Economic and financial risk insights: strong fundamentals contrast volatility, rate uncertainties

• Growth: normalisation progresses. Upside risk to full-year growth in US and Europe after a strong 2Q24, even though economic momentum is set to soften in 2H24.
• Inflation: disinflation on track, but some turbulence ahead. Reverse base effects will feed inflation volatility in 2H24, but we continue to expect a steady return to 2% targets.
• Interest rates: renewed focus on labour markets. Recent employment softening adds upside risk to our US rate call for this year.

Solid fundamentals despite market volatility. The upside surprise on 2Q24 US GDP growth (2.8% annualised) reiterates that economic fundamentals remain healthy. However, early 3Q24 data has generated a sharp rise in financial market volatility. A soft July US nonfarm payrolls report, hawkish communications from the Bank of Japan (BoJ), and rising hostilities in the Middle East saw the S&P 500 Volatility Index spike to its highest level since October 2020 (see Figure 1).

Figure 1: S&P 500 Volatility Index 

While the 20 bp rise in the unemployment rate triggered the Sahm Rule¹ recession indicator in the US (see Figure 2), the increase remains low relative to past cycles with the recession indicator distorted from COVID-19. The increased jobless rate is likely due to more cautious hiring behaviour and growing labour supply, and we do not expect imminent downturn (see Figure 3). In the euro area, the recovery continued in 2Q24, apart from in Germany where the economy contracted by 0.1% q/q. We maintain a below-consensus growth outlook for 2025 amidst heightened downside risks from geopolitics and ongoing weak prospects in Germany. Activity in China remains fragile; we see downside risks to our end-year forecasts.

Figure 2: Sahm rule recession indicator 

Figure 3: US unemployment rate increases from cycle low 

Bumpy near-term outlook, but 2% is coming into view. Reverse base effects over the coming months will unwind some of the disinflation progress seen in 2Q24, but the direction of travel remains towards the 2% central bank targets (see Figure 4). In Europe, services inflation remains the key driver of overall inflation (see Figure 5) and adds some upside risk to our 2024 CPI forecasts, but this will likely ease over the medium-term as wage growth decelerates. In Japan, a more sustainable trend in underlying inflation suggests policy normalisation will continue at a measured pace into 2025. However, recent Yen appreciation could weigh on inflation and delay the pace of rate increases. 

Figure 4: Harmonised CPI inflation

Figure 5: Euro area inflation composition

Emphasis shifts from inflation to normalisation. The July US jobs report cements our view that the Federal Reserve will begin to ease policy in September, with a rising likelihood of three rate cuts this year, one more than our current forecast of two. We maintain our view that the European Central Bank will dial back restrictive policy cautiously given ongoing services inflation strength. We still expect rate cuts to come quarterly, with the next cut in September. In Japan, we expect the BoJ will wait for calmer market conditions and monitor closely any US slowdown before acting, but that it will continue to normalise policy in 2025.

Figure 6: Japan policy interest rate and core CPI inflation

Upside risks to our 2024 US and Europe GDP forecasts remain. Disinflation continues and could bring greater rate cuts in 2H24.