Insights

One key takeaway from Wednesday’s post-FOMC press conference is the Fed’s unshaken conviction that it can avoid a recession. A risk-on mood dominated markets on Thursday, with the S&P 500 breaching new all-time highs while the 10-year Treasury yield rose 3.5 basis points (see Indicator Spotlight).

This week’s economic data releases were also resilient-to-positive. Industrial production expanded in August and the first two September regional Fed manufacturing surveys sent a positive signal. The August retail sales underscored mixed details but were overall not consistent with an imminent recession, and housing starts bounced back in August.

Still, we are not ready to abandon our US recession call on a 12-month horizon.

First, it hinges on the labor market and its passthrough to consumption. Ongoing softening in labor demand will continue to exert downward pressure on wage growth and attenuate the boost from household spending’s main driver at the same time as other consumption tailwinds are fading.

Second, aggressive rate cuts do not materially alter this expectation because monetary policy works with a lag. Current conditions are the product of past tightening and current cuts may only ripple through the economy after it is already too late.

Third, this week’s 50-bps cut keeps monetary policy restrictive. The Fed funds rate remains above even the Fed’s own estimate of the neutral rate.

Nevertheless, our subjective odds for a recession in 2024 have decreased and stocks may still rise in the short run as investors continue to expect a soft landing. Further gains will only make equities more vulnerable to the downside.

We are thus reluctant to chase equities higher and remain underweight.

The PBoC lowered the 14-day reverse repo rate by 10 bps on Monday, a move that follows a string of easing measures in late July when the central bank lowered the 7-day reverse repo rate, several maturities of the loan prime rate and the 1-year medium-term lending facility rate.

Our China Investment strategists highlighted that given their small magnitude, this week’s and July’s cuts are unlikely to move the Chinese growth needle. Additionally, already low rates provide little scope for monetary policy to meaningfully impact the economy. Moreover, they view this week’s cut as a mere seasonal boost (end of quarter, beginning of the Golden Week).

Our colleagues nevertheless expect a more meaningful monetary policy easing package before the year is out. Notably, they assign high odds to policymakers reducing interest rates on existing mortgages. Existing homeowners currently pay higher mortgage rates (4.27% on average) than new home buyers (3.45% on average), and the PBoC move would align existing and new mortgage costs within a range of 3.27% to 3.47%.

They expect this gesture could potentially lift private sector sentiment in the mainland economy. However, absent a turnaround in the labor market or meaningful fiscal stimulus targeting household disposable income, this revival in sentiment is likely to be transitory.

Domestic demand is likely to remain muted, while external demand headwinds will constrain Chinese exports. That said, although the Chinese economic outlook remains bleak, cheap valuations cushion Chinese equities on the downside. Investors should overweight and equal-weight onshore and offshore stocks, respectively, relative to global equities. 

Preliminary estimates suggest that activity continued to slow across DM economies in September.

Manufacturing PMIs contracted at a faster pace in the US, Eurozone, Germany, France and Australia, and grew at a slower pace in the UK. Services PMIs continued to expand in most regions, though the pace of growth slowed. Notably, the Olympic Games’ one-off boost to France’s services PMI in August completely wore off in September, with the country’s services PMI unexpectedly shedding a whopping 6.7 points to 48.3.

A holiday is delaying the release of Japan’s preliminary PMIs for September. In August, the country’s manufacturing PMI extended a second month of decline (after a couple of brief stabilization episodes broke a nearly two-year contraction streak).

Details of the US flash PMIs highlight a sharp worsening in domestic and foreign demand conditions in the pro-cyclical manufacturing sector, as well as a deterioration in the employment components of both sectors.

The US has been a large source of global demand this cycle and a US recession morphing into a global downturn remains our base case. Last week’s outsized rate cuts will work with a lag and are thus unlikely to alter the course of the ongoing labor market softening over the next 6-to-12 months. Meanwhile, Chinese demand is unlikely to fill the void given the stimulus is timid in scope and inadequate in nature.  

Cyclical investors should underweight equities and overweight bonds, avoiding pro-cyclical Eurozone and EM equities in favor of US equities. 

According to BCA Research’s Counterpoint Strategy service, the post-pandemic US economy has inverted from its usual ‘demand-constrained’ state to a highly unusual ‘supply-constrained’ state. This inversion is still a ways from normalizing, with labor demand still exceeding supply by 2.2 million jobs, or 1.3 percent. 

In the supply-constrained state, it is the evolution of supply, not demand, that drives output. Even as labour demand has gone into recession, the growth in labour supply has driven GDP. In a supply-constrained economy, output will go into recession only if supply goes into recession. Or if the economy ‘un-inverts’ back to demand-constrained and demand stays in recession.

If the current recession in labor demand is mild, as in 1990 or 2001, it is almost halfway complete. By the time the economy un-inverts back to demand-constrained, most of the recession in labor demand will be over, leading to a fascinating possibility:

The highly unusual inversion of the US economy means that despite suffering a typical labor demand recession, the US could cheat a GDP recession.

Many contend that the inversion of the US economy is overstated because the jobs and job openings that make up labor demand are overstated. However, our colleagues argue that the jobs data is based on the generally reliable Household Survey rather than the heavily (and recently) revised Establishment Survey. Meanwhile, the JOLTS job openings data are buttressed by their excellent explanatory power for wage inflation, which suggests that they are currently more likely to be understating demand.

One other possibility is that the supply-constrained US economy goes into recession because labor supply goes into recession. It could happen if labor participation fell sharply and/or net immigration turned into net emigration. This would be a major risk in a Trump administration, though that outcome is not a central case.

According to our Bank Credit Analyst service, an inflection point in the relative performance of US stocks is not likely to occur over the coming 6-12 months. A recession favors US equities in common currency terms barring substantially less global ex-US earnings weakness than has historically occurred, or highly atypical recessionary behavior from the US dollar.

Over the longer term, US equities’ relative outperformance is long in the tooth. Even if US stocks outperform their global ex-US peers during the next recession, it will occur due to an outsized global ex-US earnings decline that will ultimately reverse. But the US equity multiple compression which will occur during the next recession may be permanent, unless lofty expectations about AI’s potential to impact economic activity are met.

Investors’ expectations about AI’s positive impact are extremely aggressive. Our colleagues estimate that investors are expecting the deployment of AI technology to catalyze a 10-to-20-year productivity surge along the order of the IT revolution of the 1990s, with persistently high margins on the revenue generated from the improvement in growth. While artificial intelligence technology will likely lead to new revenue growth for some firms, these extraordinary aggregate expectations are not likely to be met.

Moreover, US return on equity is very elevated compared to global ex-US stocks, which underscores the risk to US earnings. Return on equity is a function of profit margins, asset turnover, and leverage. While US firms are likely more efficient than their global peers at generating revenue from assets, the rise in US ROE has been significantly driven by rising profit margins which now appear very stretched historically. Even if rich US profit margins are sustained at current levels, US equities are still overvalued given the historical relationship between relative multiples and relative ROE.

Does this mean that global ex-US outperformance is likely over a structural time horizon? Not necessarily. It may just mean that the US will stop outperforming, potentially with relative multiple compression cancelling out a better relative earnings profile.

After surprising to the upside in July on higher energy costs, Eurozone CPI resumed its deceleration in August. Headline and core CPI declined from 2.6% y/y to 2.2% and from 2.9% to 2.8%, respectively.

Energy prices contracted 0.3% y/y from July’s 1.2% increase, however services inflation, which is more sensitive to domestic economic conditions, ticked 0.2 ppts higher to 4.2% in August.

The Eurozone economy is ultimately fragile. The labor market is deteriorating, bankruptcies are rising rapidly, construction activity has collapsed and the private sector’s interest burden is rising. The external landscape is also inauspicious. We expect the US will enter a recession in the next 6-to-12 months and China’s efforts to stimulate its economy will be insufficient to meaningfully revive Chinese demand for Euro area exports.

Therefore, we expect disinflationary forces to dominate the Eurozone growth landscape on a cyclical investment horizon. Our European Investment strategists expect the ECB to cut twice this year, in September and in December, mostly in line with market expectations.

That said, they expect the central bank to ease more aggressively next year when the Eurozone is more likely to experience a recession. A dovish surprise is supportive of Bund prices and investors should overweight them on a 12-month investment timeframe. 

Consumer credit growth disappointed in June. Total credit outstanding rose by USD 8.9 billion, in June, lower than May's USD 13.9 billion, and shy of expectations of USD 10 billion. Revolving credit (which includes credit cards) declined USD 1.7 billion in June but accounted for the lion’s share of the rise in consumer credit in May.

On a 3-month basis, the New York Fed Quarterly Report on Household Debt and Credit indicates that credit card balances were the main driver of Q2’s overall growth in household debt (+0.6% q/q overall, +2.4% for credit cards). It corroborates reports from the SIFI banks’ Q2 earnings calls that credit cards are generating moderate demand growth.

Consumer credit growth is relevant in an environment of a softening labor market and dwindling excess savings, since it may support consumption growth for longer than we expect and thus push back the start of the recession beyond our current late 2024/early 2025 ETA.

That said, we continue to believe that willingness to borrow will cap credit’s contribution. Lending standards respond to credit performance. Although credit card delinquencies remain low relative to history, they have been steadily rising. Importantly, credit cards’ transition into serious delinquencies (90 days and more) has surged and continued to rise in Q2. Concurrently, the Senior Loan Officer Survey reported tightening credit standards for credit cards in Q2.

Nothing in the recent consumer credit data changes our conviction that the deceleration in labor demand will tip the economy into a recession. Investors should remain underweight risk assets on a cyclical investment horizon.

According to BCA Research’s US Political Strategy service, there is a strange quirk about Walz and the state of Nebraska that could have national consequences in the black swan scenario of an electoral college tie.

Walz was born in Nebraska, even though he has lived in, represented and governed Minnesota. Nebraska divides its electoral votes across congressional districts, unlike every other state but Maine. This gives Democrats the chance to pick up a single electoral vote in this red state due to Omaha, the state’s second congressional district.

If Harris and Walz lose Georgia, Arizona, and Nevada – where Republicans have been polling well – yet capture one electoral vote in Nebraska, then they will win 270 electoral college votes to 268, avoiding an electoral college tie of 269-269.

A tie would pitch the decision to Congress where Republicans would prevail due to majority of state-led delegations to Congress.

On the other hand, if Harris wins Arizona and Nevada (due to women’s rights and being from the West), yet loses Georgia, and then loses Pennsylvania in part because she did not pick Shapiro as her running mate, then Trump will win the election with exactly 270 electoral college votes.

Most likely Trump will win Arizona, Georgia, and Nevada, reducing the election to the sole question of Pennsylvania. So if Democrats lose Pennsylvania, then it will be blamed on her decision not to pick Shapiro.

This risk is so obvious that the Democratic wonks and campaign gurus clearly believed that Walz would make a greater material impact than Shapiro on swing voters across the Midwest, namely Michigan and Pennsylvania, and Nebraska was a cherry on top.

The Conference Board measure of CEO Confidence declined in Q3, from 54 to 52, its lowest level so far this year. Still, a reading above 50 indicates that optimistic perceptions of business conditions outweigh pessimistic assessments.

The Q3 survey marks a decline in CEO optimism, which had been improving so far this year. Perceptions of current economic conditions deteriorated sharply from 54 to 48, but CEOs remain “cautiously optimistic” about the future.

Notably, the share of CEOs expecting a recession declined further to 30% in Q3, from a high of 84% in 2023. Moreover, despite a slight increase in the share of CEOs expecting to reduce headcount, most of them reported planning to either increase or keep their workforce unchanged.

CEO confidence has typically been a leading indicator of the performance of cyclicals versus defensives.

That said, investors should note that the Conference Board surveys Chief Executives of large companies. Because smaller companies account for the lion’s share of employment, the hiring intention component of the NFIB survey is a more comprehensive payroll indicator. Recent months’ upticks have not derailed it from its well-established downtrend.

CEO Confidence is likely to continue to raise earnings expectations, which are already overly optimistic, thus making equities particularly vulnerable to disappointment.

We do not concur with the no-recession CEO consensus. Investors should position defensively.

Despite the recent market rout, gold’s performance has maintained its leadership position. Global equities are up 7.5% in 2024YTD, global bonds are up 2.6% over the same period while gold prices have rallied by a solid 17%. Given our high conviction that the US economy will tip into recession by early 2025, should investors seek refuge in gold?

Our Global Investment Strategy (GIS) team is tactically positive on gold but neutral on a 12-month horizon.  

The fundamental backdrop is supportive of gold prices on a tactical time horizon. The pivot of many central banks towards rate cuts, along with expectations of a weaker dollar and positive price momentum will support the yellow metal in the near term.

However, beyond the tactical investment timeframe, we are neutral on gold as the asset class will be exposed to crosscurrents. On one hand, among commodity groups, precious metals have the least sensitivity to the businesse cycle and gold, in particular, has outperformed other precious metals during downturns. But on the other hand, elevated prices may cap central banks' demand for gold and the tailwind from central bank diversification is thus likely to fade. Moreover, gold sentiment is extremely bullish and net speculative positions are elevated, making gold prices vulnerable.