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Sometimes markets can be cruel. This summer, just as investors were jetting off to sunnier climes and succumbing to the lure of poolside loungers, global markets suffered a bout of volatility not seen since the worst days of the Covid pandemic.

Downside surprises

At the heart of it all were risk factors that, one could argue, the market was alive to. Initially, US mega-cap technology stocks – which had been trading at punchy valuations coming into the Q2 earnings season – were already weakening on mixed news. The prospect of earnings misses and disappointments was unsettling investors.

This was followed by a Bank of Japan rate hike – reflecting its gradual shift towards policy normalisation – aimed at supporting the yen against the strong US dollar. While the timing was a surprise, the move itself had been flagged. But the rapid strengthening of the yen caught leveraged investors off-guard. It was an ‘amplification mechanism’ in markets that triggered a rapid unwinding of carry trades, adding to volatility. Dovish comments from BoJ deputy governor Uchida soothed market worries of another rate increase before year-end. The yen slipped back, helping to stabilise jittery Japanese equities.

But perhaps the most influential driver was a big downside surprise in July’s non-farm payrolls. It was another signal – backed by recent trends in employment data – that the US labour market, a key driver of consumer spending, is cooling. Investors subsequently questioned the recent narrative that a US soft landing – growth falling modestly below trend and inflation returning to target - was a foregone conclusion, threatening weaker profit growth and the recent broadening out of stock market performance, evident in July.

Priced to perfection

So, why did the VIX index – the ‘fear gauge’ of expected volatility – spike higher, and global stocks sell off?

The answer is that the runway to a soft-ish landing always looked pot-holed. Yet, many risk assets had been ‘priced for perfection’. They were discounting an even better outcome than a soft landing. But placing a zero probability on a recession materialising always looked overly optimistic. That said, while the risk of a recession is now clearly higher than anticipated – and the soft landing isn’t guaranteed – recession warning signs are not evident yet. To assess this, we consult the ‘three doctors’ – three macro variables with tried and tested track records as gold-standard recession early-warning signals.

Call the doctors

The first: The Sahm rule – measures the change in the unemployment rate (specifically, the threemonth moving average of the unemployment rate versus its low over the last 12 months). When this number is 0.5 or above – as was the case in July’s household survey – it’s a recession signal. This signal has an 11 out of 11 track record for calling recessions. It reflects an important truth about how the US economy behaves – when the labour market weakens a bit, it weakens significantly. But distortions caused by Hurricane Beryl, strong labour force growth and immigration, as well as data sampling issues could mean it’s a false signal this time.

The second: A dis-inverting US yield curve (the spread between short-term and long-term bond yields) – has famously predicted previous recessions. It’s particularly potent when the dis-inversion is a ‘bull steepener’, led by falling short-term rates, evident recently. But we’ve seen stunning shifts in US rate expectations this year. With five-to-six Fed rate cuts currently priced in for June next year, markets are not assuming that monetary policy moves into ‘accommodating’ territory during 2025. So, rates traders aren’t assuming a US recession yet.

The third: Rising credit spreads – implies elevated macro risk and higher corporate defaults. US and Euro High-Yield spreads have widened, although not to levels that have typically signalled recession. For credit specialists, the worry is whether weakening labour markets imply a turn in the default cycle. Equally, solid corporate balance sheets mean rising spreads could even be a tactical buying opportunity, technical factors – a favourable demand/supply balance - are also supportive. Either way, there’s no obvious recession red flag coming from credit markets yet.

More volatility ahead?

Despite markets stabilising, this summer’s risk asset sell-off likely signals a more volatile phase for asset markets during the second half of 2024. Even if we do remain on course for a soft landing, the runway looks bumpy. A rapid slowdown in US growth, election uncertainty, geopolitical tensions, and the risk of a policy error could all weigh on market psychology in coming months.

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