Has the rebound in US stocks ended?

Key Points

US Economy: Sliding towards cyclical recession but no systemic risk. 1) The unemployment rate is the best indicator to observe the position of the US economic cycle. The US unemployment rate has been running very steadily. In general, as long as it rises for three consecutive months, it will enter an upward trend, and once it accelerates, it confirms an economic recession. Since 1948, the US has experienced 12 rounds of rising unemployment rates, each of which has led to a recession without exception. This year, the US unemployment rate has shown signs of accelerating increase, which was the main cause of market panic triggered by the July employment data released on August 5th. 2) The safety of residents' balance sheets indicates that systemic risks are unlikely to occur in the economy. After the financial crisis and the COVID-19 pandemic, the US repaired residents' balance sheets through leveraging by government departments. Currently, the residents' debt-to-asset ratio has dropped to the levels of the 1970s and 1980s, meaning that even if asset prices plummet, the consumption constraints on US residents are relatively limited.

Fed Monetary Policy: The QE era may temporarily come to an end due to inflation. After the financial crisis, the main purpose of the Fed's QE was to repair residents' balance sheets. By the eve of the pandemic, the latter was already very healthy, but the economy and asset prices had become dependent on QE. Post-pandemic, the US has undergone structural changes, such as a sharp drop in the labor force participation rate of the 55+ age group without a rebound, leading to a wage increase due to the employment gap, coupled with unfriendly US trade policies, causing a systematic upward shift in inflation. In addition, the extremely low debt-to-asset ratio of US residents means that as long as the Fed eases monetary policy, it is expected to boost consumption and drive up inflation. Therefore, an upward shift in inflation may mean that the US will gradually "wean off" QE.

US Stocks: Post-pandemic rise is mainly driven by liquidity. Reviewing the performance of US stocks since 2015, it can be seen that in the past 10 years, US stocks have broken through four times, except in 2017 when expectations of Trump's tax reform effectively boosted the market sentiment, all driven by liquidity. In Q4 2019, the Fed organically expanded its balance sheet, from March 2020 to November 2021, the Fed implemented zero interest rates and unlimited QE post-pandemic, and since March last year, apart from the temporary expansion of the Fed due to the collapse of SVB, there has also been a siphoning effect on non-US assets. Although post-pandemic US real GDP has rebounded to around 3% year-on-year, close to pre-pandemic levels; relative to the compound growth rate of 2019, it is only 2%, a step down from the pre-pandemic level. Since 1960, the S&P 500 has outperformed the US nominal GDP in only two stages, the late 1990s and since 2015. Among them, the late 1990s and since 2023, US stocks have formed a very obvious siphoning effect on the global market.

Can US stocks continue to rise? Unless the siphoning effect reappears, but it is very difficult. First, inflation constrains the Fed's easing space. The trend of US stocks in 2018-2019 proved that simple rate cuts during an economic slowdown phase cannot push US stocks to break through. Second, the Fed's rate cuts have actually weakened the siphoning effect of US stocks, and overseas investors also have the desire to take profits before the election. Third, the key to the yen carry trade lies in the US economy, as long as the US further declines, the yen carry trade may reverse again and exacerbate global market volatility Fourth, the political cycle of the US stock market indicates that there will be annual adjustment pressure for at least one year after the new president takes office for 25-26 years.

Will the US stock market crash? It may depend on the results of the US election. If Trump is elected, tariffs may constrain the Fed's interest rate cuts, and the resilience of the US dollar may actually cause the US stock market to re-experience the suction effect after a brief adjustment. If Harris is elected, raising corporate taxes, imposing taxes on the wealthy, and imposing certain constraints on the development of artificial intelligence under the premise of seeking security. In addition, in the case of Harris being elected, the Fed may take more aggressive interest rate cut measures due to downward inflation, but this could also likely reverse the suction effect of the US stock market, triggering a trend similar to that after 2001 for both the US stock market and the US dollar.

Main Text

I. The US is sliding towards a cyclical recession, but without systemic risks

(A) The US is sliding towards a cyclical recession

The unemployment rate is one of the best indicators to observe the position of the US economic cycle. The US unemployment rate operates very steadily. In general, as long as it rises for three consecutive months, it will enter an upward trend, and once it accelerates, it confirms an economic recession. Since data has been available since 1948, the US has experienced 12 rounds of rising unemployment rates, each of which has led to a recession without exception. Although the unemployment rate is a lagging indicator of the economy, it still has a leading role in cyclical recessions. Except for the two systemic risks of the bursting of the dot-com bubble in 2001 and the subprime mortgage crisis in 2008, economic recessions only occur after the unemployment rate starts to rise (within 1 to 10 months). Since the beginning of this year, there have been signs of accelerated increase in the US unemployment rate, which was the main cause of market panic triggered by the employment data released on August 5th. From the data perspective, it is only a matter of time before the US slides into a cyclical recession, and the pace depends on uncertain factors such as the Fed's monetary policy and the election.

(B) However, the soundness of the household balance sheet indicates no systemic risks in the economy

Although we believe that the US economy will eventually decline, the soundness of the household balance sheet indicates that the economy is unlikely to face systemic risks. After the financial crisis and the COVID-19 pandemic, the US repaired the balance sheets of enterprises and households through leverage from government departments. However, the pandemic itself indirectly improved the household balance sheet, with a large influx of immigrants supplementing young labor force and pushing estate and gift taxes to historically high levels in 2022 and 2023. Over the past three years, structural changes in the US population and fiscal stimulus, combined with the surge in the stock market and real estate, have optimized the wealth effect on the household balance sheet, increased wage growth, and a healthy household balance sheet has boosted consumer willingness and formed a positive feedback loop. Currently, the household debt-to-asset ratio has dropped to historically low levels, and even if asset prices plummet, the consumption constraints on US residents are relatively limited. In the event of a liquidity crisis, as long as the Fed provides liquidity support, it can be resolved without triggering a systemic economic crisis similar to that of 2008

2. Federal Reserve Monetary Policy: The QE era may temporarily come to an end due to inflation

After the financial crisis, the main purpose of the Federal Reserve's QE was to repair residents' balance sheets. Before the epidemic, the latter was already very healthy, but the economy and asset prices had become dependent on QE. After the epidemic, the United States experienced two structural changes: first, many elderly people passed away during the epidemic, leaving their descendants (mostly middle-aged groups) to inherit their estates. In 2022 and 2023, inheritance and gift taxes hit historical highs, coupled with the rise in stock and real estate prices. The wealth expansion effect of this group after the epidemic will be more significant. Second, the U.S. labor force participation rate has not recovered to pre-epidemic levels. As of July 2024, the U.S. labor force participation rate stood at 62.7%, 0.6 percentage points lower than before the epidemic. Among the 25-54 age group, the labor force participation rate was 84.0%, 1.0 percentage point higher than before the epidemic, while the labor force participation rate for the 55 and older age group was 38.3%, 1.9 percentage points lower than before the epidemic, indicating that some middle-aged groups (especially those inheriting estates) have exited the job market, leading to a permanent gap in employment and pushing up wages. Considering the above factors, looking ahead, the U.S. trade policy may still be hawkish, and the U.S. inflation center has shifted systematically higher than before the epidemic. In addition, the U.S. residents' asset-liability ratio is very low, which means that as long as the Federal Reserve eases monetary policy, it is expected to boost consumption and push up inflation. Therefore, the upward shift in the inflation center may mean that the United States will gradually "wean off" QE.

3. The post-epidemic rise in U.S. stocks is mainly driven by liquidity

Since 2015, U.S. stocks have experienced four upward breakthroughs, with the exception of 2017 when expectations of Trump's tax reforms effectively boosted the fundamentals, the rest were all driven by liquidity.

First driving factor: Expectations of Trump's tax reforms. In mid-2015, as the expectation of a rate hike increased and the RMB depreciated due to the 811 exchange rate reform, U.S. stocks plummeted rapidly. In early 2016, the RMB exchange rate depreciated again, coupled with market expectations of multiple rate hikes by the Federal Reserve in 2016, causing a sharp drop in U.S. stocks. It wasn't until February 11-13, when central banks from China, the U.S., Europe, and the UK jointly made statements, that U.S. stocks reversed their downward trend The 2017 tax reform had a strong positive impact on the US stock market, and on April 26 of the same year, the then US President Trump officially announced the "tax reform" plan.

The second driving factor: organic expansion of the Fed's balance sheet. In 2018, the US-China trade friction, coupled with the Fed's interest rate hikes and balance sheet reduction, caused the US stock market to decline again. The interest rate cut in July 2019 temporarily helped the US stock market recover, until in October 2019, the organic expansion of the Fed's balance sheet provided a positive boost to the denominator, effectively offsetting the downward impact on the numerator, leading the US stock market to further breakthrough.

The third driving factor: zero interest rates and unlimited QE by the Fed. In March 2020, the liquidity crisis triggered by the pandemic led to a sharp drop in the US stock market. Subsequently, the Fed announced zero interest rates and unlimited QE, and introduced various targeted liquidity support tools to repair the balance sheets of various sectors, initiating a round of rising trend in the US stock market.

The fourth driving factor: Fed's liquidity support; US stocks and the US dollar rising together create a global suction effect. In November 2021, the Fed began to taper QE, ending the rise of the US stock market. In March 2022, the Fed began to raise interest rates and shrink its balance sheet, leading to a decline in the US stock market. However, in March 2023, the collapse of Silicon Valley Bank "came at the right time", allowing the Fed to provide liquidity to the US stock market through the Bank Term Financing Program (BTFP) under the background of interest rate hikes and balance sheet reduction. At the same time, the resilience of the US economy and the strengthening of the US dollar made US technology companies the center of a new wave of AI, causing a suction effect of US stocks on non-US assets.

We can also infer that the driving force behind the post-pandemic rise in US stocks comes from liquidity through economic indicators. On the one hand, although the post-pandemic real GDP of the United States has rebounded to around 3%, close to the pre-pandemic level, the compound growth rate relative to 2019 is only 2%, indicating a step down in real economic growth after the pandemic. On the other hand, since 1960, the S&P 500 has only outperformed the US nominal GDP in two periods, namely the late 1990s and since 15 years ago. In fact, the strong performance of the US stock market in the late 1990s and since last year has been a driving force of the suction effect.

4. How to view the future trend of US stocks?

(1) The US stock market temporarily lacks the foundation for a significant rise

First, inflation constrains the Fed's easing space. The trend of US stocks in 2018-2019 proved that a simple rate cut during an economic slowdown phase cannot push US stocks to break through. As mentioned earlier, due to the systematic rise in post-epidemic US inflation and the extremely healthy balance sheets of residents, once QE is implemented, the inflation center will rise again, thereby constraining the extent of QE by the Fed. Therefore, the US will gradually "wean off" QE.

Second, the Fed's rate cuts actually weaken the siphon effect of US stocks. From the end of 2023 to February this year and June this year, when the US dollar and US stocks resonated and strengthened, the siphon effect of US stocks was enhanced, putting short-term pressure on non-US assets. Expectations of rate cuts have exacerbated market concerns about the US economic slowdown, and the siphon effect of US stocks has cooled after the rate cuts began. In addition to the current high valuation of US stocks and the uncertainty of the election results, overseas investors also have the desire to take profits before the election.

Third, the key to the yen carry trade lies in the US economy, as long as the US further weakens, the yen carry trade may reverse again and intensify global market volatility. The yen carry trade involves three transactions: 1) Japanese financial institutions invest overseas, using assets such as US bonds to replace domestic bonds; 2) Borrow yen to buy Japanese stocks; 3) Borrow yen to buy US stocks and other overseas assets. The trade is mainly driven by the significant decline in Japan's risk-free interest rates, but the key to crowded trading is the relative advantage of the US economy and asset returns. In other words, the key to the reversal of the yen carry trade in July-August is the deterioration of US economic data and expectations of rate cuts. As long as the US continues to weaken, the carry trade will reverse and intensify market volatility in the US.

Fourth, the political cycle pattern of US stocks indicates that after the new president takes office, there will be at least one year of annual adjustment pressure starting from the 25th to 26th year. In reports such as "Has the Adjustment of US Stocks Ended?" (April 24, 2024), it is pointed out that there are three political cycle patterns in the US stock market: 1) In election years seeking re-election, US stocks will rise, even significantly; 2) During the stable period of a US president's term, namely: the 3rd and 4th years of the first term and the 1st and 2nd years of the second term (if re-elected), the performance of US stocks is also very stable, without annual-level adjustments occurring; 3) The years when the U.S. stock market declines are concentrated in the first two years of each president's term. The main reason why the U.S. stock market did not fall in the first two years of Obama's term was that the U.S. stock market had already plummeted in 2008. Since the beginning of this year, the U.S. stock market has repeatedly hit new highs. However, Biden's withdrawal from the election means that this year is no longer a re-election year, and there may be adjustment pressure on the U.S. stock market in the next two years.

(2) Will the U.S. stock market crash? It may depend on the outcome of the U.S. election

As mentioned earlier, the U.S. stock market no longer has the basis for a significant rise, unless the siphon effect reappears. The election result is a key variable. If Trump is re-elected, tariffs may constrain the Fed's room for interest rate cuts, and the resilience of the U.S. dollar may actually cause the U.S. stock market to re-experience the siphon effect after a brief adjustment. If Harris is elected, raising corporate taxes, imposing taxes on the wealthy, and imposing certain constraints on the development of artificial intelligence under the premise of seeking security. In addition, in the case of Harris's election, the Fed may take more aggressive interest rate cut measures due to faster inflation decline, but this could also likely reverse the siphon effect of the U.S. stock market, leading to a trend similar to that after 2001 for both the U.S. stock market and the U.S. dollar.

Risk Warning:

U.S. economic and monetary policies may exceed expectations.

Authors: Zhang Jingjing from CMB Macro (SAC License No.: S1090522050003), Wang Hebin (SAC License No.: S1090523070007), Source: CMB Macro Insights, Original Title: "CMB Macro | Has the U.S. Stock Market Rebound Ended?" 》