Charts of the Month

CHART 1 – ARE RATE CUTS GOOD FOR STOCKS?

The Federal Reserve is all but certain to commence its rate-cutting cycle this month, following in the footsteps of the Bank of England, European Central Bank and People’s Bank of China, which all lowered borrowing costs over the summer.

This begs the question do rate cuts help or hinder equity markets?

All things equal, lower interest costs should drive share prices higher because they increase the present value of a firm’s future profits and cash flows. Simply put, lower borrowing costs suggest a company will earn more (now and going forward), which makes investing in that firm’s stock more appealing.

The problem is monetary easing tends to emerge when the economy is weak and corporate profits are coming under pressure. During a recession, the decline in a company’s earnings typically swamps the positive discounting effect described above, causing share prices to fall.

That’s why, as the chart below shows, most of the major equity bear markets of the past 30 years have coincided with a US recession (shaded bars).

For much of the past decade, lower interest rates have been a net positive for equity markets, but that’s because there have been no deep and prolonged recessions. Indeed, the 2020 downturn was very short-lived, because of the aggressive policy response, and the 2022 bear market was caused by the Central Banks hiking rates.

Which helps to inform how monetary policy is likely to influence markets going forward.

If a major economic downturn can be avoided, this rate cutting cycle should boost equity markets. However, if growth slows materially or contracts, investors should brace for a meaningful market sell-off.

CHART 2 – FIRMER US MANUFACTURING ACTIVITY LIMITS THE RECESSION THREAT

The old saying that “when America sneezes, the world catches a cold” still holds true, even though Chinese growth and inflation trends now also play a dominant role in setting global economic conditions.

US services activity is by far the largest component of annual GDP, accounting for more than 75% of total output. But it tends to be relatively stable, meaning the state of the manufacturing sector typically determines whether the overall economy is expanding or contracting.

The chart below helps to gauge the risk of a US recession and is currently suggesting the probability of a contraction is relatively low.

The “ISM Recession Indicator” amalgamates three of the sub-components of the monthly ISM manufacturing index; a supply chain survey that dates back to the late 1940s.

Specifically, it adds together the new orders and backlogs sub-indices then deducts the level of inventories.

When the metric is trending higher (as it has been since May 2023) it indicates economic expansion as new orders and backlogs are outpacing inventory stockpiling. This infers end demand is rising, fuelling production growth. The converse is true when the indicator is declining, as we saw during the 2008 and 2020 recessions.

CHART 3 – RISING UNEMPLOYMENT ARGUES FOR CAUTION

The chart below shows the US unemployment rate (the number of people out of work as a percentage of the total labour force) going back to the 1950s. The shaded areas represent every US recession since then, which shows that spikes in unemployment and economic downturns go hand in hand.

At 4.3%, US unemployment is well below the levels of past recessions, but it has increased meaningfully from the 3.5% low reached in early 2023.

This is reason for caution.

The “Sahm rule” was created by an ex-Federal Reserve economist (Claudia Sahm) and is triggered whenever the three-month moving average of the national unemployment rate rises by 0.5% or more from its lowest point in the past 12 months. The indicator has successfully identified every US recession over the past 50 years.

It was triggered again last month after a weak July jobs report, which saw the US economy add only 114,000 jobs over the month. This was coupled to a whopping downward revision of prior payrolls data with the Bureau of Labour Statistics disclosing the number of US jobs created in the 12 months to March 2023 was 818,000 fewer than initially reported.

At face value, it appears the US economy is much weaker than the headline figures suggest, but there are good reasons to question the reliability of the Sahm rule this time around.

The first is that most traditional economic models are still struggling to adjust for the highly unusual conditions brought about by the pandemic. This is particularly true of labour market indicators given the vast increase in remote and flexible working arrangements.

The second is that the US has seen a significant increase in immigration in recent years so the number of people actively seeking work is likely to be far greater than the official statistic suggest. This would place upward pressure on the unemployment rate, but may not necessarily be bad news for the demand side of the economy.

CHART 4 – RECESSION RISKS IN AN ERA OF FISCAL DOMINANCE

Are recessions no more given that policymakers are spending so much money?

As Sir John Templeton said the four most dangerous words in investing are “this time is different,” but it is hard to see a major and protracted recession taking hold when most Governments are already running substantial fiscal deficits and the Central Banks are providing bundles of liquidity support.

This is particularly so in a US Presidential election year, which makes the chart below an important one to watch as we head towards polling day on 5^th November.

As we have noted before, the Treasury General Account (TGA) is the US government’s current account at the Federal Reserve. It’s used to manage day-to-day federal spending and is where the Treasury department deposits the funds it raises from tax receipts and new debt issuance.

When the balance is rising it typically means liquidity is being sucked out of the economy and markets, which tends to coincide with “risk off” events. Conversely, the TGA balance falls when the authorities wish to provide a fiscal boost to spur stronger economic growth or a stock market rally (or both).

With the election fast approaching, the odds strongly favour the TGA being bled down from its current level around U$800bn because the incumbent Democratic administration will want to goose up the economy and markets as we head towards year-end.

Should this fiscal firepower be deployed, the risk of a US recession will diminish, at least in the near-term. And that should be a constructive environment for equity markets.