Out of the past 10 bear markets, when the S&P 500 lost 20 per cent or more, eight were at the time of a US recession. This is why watching the US macroeconomic picture is crucial for investors. When the US slows down, the US and global stock markets are likely to face both volatility and drawdowns. So it’s important for us to know what to watch and where we are in the cycle.
The US economy has entered late cycle, with the unemployment rate close to previous lows. The first signs of weakness before the previous three US recessions were shrinking corporate profits. The two big costs for US companies that could hurt corporate profits are paying their employees more and paying more to service their debt. Low unemployment and healthy economic growth have historically led to a rise in wages, core inflation and interest rates.
Yet despite being late cycle, near-term recession risk remains quite low. Wages and interest rates probably have room to rise from low levels before they cause problems for companies and the economy. US unemployment has rarely been at such low levels. Clearly, in the near term, this is good news for the US economy, supporting consumer confidence. However, it does raise the probability of a recession in the medium term.
The unemployment rate has recently fallen below estimates of full employment from both the US Federal Reserve (the Fed) and the Congressional Budget Office. In the past, economic expansion has tended to last between two to four years after the point at which the unemployment rate has fallen below full employment.
So why hasn’t falling unemployment led to an acceleration in wage growth? The labour market looks tight on nearly all measures, but some economists argue that a combination of globalisation, automation and the new 'gig economy' are keeping wage growth depressed. That said, we don’t believe that the historical relationship between a tight labour market and rising wage pressures is likely to have disappeared completely. In fact, the National Federation of Independent Businesses survey shows more firms are planning to raise wages. It also shows an increase in plans to hire new staff and a rising level of firms with job vacancies that they are struggling to fill.
At the same time, workers are also positive about the labour market, with the Conference Board Consumer Confidence survey showing that a rising number of people think jobs are plentiful. Meanwhile, core inflation has fallen so far this year, but if wage growth starts to accelerate, it should start to pick up again.
If wages and core inflation do start to rise, the Fed may have to raise rates faster than expected. In the medium term, rising wages could start to put pressure on corporate profits and rising interest rates could increase the cost of servicing both corporate and consumer debt. Eventually, companies might try to preserve profitability by cutting business investment and staff, which could trigger a recession. Consumers may also reduce spending in response to higher borrowing costs.
The good news is that interest rates and wages will be rising from a very low starting point, so the economy can probably withstand at least one more year of interest rate rises and wage acceleration. Beyond the next 12 months, in the absence of an external shock, the timing of the next recession could well be determined by the pace at which wage pressures accelerate and interest rates rise.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
