The bigger question lingering for financial analysts is whether the markets overreacted to global economy fundamentals by correcting aggressively during the last quarter.
Our view continues to be that the United States economy is mid-cycle and currently, we do not see significant excesses building up. Furthermore, we expect the mid-cycle phase of the US economy to underpin the rest of developed markets.
The employment numbers for September came in below expectations, including downwards revisions to the prior two months. The unemployment rate held steady at 5.1 per cent, but the labour force participation rate dropped by 0.2 percentage points to 62.4 per cent, and appears to be moving on a downwards trend again after moving mostly sideways throughout the first half of the year.
We interpret these numbers as consistent with our view of a two-speed economy. The domestic part of the economy remains strong and the external related segments are slowing down as a result of recent weakness in emerging markets. The external sector is undoubtedly slowing sharply – the breakdown of employment growth across sectors reveals that much of the weakness last month was again concentrated in industries linked to external demand, which continues to be very weak. This effect can be seen in sectors such as manufacturing, mining, and wholesale trade. This also explains the ISM manufacturing index weakness in recent months.
In our view, the next few months of employment reports will be crucial to judge whether, and to what extent, the domestic sectors of the US economy can remain resilient to slowing global growth.
History teaches us that an external shock of this kind will only have a localised drag on the external part of the labour market. During the Asian crisis in 1998, the trade-oriented part of the labour market fell sharply, but jobs were relatively unaffected. The last weak jobs report does not change our view on domestic growth, as the domestic business surveys are a lot more important in this respect. That said, it is admittedly dovish for Fed policy. A December lift-off still seems more likely, at this stage, but the likelihood of a first increase in 2016 is higher than earlier in the year.
To take this rationale further, why do we think some recession indicators may not be very reliable right now? US profit margins have declined from their peak by an amount that has preceded a recession (or coincided with one) in many cases since 1970. However, the primary driver of the margin decline this time around is energy, as it was in 1985 when the margin decline also did not signal recession.
On a revenue-weighted basis, the profit margins of the other nine Standard & Poors (S&P) sectors have not declined. Ultimately, a lot rests on the view that the commodity price decline will generate a combination of gains and losses in the developed world that net out to a positive for consumer spending, and that the US is not headed into recession.
In terms of equity markets, we believe the obvious catalyst ahead for global markets is S&P 500 third-quarter earnings. Stability around energy prices would help as consensus earnings for 2016 are gradually revised lower. The Fed can help as well – if its outlook has become more cautious, it should stop indicating an intent to raise policy rates this year.
Over the next few months, it will be important to see government bond yields move higher. Higher interest rates are an important validation that bond markets are looking beyond current uncertainty to slow and steady developed market growth. In our view, the year-end catalysts for a more constructive market outlook rest on solid third-quarter earnings, the Fed decision and the IMF decision on whether to include the renminbi in the special drawing rights, the group of currencies it uses to determine the value of its own currency.
Cesar Perez is the global head of investment strategy at JP Morgan Private Bank.
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