Back in 1966, the economist Paul Samuelson famously commented that the stock market had predicted nine of the past five recessions.
The stock market’s powers of forecasting are the product of collective guesswork, sometimes informed, sometimes not, and, as such, they are flawed (although, unlike the economic forecasts made by governments, they usually self-correct quickly if they’re wrong). That they tend toward the pessimistic should be no surprise. Fear often outweighs greed, and it tends to move faster. Moreover, by sending a message of alarm they can prompt an intervention that heads off the recession that might have otherwise hit (or not), thereby canceling out their own prediction.
Monday’s fall in the S&P (3 percent) was the biggest one-day drop since (a little bathetically) 2022. The NASDAQ took the biggest battering (-3.4 percent) reflecting the recent weakness in the tech sector. The Dow was down 2.6 percent. The VIX, an index of volatility, spiked.
Investors have had a rough few weeks. The S&P is down 6.8 percent over the past month, NASDAQ is off 11 percent, and the Dow has fallen by a bit under 2 percent. All are still up on the year, which will give some comfort to 401(k) holders. But institutional investors, who typically have very short-term horizons, won’t be pleased.
So, what’s going on? Apart from an overdue rotation out of tech stocks, the latest jobs report disappointed. The absolute unemployment number was not high (4.3 percent), but investors look at trends, and the unemployment data have been showing a weaker job market for a little while, albeit from strong levels. Consumers (70 percent of the U.S. economy) have been showing signs of weakness too. Mixed earnings reports have not helped sentiment, and nor have recent manufacturing data. Warren Buffett contributed to the gloom by selling half his position in Apple, hitting the battered tech sector some more. Meanwhile the bond market is sending a signal that recession may be imminent (or at least that a Fed rate cut is on the way).
Goldman Sachs has increased the odds of an approaching recession, but not far, from 15 percent to 25 percent.
We won’t put a percentage on it, but we think fears that the U.S. may be headed for a hard landing any time soon look overdone, but the fear that it might be is spooking international investors. Japan has been particularly hard hit, with the Nikkei 225 off some 20 percent in a month. Also complicating matters has been the recent strength in the yen (linked to the ending of years of negative Japanese interest rates). That has meant the unraveling of “carry trades” in which investors worldwide have been funding their investments with cheap-to-borrow yen, an unraveling that is further pushing the yen up, increasing the pressure to unwind yet more carry trades, giving the vicious circle another turn.
What should Chairman Powell do? We see little basis thus far to fear a market crisis so severe that the Fed must step in. On a historical basis, real interest rates are not high, and we doubt that rates could realistically be cut far enough to rescue the dangers posed by the battered office market, problems that could indeed seep into the financial system. There are plenty of reasons for concern further into the future, above all our burgeoning debt and the growing cost of net zero, and, depending on how the election turns out, the possibility of a hard left turn on taxes, spending, and regulation. But, so far as markets are concerned, these threats still appear to be over the horizon.
A greater danger is that Powell is perceived as responding too quickly to market weakness. The idea that there is a “Powell put” would only add to the upward pressure on still generous asset prices and would diminish the Fed’s all-important inflation credibility. This would even more be true should the Fed feel pressured into an emergency rate cut, something we believe to be both unlikely and unwise — it would probably also increase the upward pressure on the yen, the last thing that embattled carry traders need.
The negative wealth effect created by a stock sell-off may help ease inflationary pressures further, but other than that, there is nothing in the current market weakness to justify a rate cut. That should wait until Powell has legitimate grounds for feeling confident that inflation is closing in on the 2 percent target. Whether that moment will have arrived by September remains to be seen: It won’t be an easy decision.