks were high. 

Recession expectations implied by the gap between U.S. investment-grade bond and Treasury yields are about half as high as they were in 2022-2023, according to BofA. 

3. Rate Cut Expectations

Spurred on by the U.S. jobs data and a dovish-sounding Federal Reserve, traders now anticipate around 100 basis points of cuts in U.S. rates by year-end. This is down from over 130 bps earlier this week, but double the roughly 50 bps anticipated on July 29. Markets also price in more than a 50% chance of a hefty 50 bps September cut. Major banks have also added to the Fed cuts they expect this year. 

Steve Ryder, portfolio manager at Aviva Investors, said the Fed was likely to cut rates three times this year, but given uncertainty around how economic data evolves, it was understandable that markets were pricing the probability that it would have to cut more. 

Elsewhere, traders see a high chance of three more European Central Bank rate cuts this year, having seen less than a full chance of a second cut in mid-July. 

4. Copper Prices and Oil Markets

Known as Dr. Copper for its track record as a boom-bust indicator, the metal's fall to 4-1/2 month lows this week puts it firmly on the recession watch list. Trading at around $8,750 a metric ton, three-month London Metal Exchange copper prices have slumped roughly 20% from a record high scaled in May, reflecting pessimism about the global economic outlook. 

Oil prices, another barometer of the health of global demand, are near multi-month lows. However, their fall has been limited by concerns that Middle East tensions could squeeze supplies from the largest oil-producing region.