Investors fear the US economy is at a turning point, but is it?

What triggered the temporary meltdown in sentiment has been extensively debated. Slowing jobs growth in the US economy is the most probable trigger as data suggested just 117,000 jobs were added during July. However, the role of Japan in raising its interest rates above zero for the first time in fourteen years is also relevant. Cheap money pouring out of Japan in search of returns has been a constant backdrop for many investors’ lives. If that is poised to change then a range of assets - inflated by what has become known as the Yen carry trade - will need to reprice lower. Concerns of a more market-orientated nature are also relevant. Much of the recent returns for investors have been amongst a small number of enormous US technology stocks seen as the long-term beneficiaries of a boom in AI investment. The sustainable returns for these firms – and the use cases they offer – remain an open question. Investors will face cycles of exuberance, hubris, and doubt. Not necessarily in that order.

There is also my favoured, if flippant, answer when investors ask why markets have fallen. There were more sellers than buyers. Slightly less flippant is the fact that these big volatility events – the Nikkei 225 Index in Japan saw its biggest one day decline in 37 years on Monday, followed by its largest ever rebound on Tuesday – should be expected with greater frequency amidst greater passive investment, and algorithmically traded liquidity. There is another column on the diluted economic and social function of volatile financial markets – but that is not for today. Rather what is the case that the US economy is now at a turning point? With the US stock market now accounting for 60% of all stock market value around the world - and therefore of a large portion almost all pensions - the answer will have a significant impact on the finances of Times readers.

The US jobs data for July wasn’t solely at risk of misinterpretation from the impact of Hurricane Beryl, but also problems with sampling the US workforce. Payroll data suggests the US has added a healthy 2.5 million jobs over the last year. The household survey that purports to measure the same thing suggests job growth of just 57,000. Doubt over what is going on in the labour market has parallels with the UK. The main conclusion I would draw is that it is unwise to draw big conclusions on relatively small changes in this data. And yet that was precisely what markets did. The release of the latest US labour market data breached a closely watched indicator known as the Sahm Rule - after former Federal Reserve economist, Claudia Sahm. This rule - triggered when unemployment rise by 0.5% from its 12-month low - purports to predict a US recession. It did this successfully in 1990, 2001, and 2008.    

The problem is that we have been here before with such “rules”. In July 2022 the US yield curve - the gap in interest rates between short and long dated US debt – turned negative. This “inverted yield curve” is perhaps the most celebrated of market rules. It triggered a wide range of forecasters to predict a US recession in 2023 - and yet the economy accelerated and defied the doom-mongers. Such rules are great until they are not. Despite this we had the big Wall Street investment banks chasing headlines by raising their likelihood of recession predictions. Goldman Sachs to 25%. JP Morgan to 35%. Forget the fact that such statistical quantification is intellectually flawed, this helped reinforce the nervous narrative.   

At times like this it is valuable to look at a broader range of indicators. In 2022 when the yield curve inverted the Federal Reserve was selling trillions of dollars’ worth of bonds back to private investors. This was, and remains, distortionary. Today as the Sahm Rule has been triggered the role of ongoing deficit spending from the Biden administration, the return of real income growth needs to provide added context. There can be little doubt that the US jobs market is closer to maxing out than at any time since the pandemic. However with participation of US workers still rebounding - contrary to most expectations - the amount of spare capacity left is an open question for US policymakers considering their first interest rate cut next month.

And it is that interest rate cutting cycle that looks most relevant to me. With existing home sales down 40% from their peak - and total bank lending flat since late 2022 - it is a reacceleration of the US credit cycle that is a key unknown. The animal spirits required to add to $17.7 trillion of household debt will be a major determinant. Part of this will hinge on how Federal Reserve Chairman, Jerome Powell, navigates the run-in to any interest rate cut. But in election year where consumer confidence and perceptions of the US economy are split down partisan lines how Vice President Kamala Harris, and former President Donald Trump conduct their campaigns will also play a role. For Harris this is straightforward. Her campaign will amplify an economic record of the last four years that – even after stripping out the COVID-19 pandemic - produced a higher rate of economic growth and jobs creation than the first Trump administration. For Trump the calculation is harder. Trashing the Biden record could be a pyric victory if it pushes the US economy into a recession on his watch.

Overall I think the US economy - for all its federal government indebtedness, with no signs of a more austere stance - is in better shape than recent headlines suggest. The bigger issue is whether US debt markets and equity markets are simply too big to fail without global collateral damage. It is that sheer scale that frays investor nerves as much as the volatile data.