The markets are experiencing historic days. Investors have pressed the panic button in the face of the possible entry of the United States economy into recession, which has led to heavy losses in stock market worldwide.
With unemployment in the US rising to 4.2%, there is one word that has taken over the American scene: recession. The idea of a strong and imminent economic contraction has taken hold and the most recent data has activated one of its main arguments.
In the United States, Wall Street began the week with losses of up to 6% on the Nasdaq Composite – a drop that moderated to 2.5%, as better-than-expected data on the development of the services sector reassured the most pessimistic analysts.
The ISM services sector index, which rose to 51.4 in July from 48.8 the previous month, somewhat allayed investors’ worst fears.
ING strategists comment that “the situation looks favourable, with a growing economy, job creation and inflation above target”.
Last Friday the danger signal
But the trigger for the stock market falls was the historic collapse of the Japanese stock market: the Nikkei plunged 12.4% in its worst day since 1987. In Europe, the Euro Stoxx 50 fell 1.4%.
The beginning of this storm, however, was triggered last Friday with the release of weak employment data in the United States. The country created 114,000 jobs in July, below the 175,000 that the market expected, and the unemployment rate increased by two tenths, to 4.3%. Two numbers that caused a storm of storms for investors who thought that the world’s largest economy could withstand high interest rates without falling into recession. Now, the same investors fear that the Fed’s decision to keep interest rates unchanged until September – as its chairman, Jerome Powell, suggested at the July meeting – will worsen the economic slowdown, so much so that some consider an intervention necessary.
While doubts about tech companies have already begun to erode the foundations of major global indexes, the latest US employment data has turned that uncertainty into chaos.
Sam’s rule
However, this situation was predicted by American economist Claudia Sam, warning that the world’s largest economy is very close to recession, based on the “Sam rule”, which bears her name.
This rule says that a country enters a recession when the three-month average unemployment rate rises by 0.5 percentage points or more from its lowest point last year.
That threshold was crossed when recent US government data revealed that the unemployment rate rose to 4.3%, the highest level since October 2021. In July, the Sam rule reached 0.53 points, as reported by the Federal Reserve Bank of St Louis.
But why is such a specific rule useful for predicting a recession? The reason is the logic behind it. If the economy is in a period of consecutive layoffs, this spiral has a clear effect on the economy and it is difficult to escape the logic of a recession. People lose their jobs or fear losing them, and as a result, consumer spending falls, which causes companies to earn less. This situation leads to companies laying off employees, a cycle that eventually causes the economy to enter a period of contraction.
The rule has been confirmed 8 times
“Sam’s rule” has been confirmed in the last 8 recessions, that is, in all those that have occurred in the US since 1960. The only time it was not observed, in 1992, was in the months following the recession in which the country was.
Speaking on Bloomberg Television’s Bloomberg Surveillance program, Sam, now chief economist at New Century Advisors, commented on the unexpected rise in the unemployment rate in the July jobs report, noting that this trend is historically consistent with the early stages of a recession.
No immediate measures
Amid the financial market turmoil and growing panic, Sam recommended that the U.S. central bank take no immediate action, stressing the importance of remaining calm. He praised the Fed’s slow and deliberate approach, noting that quick emotional reactions would be detrimental. But he also said the Fed may need to adjust based on economic changes and the impact on markets.
With the Fed’s benchmark interest rate currently between 5.25% and 5.5%, the US economist believes policymakers have considerable flexibility to act if necessary. Regarding the rule, Jerome Powell himself spoke about it at last Wednesday’s press conference, following the meeting in which the Fed decided to keep interest rates unchanged: “It’s a statistical regularity, it’s not a rule that shows something is going to happen 100%.”
However, the disappointing results of the big US tech companies and the fact that the Fed is already open to cutting interest rates from September have caused a real panic in a market that has had to assimilate very quickly a complete change of narrative. We have gone from a soft landing to the need for aggressive cuts to avoid a recession that seems increasingly predestined. So much urgency has been created that the Bloomberg consensus already gives a 60% probability of a rate cut at an emergency meeting.
The fear index
The so-called fear index, Vix, which measures what investors pay to protect themselves against the risk of Wall Street falls, has, however, been trading at historically very low levels. The index has soared to 42 points, a level not seen since the 2020 pandemic.
Citi strategists acknowledge that in recent weeks “we have seen heightened risks of a hard landing as our economists believed the Sam rule could be triggered soon.
“In this case, it turns out that we should have worried less about the election and more about the rising risks of a hard landing, which means we should have reduced equity risk even further,” Citi strategists warn.