Global markets have been whipsawed by a series of sharp blows in the last few days, but mainly centering around concerns about the health of the U.S. economy. Our view remains that household and corporate balance sheets' strength implies recession is unlikely, but risks are building. If economic data continue to deteriorate, the Fed stands in a good position to respond aggressively— but our forecast remains for the Fed to cut rates by 25bps in September and December—with another 25bps cut in November added to the mix now. 

Unfortunately for markets, the negativity of the current narrative implies it may take a combination of solid economic data, earnings numbers, and reassuring Fed speak to settle nerves. 

Recent economic data and market reaction 

Markets were already floundering, but the disappointing July U.S. jobs report largely drove the sharp sell-off on Friday. As a reminder, U.S. nonfarm payrolls slowed to +114,000 m/m (versus expectations of 175,000), with downward revisions to prior months of -29,000. Private payrolls rose just +97,000 m/m. The unemployment rate rose from 4.1% to 4.3%. 

Markets responded to this data with dismay (and more than a tinge of panic), with several analysts pondering if the U.S. economy is already in recession and even raising the possibility of an intra- meeting emergency Fed cut. 

Broad market’s price action too looks very dramatic 

At the start of U.S. trading today, the S&P 500 was down 4.2%, with the Nasdaq also declining 5.4%, joining the Magnificent 7 in correction territory. This solidly risk-off tone saw yields lower, with the U.S. 10y yield below 3.8% and down more than 30 basis points since last week’s FOMC meeting (at the time of writing), and the 2y yield at one point down almost 60 basis points over the past few days. The 2s10s yield-curve spread—a classic indicator of recession—has steepened rapidly and is flirting with dis-inversion for the first time since July 2022. 

Price action in the U.S. joins the significant overnight moves in Asia, which saw a broad sell-off in Japanese markets: the Yen continued to rally against the dollar, while TOPIX and Nikkei were both down by 12%, with the latter down more than 20% from its July peak. 

How bad was the July jobs report? 

Pre-covid, a 150k increase in payrolls would be considered consistent with a very solid economy, a number between 100k and 150k would be consistent with a slowing economy, a number between 75k and 100K would be starting to ring alarm bells about the direction of the economy, and a number below 50k would be cause for serious concern. From that basis, a continued decline in job gains over the coming months from July’s 114k print would be a serious reason for worry and, as such, the market is perhaps justified in its response. However, there are two complicating factors to the current environment:

1. This is just one month’s data, and payrolls can typically fluctuate. It’s worth pointing out that the April 2024 payroll number was initially 165,000 and then was revised down to 108,000 before rebounding to 216,000 the following month. Without stating the obvious, one month does not make a trend, so next month’s jobs report will be very important.
2. Economists are trying to determine how much of the slowing in U.S. employment in July was due to Hurricane Beryl. An unusually high number of non-agricultural workers reported not being at work due to bad weather and/or on temporary layoff. At the same time, the decrease in workweek hours would also be consistent with weather conditions being at play. Interestingly, the San Francisco Fed recently released a paper suggesting a weather-related drag of 15,000-30,000 job gains in July. 
   Equally, however, several segments of last Friday’s report point to a fundamental decline. For example, the narrowness of sectoral job creation, which wouldn’t typically be consistent with bad weather, and an increase in the number of workers transitioning from employed to unemployed. In addition, the BLS noted that Hurricane Beryl did not significantly affect unemployment (this is slightly strange, and analysts are struggling to explain this).

Markets reacted not only to a disappointing payroll report but also to a rise in the unemployment rate, which triggered the Sahm Rule. This rule indicates recession if the three-month average unemployment rate rises by 0.5% over 12 months. However, this particular recession signal may be weaker than it appears. 

The Sahm Rule typically applies when unemployment rises due to layoffs. In this case, the increase stems largely from a growing labor force, not job losses, so it doesn't necessarily signal a recession. Claudia Sahm, the rule's creator, says, "The Sahm rule is correctly signaling caution about a cooling labor market, but the impact is exaggerated due to the shift from pandemic labor shortages to increased immigration." 

Taking a deep breath and a step back 

Given the uncertainty surrounding the latest jobs report, it is important to look at the totality of data (to borrow Jay Powell’s words). It is early days still, but the Atlanta Fed’s GDPnow estimate suggests that Q3 GDP is currently tracking at 2.5%. However, last week’s weaker than expected ISM Manufacturing report (46.8 versus expectations of 48.8) and rise in initial jobless claims to their highest in nearly a year are worrying. 

U.S. economic growth is clearly downshifting, and the labor market has been cooling for several months. Although on the surface, the labor market appeared to be in good health (the 3-month average payroll growth sits at 170,000), under the surface, companies have been re-evaluating labor costs. Recent surveys show that job openings have declined meaningfully, and smaller businesses have been pulling back on hiring plans. As we noted in the latest Global Market Perspectives, “labor market surveys suggest a further weakening in labor demand should soon appear in the data, likely pushing jobless claims and unemployment slightly higher.” 

So yes, the market is right to be concerned. But whether labor market weakness tips over into widespread job losses depends on the economy’s underlying strength. If household balance sheets are strong and company profit margins remain healthy, mass job layoffs and an income decline spiral should be avoided. 

So far, there have been clear signs of strains amongst lower-income households. However, middle- and higher-income households, who are responsible for around 60-70% of consumer spending, remain in good shape. Coupled with gains from property and equity market exposure, household balance sheets have broadly remained strong. Total U.S. household net worth as a percentage of disposable income sits close to an all-time high. 

Similarly, while small businesses are showing signs of weakness, large business confidence remains very robust. Indeed, second quarter earnings so far have come in better than expected, with most companies beating expectations and earnings tracking to grow nearly 13%, above the pre-earnings season forecast of 8%. Broad corporate balance sheets are also in good shape— interest payments as a percentage of profits are at the lowest levels since 1957. 

Overall, while recession risk has been rising, strong household and corporate balance sheets should prevent the unfolding economic slowdown from mutating into a hard landing. 

And then there’s everything else… 

In addition to the weak employment data, markets have been responding to a confluence of additional events. 

Bank of Japan: Last week, the BOJ raised interest rates more than expected and announced a plan to halve its gross monthly bond purchases over the next couple of years—a more hawkish plan than investors had anticipated. This has helped to drive a 9% appreciation in the yen since early August. While yen appreciation was widely expected, the speed of the yen rally has caught many off guard. 

The currency shift has made the yen less attractive for carry trades, where investors borrow yen at near-zero interest rates to invest in higher-yielding assets like U.S. equities. As the yen strengthens, these trades unwind, contributing to U.S. equity market weakness and increasing risk-off sentiment. Note that this can create a self-reinforcing loop, whereby equity market weakness begets further yen strength, and so on. 

Big Tech: Coming into this earnings season, there were already worries that Big Tech would disappoint lofty expectations. In fact, six of the Magnificent 7 have disappointed markets. News that Warren Buffett’s Berkshire Hathway decided to reduce its stake in Apple by almost 50% in Q2 didn’t help. Yet, the structural strengths of these companies (strong liquidity, high quality, innovation, productivity boosters) suggest that investors are looking for the right opportunity to re-enter the market. 

Middle East: Recent events in the region have raised the risk of full-blown conflict. While the impact on oil prices has not been so significant, the risk of a serious war has inevitably added to risk-off sentiment. 

Federal Reserve 

Markets have shifted from pricing in 50bps of easing this year to more than 125bps. This would imply back-to-back 50bps cuts in September and November and a 25bps cut in December. Some analysts are even suggesting an intra-meeting emergency cut is warranted. This seems a panicked reaction—intra-meeting cuts have typically only happened in the event of financial crisis. Chicago Fed President Goolsbee (one of the more dovish voices on the FOMC) spoke on Friday evening and noted that the jobs report is one data point and reminded that there will be a lot of information between now and the next meeting and it “will determine the size or if there is action at all.” 

Our take on Fed easing is less aggressive than market pricing. While the weakness of the July jobs report and market sentiment advocates for adding another rate cut to the mix, the Fed would need to see additional evidence of elevated recession risk before it turns to back-to-back 50bps cuts. 

We expect 25bps rate cuts in September, November, and December (our original forecast was for cuts in only September and December). Yet, if the August employment report confirms July’s weakness and additional economic data show similar cooling, a 50bps cut in September will become our baseline. 

Importantly, in the worst-case scenario whereby economic slowdown tips towards recession, the Fed has plenty of room to cut rates and loosen financial conditions.