Stock markets this week have been on the backfoot over credit risk, which has overshadowed generally positive news on the economic front. Is it time to take a more positive attitude towards the economy? Will there be a rebound soon? Or is there more to the story?
Earlier this week, Fitch became the second credit agency to downgrade US sovereign debt. That means two out of three of the rating agencies have issued downgrades, making the US technically no longer an AAA-rated country. But, just with the definition of a recession, there is some wiggle room. Fitch said it was concerned about the rising levels of debt, and how lifting the debt ceiling at the 11th hour raised risk. The agency had warned back in May that it would likely take this action.
How the Markets Could Move
The last time a rating agency cut the US’ rating was back in 2011, which was followed by a substantial drop in the stock market. So, it was understandable there would be concerns this time around, as well. However, analysts have been insistent that the impact this time around will be minimal and transient. They have also questioned the timing since it came after a series of positive developments in the economy.
US Q2 GDP grew faster than expected, durable goods orders increased, and preliminary measures of inflation were down. All of this was positive news for the economy that otherwise would be expected to push the stock market higher and weigh on the dollar. The peak of earnings season is over, and so far over 80% of the companies that have reported have exceeded expectations for profits. A majority of economists now no longer predict a recession this year. Even the most outspoken people for a recession last year have changed their minds. JPMorgan CEO Jamie Dimon – who previously warned of an “economic hurricane” – is now talking about a resilient economy and says he’s not worried about the outlook.
Is it too good to be true?
The data being cited to support the theory of US economic resilience is backwards-looking. It’s almost entirely data from Q2, which ended over a month ago. The second quarter was already expected to be positive. It’s what happens through the rest of the year that is the concern, particularly after September, which is when the market usually has a downturn.
What generally brought up the concern about a recession was the Fed’s aggressive rate hiking, starting last year. Now, it seems that the cycle is almost over. The thing is, however, typically the recession doesn’t hit while the Fed is still in hiking mode. In fact, in the past, the Fed has cut interest rates a couple of times before the market crash that occurs near the start of a recession.
What’s the outlook like?
The other factor is the yield curve inversion, where short-term debt pays higher interest rates than longer-term debt. The level of inversion has been declining lately, as shorter-term debt has started to cost less. One of the drivers of the inversion is the Fed raising rates, which is expected to be followed by the Fed cutting rates when a recession happens.
Once the Fed reaches its peak rate, the inversion of the curve starts to shrink. This also happens in the months before a recession. Generally speaking, there is relatively good economic data ahead of the market crash that catches most traders by surprise. On the other hand, it is quite rare for there to be a recession in an election year, as the government typically increases spending ahead of voters going to the polls.
In the end, while good economic indicators are a positive sign; it might be a bit too early to say if the danger of a recession is over.
