Some Investors Expect Rate Cuts Will Save the Day, but Will the Economy Follow the Script?

In some ways, economic cycles are a little like movie genres. They each feature unique and unexpected plot twists but ultimately follow a similar path to conclusion. The genre that probably best fits the post-COVID economy is that of a suspense thriller. Typically, thrillers serve up unexpected twists, a few unlikely turns and a prevailing sense of threat along the way only to be solved when a hero arrives to make everything right again. And so it has been with the post-COVID economy.

The unexpected arrival of COVID brought with it snarled supply chains, unprecedented fiscal and monetary stimulus, a sharp spike in inflation and, eventually, the unlikely resiliency of the job market in the face of slowing growth. At the same time, there has been a prevailing sense of dread that the Fed would hold interest rates too high for too long, which would lead to an eventual recession. But just like the hero in a Hollywood thriller, Federal Reserve Chairman Jerome Powell announced during his speech in Jackson Hole Wyoming last week that help was on the way in the form of rate cuts. While the markets had already priced in a rate cut at the Fed’s September meeting, Powell’s comments offered welcome reassurance and, for many, a sense that the Fed would once again ride to the rescue and save the day.

While we acknowledge that a rate cut in September may improve the odds of a soft landing (the economy’s version of a Hollywood ending), based on economic data, we believe it is still more likely that another twist remains. Powell’s announcement fits with the narrative we’ve been articulating for the past year. We’ve believed that the Fed wouldn’t cut until it saw signs of a weakening labor market and the pace of wage growth showed that it was sustainably closing in on the Fed’s target of 3 to 3.5 percent—a pace it believes is consistent with 2 percent inflation. With the latest Jobs report and other indicators showing both of the Fed’s criteria had been met, it has little choice but to begin cutting rates. Unfortunately, despite what we believe will be a 25-basis-point cut next month, this story may still end in economic contraction. If it does, it wouldn’t be unusual. In fact, the Fed began cutting rates prior to the beginning of each of the past four recessions.

Part of the reason initial rate cuts have had a dismal record in preventing a recession is that the Fed typically starts to lower rates only after signs emerge that the labor market is weakening. Indeed, recent signs of a softening job market—including last week’s significant downward revision of Nonfarm payrolls in the 12-month period ending March 2024—prompted Chairman Powell to note in his Jackson Hole comments, “We do not seek or welcome further cooling in labor market conditions,” adding, “We will do everything we can to support a strong labor market as we make further progress toward price stability." The strength of Powell’s statement is noteworthy and suggests that the Fed is concerned about the recent rise in unemployment gaining momentum. Given that labor data is a lagging indicator, it raises the question of whether the Fed is already too late in drawing its line in the sand of maintaining the current employment picture.

However, the Federal Open Markets Committee may be hamstrung when it comes to how far it can go in supporting the labor market. That’s because, as we detail later, while demand for labor has cooled on the manufacturing side of the economy, the latest S&P Global Composite Purchasing Managers Index shows that service providers continue to have difficulty finding workers. Additionally, while many have suggested that a softening job market would turn down the heat on wage growth, a report out last week from the Federal Reserve Bank of New York suggests that potential hires are still demanding higher wages even as the group as a whole is less confident that they will have a job next year.

Add to all this the fact that businesses are reporting higher input costs (and specifically wages) at a time when they have seen their ability to pass along costs to consumers in the form of higher prices dwindle, and it makes the case for a happy ending less certain. Given current valuations in some areas of the market, anything less than a soft landing could cause elevated volatility and below average returns for some investors. For example, the Shiller Cyclically Adjusted P/E (CAPE) ratio, while down slightly from its recent 2021 high, remains at the third highest level of the last 150 years, behind only 2021, and2000 but above 1929. The CAPE ratio measures valuations adjusted to strip out the temporary impacts of the business cycle. The adjustment allows investors to compare price multiples during various economic backdrops. Elevated valuations were also highlighted in last week’s release of minutes from the latest Federal Reserve Board meeting. According to the minutes, “The staff judged that asset valuation pressures remained elevated, with estimates of risk premiums across key markets low compared with historical standards.”

Elevated valuations against a backdrop of a slowing economy has led to our cautious tone in the near term; however, there are opportunities in the markets for intermediate to long-term focused investors. We believe these asset classes offer what we view as attractive risk–reward profiles whether the Fed is able to pull off the difficult feat of a soft landing or, as we believe is a more likely outcome, the economy eventually sinks under the cumulative weight of the Fed’s previous rate hikes. For example, Small and Mid-Cap equities are trading at low relative valuations yet historically have been beneficiaries of economic growth following a recession. Similarly, while the S&P 500 has posted strong gains this year, the performance has been driven almost exclusively by the handful of tech juggernauts—meaning other stocks in the index are trading at much lower multiples and could benefit should the market broaden (if the Fed is successful in navigating a soft landing) or may hold up better given their relative valuations should the economy dip into a mild recession.

Wall Street wrap

Services shine while manufacturing lags: Of all the reports out last week, the latest S&P Global Composite Purchasing Managers Index report may have most clearly illustrated the challenge the Fed faces in achieving a soft landing. While the report showed that U.S. business activity climbed again in August, the details show just how disjointed the economy is right now. The latest preliminary data, which tracks both the manufacturing and service sectors, shows that the Composite Output Index came in with a reading of 54.1 (levels above 50 signal growth), off modestly from July’s reading of 54.3.

While the headline number suggest solid economic growth, it masks the unevenness of the economy. The Manufacturing Purchasing Managers Index came in at 48, down 1.6 points from July and marking an eight-month low; and the Manufacturing Output index hit a 14-month low of 47.8, down from the prior month’s 50.5. Conversely, the Services Business Activity index rose to 55.2, up from July’s reading of 55 and now at a two-month high. Similarly, new orders for manufacturing declined for a second consecutive month and tumbled at the sharpest pace since December. Meanwhile, the services side of the economy recorded the second strongest uptick since June 2023.

A rise in the cost of inputs was one area that was consistent for both sides of the economy and raises concerns about profit margins going forward. Average input costs for services and manufacturing remained at July’s historically elevated level, tying the four-month high for the reading. Businesses singled out higher staffing costs and raw material prices as the driving force of elevated input costs. Despite the elevated cost increase, prices charged for goods and services rose at the slowest rate since January of this year and, before that, June 2020. The rate of price inflation is now only marginally higher than the average recorded in the decade before COVID. Should this dynamic continue, businesses will face profit margin pressures and may look to cut costs or try to regain pricing power.

The composite employment reading declined, with both services and manufacturing reporting declines in hiring indicating net job losses for the third time in the past five months. However, the stall in hiring in manufacturing resulted from concerns about the business outlook in the sector, while declining employment in services was mostly due to difficulty in finding new workers.

The unevenness illustrated in the report suggests the economy may not be as resilient as many hope. The Chief Business Economist of S&P Global Market Intelligence, Chris Williamson, said in a statement released with the data, “(The) soft landing scenario looks less convincing, however, when you scratch beneath the surface of the headline numbers. Growth has become increasingly dependent on the services sector as manufacturing, which often leads the economic cycle, has fallen into decline. The manufacturing sector’s forward-looking orders-to-inventory ratio has fallen to one of the lowest levels since the global financial crisis. At the same time, services sector growth is constrained by hiring difficulties, which continue to push up pay rates and means overall input cost inflation remains elevated by historical standards.”

Another sign of sticky wage pressures: A release out last week from the Federal Reserve Bank of New York shows that in July the number of employees satisfied with their current level of pay declined by 3.2 percent year over year. At the same time, the lowest amount respondents would be willing to accept for a new job—known as the reservation wage—rose faster than inflation to 3.18 percent on a year-over-year basis. This is consistent with trends seen since the arrival of COVID in 2020. On an inflation-adjusted basis, the reservation wage has risen by 8.2 percent between March 2020 and July of this year. The latest increase comes despite the uptick in the percentage of respondents expecting to be unemployed; it rose to 4.4 percent from July 2023’s level of 3.9 percent, the highest level in data going back to 2014. This is noteworthy because it flies in the face of the economic theory that a softening outlook for employment should alleviate sustained wage pressures.  Existing workers are likely demanding higher wages to change employers or may even choose to opt out of the labor market if wage demands are not met. Similarly, potential workers who are on the sidelines are likely to remain out of the labor market unless wages rise to bring them off the sidelines.

Forward-looking indicators fall again: The Leading Economic Index (LEI) from the Conference Board fell by 0.6 percent in July, the fifth straight month of decline and the 28th of the last 29 months. Over the past six months the LEI has fallen at an annualized pace of 4.2 percent. While the latest six-month annualized reading is slightly better than the −4.4 percent threshold that has historically indicated a coming recession, the latest level still suggests weakness in the coming months. The Conference Board notes that for a fourth straight month the index is no longer signaling a recession. However, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “In July, weakness was widespread among non-financial components. A sharp deterioration in new orders, persistently weak consumer expectations of business conditions, softer building permits and hours worked in manufacturing drove the decline, together with the still-negative yield spread. These data continue to suggest headwinds in economic growth going forward. The Conference Board expects U.S. real GDP (Gross Domestic Product) growth to slow over the next few quarters as consumers and businesses continue cutting spending and investments.”

Payroll numbers revised lower: The Quarterly Census of Employment and Wages from the Bureau of Labor Statistics shows that employment gains for the 12 months ended March 2024 were far lower than originally reported. The report, which includes updated estimates to previous Nonfarm payroll numbers, shows that 818,000 fewer jobs were created during the period. This marks the second largest downward revision in the measure’s history and ranks behind only the revision that took place in 2009. The new estimates peg the total jobs added at just more than 2 million compared to initial estimates of 2.9 million. The new total still suggests a healthy 173,000 new jobs per month; however, we believe that it is more likely that most of the downward revision is concentrated in the past six to eight months, which would mean that job gains in recent months may have dipped to less than 10,000 in some months. If so, this would be more in line with Purchasing Managers Index data we’ve been following and consistent with a variety of other labor market data we’ve been reporting.

Continuing jobless claims move higher: Initial jobless claims were 232,000, up 4,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 236,500, a decrease of 750 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.863 million, up 4,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.865 million, an increase of 4,750 from last week’s revised number and the highest level since November 2021. We view continuing claims as a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data.

The week ahead

Monday: Data on durable goods orders for July will be released to start the day. We’ll be watching for signs of the direction of business spending in light of signs of slowing economic growth.

Tuesday: We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher in the past several months. We will be looking to see if home prices continue to rise despite elevated interest rates, which could lead to higher inflation readings several months from now.

The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges in finding work. We will also be watching to see if perceptions of current economic conditions are softening.

Wednesday: NVDIA will report its earnings. Given that this technology giant represents 7 percent of the market cap of the S&P 500, its report is likely to set the tone for stocks this week.

Thursday: The Bureau of Economic Advisors will release its second estimate of gross domestic product growth for the second quarter. Initial estimates pegged growth at 2.3 percent, above Wall Street expectations. We will be looking for any significant divergence from the initial reading.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have varied from week to week but overall have been trending higher, and we’ll continue to monitor this report for further signs of eroding strength of the employment picture.

Friday: The July Personal Consumption Expenditures Price Index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making interest rate decisions. We’ll be monitoring to see if the latest data shows continued progress in the disinflation process.

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