Weak Jobs Data Ignite A Market Sell-Off; Economic Weakness Abounds

In past blogs, we have maintained that 1) there will be at least two rate cuts this year (a total of 50 basis points), and 2) because of the long lags between the time the Fed acts and its impact on the economy, the Fed is now significantly behind the curve. The very weak jobs report on Friday implies a rapidly cooling economy. So, now it appears that we could see as much as 100 basis points of easing before year’s end: 50 basis points in September (market odds nearing 50%), and 25 basis points each at the Fed’s November and December meetings. We say this because, besides the labor market (which is a Fed mandate along with inflation), incoming data continue to show economic weakness. For example, the ISM Manufacturing Index came in below 50 again in June – anything below 50 means “contraction,” and it has been below 50 for 20 of the last 21 months.

To say that Friday’s Nonfarm Payroll number disappointed is an understatement. It came in at +114K. And because of the Birth/Death model (B/D), the Nonfarm Payroll numbers are no longer a reliable indicator of the true state of the employment market. Every month, there are more than 100,000 jobs that appear out of thin air due to that B/D model. This is a long-term trend developed 25 years ago regarding small businesses. Because BLS doesn’t survey small businesses, in the 1990s there was some political push-back on this which resulted in a study that determined that small businesses grow, on average, about 100,000 per month. We think that’s quite high – but every politician is happy when Non-Farm Payrolls grow every month, so there is no pressure for change to something more accurate.

Today’s Payroll number, at +114K, means that, ex-the B/D model, there was really near zero growth. The market, by the way, was expecting +185K. And, as has become habit, there were downward revisions of -29K to the past two months. But no one pays attention to those revisions – that’s yesterday’s news.

The other survey that is taken is called the Household Survey. It is the survey from which the Unemployment Rate (U3) is calculated. It has now risen from 3.4% in April 2023 to 4.3%. There is something in the Economics world called the Sahm Rule. In its simplified form, this rule determined that whenever the three-month moving average of the U3 unemployment rate rises 50 basis points or more above its minimum value in the prior 12 months, a Recession occurs. While the low U3 rate was 3.4% in April ’23, 12 months ago, in July ’23, it was 3.5%. Using the last three months of data, the U3 average is 4.17% (4.1% in May and June and 4.3% in July). This is 67 basis points higher than July 2023’s 3.5% level. Thus, it has triggered the Sahm rule. (Note that even if the U3 unemployment rate had stayed at 4.1% in July, the Sahm rule would still have been triggered.)

In addition to all this, we see that the workweek has shrunk to 34.2 hours from 34.3. Economist David Rosenberg says that in terms of total labor input, the payroll equivalent actually shrank by -350K in July. Additionally, we have been seeing an uptrend both in Initial Unemployment Claims and in Continuing Unemployment Claims.

All in, we have an economic slowdown for sure; with a high probability that a Recession is approaching. And given these employment numbers, we suspect that Q3’s GDP growth will be close to 0%, if not negative.

Equity market reacted poorly to the economic data on Friday with the S&P 500 falling -100 points (-1.8%), the Nasdaq off -418 points (-2.4%), and the DJIA down 611 points (-1.5%). Even the small cap Russell 2000, lately a Wall Street favorite, gave back -77 points (-3.0%). The table shows the performance of those indexes over the past week and year-to-date. While both the S&P 500 and the Nasdaq show double digit returns on a year-to-date basis, they are significantly off their recent highs, as are the DJIA and Russell 2000.

It’s a similar story for the Magnificent 7. As shown in the table above, since their peaks earlier in July, all of the Mag 7 have fallen, with five of the seven registering double-digit declines.

So, why the sudden sell-off? It turns out that, with Friday’s jobs data, markets finally put all of the other weak data, that we have been discussing for the past few months, into proper perspective. Our view is that the equity markets should have been prepared for a poor jobs report from last week JOLTS (Job Openings and Labor Turnover Survey). The JOLTS chart below shows that the Quit Rate and Job Openings are both in steep decline, as is the Hiring Rate. Truth be told, during the week the markets were softening. Friday’s jobs report, however, sealed the deal.

In general, when the employment data tank, it isn’t too long before the consumer tightens the purse strings. In fact, we have already seen rising consumer loan delinquencies, especially in auto and credit card loans. That coupled with wages growing at a slower rate than inflation implies a weak consumer for the foreseeable future.

In addition, comments from retailers in the Q2 reporting period are also telling.

• McDonalds says the lower-end consumer has cut back and reported lower quarterly sales, the first negative quarter since the pandemic;
• Wendy’s, like McDonalds, cut its sales outlook for the rest of the year;
• Like Nestle, Hershey also slashed its near-term outlook;
• Qualcomm, in the IT industry, says it expects revenues to be flat in the coming year.

Inflation

In the Fed’s latest policy statement (Wednesday, July 31^st), there was a significant change. The statement changed from being “highly attentive to inflation risks” to “attentive to the risks of both sides of the dual mandate,” i.e., to both inflation and the labor market. (Note: We suspect that they had some inside information as to what was in the jobs report.) The change in the policy statement means that they finally see what we have seen for the past few months: that inflation is on the wane and the upcoming issue is the economy (i.e., Recession avoidance). Many economic commentators now are in agreement with the position we took several months ago, i.e., the Fed is behind the curve, especially given the lags in the transmission of policy changes to the economy. As a result, markets have now priced in odds of 100% for three rate cuts by year’s end, one at each remaining meeting in 2024 (September, November, and December). In addition, market odds are near 50% that the September Fed meeting will produce a 50 basis point cut.

As we have discussed in past blogs, the Fed’s “neutral” policy rate is 2.75%. Anything above that neutral rate means policy is restrictive. “Neutral,” then, is currently 265 basis points (2.65 percentage points) away. Even if the Fed cuts at 50 basis points per meeting in 2025, they wouldn’t reach “neutral” until their July 30-31 meeting set. And, with the lags in the transmission of policy, it will be late in the year or into 2026 before the Fed’s policy will reach “neutral.” The problem is, given the slowdown in the economy that we already see, they should be approaching “neutral” now, not debating at what meeting the first rate cut will occur. Hence, we see them as way, way behind the curve.

We get the next CPI reading on Wednesday, August 14^th. We are highly confident that disinflation (a lower annual rate of inflation) will continue. We noted the fall in the commodity prices in last week’s blog. This week we note that consumer delinquencies are rapidly rising and that the Federal Housing Finance Agency’s Home Price Index indicates that home prices were flat (rose 0%) in June. The prices of used cars have been the poster child for this inflationary bout. Note, from the chart, what has happened to the price of a used Tesla!

As we have explained in past blogs, the shelter component of the CPI has a 36% weighting in that index. And, as we’ve pointed out, the data on that shelter component in the current index is 12 months old. The chart below shows a close correlation between the CPI’s rent index and the real time market rent index lagged 12 months. The blue line is the CPI rent index. Note that the most likely future path is highly correlated with the red line.

Final Thoughts

With the release of the jobs data on Friday (August 2^nd), markets now find themselves grappling with the very high probability of Recession. As a result, interest rates tumbled on Friday. The 10-Year T-Note yield, for example, fell nearly 18 basis points from just below 4.00% to end the day just shy of 3.80%. In the scheme of things, that is a large move. Markets were clearly surprised by the weakness in jobs. But readers of this blog know that we have been chronicling emerging economic weakness for some time. So, this wasn’t a shock to us.

The equity markets reacted with a large down spike, while, as noted, bonds caught a bid.

Besides the jobs report, other incoming data also have disappointed, especially those who thought the economy was headed for a “soft” or “no” landing. Manufacturing is clearly in Recession, and has been for some time with the ISM Manufacturing PMI showing up once again in contraction (now for 20 of the past 21 months). Other weak data include a significant rise in consumer loan delinquencies and a weakening in the growth rate of wages.

Given the frailty of the economy and an assured descent in the inflation readings through year’s end, markets now believe, with 100% confidence, that the Fed will reduce interest rates at its last three meetings in 2024 (September, November, and December), and there is a growing belief that the Fed will lower 50 basis points (not the usual 25 basis points) in September. Still, because of the long lags in the transmission of monetary policy changes to the economy, we believe that this Fed is significantly behind the curve, just like they were late to the inflation fight in 2022.

Nevertheless, the good news is, after two long years, it appears that the inflation genie is retreating back into the bottle. We expect the CPI to be at or under the Fed’s 2% target rate by year’s end.

(Joshua Barone and Eugene Hoover contributed to this blog.)