'Recession risk is low': 3 reasons why the market meltdown is an overreaction, according to Bank of America

Chief US Economist Michael Gapen says markets are overreacting. 3 reasons why — including how Hurricane Beryl skewed the latest economic data.

• Stocks tumbled after weak economic data, sending ripples across the global economy.
• But BofA's Chief US Economist Michael Gapen says the market is overblowing recession risks.
• Gapen also says the economy is "not even close" to needing an emergency Fed rate cut.

The stock market is going through an upheaval, and Wall Street is buzzing about the possibility of a recession.

The S&P 500 closed 3% lower on Monday while the Dow dropped 2.6% , marking the third consecutive trading day of stock market losses. The VIX, Wall Street's fear gauge, briefly breached 50 on Monday morning, a level not hit since the beginning of the COVID-19 pandemic in March 2020. The poor jobs data that is partially fueling the market chaos is prompting some economists to call for an emergency rate cut.

But Bank of America has some reassuring news for anxious investors: we're still on track for a soft landing.

A recession is "highly unlikely," according to Michael Gapen, the bank's chief US economist. Gapen also believes the Fed is "not even close" to an emergency rate cut. In a recent note, he shared three reasons he believes the market is overreacting to the latest economic data.

Hurricane Beryl blew the jobs report out of proportion

There's an unlikely culprit that's to blame for last week's listless jobs report: Hurricane Beryl.

Although last Friday's job report stated that "Hurricane Beryl had no discernible effect" on the collection of unemployment numbers, Bank of America believes that the Category 5 Atlantic hurricane that swept through the Gulf Coast of the US in July certainly had an impact.

According to the jobs report, 436,000 people were employed but unable to work because of bad weather in July. That's more than seven times the June number of 59,000. And compared to the historic July average of 33,000 from 2000 to 2019, this year's July data certainly seems like an outlier.

How does crazy weather affect the jobs report? Three million Texas households and businesses lost power when the hurricane made landfall. A disruption of this scale prevents employees from going to work, recording hours, and showing up on payroll. Bad weather can also decrease the number of hours worked and increase the number of temporary layoffs. Gapen believes that investors should take this one-time natural disaster into account for some much-needed context when approaching last week's jobs report.

The Sahm Rule is Sahm-times wrong

The triggering of the Sahm Rule recession indicator was another factor that pushed markets to panic. The Sahm Rule states that an economy has entered a recession when the three-month moving average of the US unemployment rate is 0.5% or more above its lowest point during the prior 12 months. Last week, this indicator flashed positive as the moving average rose to 0.53% above the one-year trough. Investors are especially concerned because the Sahm Rule has had a perfect track record of identifying recessions going back to at least the 1960s.

In Gapen's opinion, what has worked to predict recession in the past isn't likely to work in the present, given the unique trajectory of the US economy post-Covid. Historically, increasing job layoffs and unemployment have snowballed into an economic downturn.

"The US does not have recessions without layoffs picking up sharply," Gapen wrote. And according to the data, layoffs are still subdued.

Even Claudia Sahm, the rule's creator, says that the Sahm Rule might not be the most applicable to the current situation. She points out that the rise in the unemployment rate over the last year isn't due to job layoffs but rather labor supply boosted by immigration, and Gapen agrees. In fact, labor force growth might actually be underestimated, considering the difficulty in estimating immigration, according to Bank of America.

The ISM manufacturing index was unsatisfactory — but not really relevant

Gapen also wants investors to know that a lower ISM manufacturing index shouldn't necessarily spark bearish sentiment. Last week, the index, which measures the level of economic activity in the US manufacturing sector on a monthly basis, dropped to 46.8 from 48.5.

Wall Street is sensitive to manufacturing output because industrials, durable goods, and other related areas are highly cyclical and correlated to the booms and busts of a business cycle. However, Gapen doesn't believe that the manufacturing industry is the most accurate indicator of recession risk in a post-pandemic economy. The economic rebound of the last few years has been largely driven by increased services output, not manufacturing. US manufacturing has been on a steady decline ever since the 1950s, falling from 25% of GDP to a meager sub-10% proportion by 2024. Given that manufacturing plays such a small role in the US economy, Gapen finds it highly improbable that a decline in the sector could have the ability to spark a recession.

Additionally, Gapen points out that the latest ISM manufacturing index is solidly in line with recent performance. From January 2023 to June 2024, the average reading on the ISM manufacturing index was 47.7, only slightly above the current reading.

Be on the lookout for rate cuts, not recession

Gapen believes that a recession is highly unlikely in the current scenario. If anything, the last few days will solidify the occurrence of a rate cut in September. Bank of America forecasts a 25 basis point rate cut starting this fall and continuing quarterly until mid-2026. The bank believes that rates will bottom out around 3.25-3.5%.

Although some economists are speculating that the Fed will enact an emergency rate cut before its September meeting, Gapen is extremely doubtful this will happen.

"Our point is simply to say that history suggests the bar for intermeeting cuts is extremely high and that conditions on the ground today do not warrant such an action," Gapen wrote in a separate August 6 note. In recent history, the Fed has only resorted to such drastic measures in reaction to events such as the COVID-19 pandemic, the global financial crisis, and 9/11.

Ultimately, Gapen believes that the market meltdown is a dramatic overreaction to recent economic data.

"The economy is cooling but remains resilient enough to stay in expansion," Gapen affirmed.