CICC: Trade Recession or Trade Rate Cut?

What is the current state of the U.S. economy? - A panoramic economic tracking framework

The key disagreement in the current global market is whether the U.S. economy will enter a recession. Due to the mixed economic data, pessimists focus on weak data while optimists focus on strong data, each using data to support their own arguments, making it difficult to reach a consensus. In order to confirm the true situation of the U.S. economy, it is necessary to distinguish between primary and secondary indicators, ignore noise, conduct a comprehensive analysis. We propose a panoramic tracking framework for the U.S. economy, grouping more than 70 common U.S. economic indicators into core indicators, auxiliary indicators, and forward-looking (high-frequency) indicators, and scoring each of the 6 areas of overall, consumption, investment, real estate, credit, and employment to provide a comprehensive and prioritized tracking framework.

Core indicators are the most crucial indicators for judging the state of the economy, playing a decisive role, such as real personal consumption, total fixed assets, etc. When other indicators diverge from core indicators, the signal of the core indicators should generally be used. The disadvantage of core indicators is that they have fewer indicators, the information is more general, the granularity is poor, and sometimes there is a lag or even systematic bias, so other indicators are also needed to provide correction or prediction.

Auxiliary indicators are divided into 2 categories. One category provides internal structural information for total indicators, for example, in employment data, non-farm employment (total employment) is a core indicator, while full-time employment and part-time employment are auxiliary indicators. The other category includes related indicators with lower importance than core indicators, such as job vacancy rate and long-term unemployment rate in employment data. Forward-looking indicators are related indicators that lead core indicators or are more high-frequency (able to be updated weekly or daily), for example, for investment, capital expenditure plans are forward-looking indicators. For consumption, household income and consumer expectations are forward-looking indicators.

By using these 3 types of indicators to calculate the short-term changes, medium-term trends, and cyclical positions of these 6 economic sectors, and providing an overall score, we found that the core indicators of consumption are relatively healthy, and forward-looking indicators have not significantly weakened; core indicators of investment data are healthy, but forward-looking indicators are cooling down; core indicators of real estate are diverging, and forward-looking indicators are cooling down; core indicators of credit and employment have already cooled down significantly.

Summary: Consumption>Investment>Real Estate>Employment>Credit. We believe that the U.S. economy is only cooling down, not yet in recession, with some economic sectors indicating downside risks.

Although the economy may not be in recession, recession trades are still worth participating in

At the current point in time, the probability of both a soft landing and a hard landing for the U.S. is not low. We believe that recession trades are still worth participating in, considering two aspects:

First, the market underestimates the risk of recession, providing opportunities for contrarian trades. Looking at the popular views this year, whether it is the expectation of the Fed's shallow rate cuts, preemptive rate cuts, or bullish views on U.S. stocks, copper, oil, or the expectation of overseas interest rates being "higher for longer," all are based on the strong assumption of "no recession in the U.S." When popular sentiment significantly underestimates the risk of a U.S. recession, we have been consistently predicting that the Federal Reserve will cut interest rates earlier and more deeply (rather than shallow and slow cuts), over-allocating to safe assets represented by U.S. bonds and gold (rather than risk assets such as copper and oil), warning of global stock market volatility. The recent market expectations adjustment and asset performance are consistent with our predictions.

Second, the logic of recession trading is difficult to falsify in the short term. Although the current U.S. economy is performing well, under the triple pressure of U.S. residents' excessive savings being nearly exhausted, gradually emerging high interest rate pressures, and declining fiscal support, the economic downturn has been confirmed, and there may be more data in the future indicating economic downward pressure, ending the current situation of data differentiation.

From a historical retrospective perspective, in macro environments similar to the current one, the U.S. has historically ended up in a recession: the Federal Reserve's aggressive rate hikes in the context of high oil prices and high inflation have all ended in recession. In the past 50 years, every time the U.S. bond yield curve has consistently inverted deeply, the U.S. economy has also invariably entered a recession.

In the past 50 years, every time the Sam rule has been triggered, the economy has invariably entered a recession. In July, the U.S. unemployment rate unexpectedly rose triggering the Sam rule, although the unemployment rate fell slightly in August, the Beveridge curve indicates a non-linear risk of rising unemployment rate: over the past year, the vertical Beveridge curve and Phillips curve largely due to the economy being in a "full employment" state, with the unemployment rate remaining stable. According to historical empirical evidence, the Beveridge curve has reached the inflection point of slope change, reflecting the economy transitioning to a "not full employment" state, with an increasing risk of accelerated rise in the unemployment rate. Although we can argue for the uniqueness of this cycle with "this time is different," in reality, each cycle has its own uniqueness, and historically, betting on "this time is different" has not been very successful

Rate Cut Trades Have Higher Win Rates Than Recession Trades, Increase Allocation During Short-Term Volatility in September

While recession trades are worth considering, the uncertainty is relatively high. Is there a trade direction with higher certainty? We believe rate cut trades offer higher certainty. There are two possibilities in the future:

1. The U.S. economy falls into a recession, and the Federal Reserve is forced to significantly cut rates to address economic difficulties.

2. Due to the decisive rate cut by the Federal Reserve, the economy avoids a crisis and achieves a soft landing.

Regardless of whether the U.S. economy eventually enters a recession, it may lead to an earlier and deeper rate cut by the Federal Reserve, rather than a "shallow rate cut." We previously indicated that starting rate cuts in September is the base case scenario, and the possibility of a 50bp rate cut or an early rate cut through an emergency meeting is not ruled out, which has become a market consensus. We maintain our previous judgment that if you are unwilling to participate in recession trades, then rate cut trades may be an excellent hedge against recession risks.

In the context of a slowing economic outlook, the biggest constraint on the Federal Reserve's rate cuts is the risk of rising inflation. However, our inflation forecasting model shows no risk of "second inflation" in the second half of the year (see later inflation forecast), which has relieved concerns about rate cuts.

An earlier and deeper rate cut by the Federal Reserve will open up new upside potential for assets such as U.S. bonds and gold. According to the "rate expectation + term premium" framework, the equilibrium price of the ten-year U.S. bond rate is around 3.5% ("Has the U.S. Entered a High-Interest Rate Era?"). Gold not only benefits from recession risks, rate cut trades, and election trades (see "European and American Elections and Asset Variables"), but also is supported by structural factors such as deglobalization and de-dollarization.

At the same time, we also point out that there will be more uncertainties in overseas markets in September, with the second round of U.S. presidential candidate debates scheduled for September 11, the Federal Open Market Committee (FOMC) meeting starting the rate cut cycle on September 19, and the Bank of Japan announcing its latest interest rate decision on September 20, with the market focusing on the prospect of a rate hike by the Bank of Japan in the fourth quarter. Faced with many uncertainties, global asset volatility may increase in September, and if U.S. bonds and gold experience a pullback, it is recommended to increase allocation on dips For risk assets, overseas stock markets often decline in the early stages of recession, and the expectation of interest rate cuts is difficult to hedge against recession pressure. Against the backdrop of increased market uncertainties in September, overseas stock markets may still not fully price risk. It is recommended to be cautious and patient with neutral positioning in overseas stocks, and to wait for policy support from the Federal Reserve before increasing exposure.

Commodity trends are more affected by economic cycles than by "super cycles". Global economic growth and demand are weakening, inventories are not tight, and Trump advocates increasing oil and gas supply while opposing green transformation. Considering that Trump's approval rating is very close to Harris's, if Trump's support rate further rises in September, the election trading may resume, which could be bearish for commodities. Taking into account risks and returns, we currently maintain underweight positions in copper, oil, and other commodities.

August U.S. inflation may remain low, with low risk of secondary inflation in the second half of the year

The August U.S. CPI will be released on September 11th (Wednesday). CICC's broad asset allocation model predicts a month-on-month nominal CPI of 0.14% (consensus expectation 0.2%, previous value 0.15%), and a month-on-month core CPI of 0.18% (consensus expectation 0.2%, previous value 0.17%).

Nominal CPI turning negative on a month-on-month basis is mainly due to energy prices falling beyond seasonal trends

The core CPI month-on-month is still within a 20bp range, influenced by two factors: high-frequency data shows a continued decline in the month-on-month of used cars, while rent inflation last month was significantly affected by sample rotation effects, showing a clear upward trend. This month, the growth rate may relatively slow down.

By predicting the year-on-year growth rate based on the month-on-month, we predict that in August, the nominal CPI will decrease significantly by 2.5% year-on-year, and the core CPI will decrease to 3.1% year-on-year.

Looking ahead to the next 1-2 quarters, we expect the downward trend in US inflation to continue: rent inflation may accelerate its decline under the influence of lagging effects, becoming a cornerstone for inflation improvement; easing supply chain pressures will lower core goods inflation; a significant cooling in the labor market will help further improve inflation in other core services.

This year, there have been more abnormal inflation data, increasing the probability of errors in monthly statistical predictions, but with limited impact on predicting inflation trends. The CICC's broad asset inflation sub-item prediction model shows that as long as there are no black swan events, CPI inflation is likely to remain in the range of 2.5%-3% this year, and PCE will remain in the range of 2%-2.5%. The risk of secondary inflation in the second half of the year is low, relieving the Fed of concerns about cutting interest rates again.

Authors of this article: Li Zhao S0080523050001, Yang Xiaoqing S0080523040004, Qu Botao S0080123080031, Source: Zhongjin Insight, Original Title: "Zhongjin: Trading Decline or Trading Rate Cut?"