Fears that the Federal Reserve’s interest rate hikes to tackle soaring inflation would tip the US economy into a recession, with knock-on effects for the rest of the world, have weighed on investor sentiment for some time. But these fears came to a head in early August when markets slumped around the world.
While the exact causes of the downturn have been widely questioned, investors’ nerves regarding a recession were certainly rattled by the release of data showing the July US unemployment rate rose for the fourth month in a row to 4.3%.1 The stocks that fell the most in the US included the Magnificent 7 mega caps that had performed so strongly over the last year, with microchip maker Nvidia taking the heaviest hit.
Investors questioned whether the Fed had kept interest rates too high at between 5.25% and 5.5% – the highest in 23 years – despite evidence of a cooling economy, such as weaker than expected US retail sales in April and May. 2
Equity markets calmed down after the early-August turmoil, but the episode highlighted the depth of investors’ ongoing concerns about a US recession – and the ramifications that could have globally. Eyes remain on the Fed and whether, or how far, it might cut rates at its next decision meeting in September.
Monumental challenge
So far, the US economy has held up well. GDP grew at a 2.8% annualised rate in the second quarter, exceeding economists’ expectations of 2%.3 Data released last week also showed stronger than expected US retail sales in July and robust results from Walmart, the world’s largest retailer.4
The Fed still faces a monumental challenge. Inflation has fallen, but it has been sticky, making the US central bank cautious about pivoting to interest rate cuts. The Fed walks a tightrope between taming inflation and tipping the economy into recession. Failure to act in September could push the biggest economy toward recession. But too much of a rate cut could panic investors.
Weaker growth elsewhere
So far, other developed economies have held up reasonably well, although not as robustly as the US, which has grown faster than other G7 nations since 2021.5
Latest data shows the UK economy grew 0.6% in the second quarter of 2024 and was up 0.9% on the year.6 While the UK faces chronic challenges in terms of low productivity growth, strained public finances and inadequate infrastructure, in August the Bank of England upgraded its UK GDP growth forecast for 2024 from 0.5% to 1.25%.7
Meanwhile the eurozone economy has been anaemic, but it still grew 0.3% in the second quarter of this year, allaying fears that it has been running out of steam. Recent business surveys have indicated that it has been impacted by geopolitical tensions, weaker global growth and fragile consumer confidence.8
Scope for cuts
A core issue facing markets since last year has been whether the Fed could engineer a soft landing while still bringing inflation down to its 2% target rate. Arguably, there has already been a soft landing. The spike that was seen in inflation and the monetary policy responses represented two of the biggest shifts that the world has seen in a generation or more, yet economies have not cratered. This resilience encourages us to believe that we may get a technical recession here or there, but inflation has fallen toward long-term targets, employment remains robust, and economies are on an even keel. Furthermore, the Fed has substantial scope to cut rates.
As such, the market swings seen this month have not changed our fundamental view of the economy or investment markets. We are still optimistic about equity markets in general, giving the asset class a positive four out of five in our Tactical Asset Allocation (TAA) score and believe the best opportunities for equities are in Asia ex Japan, emerging markets, the UK and US small caps.
The interest rate now widely expected in the US should be supportive for US small caps, for which we raised our TAA outlook ranking from a neutral three to a positive four in the first quarter of this year. Being more sensitive to high interest rates than their larger counterparts, small caps have underperformed amid the monetary tightening seen over the last two years to the point they offer attractive valuations. We are, however, neutral on the wider US equities market, which has been dominated by the Magnificent 7 behemoths. This small group of stocks has benefited immensely from enthusiasm for the AI theme and we believe the degree of their outperformance without a correction at some point would be highly unusual.
It is easy to get caught up in the negative emotions stirred up by recessions, but it is crucial to keep a long-term perspective. Time in the market is more beneficial than timing the market. History has shown that while investors will experience market dips and volatility from time to time, these events won’t stop the long-term positive performance of markets.
1Source: US Bureau of Labor Statistics, 2 August 2024
2Source: FT.com, 15 May and 18 June 2024
3Source: Bureau of Economic Analysis/FT.com, 25 July 2024
4Source: FT.com, 15 August 2024
5Source: LSEG/FT.com, 6 August 2024
6Source: ONS, 15 August 2024
7Source: FT.com, 15 August 2024
8Source: FT.com, 30 July 2024
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