Economic Indicators Flash Recession Warnings as Markets Tumble
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Key Highlights:
Global markets experienced significant declines on Monday, leading to a spike in volatility.
A reliable economic indicator is signaling that the US economy may already be in recession.
The US earnings season has presented mixed results thus far.
Investors remain skeptical about the payoff from tech companies' substantial AI investments.
Explore these topics in depth in this week's review.
Market Overview
The broad sell-off that has been unsettling markets since the start of the month escalated on Monday, with global stocks, cryptocurrencies, and other risk assets taking a hit. The downturn was fueled by concerns that the Federal Reserve might have been too slow to react to indications of a cooling US economy. This worry was exacerbated by Friday's data showing a sharper-than-expected slowdown in job growth for July and an unemployment rate that reached its highest point in nearly three years.
The global sell-off led to a 3.4% drop in the Nasdaq on Monday, driven by a retreat from high-priced tech stocks as investors questioned whether their heavy investments in AI will yield returns (more on this later). Adding to the market's woes was the weekend news that Warren Buffett’s Berkshire Hathaway had nearly halved its substantial stake in Apple during the second quarter. As US stocks tumbled, the VIX – often referred to as Wall Street’s “fear gauge” – recorded its largest single-day increase in more than 30 years, reaching levels not seen since the early stages of the pandemic.
The VIX volatility index surged to its highest level since the early days of the pandemic on Monday. Source: Bloomberg
In Japan, the Nikkei 225 plunged by 12.4% on Monday, marking its steepest decline since the 1987 Black Monday crash. This sharp drop was partly triggered by the release of the disappointing US jobs report on Friday, giving Asian markets their first opportunity to react on Monday. Additionally, the surge in the yen, which negatively impacts Japan's export-driven stock market, played a significant role in the downturn. The yen's rapid rise followed an unexpected interest rate hike by the Bank of Japan last week, prompting many traders to unwind their yen-funded carry trades.
In yen terms, the Nikkei 225 suffered its worst one-day drop ever on Monday. Source: Bloomberg
Cryptocurrencies were hit hard by Monday's wave of risk aversion in global markets, with Bitcoin plunging over 16% at one point and Ether experiencing its steepest drop since 2021. This followed significant investor withdrawals from US Bitcoin ETFs just days earlier, marking the largest outflows in three months on August 2nd. Contributing to the negative sentiment is the looming potential sale of seized Bitcoins by governments, along with those being returned to creditors through bankruptcy proceedings, which could further depress prices due to the increased supply.
The crypto rout briefly sent bitcoin bellow $50,000 at the start of the week. Source: Bloomberg
Macro Overview
Last Friday’s US labor market report raised alarms because the increase in the unemployment rate triggered the “Sahm Rule.” This indicator, developed by a former Federal Reserve economist, signals the early stages of a recession when the three-month average unemployment rate rises by half a percentage point from its lowest level within the past year. The logic is straightforward: a rapid rise in unemployment, particularly from low levels, signals economic trouble. As unemployment increases, consumer spending typically declines, leading to lower sales of goods and services. This decline can force businesses to cut even more jobs, creating a self-perpetuating cycle that quickly worsens economic conditions.
The latest rise in US unemployment triggered the Sahm Rule, implying that the world’s biggest economy is in the early stages of a recession. Source: Bloomberg
For investors, the Sahm Rule's accuracy is particularly concerning: it has successfully identified every past US recession with only one false positive, and even then, the "false" signal was merely premature by six months. However, it’s important to note that, like all backtested indicators, it was developed based on historical data after previous recessions had occurred—except in 2020, when it proved its reliability in real-time.
The Sahm Rule correctly identified every previous US recession and generated only one false positive signal (although, in that instance, a recession still hit 6 months later). Source: Coolabah Capital Investments
Now, it’s worth mentioning that the rule’s inventor has been on the record saying that the indicator may give a false positive this time due to the distorted conditions created by the pandemic. In other words, she doesn’t think that the US is currently in recession. But she does believe that the momentum is heading in that direction. And considering that most investors had all but ruled out a US downturn, you can understand why they were seriously caught off guard when the Sahm Rule was triggered last Friday…
Bank of America's latest fund manager survey showed most investors thought the global economy was heading for a soft landing (i.e. no recession). Source: Bank of America
Earnings Season
As volatility surges in US markets, it's an important moment to reassess stock fundamentals, especially during this pivotal second-quarter earnings season. Investors are paying close attention to Corporate America's performance amidst rising recession concerns and high valuations in the US.
By the end of last week, about 75% of S&P 500 companies had released their latest earnings reports, with results being somewhat mixed. While 59% of these companies reported revenues above estimates, this figure falls short of the 10-year average of 64%, according to FactSet. On the other hand, 78% of companies exceeded earnings-per-share (EPS) expectations, surpassing the 10-year average of 74%. Despite these positive earnings surprises, the market’s response has been muted, with investors reacting more harshly than usual to negative results.
Of the S&P 500 firms that have provided their latest updates, 78% of them have reported earnings-per-share above estimates. Source: FactSet
Moreover, companies that are outpacing revenue with stronger earnings indicate improving profit margins, which is indeed the case. FactSet's "blended" S&P 500 profit margin for the second quarter, which aggregates actual results from reported companies with estimates for those yet to report, stands at 12.3%. This is higher than both the same period last year and the first quarter of 2024.
Regarding growth, the S&P 500's blended year-over-year EPS growth rate for the second quarter is 11.5%. If this holds after the full reporting season, it would represent the fastest earnings growth since late 2021 and mark the fourth consecutive quarter of positive growth. However, whether this momentum is sufficient to sustain the S&P 500's rally over the past two years remains uncertain.
FactSet's blended year-over-year earnings-per-share growth rate for the S&P 500 for the second quarter is 11.5%. Source: FactSet
Big Tech
The AI boom has compelled tech companies to shift from post-pandemic cost-cutting measures to making substantial investments in data centers. Heading into this earnings season, Big Tech was expected to demonstrate that their massive AI investments were driving real sales growth. However, they fell short of investor expectations, with shares of Alphabet, Microsoft, and Amazon all declining after their earnings reports.
Alphabet's AI growth projections lacked clear details, and concerns over a more than 50% increase in capital expenditures this year overshadowed its slightly better-than-expected earnings. Microsoft disappointed investors with an unexpected slowdown in growth within its key cloud division—the area most likely to benefit from AI due to its high demand for computational resources. The company's capital expenditures have surged, which isn't surprising given it's opening a new data center every three days. Lastly, Amazon's quarterly revenue missed expectations, and its forecast for the upcoming quarter further let down investors.
Microsoft’s capital expenditures have ballooned as the firm builds new datacenters. Source: Bloomberg
Meta stood out from the rest by unexpectedly increasing its forecast for capital expenditures, attributing this to AI investments. Additionally, its second-quarter revenue surpassed expectations. The company’s CEO highlighted that AI spending has been instrumental in enhancing the targeting of ads and improving content recommendations. Specifically, Meta is leveraging algorithms to optimize ad placements and is beginning to introduce generative AI features that enable marketers with limited budgets to create more engaging promotions.
Despite Meta's positive performance, Big Tech's recent updates have done little to ease concerns about whether substantial AI investments will yield returns. As a result, impatient investors are shifting their focus to utilities, which are already benefiting financially from the rising electricity demands of data centers. These stocks offer a more affordable way for investors to gain exposure to the AI boom compared to pricier tech stocks. For instance, investors funneled over $1.7 billion into U.S. utilities funds in May and June—their best inflow in nearly two years—with an additional $1.1 billion expected in July.
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