We may have finally moved into the “bad news is bad” phase of equity market performance as weak reports produced at the end of last week, particularly relating to employment, are calling into question the trajectory of U.S. economic growth. The July ISM manufacturing survey moved further into contraction at 46.8. Still, the most concerning aspect of the report was the employment subcomponent, which fell to 43.4, the lowest level since November of 2021. This followed a spike in the weekly initial jobless claims data and the below-consensus July nonfarm payroll growth, which was accompanied by an increase in the unemployment rate to 4.3%.

Equity markets have pulled back roughly 8% from their mid-July highs, with the NASDAQ index, which houses all the Magnificent Seven industry champions, experiencing a full 10% correction off their strong year-to-date advances. With volatility picking up in the equity markets due to concerns around economic growth, the bond market has again proven to be a negatively correlated refuge, with the 10-year treasury yield falling to 3.80% when it was trading at 4.15% at the beginning of last week. Shorter-term yields have fallen at a more rapid rate, with the two-to-ten-year yield curve inversion nearly eradicated after two years of an extraordinary negative slope.

Will the Fed Cut Interest Rates?

Coming out of the FOMC meeting on Wednesday, it was nearly certain that the Fed would implement the first 25 bps rate cut of this cycle at its September meeting. However, with the recent data releases, the probability of an even-more-aggressive 50 bps cut at the meeting increased to roughly 95%. The Fed is suddenly being viewed as being “behind the curve” regarding an economic slowdown in the same way it was accused of tightening too late when inflation rates began increasing in 2022.

In his press conference after the FOMC meeting, Chairman Powell admitted that downside risks to the Fed’s employment mandate “are real now” after over two years of a singular focus on the price stability mandate. However, the Chairman pronounced the labor market as merely normalizing, not yet deteriorating. With job growth still comfortably positive and job openings still rather robust, this assessment appears accurate. Still, the higher-rate regime engineered by the Fed and the higher price levels may be beginning to impact consumer spending, which may lead to further labor market weakness.

Do Employment Data Points Auger Recession?

It is difficult to extrapolate from a few weaker-than-expected data points in July the onset of recession, given the U.S. economy’s roughly 2.0% GDP growth over the first half of the year. Even the big miss in the July payrolls report could have been largely due to the impact of Hurricane Beryl in Texas. If so, there may be a rebound in the August numbers. There’s another employment indicator producing angst for economists and markets: the triggering in July of the so-called Sahm Rule. Named for former Fed official Dr. Claudia Sahm, the Sahm Rule holds that a recession usually ensues when the three-month moving average of the unemployment rate rises by 0.5 percentage points over its recent lows.

One aspect of the recent rise in the unemployment rate, which Dr. Sahm has acknowledged in recent interviews, is the increase in the labor force participation rate, which might mean the unemployment rate is increasing as much due to increasing labor supply as reduced labor demand. Notable in the July data was an increase in the prime age (24-59) labor force participation rate to 84.0 %, the highest since 2001, as the combination of immigration and the loss of stimulus benefits has increased the labor supply that was lost to the effects of the pandemic.

Other Contributing Factors

Besides the weaker employment reports and manufacturing surveys, there are some other developments adding to the recent market pullback:

  • Since becoming the presumptive Democratic Party Candidate, Vice President Harris has rallied in the presidential election polls over the past two weeks, particularly in the key swing states. This development has introduced greater uncertainty as to the outcome than existed in markets prior to her entrance into the race.
  • Geopolitical risks have heightened in the Mideast as Israel executed successful surgical strikes on key enemy leaders. Markets are awaiting Iran’s response and are worried about potential oil supply disruptions.
  • The second-quarter earnings season has been reasonably strong, but weak reports from Intel and some consumer companies last week are adding to market jitters.

It would be foolish to completely dismiss the recent price action as nothing more than a typical pullback or correction in an ongoing bull market. The higher interest rates implemented by the Fed over the past few years may finally be exerting their lagged effect. We will continue to monitor signs of any further weakness in consumer and business spending, but we reiterate that jobs and wages continue to grow, which should provide some ballast for consumer spending. Businesses have controlled inventories rather well, which should allow the economy to avoid any meaningful inventory destocking. Both consumer and corporate debt are at low levels relative to incomes and earnings.

Excessive monetary tightening usually leads to credit crunches like the Silicon Valley Bank crisis in March of last year. So far, there are no apparent signs of such credit restrictions, and the Fed has given itself much more cushion to cut rates to react to any such signs.

While we continue to monitor this economic slowdown to determine whether it is indeed deepening, please reach out through your key Cerity Partners contacts with any questions or concerns.

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