This week in the markets: recession fears

With the holidays now firmly in the rear-view mirror, the investment mood is tracking the drawing in of the evenings as autumn begins. After two years of rising interest rates, the big question is whether or not the US can avoid a recession.

Jobs data disappoint again

Just as happened at the start of August, a set of weak labour market figures has unsettled markets. Last week was the worst of the year for equity investors, with the S&P500 down by 4% and the tech-heavy Nasdaq off by 6%.

Non-farm payroll data showed that the US economy created just 142,000 new jobs in August, lower than the 160,000 that economists had forecast. It felt like a re-run of the weak jobs report a month earlier which triggered a weak of turbulence in markets during the holiday period.

Unsurprisingly, the shares that were hardest hit were those perceived to be the most exposed to an economic downturn or recession. Computer chip stocks, and especially those that had been buoyed by the AI growth story, bore the brunt of investors’ reassessment. Intel, Broadcom and Nvidia were all down by 15%.

Bonds back in focus

The change in sentiment was just as evident in the bond market. Fixed income investments have moved to the top of the performance tables, as they tend to at times of uncertainty. At the same time, the relationship between short-dated bond yields (linked to interest rate expectations) and longer-dated ones (driven by growth and inflation forecasts) made an important shift last week.

For much of the last two years, short yields have been higher than longer ones. That is typically a sign of trouble to come as it reflects tight monetary policy today and worries about growth tomorrow. It is seen as a fairly foolproof recession signal.

However, recessions tend to arrive when that relationship flips back to the more normal state of affairs of lower short-term yields and higher longer ones. And that is what duly occurred last week. For some, it pointed to the imminence of an economic slowdown.

One reason that short term bond yields are falling is that speculation is growing that the Federal Reserve will next week cut interest rates, not by the expected quarter percentage point but by a larger half point. That might sound like good news - cutting the cost of borrowing for businesses and households - but a glass half empty view of a big rate cut is that is shows how concerned the Fed has become about the growth outlook.

Investors holding the line

That all sounds gloomy for the markets, but in reality the bad news is yet to show up in the broader indices. For investors with a balanced portfolio that is not too exposed to the Magnificent Seven tech stocks, things are holding up better than the headline index level might suggest.

The equal weighted S&P 500 index is still very much on a rising trajectory, with 72% of shares in an uptrend. And even the capitalisation weighted index remains 15% up year to date. The Russell 2000 index of smaller companies also looks like it is still breaking out of a two-year sideways movement to the upside.

Those market moves are justified by still positive earnings forecasts. For 2024 as a whole, the forecast growth rate is nearly 10% and more than 14% for next year. Clearly, if there is a recession, those expectations may be disappointed.

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