What Some Investors May Be Missing Under the Surface of the Economic Narrative

Over the past year, economic sentiment has bounced between inflation fears and recession worries. For example, in the fourth quarter of 2023, several favorable inflation reports led to confidence that price pressures were easing. In response to the data, the Fed struck an optimistic tone that rate cuts were on the near-term horizon. Investors embraced the Fed’s new tone and at the beginning of the year quickly priced in six to seven rate cuts during 2024. Stocks catapulted higher as economic data—and the labor market in particular—showed resilience. The result was a broad equity market rally that sent all segments and sectors of stocks higher. Unfortunately, much as we forecasted, the inflation optimism proved premature as price pressures reignited during the first quarter. Investors reacted by lowering their expectations for the number of rate cuts as well as the timing of the cuts.   

With the inflation boogeyman back on the prowl in the second quarter, the Fed took a firmer tone that interest rates were set to remain higher for longer. Ironically, as this narrative was taking hold early in the third quarter of this year, inflation began showing signs of cooling, with growing signs the labor market was weakening. As price pressures eased, the Federal Open Markets Committee (FOMC) finally delivered the long-awaited rate cut. The size of the cut—50 basis points—was larger than many had anticipated. The move came as members of the FOMC once again shifted its infamous dot plot of expectations to show another half-point in rate cuts coming by the end of this year. Against this backdrop investors cheered, as they took the Fed’s move as a sign that the oft-discussed soft landing was indeed materializing.   

The economy and markets are connected

The above review highlights just how quickly economic data has moved in this odd post-COVID cycle. And, more importantly, we believe these rapid-fire changes have driven market performance over the past year. For example, after markets faltered in the third quarter of 2023, the mere expectation of rate cuts helped them quickly reverse course, with equities broadly moving higher as the year drew to a close. As the narrative of rate cuts lost steam during the first quarter of this year, investors began to narrow their focus to areas of the market they believed were less economically and interest rate sensitive. This group of stocks continued to gain as expectations of the timing of a rate cut were pushed further into the future.

Indeed, as we noted in our second-quarter commentary, a final reading showed a historically low 28 percent of companies actually beat the S&P 500 Large Cap index during the quarter. The rally was driven by the largest companies dubbed “the Magnificent 7,” which were up collectively by 17 percent. Meanwhile, the other 493 companies in the index were actually down 1.02 percent. Looking at this through a slightly different lens, these seven companies pushed the S&P 500 up 4.28 percent, while an equal-weighted version (i.e., each of the companies weighed the same) fell 2.63 percent. This theme continued in other segments of equity markets as U.S. Mid-Cap and Small Cap indices actually fell 3.45 percent and 3.11 percent, respectively. 

But the pattern shifted in the third quarter as inflation began faltering and expectations for rate cuts and a soft landing grew. Equity markets broadened, and 66 percent of companies outperformed the index. Once again, the surge in broad optimism was driven by rate cut expectations, which led to falling interest rates in the bond market. This trend reversal gained steam following the release of the June Consumer Price Index report in mid-July, which showed inflation pressures dwindling. Also likely adding fuel to the fire was the June jobs report, which showed unemployment reaching a level just shy of triggering the so-called Sahm rule. The rule has gained focus this year due to its accuracy in “forecasting” all prior recessions since at least 1940. Federal Reserve Chairman Jerome Powell further fanned the market rally in late August when he announced at the Kansas City Federal Reserve’s annual Jackson Hole Symposium that the time had come to cut rates. The Fed then followed through with a larger than expected half-point rate cut, and Powell expressed optimism that a soft landing, despite growing signs of labor market weakness, was still a real probability.

Much as they did in the fourth quarter of 2023, a broad swath of equites embraced the soft-landing narrative, and the major indices moved higher. The S&P 500 market-capitalization-weighted index of U.S. Large Cap stocks finished the quarter up a strong 5.89 percent. But this time performance was driven by the “other 493” names outside the so-called “Magnificent 7.” The broad list of stocks rose 8.02 percent versus the Magnificent 7’s return of 1.69 percent. Similarly, U.S. Mid-Cap and Small Cap stocks provided outperformance as they rose 6.94 percent and 10.11 percent, respectively. International Developed and Emerging Market equities also rose 7.35 percent and 8.82 percent, respectively. Finally, the Barclays Aggregate of U.S. Investment Grade Fixed Income rode lower interest rates to a 5.2 percent return (bond yields and prices move inversely). Longer-term Treasurys as represented by the ICE 20-year Treasury Index rose by 7.97 percent. Importantly, fixed income and Treasurys performed well in mid-July, when market volatility spiked as the Japanese carry trade unwound. Simply put, it was a good quarter for diversification, which we believe wins in the long term.

A consistent belief in a churning world  

Despite the rapidly shifting economic landscape, investors appear to be committed to the belief that a soft landing is the most likely outcome. The soft-landing narrative gained traction during the most recent quarter thanks to rate cuts. However, the size of the cut may actually suggest more caution is warranted. 

We’re focused on the employment picture because the labor market has historically been the breaking point before the U.S. economy tips into a recession.

While many focused on easing inflationary pressures during the quarter as the reason the Fed had room to cut rates, we believe the decision on timing and size of the cut was primarily driven by growing signs that the labor market is weakening, including recent revisions to earlier data that show the job numbers are not as strong as originally believed. At the September post-meeting news conference Powell expressed confidence that strength in the labor market can be maintained, noting, “We will do everything we can to support a strong labor market as we make further progress toward price stability.” However, we believe evidence of underlying concerns by the Fed can be found elsewhere.  

1. At Jackson Hole, where Powell announced that it was time to initiate rate cuts, the biggest line in his speech was this: “We do not seek or welcome any further deterioration in the labor market.” This was the Fed drawing the line in the sand as to why it was cutting rates.  

2. Powell also noted that if the Fed knew the July employment report in advance, they might have cut rates at their July 31 meeting (it came out two days after). This was when the Sahm rule was broken, which is a measure that was designed to gauge when cutting may be too late because the labor market weakness is moving from gradual to non-linear (or trending). This is the point at which enough people become unemployed that it impacts future economic growth. 

3. Powell also mentioned the Quarterly Census of Employment and Wages revision to Nonfarm payrolls that the Fed was previously pointing to as evidence that the labor market was strong. That 818,000 downward revision brought the accuracy of that report into question.  

4. Powell also noted that Nonfarm private payrolls were trending lower. In June and August, they were below 100,000, which is within the margin of error of the first estimates and, given other factors, may be moving closer to 0. And the breadth here is weakening, with the diffusion index of industries reporting growth hitting 49.2 percent in July and a closer look showing that cyclical industries are contracting.  

Other labor market indicators also continued to weaken during the quarter, with the Conference Board’s labor differential remaining on its downward trajectory this year from 31.30 in January to now 12.6 to close the quarter. This dataset historically has a strong inverse correlation to the unemployment rate and points to rising unemployment in the future. Likewise, the employment index component of the Institute for Supply Management’s Purchasing Managers Index for manufacturing spent the entire quarter in contraction (below 50) and included two readings of 43, which were historically low. The employment reading for ISM’s Services side of the economy also ended the quarter at a contractionary level.  

We’re focused on the employment picture because the labor market has historically been the breaking point before the U.S. economy tips into a recession. This bumps up against an overall economy that has appeared resilient with solid GDP growth that looks like it will continue when the third-quarter estimate is announced. However, the labor market typically doesn’t show signs of strain until late in an economic cycle and is usually the last leg of the stool to give way before the economy falters. We believe this is why the Fed acted and what is behind the size of the cut. Unfortunately, if history is any guide, the recent Fed action may not be enough. 

As we’ve noted in past commentaries, the Fed has actually cut rates prior to the beginning of the past four recessions. The reason preemptive cuts have a poor record of preventing economic contractions is that the Fed typically waits for signs that the labor market is weakening, but by the time the signs appear, it is usually too late. This time the Fed had to wait even longer to cut because inflation was elevated. And while it decreased, we don’t believe that inflation embers are fully extinguished. Wage growth remains above the 3 to 3.5 percent level that the Fed believes is consistent with inflation sustainably growing at 2 percent. The stubbornness of the pace of wage growth is likely because, despite the labor market weakening, unemployment remains low.  

Historically speaking, once the labor market starts to lose strength, at some point the weakness gains momentum, and the decline goes from gradual to rapid. In essence, this is what the Sahm rule attempts to gauge. It’s a momentum measure. Although the rule was triggered in July, investors shrugged it off much as they have with other data that has suggested caution is warranted. Additionally, there is some debate whether the rise in unemployment is being caused by immigration, which has resulted in the pool of workers growing faster than the economy can absorb them. 

As if the employment and economic pictures weren’t muddled enough already, the September jobs report, released shortly after the end of the third quarter, threw investors another wrinkle. Instead of showing more weakness, the data came in surprisingly strong. Indeed, wage growth—which we have often called the Fed’s final frontier—rose back to 4 percent, well above the Fed’s 3 to 3.5 percent range. This has reintroduced the question of whether inflation is actually dead. 

Think about this in the context the Fed has continually framed the difficult decision on when to cut rates: If it cuts too early or by too much, it risks reigniting inflation; cutting too little or too late risks resulting in a recession. This explains the delicate balancing act the Fed is navigating as it tries to thread the needle on returning the economy nearer to economic equilibrium.   

Unwavering investor optimism in the face of risk  

While consumers have expressed concerns regarding the economy and their financial situations, they remain incredibly optimistic about the equity markets, even as the labor market has shown signs of weakening.   We remain optimistic about the U.S. economy and financial markets over the long term but are fearful some are likely tempted to lean in further than they should given their financial plans.  

Historically, heightened levels of optimism about the stock market have been a contrarian indicator, and during the third quarter investor optimism grew. The American Association of Individual Investors (AAII) sentiment survey saw four readings with more than 50 percent of respondents saying they have a bullish outlook on stocks in the next six months. Overall, average one-year returns when bullish readings are at current levels are positive but weaker than long-term average returns. Similarly, despite increasing overall concerns about the labor market and current economic conditions, a near-record percentage of respondents to the Conference Board’s Consumer Confidence survey indicated they expect stock prices to increase. The Conference Board survey showed 50.6 percent of respondents held an optimistic take on the market in July. That reading was eclipsed only by a 51 in January of 2018, which was followed by a period of equity market weakness. Other than a few months this year, the next highest reading for this measure was in January 2000, which also preceded a period of weak performance for stocks. While we are not suggesting that the optimism captured in the AAII and Conference Board data is a sure indicator of future market weakness, it does reinforce our nearer-term concerns that some segments of equity markets have been swept up in the optimism and that elevated valuations for these groups could be a headwind to future performance. 

A bifurcated economy in search of balance 

The U.S. economy has become highly bifurcated as elevated interest rates have had widely varying impacts on different segments and industries. Low- and middle-income consumers continue to struggle as floating-rate debt (such as credit cards and auto loans) remains elevated. Contrast that with higher-income consumers, who often have fixed-rate mortgages with houses that have appreciated in value even as rates have increased. These individuals often have savings accounts that have benefited from increased rates, while equity markets have also pushed to all-time highs. The appreciation in home prices despite higher interest rates has caused limited supply in the marketplace and has resulted in housing prices compared to median household incomes moving to all-time highs. Housing remains unaffordable for many, which may create upward pressure on rents. Large companies are getting larger, while smaller companies that rely on floating-rate debt are struggling. Manufacturing has been in a slow environment for much of the recent past, while the services side has remained relatively robust. With the unemployment rate still low, it is unclear where future workers will come from to meet demand. Absent a steady influx of available workers, wages will likely continue to rise, which could lead to an inflationary price spiral. 

A divided economy has led to a market of haves and have nots  

Returning to our opening narrative on the churning beneath the surface, while crosscurrents have been masked by the performance of a handful of mega-cap technology names, today’s landscape also offers its own set of opportunities. Investor optimism has been focused on the largest companies, which has resulted in them dramatically outperforming the rest of the market over the past couple of years. The good news remains that other parts of the market have largely been overlooked and continue to trade at more attractive valuations.  

On the other hand, if there is a recession, it is likely to mark the end of the remaining inflationary pressures.

The more reasonable multiples some areas of the market are trading at offer intermediate- to long-term opportunities whether the Fed achieves its goal of a soft landing or not. These pockets are where we are focused. If there is a soft landing, we believe it will likely be because inflation has been snuffed out and the Fed will be free to lower interest rates. If that is the case, we expect economic growth to broaden and market participation to spread to include previously underappreciated stocks, including sectors that are sensitive to economic growth and interest rates. On the other hand, if there is a recession, it is likely to mark the end of the remaining inflationary pressures. And we continue to believe that any recession would be mild, as the Fed would be able to swoop in and cut rates. If we have a recession and the Fed cuts rates as a result, investors will begin to think about the other side, where the economy becomes a tailwind rather than a headwind and economically sensitive businesses are positioned to thrive.   

Certainly, there are other potential paths given the size and complexity of the U.S. economy. It’s possible that interest rates will remain high and the U.S. economy will continue to have enough momentum to push forward. While this could persist for some time, it is highly unlikely to lead to perpetual growth. 

The case for tuning out emotion 

While markets as a whole have pushed higher over the past year, as we showed in the opening of this commentary, the overall move masks the relative churning under the surface. As such, we continue to urge investors to stay true to their financial plans, to remain diversified and be ready for whatever comes next. Your financial plan and the diversified asset allocation contained within it is built to account for the reality that recessions occur and stock markets do falter for periods of time. Optimism is an admirable trait in everyday life as well as the investing world and often is rewarded.   

However, caution, prudence and a little humility are also worthy traits. Financially, you can deploy these by adhering to a disciplined process as part of a financial plan—particularly in periods when fear and greed can become emotional barriers.  

Just as emotion appears to have played an outsized role in the markets during the third quarter, we are fast approaching another source of strong feelings—the election. We believe the statements we’ve made here hold true no matter who wins. Voting is essential to democracy, and we encourage you to cast your ballot in the voting booth, not with your portfolio. 

There are always relative winners in an economy. However, there are large divergences that have developed that have to sort themselves out before the economy can return to equilibrium. Could this occur without a recession? Perhaps. Anything is possible, particularly in today’s environment. However, we believe that either way, volatility lies ahead as the economy grapples to reach some sort of balance.   

Against this backdrop, we believe the best course is to stay true to your plan and the process; stay true to diversification and a long-term focus. Doing so should result in the coming months registering as little more than a blip on your long-term path to gaining or keeping financial security.  

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here. 

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