(Bloomberg) -- For those on Wall Street clinging to the bull case on the economy, life is getting harder.
Troubling data – long foretold in the bond and commodity markets – woke traders across risky assets up from their slumber this week, in the worst performance for stocks since the 2023 regional bank crisis.
After rebounding from the early-August swoon, traders succumbed to growth fears thanks to a steady drumbeat of dispiriting economic news of late led by the labor market. The S&P 500 fell four straight days, credit spreads widened at the fastest clip since early August and an index of computer-chip makers plunged 12% — the most since the pandemic meltdown.
With the stock benchmark up 13% this year, the gyrations are a mere blip in bulled-up charts and risk-sensitive assets are still largely pricing in a soft landing ahead. Yet the trading action — on Friday in particular — was a rare instance of accord among cross-asset investors. Up until recently, they had never been more divided about the future of the economy than at any time since 2019, according to one measure.
All told as more than two years of hawkish Federal Reserve policy action take their toll, equities this week — dragged down by economically sensitive companies — joined longer-lasting market tumbles that have afflicted oil, copper and bond yields for more than a month.
“Investors may be waking up to the recession risk right now, but only after hitting the snooze button ten times,” said Michael O’Rourke, chief market strategist at JonesTrading. “The environment has only deteriorated when you consider both the economic data and the subsequent earnings reports.”
Bond investors — historically dubbed the smart money, rightly or wrongly, for their propensity to foresee a shift in the economic direction — priced in faster interest-rate cuts. That pushed two-year Treasury yields to the lowest level since 2022. The commodity complex similarly sent warning signs on the outlook for the consumption and investment cycle, with two major proxies of global growth scoring big losses. Oil erased all of its 2024 gains, while copper fell in 13 of the last 16 weeks.
While markets have charted different courses in 2024, this week’s move does have an obvious precursor: the start of August, when early inklings of labor market weakness caused bond yields and equities to plunge in a volatility tempest that ended as quickly as it began. The latest flareup reflects the same set of concerns that drove the first rout — that the economy may be grinding to a halt too quickly for the Fed to rescue it, without urgent policy redress.
Framed one way, the in-tandem selloff in risky assets validates the caution that has been particularly pronounced in government bonds. To see how stocks and credit have diverged from other assets in pricing upbeat growth scenarios, consider a model kept by JPMorgan Chase & Co. strategists including Nikolaos Panigirtzoglou. It derives the probability of a recession from various assets, by comparing their movements to past cycles. As of Wednesday, the chances of an economic contraction were considered relatively low in equities and investment-grade credit at only 9%, the model showed.
By contrast, the odds priced in commodities and government bonds were much higher, at 62% and 70%, respectively.
“I think no market is really pricing in a reasonable chance of a recession, but the totality of data suggests that risks of a recession are growing,” said Priya Misra, portfolio manager at JPMorgan Asset Management. “While there is so much hand-wringing about a 25bp or 50bp cut from the Fed in September, all markets will move if a recession is upon us. It will take a while for rate cuts to filter through into the economy.”
Of course, dissecting noisy financial assets to divine a clean economic message is fraught with risk at the best of times. Markets, like central bankers, struggled to predict the busines cycle again and again throughout the inflation era. Meanwhile a slew of investment factors, like trader sentiment and money flows, can drive prices beyond what’s justified by market fundamentals. Contributing to the recent equity pullback have been stretched positioning and valuations, especially among technology megacaps.
Still the sentiment gap between stocks and bonds was noticeable last month. An equal-weight version of the S&P 500 — which gives Big Tech companies the same weighting as the humble consumer staple — ended August at an all-time high in an upbeat signal about the business cycle ahead. Meanwhile, the yield on two-year Treasuries kept falling, reflecting conviction that Jerome Powell & Co. will be forced to enact a faster-than-expected pace of rate cuts.
If that conviction builds, risky assets may be forced to take fresh cues from the world’s most important bond market. It’s not perfect science, but for three sessions in a row earlier this week, the S&P 500 stood within 2.5% of a 52-week high, while two-year rates sat within 50 basis points of a 52-week low — a cluster of divergence not seen since 2019.
Still any prophesies on a recession have proved wrong throughout the stock-bull market and especially in this post-pandemic era. The bond market hasn’t always called it right either. And up until this week, the yield on two-year Treasuries had surpassed that of 10-year bonds since 2022 — for the longest inversion ever.
Now with the shape of the yield curve normalizing for the first time in this market cycle, fresh questions are getting raised on whether it’s a reliable harbinger for recession.
The history is ominous. The last four economic downturns only started after the yield curve turned positive again. Yet a soft landing would also likely spur a steeper curve as the Fed cuts interest rates, thereby fueling lower yields at the short end.
“So whichever way you lean, a positive sloping curve (if we continue to move in that direction) likely brings forward the moment of truth as to whether the yield curve has completely failed as a leading indicator in this cycle, or whether its powers were just felt later than in other cycles through history,” Jim Reid, a strategist at Deutsche Bank AG, wrote in a note this week.
To Nathan Thooft at Manulife Asset Management in Boston, which oversees $160 billion in assets, a slowdown is looming but the economy will be able to avoid a major downturn. Yet that’s not stopping his firm from cutting equity holdings in recent weeks.
“This was less driven by fears of a major downturn in the US economy, but more due to technicals and sentiment weakening, valuations being rich, election and seasonality,” said the chief investment officer of multi-asset solutions.
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