The narrative in markets over the last year has been simple: will the US achieve the mythical ‘soft landing’ or will higher rates push the US economy into recession? A ‘soft landing’ is now the consensus view and is fully priced into markets. Is this truly the end of the debate?
We think not.
Our view is that markets are entering a new stage, where risks are more symmetric rather than skewed to the downside, with the changing skew being driven by conflicting signals from US data. We see signs of an emerging upside risk, that of a ‘second wind’ to economic growth, spurred by recent strong non-farm payrolls and GDP reports. But at the same time, softening hiring intentions data and subdued business surveys still suggest that a recession cannot be ruled out. These scenarios have very different implications and a nimble approach will be key to navigating markets over the coming months.
The narrative in markets has shifted away from ‘recession risk’ but our view is that investors risk becoming complacent. A soft landing may now be the most likely scenario, but recession risks are still very elevated. Historically, during most cycles, the economy often appears to be headed for a 'soft landing' just before going into recession.
One critical signpost of a recession – a significant rise in the unemployment rate – remains absent. However, it is not unusual for the unemployment rate to take some time to show a definitive rise at the beginning of a recession.
Our analysis shows that in US recessions, the first 0.5 percentage point (ppt) rise from the low in the unemployment rate can take an extended period (on average eight months), while the rise beyond that occurs much faster (on average three months for the next 0.5ppt).
Source: QIC & Bloomberg, 13 February 2024The reason is that businesses initially tend to respond to softer conditions via reducing hiring and reducing hours worked. In other words, they hoard labour. It is only as economic weakness persists that employers cut jobs.
Our analysis shows this pattern is consistent across a number of developed economies. When the unemployment rate rises a mild-to-moderate amount, most of the adjustment in the labour market is via a reduction in average hours worked, rather than employment. It is only during severe downturns in the labour market that broad-based job losses occur.
Source: QIC & Bloomberg, 13 February 2024We are tracking the labour markets of a number of developed market economies, including Australia, versus historical cycles and the majority are still within the normal bounds of typical pre-recession behaviour. We note, in particular, that the Australian labour market has softened at an accelerating pace since Q4 2023 in line with the softening in business conditions. Thus, we cannot rule out recession risks in the US and Australia and we remain cautious about valuations in credit markets in such a scenario.
Nevertheless, it is also true that the US economy has been more resilient than most expected in the face of the fastest tightening in monetary policy in decades. It’s possible that a decade of abnormal rate settings made us all under-estimate the true neutral rate of interest, and we are simply now back to normal levels, not restrictive levels as is commonly thought. It may also be that the easing in broad financial conditions since November (as markets increased expectations of rate cuts by the Federal Reserve) has helped to reduce the immediate prospects of a deep downturn.
Regardless of the reason, the upside surprises in US GDP data recently means we have begun to factor a ‘second wind’ scenario into our estimates. In this scenario, growth is above trend and the labour market treads water, meaning that the deceleration in inflation begins to stall. Not only would that delay much anticipated rate cuts, but it could even put further rate hikes back into play. To be clear, we see this as a tail-risk, not our central scenario. But it is an important scenario to consider as markets are not currently priced for it, and it would likely be highly disruptive.
Investors need to be aware that the US economy is at a crossroad and risks to the outlook are increasingly two-sided. While market participants have been pleasantly surprised by 2023, we’re not so sure that markets will have a smooth 2024. We expect volatility to rise again in 2024. That volatility will likely present great opportunities, but right now we are choosing to keep some of our powder dry.
Further information
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