INVESTMENT NEWS AUGUST '24
RECESSION LOOMS AS CENTRAL BANKS NAVIGATE ECONOMIC TIGHTROPE
Global economic indicators are signaling a potential downturn, challenging recent market optimism and raising concerns for investors.
What are potential effects?
This shift in economic outlook impacts investment strategies and market performance. As central banks navigate inflation and unemployment concerns, the risk of economic turbulence increases, affecting companies' financial planning and risk management.
What are the key causes and indicators?
- U.S. employment growth slowed in July, with unemployment rising to 4.3%. This adds to existing recession indicators, suggesting a need for companies to prepare for potential economic challenges.
- The Federal Reserve and European Central Bank are cautious about lowering interest rates due to ongoing inflation concerns. This stance could amplify economic pressures, affecting business financing and investment decisions.
- Global markets experienced a significant decline in early August, triggered by central bank decisions and underwhelming tech sector earnings. The Bank of Japan's interest rate increase particularly disrupted markets by unwinding the JPY carry trade.
Speed read
- At the end of July, the return on the S&P 500 was +17%. However, at the beginning of August, equities worldwide fell significantly (Nikkei -12%).
- The causes were, (1) the FED deciding not to lower interest rates on July 30, (2) the BoJ raising interest rates on July 31, (3) the disappointing employment figures in the US on August 1, (4) disappointing profit figures/forecasts of Big Tech shares in the US.
- The BoJ's interest rate hike in particular had a huge impact on the financial markets because it led to an accelerated reduction of the JPY carry trade, which amounted to no less than USD4tr.
- For a long time, investors have ignored the consequences of Fed rate hikes and the importance of leading indicators such as the Conference Board LEI and the Inverted Yield Curve.
- The turning point in sentiment was employment in July, when it emerged that “only” 114,000 jobs had been added in the US and unemployment had increased by +0.2% to 4.3%.
- The latter means that another important leading indicator has been added that predicts a recession.
- The disappointing employment figures were offset by better-than-expected economic growth (2024Q2 +0.7% qoq) and too high inflation (+3.0%). The FED therefore decided again not to lower interest rates.
- The longer the FED hesitates between excessive inflation on the one hand and rising unemployment on the other, the greater the risk of a hard landing. The chance of an interest rate cut in September is therefore increasing rapidly.
- For the ECB, better-than-expected growth in 2024Q2 (+0.3%) and disappointing (core) inflation (+2.9%) were also reasons not to cut interest rates further in July.
- Germany's economy continued to perform extremely poorly in 2024Q2.
- Given the deteriorating fundamentals, we maintain our advice to keep part of the assets in Cash and Gold and (government) bonds, that will also benefit once the FED is starting to cut interest rates.
ECONOMY
Although we wrote last month that “a recession in the US occurs on average 24 months after the first interest rate hike by the FED and 27 months have already passed”, investor confidence in the strength of the US economy remained high. Important leading indicators, such as the Conference Board LEI and the Inverted Yield Curve, were ignored. The turning point in sentiment was August 1st, when it emerged that “only” 114,000 jobs had been added in July and unemployment had risen by +0.2% to 4.3%. The latter means that another important leading indicator has been added that predicts a recession. An unemployment rate around the Non Accelerating Inflation Rate of Unemployment (NAIRU) is always accompanied by a recession in the US. It is also a point where the Fed normally starts cutting rates. However, the FED decided not to do this (yet) at the end of July.
The disappointing employment figures were offset by better-than-expected economic growth (2024Q2 +0.7% qoq) and too high inflation (+3.0%). FED Governor Powell said, “It's going to be inflation data, it's going to be the employment data, it's going to be the balance of risks as we see it”. It illustrates the dilemma the Fed is dealing with. However, real interest rates are now as high as they were on the eve of the Great Recession in 2007. The longer the FED hesitates between excessive inflation on the one hand and rising unemployment on the other, the greater the risk of a hard landing becomes. The chance of an interest rate cut in September is therefore increasing rapidly. For the ECB, better-than-expected growth in 2024Q2 (+0.3%) and disappointing (core) inflation (+2.9%) were reasons not to cut interest rates further in July, although the German economy continued to perform extremely poorly in 2024Q2.
Financial Markets
At the end of July, the return on the S&P 500 was +15,8%. the beginning of August the sentiment completely changed with the S&P500 index decreased to + 8,7 % and the Japanese index the Nikkei dropped -12% ytd. The causes were (1) the FED deciding not to lower interest rates on July 30, (2) the Bank of Japan (BoJ) raising interest rates on July 31, (3) the disappointing employment figures in the US on August 1, (4) the profit figures/forecasts of Big Tech shares in the US, which on balance were disappointing. Although investors were rightly more concerned about the prospects for both the economy and corporate profits, the BoJ's rate hike played a particularly important role. For years, investors have been able to borrow money from the BoJ for (almost) free. It was estimated that this so-called carry trade amounted to USD4tr. This money was invested in higher-yielding assets. As it has become more expensive since July 31, many investors have reversed these carry trades. This caused a (temporary) enormous wave of sales in the more risky assets.
Now that the markets appear to have processed this sell-off from carry trades, we are back to fundamentals. The stock market in the US is historically expensive, more and more leading indicators indicate that a recession is approaching, the profit outlook is starting to disappoint and both the FED and the ECB cannot proactively cut interest rates aggressively because inflation remains stubbornly high. We therefore maintain our advice to keep part of the assets in Cash, Gold and (government) bonds that will also benefit as soon as the FED starts cutting interest rates.
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