Markets spend most of their time thinking ahead, but ultimately depend on the state of the economy. When the economic outlook becomes very turbulent, forward looking markets can become very displaced from the here and now. With this in mind, the answer to these two questions are pivotal for the outlook for markets: What is the current state of the economy and what are markets pricing in? If we can gather a clear understanding of current economic conditions, we can weigh them against what is priced in by markets and then see where the risks lie. If markets have become too fearful, to bearish for the current state of the economy it could mean that the risks are skewed to the upside. Conversely, overly optimistic markets may need too much to go right to be plausible in a central scenario.
We therefore have two objectives in this paper: Firstly, to condense the vast array of noise economic data into the underlying momentum of economy, asking if it points to a recession; and, secondly, to broadly assess the market for tell-tail signs that a recession have become priced in. In the first instance we create a dashboard of economic indicators to cover the broad health of the US economy and compared this to two key downturns –the end of the Dotcom bubble and the Great Financial Crisis (GFC). We also boil this down to create an economic activity indicator. Together both can give us a clearer picture of where the economy is heading and does it look like a recession. Turning to the markets, we have sifted through dozens of financial and market based indicators before we isolated almost 20 that can build a strong understanding of what the investors are collectively thinking.
We find than in previous recessions the decline in economic indicators was more broad-based than it is now, particularly with the improvement we saw in July’s data, that carried through until August -this means that we are probably not yet in a recession in the US at this stage. But we are not out of the woods because our activity index is heading lower and the momentum is yet to slow. This index tends to slight lead corporate earnings and one of the key insights is that during severe downturns this index has to improve before we then see a follow through into earnings. This means that an improvement in this index can increase our conviction during turning points.
We track the financial and market data from June onwards and compare the peak-to-trough changes with the peak-to-trough changes during the Dotcom bubble bursting and the GFC. This gives us an insight into what we can expect should the economy go into a deeper downturn synonymous with a recession.
We conclude that the slowdown in US growth is not broad based enough yet for a prolonged bear market, but year-on-year activity is nevertheless in decline. Labour market resilience will be pivotal in preserving a softer landing. If the slowdown in activity wanes, then that would be a clearer signal to the market to become more positive, especially if alongside a genuine Fed pivot. We also think that a post Dotcom bubble secular decline is unlikely too because equity risk premiums look much more fairly valued now than in 2000. This means that if a significant recession is avoided, in line with our central scenario, and the US economy is only bruised by the current economic headwinds, then equities can consolidate from here. Of the indicators to watch we will pay close attention to labour markets, earnings, the yield curve and equity risk premium. These are key for signs economic momentum, corporate health, monetary policy direction and risk aversion. They will also give us some direction as to whether the US equity market will break out from the top of bottom of the range after a period of consolidation.
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