A screen above the trading floor of the New York Stock Exchange shows the closing number for the Dow Jones industrial average on Aug. 5.Richard Drew/The Associated Press
The sell-off in equity markets is raising fears of economic troubles in the United States and the potential for a recession, but those concerns look overblown when compared to a bevy of indicators pointing to a firm expansion.
Major stock indexes staged a rebound on Tuesday, retracing some of the steep decline from recent sessions. In the U.S., the S&P 500 rose 1 per cent Tuesday after falling 3 per cent Monday; the Dow Jones Industrial Average rose 0.8 per cent after its 2.6-per-cent fall on Monday. As investors are making sense of the volatility, one of the prevailing theories is that the U.S. economy is crumbling under the weight of higher interest rates and that the Federal Reserve has kept rates at restrictive levels for too long, endangering the prospect of a soft landing.
Stocks tumbled on Friday after the U.S. reported surprisingly weak numbers on job creation, with the unemployment rate climbing to 4.3 per cent – the highest level since 2017, not including the early pandemic years. The jobless rate has risen enough that the “Sahm rule,” created by former Fed economist Claudia Sahm, is signalling the U.S. has entered a recession.
But elsewhere, the data point to robust growth. The U.S. economy grew at an annualized rate of 2.8 per cent in the second quarter, and the Federal Reserve Bank of Atlanta is projecting a similar expansion in the current quarter – nowhere close to a recession.
“I would say the U.S. economy is slowing, but it’s not contracting,” said Sal Guatieri, senior economist at Bank of Montreal, in an interview. “We’re not seeing clear signs that the economy is rolling over.”
The slowdown is apparent in the labour market. The number of U.S. employees has risen by a monthly average of 194,000 over the past six months, down from 225,000 over the previous six-month period.
Still, the unemployment rate is being driven higher by new job seekers, re-entrants to the labour market and people on temporary layoff, possibly because of adverse weather conditions. The layoff rate is still subdued, relative to typical levels before the pandemic.
Dr. Sahm told The Globe last year that it’s possible her eponymous rule could send a false signal of recession, in the event that labour force growth exceeded the pace of hiring. “It’s not a law of nature,” she said. “It’s just an empirical pattern that works in the United States.”
A similar dynamic is found in Canada, where historically strong population growth is outpacing job creation. The unemployment rate has climbed to 6.4 per cent as of June, up from 4.8 per cent two summers ago. The consequences are being felt acutely by newcomers to Canada and young people, who are taking longer to find jobs; those with employment have mostly been spared by the labour slowdown.
John Higgins, chief markets economist at Capital Economics, said the equity rout feels less like the dot-com crash of 2000 than the situation in 1998, which saw a temporary slide in share prices and a rebounding Japanese yen.
“Even then, there is a big difference between the present and 1998: the absence of a major problem in, and risk to, the U.S. financial system,” he wrote in a client note on Monday.
In addition to economic concerns, Mr. Higgins pointed to several other factors that were weighing on markets. Some technology firms have posted underwhelming financial results, after a boom period for companies tied to artificial intelligence. Republican presidential candidate Donald Trump has also railed against “too big” tech companies and has said that Taiwan – a major supplier of computer chips – would have to pay the U.S. for protection against Chinese aggression.
Market gyrations have been most pronounced in Japan, where the country’s main stock index fell 12.4 per cent on Monday before rebounding 10.2 per cent on Tuesday. Some analysts think a combination of macroeconomic and technical factors playing out in Japan may explain the broader sell-off around the world as much as souring sentiment about the U.S. economy.
Over the past two years, the yen has weakened significantly compared to other currencies, as the Bank of Japan held interest rates at rock-bottom while the Fed and other central banks launched into a once-in-a-generation tightening cycle. The combination of low interest rates and weak currency encouraged global investors to borrow money in Japan and use it to buy higher-yielding and riskier assets in other countries – a strategy known as the “carry trade.”
This dynamic has shifted into reverse over the past month, as the Bank of Japan has raised interest rates while other central banks have started to cut and the Fed has signalled it’s on the cusp of an easing cycle. As a result, the yen has appreciated sharply against other currencies, rising more than 10 per cent against the U.S. dollar since mid-July.
These exchange rate moves have caused losses for hedge funds and other large investors engaged in the carry trade, prompting them to unwind positions, either to meet margin calls or rebalance the risk weighting in their portfolios. That has meant liquidating their holdings of U.S. and other assets to buy yen, and may be one reason for the aggressive selling seen in recent days around the world.
At the same time, the appreciation of the yen has dampened investor enthusiasm for Japanese exporters who tend to benefit from a weak exchange rate.
BMO’s Mr. Guatieri said he’d be “surprised” if the U.S. fell into a recession, barring some kind of shock that led to one.
“I think the Fed will achieve this so-called soft landing, as long as they begin cutting interest rates fairly soon, next month, and as long as we don’t see a further correction in the stock market,” he said. “We are still on track for a soft landing.”