The recent spike in unemployment has once again brought attention to the Sahm rule, a highly regarded recession signal (refer to the chart). According to the Sahm rule, recessions commence when the three-month moving average of the national unemployment rate is 0.5 percentage points or more above its low over the prior twelve months. If unemployment continues to rise and triggers the Sahm Rule by year-end, the probability of a stock market rally diminishes. Notably, historically, equities have experienced an average decline of 8.1% before a Sahm trigger, making the potential occurrence without a market correction unprecedented.
The recent soft inflation figures and robust consumer sentiment reinforce the belief that the Fed has concluded its hiking cycle, resulting in eased yields and higher equity valuations. However, this occurs amidst escalating default rates and delinquency rates, consequently leading to higher yields in the high-yield (HY) space.
Consideration should also be given to the looming possibility of a U.S. government shutdown and the fiscal juggernaut, characterized by the highest fiscal deficit the U.S. has witnessed in non-recessionary times. Examining the composition of buyers is crucial, as international sovereign funds and central banks have recently reduced their U.S. Treasury holdings. Additionally, there is a notable increase in the number of yield-sensitive subscribers.
As global growth decelerates in the coming quarters, it may pose challenges for emerging markets (EMs) as their exports slow down. However, one should inquire which EM country still has the potential for some carry. While many EMs have slashed rates to stimulate growth, potentially negatively impacting their currencies, Colombia and Mexico have adopted a cautious approach.
China's decelerating growth and escalating public debt have exerted pressure on its foreign exchange market. The recent meeting between the Chinese Prime Minister and President Biden suggests that while China aspires to be self-sufficient, it recognizes the need for foreign investment. China currently grapples with a classic case of debt overhang amidst slowing growth. Furthermore, its banking sector faces challenges, including a surge in non-performing assets (NPAs) and lower nominal interest rates impacting bank profitability.
U.S. Treasuries (UST) are exhibiting higher volatility than pre-pandemic levels amid rising uncertainty regarding the soft landing versus recession scenario within the higher-for-longer regime. This contrasts with equity volatility, which is trading near decade lows due to growing optimism about no more rate hikes and mega-cap companies driving the index higher. Moreover, if yields persist near the 5% levels, the Treasury is poised to spend more on interest payments than on Medicare.
The United Kingdom is likely entering a recession, marked by surging interest rates and a rising unemployment rate. This situation is expected to prompt the central bank to ease policy and provide support to the economy. The Bank of England anticipates that unemployment will increase from 4.3% to 6.1% by 2026.
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