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The reckoning for markets has arrived, but just how bad will it get?

Natale Labia
By Natale Labia
6 Aug 2024
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Is this it? For years we have been warning that markets have lost their grasp on reality, that interest rates are too high, that the US economy cannot keep growing indefinitely, that a recession in the US is inevitable. The first few weeks of this month may go down as the moment when reality, finally and inexorably, bit. And bit hard.

Global stocks tumbled on Monday, with Japan’s Nikkei 225 index plummeting 13%, as markets were rattled by the prospect of a US recession and wiping out gains for the year. 

The rout was its biggest one-day points fall in history, plunging more than 4,450 points and passing the 3,836 lost on the infamous “Black Monday” in October 1987. It was the blackest Monday in Japanese trading history.

In Europe the benchmark Stoxx Europe 600 shed 3%. Wall Street’s benchmark S&P 500 dropped 3%, its sharpest one-day drop since September 2022, while the tech-dominated Nasdaq Composite fell 3.4%. While prices have stabilised since, they have not fully recovered.

The declines come amid fears that the Federal Reserve has been too slow to respond to signs the US economy is cooling and may be forced to cut interest rates rapidly. 

Other than tearaway capex spending in the pursuit of an elusive artificial intelligence productivity boost, which may go down as yet another bubble, actual numbers coming out of US and indeed global corporates are gloomy. 

From McDonalds to Nike, Hersheys to Walmart, companies have reported that the usually ebullient US consumer is tiring. 

McDonald’s revealed this week that fewer diners were turning up at its roughly 13,500 US restaurants’ service counters and drive-through windows. Hershey, the food company famous for its chocolate bars, on Thursday said consumers were “pulling back on discretionary spending” as it revealed organic net sales fell by a sixth. Rival Kraft Heinz blamed “waning consumer sentiment” as it reported falling sales volumes across North America. Starbucks, the coffee chain, disclosed a second quarter in which sales had declined in the US compared with the year before.

Catalyst for a meltdown


Markets only needed a catalyst for a meltdown, and the US employment numbers released on Friday provided just that. For months, investors have been irrationally treating good news as good news, and bad news as good news, too. Good data showed growth in earnings and disappointing data that missed forecasts was seen as more likely to herald a cut in interest rates, which theoretically – in the event of the much-trumpeted “soft landing” – would give equity markets a further leg-up.

Yet on Friday the narrative changed. The employment report released on Friday showed companies added a mere 114,000 positions across the world’s largest economy last month, significantly lower than the 215,000 average gain over the past 12 months. 

The unemployment rate rose 0.2 percentage points to 4.3%, triggering the much feared Sahm Rule, which links the start of a recession to when the three-month moving average of the jobless rate rises at least half a percentage point above its low over the past 12 months. 

US recession


Suddenly bad news was very bad indeed; the odds of a US recession in late 2024 or early 2025 went from being unlikely to alarmingly probable.

Where to from here? First, expect further volatility over the medium term. It is far from ideal that this is all playing out in the dog days of the European and US summer. 

Most money managers are in Paris watching athletics or unwinding on the Mediterranean. With trading volumes thin, moves are more violent than usual. Stock moves have been extreme; when certain businesses were sold off this week, share prices simply dropped like a knife with no buyers around brave enough to try to catch them. 

However, there is a chance that all calms down. Then, perhaps, the chaos will resume when managers are back at their desks in September. Price stability and discovery will not happen overnight.

Second, this is not 2008. The financial sector is healthy, credit markets are functioning (for the moment). This is more likely to be an old fashioned inventory-led recession, where companies have to aggressively discount items to move stock (as is already happening in the US, according to Walmart and other retailers), filtering through to tighter margins, lower profits, rising unemployment, and lower aggregate demand across the economy. As a result, the effects on the broader economy may not be as sudden and violent as experienced in those heady days of late 2008. This comes with the caveat that the recovery, too, might not be as immediate.

All eyes on the Fed


Finally, all eyes are on the Fed and other central banks. The sharper than expected fall in US jobs growth in July has raised concerns that the Federal Reserve is moving too slowly to lower borrowing costs for Americans, risking the very recession it has been trying to avoid. Now, the question is simply how much room does the Fed have to cut, and how quickly? There is even speculation of an extremely rare emergency rate cut before the next scheduled meeting of the Federal Open Market Committee on September 18.

Yet Fed governor Jerome Powell may not be so lucky. The worst case scenario is that inflation numbers in the next month come in hotter than expected, limiting his room for monetary easing and forcing him into stalling on any cuts. While the Fed has two mandates – both price stability and full employment – the former trumps the latter.

Whether these market moves go down as a “healthy” correction or the beginning of a longer, more drawn out bear market, no one knows. However, one thing is clear. The sense of blind, irrational optimism that has pervaded financial markets over the past two years has evaporated. Buckle up. DM

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