Fear of a US recession is overdone

Equity markets have rallied strongly over the last two years, with stock market indices in the UK, US, Europe and Japan all hitting record highs in 2024. However, in the last few weeks, volatility has increased and there have been some significant market falls.

These have been caused by concerns about two main issues – a potential recession in the US and stretched valuations in the technology sector. We think that fears of recession in the US are exaggerated and that a correction in some technology names is healthy and has made their market values more realistic.

Fear of a US recession

A recession in the US has a global impact, as consumers in the world’s largest economy rein in their spending. However, we still expect that the Federal Reserve will be able to bring – and keep – inflation close to its 2% target without tipping the country into recession.

Market fears that the US central bank had held interest rates too high for too long were sparked by some negative economic news, but we believe there are reasons to believe that certain one-off factors were behind this. We do not believe there is evidence of a broader systemic issue in the country that has dramatically altered the outlook.

Two economic releases for July prompted the concerns. The first was a survey of purchasing managers at key US manufacturers – the ISM Manufacturing survey – and the second was an employment report.

Manufacturing has been weak in the US for over a year but there were signs more recently that things were improving. The manufacturing survey showed a sharp reversal in these recent improvements and highlighted that manufacturing may be deteriorating again.

However, this was also a month that saw some significant weather-related impacts from Hurricane Beryl and the shutdown of the auto industry by a cyberattack. We need to see further weakness in this series to confirm that any slowdown in manufacturing is serious. Also, a similar survey in the services sector showed it was healthy and expanded in July.

The US employment report was weaker than expected, but the market reaction has been extreme, suggesting that the US economy is heading into recession and the Federal Reserve will need to dramatically cut rates.

All through the period of high interest rates, the US jobs market has been hot, with a shortage of skilled workers meaning wage settlements have been high. This is one driver of the inflation problem the US central bank is trying to resolve.

A slowdown in the jobs market is likely to be welcomed by the Federal Reserve. There has been a gradual easing in the labour market as a greater supply of workers becomes available and this trend looks set to continue. The rise in the unemployment rate from 4.1% to 4.3% in the July report was largely due to the layoff of temporary workers and the fact that 420,000 people decided to join the labour force – but unfortunately most couldn’t find any work in the month. At this stage, labour market stress is not at levels we would consider concerning, particularly given the weather-related impacts in July.

Technology impact

The technology sector has led the recent bull run, with optimism about prospects for artificial intelligence (AI) boosting valuations, particularly the so-called Magnificent Seven – Apple, Tesla, Alphabet, NVIDIA, Microsoft, Amazon and Meta Platforms. Some of these companies have been leading the losses. The fall in the FTSE 100 has been limited compared with other major indices because of its lack of exposure to the sector.

The US economic slowdown in the US – something the Federal Reserve will want to see if it is to bring inflation under control – has been reflected in company earnings for several months. However, it hasn’t been reflected in the results of the key technology companies as much. In fact, demand has been strong in relation to artificial intelligence AI-led services, leading to significant expansion in the infrastructure needed to provide these offerings.

The recent Microsoft results disappointed due to the Azure cloud business not growing as fast as anticipated, which led to suggestions that maybe even some of the big technology names are subject to a broader growth downturn. We think it is likely that the growth slowdown will impact these companies but won’t necessarily derail the demand they are seeing more broadly. Valuations need to be more realistic, incorporating this more cautious outcome rather than the over-optimistic scenario that has prevailed so far.

There are other factors that could dampen the outlook. There are likely to be further difficulties with manufacturing newly designed chips, as recently experienced at semiconductor group Intel. There are also tensions between Washington and Beijing to consider, with the US administration attempting to halt exports of cutting-edge technology to China, which will impact sales at Western technology groups.

Broader geopolitical concerns are also driving market falls. There are concerns about escalation in the Middle East and Russia’s war in Ukraine, which shows no sign of any resolution soon.

In broader markets, 10% corrections in a 12-month period are normal. We need to scrutinise data for any acceleration in the downturn. The current volatility is likely to continue through the current second-quarter earnings season, but we are yet to see any strong evidence that a significant economic growth downturn lies ahead that would spark a more substantial downside move in equity markets.