Recession or soft landing: What’s next for the US economy?

The market shock and recovery

The July jobs report was a disappointment to the markets. The US labour market added 114,000 jobs in July, falling short of the 175,000 jobs forecast. The unemployment rate rose to 4.3%, the highest level since October 2021.

On the other side of the world, the Bank of Japan hiked interest rates for the second time in a decade. This move, along with signals from the Federal Reserve suggesting upcoming rate cuts, resulted in a rapid appreciation of the yen. 

The strengthened Yen led to the unwinding of the popular Yen carry trade. Carry trades involve borrowing in a low-interest-rate currency—such as the Japanese yen—to invest in higher-yielding assets. This strategy has been particularly lucrative, especially given the Bank of Japan’s prolonged zero-interest-rate policy.

The markets reacted violently; the S&P 500 index, along with the global equity markets (ACWI) dropped about 6% in three consecutive days, erasing July’s gains. The TOPIX declined by 20%, wiping all of the gains from 2024.

By 6 August, the market had begun to recover as traders and market participants digested the statements from Federal Reserve policymakers pushing back against the idea that the US economy was heading towards a recession and signalling rate cuts in the upcoming FOMC meetings.

Is a recession coming?

The July jobs report and the early August market drop had given investors a rude awakening and raised doubts about the rosy soft landing scenario. History indicates that increases in the unemployment rate have been a reliable indicator of a recession. 

The July employment data provided the most significant red flag so far. Job growth slowed more than anticipated, with gains in jobs concentrated in a limited number of sectors.

Other signs of strain in the economy include rising delinquencies on credit card and auto loan payments, increased filings for unemployment benefits, and lower-income households starting to tighten their spending.

What triggers the Sahm rule?

Market bears have been referencing the Sahm Rule recession indicator. Introduced by economist Claudia Sahm in 2019, the indicator suggests a recession is likely when the three-month average unemployment rate increases by 0.50% or more from its 12-month low. This threshold has been triggered, with the unemployment rate rising to 4.3%. 

Historical recessions, excluding COVID-19, have shown a gradual increase in unemployment before a significant spike. The Sahm Rule has gained attention for its consistent accuracy, aligning with every U.S. recession since 1970. 

All is lost? Not necessarily.

So one might ask: How accurate is the Sahm rule recession indicator? The creator of the rule, Claudia Sahm, wrote in an opinion editorial in Bloomberg that “her recession rule was meant to be broken.” 

While the U.S. economy is showing signs of slowing down, it’s not stalling. Key indicators like consumer spending, personal income, and job growth, which the National Bureau of Economic Research uses to gauge recessions, remain solidly positive. GDP growth accelerated in the second quarter and is expected to continue in the third, supported by strong productivity gains and a rebounding service sector.

Moreover, inflation has eased significantly, providing the Federal Reserve with greater flexibility to reduce interest rates if the economy weakens further, without the immediate risk of reigniting inflation. 

Fed Chair Jerome Powell hinted that rate cuts could come as early as September, a move now seen as almost certain by the market. Some investors even anticipate earlier action, though most Fed watchers view an emergency rate cut as unlikely.

What to do in case of a recession?

In August, we received many questions from our clients on what they should do in case of a recession. The news is bleak, the economic numbers are weak and all markets look like they have peaked. These are scary times for investors. 

We hope this article was reassuring – there are many things to be optimistic about but it is always wise to recognise that the risks have not gone away. 

Recessions, like death and taxes, are a part of life. As individual investors, it’s important to understand that we have no control over macroeconomic factors like interest rates, inflation, or currency movements. While these elements are relevant and can influence the markets, they are beyond our influence. By acknowledging this, we can focus on what we do control—our investment strategy, asset allocation, and risk management.

Once an investment plan with a robust strategic asset allocation has been formulated, the difficult part comes in – staying level-headed when everything is screaming for you to head out the door and hide in cash. 

Staying invested during periods of economic uncertainty, even when the possibility of a recession looms, is crucial for long-term portfolio growth. Historical data over the past 30 years shows that despite several recessions, the stock market has consistently recovered and reached new highs.

For instance, after the dot-com bubble burst in 2000 and the global financial crisis in 2008, the S&P 500 experienced significant declines, yet within a few years, it not only recovered but continued to achieve record levels.

Research done by Dimensional Fund Advisors shows that even after 30% market declines, the market can rebound significantly, yielding up to 50%, three years after a severe decline.

Of course, history doesn’t always repeat itself and past performance is not necessarily an indicator of future performance. However, history is informative and can be of comfort and a welcome antidote to news that spell doom and gloom.