Market instability amid shifts in economic data
This week, Wall Street seems to be entering “be careful what you wish for” territory as investors pivot from urging the Federal Reserve to decrease its primary lending rate to expressing concerns over the genuine motive behind the now-inevitable rate cut in September.
Over the last two trading days, U.S. stocks have lost more than .2 trillion in value, transforming an early-week gain following the Fed’s July rate decision into one of the year’s largest losses, as attention shifts from inflation issues to the overall wellbeing of the global economy.
The decline in labor market metrics has been a primary catalyst for this shift, beginning with a subdued June jobs openings report from the Labor Department that indicated a slowing quits rate, hinting that workers were struggling to secure new jobs and wages as effortlessly as before.
This was followed by an uptick in weekly jobless claims, reaching the highest levels in nearly a year for the week ending July 27, alongside data revealing sluggish wage growth and modest employment costs from payroll processing firm ADP, market research organization Challenger Gray, and the U.S. Labor Department.
These findings were capped by Friday’s nonfarm-payroll report, which illustrated a significant slowdown in hiring for July, the softest wage growth seen in over three years, and a headline unemployment rate of 4.3%, marking the highest level since October 2021.
Moreover, data from the ISM’s closely monitored July index of business activity within the manufacturing sector plummeted to its lowest point in eight months, with disappointing figures for new orders, hiring, and near-term sentiment.
Beyond triggering the ongoing market downturn—which has pushed the tech-heavy Nasdaq index into correction territory—this mixed bag of economic data has also set off one of Wall Street’s pivotal recession alarms.
The Sahm Rule, named after former Fed economist Claudia Sahm, indicates that the economy risks recession when the three-month moving average of the unemployment rate climbs by 0.5 percentage points above the lowest level from the past year.
Although its construction may seem peculiar, this rule is vigilantly monitored on Wall Street, as it “applies to the unemployment rate reported in real-time, rather than the more precise revised figures that can reveal a recession had begun months or even years prior,” as noted by Comerica Bank’s chief economist Bill Adams.
He also mentions that external factors, such as Hurricane Beryl, might have distorted some of July’s weaknesses; however, a rising Labor Force Participation Rate could indicate optimism in the job market. “Nonetheless, the activation of the Sahm rule and the rise in the unemployment rate will contribute to worries that the economy is deteriorating more than anticipated in the latter half of 2024,” he concluded.
Indicators of recession and Fed’s potential response
This likely clarifies the bond market’s strong reaction to the recent sequence of employment and activity data, which occurred well ahead of the stock market’s response time.
Benchmark 10-year Treasury note yields, which underpin various consumer financial products such as auto loans and mortgages, dropped to their lowest levels since December by the week’s end, with the latest figure at 3.831%
Bond yields typically move inversely to prices and tend to decrease when investors speculate on Fed rate cuts or are concerned about slowing GDP growth trajectories.
The former usually propels stock prices upward, while the latter often leads to sharp declines, as weaker growth generally translates to slower sales and diminished corporate profits.
This past week, however, markets faced a blend of both scenarios.
“The economy and stock market have displayed resilience due to low unemployment and continuing consumer spending,” commented Chris Zaccarelli, chief investment officer for Independent Advisor Alliance.
“However, if that trend is changing, then the Fed has made a critical misjudgment in maintaining rates too elevated for an extended period,” he added. “Should this mark the onset of a downturn in the economy, all bets are off, and the Fed will need to implement rate cuts more significantly and frequently than they indicated just two days prior.”
Yung-Yu Ma, chief investment officer at BMO Wealth Management, shares this viewpoint but also points out that, on this occasion, markets detected economic weaknesses sooner than the Fed typically does, contributing to the significant response.
“The July jobs report was not actually that much weaker than June’s, but the downward trend is now strikingly evident,” he remarked.
“The Fed is already falling behind, and a 50-basis-point cut in September would merely be a catch-up measure,” he continued.
Projections concerning a 50-basis-point (0.5 percentage point) cut, which were largely hedging just two weeks ago, surged to more than 70% last week after the July jobs report, with traders anticipating additional and deeper reductions in the final two meetings of the year.
“The latest labor market snapshot aligns with a deceleration, not necessarily a recession,” stated Jeffery Roach, chief economist for LPL Financial in Charlotte.
“Nonetheless, early warning indicators suggest further weakness (and) the number of individuals working part-time for economic reasons has risen to its highest since June 2021,” he added. “If the labor market deteriorates further, markets are likely to adjust for three rate cuts this year.”
But is the economy truly heading towards recession? After all, second-quarter growth was recently revised to 2.8%, a considerably stronger-than-expected figure that was bolstered by business inventories (a positive indicator of anticipated demand) and consumer spending (the most vital component of U.S. growth).
The Atlanta Fed’s GDPNow forecasting tool currently estimates a 2.5% advance for the current quarter, although downward adjustments are likely in the coming weeks to accommodate the recent jobs and activity data.
“We doubt the economy is presently in a recession, considering the rise in the unemployment rate is influenced by rapid workforce growth and significantly slower—but not negative—employment growth, rather than extensive layoffs,” said Ian Shepherdson of Pantheon Macroeconomics.
“Still, the labor market is no longer tight, and any further increase in the unemployment rate from this point would substantially exceed the Fed’s estimate of its long-term neutral rate,” he noted.
“We maintain our belief that the Fed will ease by 125 basis points by year’s end, but the first cut is likely to be 50 basis points if August’s employment data mirrors July’s weaknesses,” he concluded.
