MW Growth scare, carry trade and recession fear are a toxic mix for the market
By Ed Yardeni and Eric Wallerstein
U.S. stocks could rally after the November election - but a lot has to go right
The rapid unwind of carry trades injected another dose of volatility into the financial markets.
Last week's U.S. employment report for July was shockingly weak. So much so that the financial markets immediately priced in an imminent recession and a much more aggressive response by the U.S. Federal Reserve to end it as soon as possible.
But a weak July employment report does not a recession make. The financial markets reacted on Friday as though it does, but we believe that report was a weather-impacted anomaly and not representative of the strength of the U.S. labor market.
Instead, what the U.S. economy has been going through is a sequence of rolling recessions depressing different sectors at different times, allowing the overall economy to continue to grow. Yet Friday's employment report clearly raises the question of whether the overall economy is now rolling into an employment-led recession.
The stock market's adverse reaction to Friday's jobs report apparently was to price in a hard landing and to expect a series of federal funds rate cuts by the Fed, including a 50-basis-point cut in September. Helping to unnerve investors was that the increase in the unemployment rate might have triggered the Sahm Rule, implying that the jobless rate is about to soar, as it has in the past once the rule was triggered.
Read: The market has a sinking feeling that the Fed has fallen behind the curve
More: The U.S. economy is getting closer to a recession. What is the Fed waiting for?
Carry trade drops stocks
Friday's market selloff was exacerbated by a mad scramble by speculators to cover their carry trades in the "Magnificent Seven" stocks (which includes Alphabet $(GOOGL)$, Amazon.com $(AMZN)$, Apple $(AAPL)$, Meta Platforms (META), Microsoft $(MSFT)$ and Nvidia $(NVDA)$) and other financial assets around the world. The one exception was U.S. Treasury securities, which rallied strongly in reaction to the global financial turmoil. In addition, investor sentiment had been overly bullish in the stock market, making it vulnerable to the tumultuous selloff that occurred on Friday.
The rapid unwind of carry trades injected another dose of volatility into the financial markets. Carry traders borrowing at ultralow rates in Japan effectively short the Japanese yen $(USDJPY.FOREX)$, borrowing and selling it to then buy other currencies of countries with higher interest rates so they can invest in those countries' assets.
Carry trades have worked out well since global central banks (except for the Bank of Japan) began raising interest rates in 2022, and especially last year as the weakening yen gave the trade extra juice. (The preponderance of carry trades also helped push the yen to weaker than 161.00 to the U.S. dollar (DX00) thanks to all the selling pressure.)
Carry trades are great, until they're not. This one started to unravel in the past few weeks after Japan's Ministry of Finance defended the currency and the Bank of Japan subsequently started to tighten monetary policy. The rising yen forced carry traders to cover their shorts in the yen rapidly and to liquidate their assets that were financed by their carry trades. Many had piled into momentum stocks, including the Magnificent Seven and those in the Nasdaq 100 NDX.
Read: Japan's Nikkei 225 index (NIY00) plunges as global sell-off resumes
Pushing hard against the hard-landers
Now the diehard economic hard-landers are back and whooping it up. Yes, they are right that the 114,000 in total and 97,000 increases in private-industry payrolls were weak. However, they were increases, not decreases, and there's no reason to think they will be followed up by decreases. In fact, we expect to see bigger increases in the August employment report early next month.
The three-month average increase in total payrolls through July was 170,000. That compares to the pre-pandemic monthly average of 178,000 from 2018 through 2019. We don't see a recession in that comparison.
Also, payroll employment rose to a record high in July. It is highly correlated with S&P 500 SPX companies' collective forward earnings, since companies tend to hire when they are profitable and fire when they are unprofitable. S&P 500 forward earnings rose to a record high in July.
Payroll employment is one of the four components of the Index of Coincident Economic Indicators $(CEI)$. So this one at least doesn't confirm that a recession might have started in July. However, we acknowledge that the other three components, when they are reported later this month, might do so. We know from Friday's report that aggregate hours worked in manufacturing fell 0.6% month-over-month following a solid gain of 0.8% over the previous two months. That means that industrial production, another CEI component, probably fell last month.
There is also a hint of a recession in private-industry average workweek, which fell 0.2% during July. It is a component of the Index of Leading Economic Indicators. It offset the 0.1% increase in private-industry payrolls. So aggregate hours worked edged down 0.1% during July (Fig. 5). Conceivably, that's a sign that a recession has started, but it's not a clear one at all since this series, which rose to a record high in June, can be volatile from month to month.
Our bet is that aggregate hours worked will be back at a record high in August as the average workweek, which is also volatile m/m, rebounds and payroll increases accelerate. That's because we blame the weather for the weakness in July's payrolls.
The U.S. Bureau of Labor Statistics $(BLS.SI)$ noted in Friday's employment report that Hurricane Beryl had no impact on the report. However, the BLS didn't say that the weather had no impact. Consider the following:
We think the rise in the July unemployment rate from 4.1% in June to 4.3% in July had to do with inclement weather including Beryl's impact on Texas. According to the BLS household employment survey, 1.54 million workers were either not working or working only part-time due to weather in July. That was up from 280,000 in June and one of the top five monthly readings for workers impacted by weather since 2018.
Some of these layoffs showed up in the initial unemployment claims in Texas, which rose to 31,685 in the week ended July 20 and remained elevated at 25,453 in the week ended July 27. Texas claims also put significantly boosted pressure on national figures: 87% of the not seasonally adjusted increase in continuing claims for the week ended July 20 - which rose to a near-three-year-high of 1.88 million - came from Texas.
Given the above, we are hard-pressed to fathom why the BLS included the following warning label on its latest employment report: "Hurricane Beryl made landfall on the central coast of Texas on July 8, 2024, during the reference periods for both the household and establishment surveys. Hurricane Beryl had no discernible effect on the national employment and unemployment data for July, and the response rates for the two surveys were within normal ranges." Go figure.
There's evidence that many of July's layoffs were temporary and should be reversed in the August report. Workers on temporary layoff jumped to more than 0.6% of the total labor force in July, the highest since late 2021. Workers reentering the labor force are actually the primary driver of rising unemployment right now, rising to 1.3% in July, another post-2021 high. Meanwhile, permanent job losers are still around 1.0% of the total labor force.
As workers impacted by July's inclement weather return to their jobs in August, we expect to see lower national unemployment claims and higher national payroll employment. Fed officials have plenty of time between now and their speeches at the Jackson Hole symposium in late August to digest the report and see what we're seeing.
We continue to expect that the S&P 500 will churn below its July 16 record high through the U.S. presidential election in November, followed by a year-end rally to new record highs. We are assuming that the both the U.S. labor market and U.S. economy are in good shape, the carry trade will unravel quickly, the Magnificent Seven will remain relatively magnificent and the stock market rally will broaden. In other words, a lot has to go right.
Ed Yardeni is president of Yardeni Research Inc., a provider of global investment strategy and asset-allocation analyses and recommendations. Eric Wallerstein is Yardeni Research's chief markets strategist. This article is excerpted from Yardeni Research's "Morning Briefing" for Aug. 5, 2024. Individual investors can read Yardeni Research reports here. Follow Yardeni on LinkedIn and his blog.
Also read: Memo to the Fed: The economy's growth scare is your wake-up call
Plus: Stock-market investors went from cheering a 'Goldilocks' economy to fearing recession. Here's what's next.
-Ed Yardeni -Eric Wallerstein
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August 10, 2024 10:15 ET (14:15 GMT)
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