Investors fear the US economy is at a turning point, but is it?

Fears over the health of America’s economy have rattled financial markets. Last Monday global stock indices suffered their biggest one-day fall in almost two years. Trading floors buzzed with speculation about an emergency interest rate cut by the US Federal Reserve. By the end of the week a semblance of calm had been restored, but confidence remains superficial. Data published in the next few weeks will be pored over for signs of fracturing in the world’s largest economy.

What triggered the meltdown in sentiment has been debated extensively. Slowing jobs growth in the United States was the most probable trigger, with figures suggesting that only 117,000 jobs had been added during July. However, the role of Japan in raising its interest rates above zero for the first time in 14 years is also relevant. Cheap money pouring out of Japan in search of returns has been a constant backdrop for many investors’ lives; if that is poised to change, then a range of assets, inflated by what has become known as the Yen carry trade, will need to be repriced lower.

Concerns of a more market-orientated nature are also relevant. A large proportion of the recent returns for investors has come from a small number of enormous American technology stocks seen as likely long-term beneficiaries from a boom in artificial intelligence investment. The sustainable returns for these companies, and the use cases they offer, remain an open question. Investors will face cycles of exuberance, hubris and doubt. Not necessarily in that order.

There is also my favoured, if flippant, answer when investors ask why markets have fallen. There were more sellers than buyers. Slightly less flippant is the fact that these big-volatility events (the Nikkei 225 index in Japan recorded its biggest one-day decline in 37 years on Monday, followed by its largest rebound on Tuesday) should be expected with greater frequency amid greater passive investment and algorithmically traded liquidity. There is another column to be written on the diluted economic and social function of volatile financial markets, but that is not for today. Rather, what is the case that the US economy is now at a turning point? With the US stock market now accounting for 60 per cent of all stock market value around the world, and therefore of a large portion almost all pensions, the answer will have a significant impact on the finances of readers of The Times.

The US jobs data for July wasn’t solely at risk of misinterpretation from the impact of Hurricane Beryl, but also from problems with sampling the American workforce. Payroll data suggests the US has added a healthy 2.5 million jobs over the past year. The household survey that purports to measure the same thing suggests jobs growth of only 57,000. Doubt over what is going on in the labour market has parallels with Britain.

I would suggest that it is unwise to draw big conclusions on relatively small changes in these numbers, yet that was precisely what markets did. The release of the latest US labour market data breached a closely watched indicator known as the Sahm Rule, named after Claudia Sahm, the former Fed economist. This rule, triggered when unemployment rises by 0.5 per cent from its 12-month low, purports to predict a US recession. It did this successfully in 1990, 2001 and 2008.

The problem is that we have been here before with such “rules”. In July 2022 the US yield curve, the gap in interest rates between short and long-dated US debt, turned negative. This “inverted yield curve” is perhaps the most celebrated of market rules. It triggered a wide range of forecasters to predict an American recession in 2023; instead, the economy accelerated and defied the doom-mongers. Such rules are great until they’re not.

Despite this, we had the big Wall Street investment banks chasing headlines by raising their likelihood of recession predictions, Goldman Sachs to 25 per cent, JP Morgan to 35 per cent. Forget the fact that such statistical quantification is intellectually flawed, this helped to reinforce the nervous narrative.

At times like this, it is valuable to look at a broader range of indicators. In 2022, when the yield curve inverted, the Fed was selling bonds worth trillions of dollars back to private investors. This was, and remains, distortionary. Today, as the Sahm Rule has been triggered, the role of deficit spending from the Biden administration and the return of real income growth need to provide added context. There can be little doubt that the US jobs market is closer to maxing out than at any time since the pandemic. However, with the participation of American workers still rebounding, contrary to most expectations, the amount of spare capacity left is an open question for Fed policymakers considering their first interest rate cut next month.

And it is that interest rate-cutting cycle that looks most relevant to me. With existing home sales down by 40 per cent from their peak and total bank lending flat since late 2022, it is a reacceleration of the US credit cycle that is a key unknown. The animal spirits required to add to $17.7 trillion of household debt will be a big determinant. Part of this will hinge on how Jerome Powell, the Fed chairman, navigates the run-in to any interest rate cut.

In an election year in which consumer confidence and perceptions of the economy are split down partisan lines, how Kamala Harris and Donald Trump conduct their respective presidential election campaigns also will play a role. For Harris, this is straightforward. The vice-president’s campaign will amplify an economic record of the past four years that, even after stripping out the pandemic, produced a higher rate of economic growth and jobs creation than the first Trump administration. For Trump, the calculation is harder. Trashing the Biden record could be a pyrrhic victory if it pushes the US economy into a recession on his watch.

Overall, I think the US economy (for all its federal government indebtedness, with no signs of a more austere stance) is in better shape than recent headlines suggest. The bigger issue is whether US debt markets and equity markets are simply too big to fail without global collateral damage. It is that sheer scale that frays investors’ nerves as much as the volatile data.

Simon French is managing director, chief economist and head of research at Panmure Liberum