Chief Investment Strategist
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As the US economy navigates through the complex landscape of post-pandemic recovery, high interest rates and ongoing geopolitical tensions, investors are closely watching for signals that could indicate whether the economy will experience a soft landing or a recession (hard landing). This is the biggest market debate right now, and understanding these scenarios and how to position investment strategies accordingly is crucial for mitigating risks and capitalizing on opportunities.
A soft landing occurs when an economy slows down from a rapid growth phase to a more sustainable pace without falling into a recession. It is characterized by moderate economic growth, manageable inflation, and relatively stable employment levels. In this scenario, the Federal Reserve (Fed) typically adjusts monetary policy to ensure that inflation is controlled while supporting economic stability. A soft landing also means a decline in market volatility, which can be beneficial for investors.
A hard landing refers to a sharp and sudden economic slowdown that typically results in a recession. This scenario is marked by significant declines in economic activity, rising unemployment, and possibly deflation. A hard landing can be triggered by aggressive monetary tightening, a financial crisis, or severe external shocks.
According to the National Bureau of Economic Research (NBER), a recession is "a significant decline in economic activity that is spread across the economy and lasts more than a few months." This decline is visible in indicators such as real GDP, real income, employment, industrial production, and wholesale-retail sales. Recessions are marked by a sustained period of economic contraction. Unemployment rates rise, consumer spending and business investment decrease, and overall economic output declines. Typically, financial markets experience increased volatility in a hard landing.
Investors have been cautioned by significant volatility in the equity markets over the last week. The key question on everybody’s mind is whether the US economy would be able to achieve a soft landing, or faces threat of a hard landing pushing it to a recessionary scenario. The US macro backdrop remains mixed, much like a two-lane economy. Some parts of the economy continue to be resilient, while others are feeling the pain from the high interest rates.
This continues to make the market narrative split, with some calling for an intermeeting cut from the Fed or a 50bps rate cut in September, while others are calmer and looking for the Fed to move slower in this cycle amid resurgent inflation concerns.
Certain classic recession indicators are emerging. The labor data report from August 2 was one of the key triggers for the meltdown in markets. It showed unemployment rate jumping to 4.3%, the highest since 2021, and triggering the Sahm rule. This rule is triggered when the 3-month average US unemployment rate is up more than 0.5% from its low over the previous 12 months. This indicator has correctly identified every recession since WWII. This is because there is a powerful feedback loop here, which suggests that small increases in the unemployment rate can turn into large ones. Workers without paycheck weigh on consumer demand, leading to more workers without paycheck.
But does that mean that the US economy is now entering a recession? Claudia Sahm, the creator of the Sahm rule, has herself said that the US is not in a recession despite the indicator bearing her name suggesting so.
Most of the indicators that the NBER tracks for a recession continue to look solid. Real consumer spending in the second quarter rose at 2.6%, and monthly payroll gains have averaged 170k in the last three months. Even the jump in unemployment rate that triggered the Sahm rule may not be alarming to some, given the unemployment rate has averaged at 5.8% in the last 20 years. But some others would argue that the absolute rate of unemployment matters less than the pace of change and the US economy entered a recession in 1969-70 with 3.5% unemployment rate.
Also, the increase in unemployment rate to 4.3% in July, which triggered the Sahm rule, may have been distorted by the pandemic and is particularly a result of surge in immigration. This makes the rise in unemployment rate due to an increase in supply of workers rather than the decrease in demand of workers that usually triggers a recession. The increased immigrant population can, on the other hand, propel economic growth via consumption. This could eventually bring an increase in the number of jobs, putting downward pressure on the unemployment rate.
Other labor market indicators such as job openings, quits rate or initial and continuing jobless claims have also been signalling a slowdown. There are also other indicators suggesting some stress on the economy include household and credit card debt. Data from the Federal Reserve Bank of New York showed total household debt increased by over 1% in Q1 as households ran out of pandemic-era savings. But on the positive side, wage increases are outpacing inflation. Retail sales remained solid in June, with online store sales rising almost 2% month-over-month and spending at food and drink establishments showing modest growth.
The US corporate earnings season has also been a mixed bag. As on August 2, 75% of the companies in the S&P 500 have reported actual results for Q2 2024. FactSet reported that 59% of S&P 500 companies have reported actual revenues above estimates, which is below the 5-year average of 69% and below the 10-year average of 64%. But on the other, 78% have reported better-than-predicted earnings-per-share (EPS) figures, and that’s above the 10-year average of 74%. Meanwhile, guidance cuts have picked up. Overall, the earnings season has not provided the enthusiasm that the equity markets had priced in after a strong run higher year-to-date.
This duality reflects a robust spending environment among wealthier Americans who have the capacity to maintain their spending habits, contrasted with growing financial strain in other segments.
Zooming out, there are evident cracks in the US economy, but these are not yet alarming. Investors need to closely monitor economic data to see if further slowdowns in spending, employment or income could spark recession concerns further, while also remaining on alert for external shocks from geopolitics or tight financial conditions.
These factors will determine whether the US economy can achieve the coveted soft landing or faces steeper recession risks. This will also have an impact on how quickly the Fed moves in its easing cycle.
This split market narrative can make it rather difficult for investors to position themselves. The prudent next step could be to assess the beta of your portfolio relative to the market. If your portfolio outperforms the market on up days, and underperforms the market on down days, then that is signal that the portfolio has a relatively higher beta than the market.
Now, if you think that a recession is incoming, then it may be prudent to reduce the beta of your portfolio to hedge against the risk of falling markets. This can be achieved by introducing exposures to factors like low-volatility and high-quality stocks or overweighting bonds that tend to outperform in declining markets.
However, if you think that the markets are unduly worried about a recession and have over-priced one, then it may be prudent to consider increasing the beat of your portfolio by adding exposure to undervalued cyclical stocks, emerging markets or commodities.
Below we outline strategies for both soft and hard landing scenarios:
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