Fear gripped global markets this week – but was it all overblown?

This week has been a rollercoaster ride for investors.

Financial markets across the world were gripped by a fearsome selloff that surprised even seasoned investors with its speed and ferocity, as well as what caused it all in the first place.

Two key factors drove the market rout. First, a weaker than expected US jobs number. Second, an interest rate move by Japan’s central bank.

Fear of a US recession began to spread like wildfire, and panic set in across global markets. Japanese stocks saw their biggest single-day drop since 1987.

But now, in the relative calm after the storm, there are signs this rout may have been an overreaction. On Tuesday, US stock futures rose, and Japanese stocks bounced back quickly, recouping much of their 12% loss.

We have good reason to be worried the US could go into recession, but there’s no guarantee it will.

What happened?

Panic set in on Friday last week, when the US Bureau of Labour Statistics released economic data for July. This showed that the US unemployment rate had risen by 0.2 percentage points to 4.3%, while the number of employed people had grown by just 114,000.

This was a much lower figure than had been anticipated by markets, well down on the average monthly gain of 215,000 people observed over the previous 12 months. This weak result was taken by markets as an indication the US was likely to be in recession.

Across the Pacific, the Bank of Japan had just announced its first significant change in policy stance for some time. It finally decided to end its highly stimulatory monetary policy setting, increasing its key interest rate from almost zero to 0.25%, and reducing its purchases of Japanese government bonds.

Together, these two events weakened the interest rate on US bonds and strengthened the interest rate on Japanese bonds. The Japanese yen surged against the US dollar, forcing some hedge funds to sell their positions to meet “margin calls” on the positions they had taken.

Margin calls happen when traders are forced to come up with money quickly to cover losing bets.

But is the US actually in recession?

Fears of an imminent recession in the US are based on the so-called “Sahm Rule”, named after the US economist, Claudia Sahm, who developed it.

This rule signals the US is in recession when the unemployment rate’s three-month moving average increases by 0.50 points or more above this figure’s lowest level in the previous 12 months, which occurred with last Friday’s jobs data release.

However, the latest figures on economic activity indicate the US is still showing solid growth, while key index figures for the services sector showed a rebound in July.

This means that even if there is a US recession, it is unlikely to be as severe as those experienced during the COVID crisis or the global financial crisis.

Recessions don’t tend to last as long as expansions. This is one of the reasons economies grow over time. Growing economies grow company earnings which grow share prices over the long term.

In the US the share market typically falls during a recession then recovers, climbing back to new heights.

Why was Australia affected?

It’s reasonable to ask how Australia got caught up in all this. Our own share market steadied somewhat on Tuesday following a 3.7% tumble at the start of the week.

But this has less to do with the local economy and more to do with how globally interconnected financial markets have become in recent times. The increasing use of algorithmic trading, which removes the human element, could mean we see more of these dramatic market corrections in the future.

The widespread global selloff that occurred this week is unlikely to have any long-term implications for Australia.

Our own Reserve Bank is unlikely to respond to it directly, remaining solely focused on returning inflation back to target – deciding to hold its cash rate steady at 4.35% on Tuesday.

While a recession in Australia is always possible, it is unlikely to be influenced by these types of financial market gyrations. Australia’s own fortunes are much more tied to the outlook for the Chinese economy and commodity prices.