Time To Monitor The Labor Market More Closely
Equities staged a late week rally after the dust settled from Wednesday’s dovish leaning Fed meeting and Friday’s weaker than expected jobs report. The S&P 500 gained +0.54% on the week, the Nasdaq Composite rallied +1.43% on the back of better-than-expected results out of Apple, and the small cap Russell 2000 appreciated +1.68%. Chinese equities continued their string of outperformance with the iShares China Large Cap ETF (FXI) ripping +5.64% on the week and this led emerging market equities to a solid +3.15% weekly gain. As for U.S. equities whether one looks at the S&P 500 or Nasdaq Composite – they have not made much upward progress since mid-February. In a nutshell a lot of chopping around with not much directional progress.
It’s still too early to tell if the 22 day -5.5% correction in the S&P 500 is over, but it should be recognized that a fair amount of uncertainty has been removed over the last several weeks, to wit:
Earnings – nearly 85% of the companies that make up the S&P 500 have reported, with roughly 73% of companies beating expectations. All in all, equities remain in a bifurcated world where the large dominate players in their respective industries continue to put up superior results and are just flat out better positioned to navigate the current economic landscape relative to their smaller competitors. What’s more is that when the big guys sense even the slightest bit of competitive threat they go on the offensive and in some cases where they can’t squash the competition with their superiority, they gobble them up. Have a look at the below graphic from Crunchbase on the number of acquisitions made by the MegaCap Tech contingent since the late-90’s.
The Fed: Last week’s FOMC meeting removed some ambiguity on the Fed’s preferred policy path going forward. The Fed acknowledged that “in recent months, there has been a lack of further progress toward the Committee’s 2% inflation objective’, but Powell made it clear that the majority view within the Fed is that they remain unconvinced that the bump in inflation in the opening months of the year is going to be sustained.
During the press conference Powell was firm in pushing back against the litany of questions on the next move being a hike. He discussed scenarios that could cause the Fed to cut or hike, but as the press conference went on it became very clear that the bar for a rate hike is much higher than the bar for a rate cut. Powell was very explicit in stating that he believes the fed funds rate is restrictive at current levels, and while his confidence is not as high as it was at the turn of the year, his base case is that the current setting will be enough to bring inflation back to target. He highlighted the impact higher rates are having on interest-sensitive areas like housing and capital spending, saying specifically that “demand has come down a lot” – not a little, but a lot. He’s not wrong in pointing out that the cost of capital is meaningfully higher in many areas: mortgage rates have been holding in the 6 - 7% range for over 18 months now, home equity lines of credit are reaching double digits, and credit card rates are north of 20%.
Interest rates on new car loans are at their highest level in the past two decades.
Interest rates paid on short-term loans by small businesses are at their highest level since before the GFC.
Powell also said that rate hikes were not on the table for discussion at the meeting, and instead chose to highlight what it would take to ratchet up the current level of restraint:
“I’d say it’s unlikely the next move will be a hike…we’d need to see persuasive evidence our policy stance is not sufficiently restrictive…we’re not seeing that at present.”
Lastly, Powell must have said at least three times that what could drive the Fed to cut rates sooner than current forward guidance would be an “unexpected weakening in the labor market.”. Bottomline, Powell and the Fed are playing for time in the current ‘higher for longer’ regime while erroring on the side of caution in not wanting to get too cute and risk tipping the economy into recession with any further restrictive policy. Investors recognize this and as a result took the weaker than expected jobs report on Friday as a way to express that the “Fed Put” is back (the Nasdaq ripped higher by 2%) – where weaker economic and inflation data provides cover for the Fed to on the margin get incrementally more dovish on its way to eventually easing policy.
Economic data: over the last several weeks we have witnessed a broad slowing in economic data: both the ISM manufacturing and ISM services PMI’s slipped below the 50-breakeven level, Consumer Confidence slipped for the third consecutive month, JOLTS showing signs of a softening labor market, and this was confirmed by Friday’s weakening April nonfarm payroll report. As for the labor market, several metrics that have historically served as leading indicators for job growth (temp employment, NFIB hiring plans, “jobs plentiful” vs. “jobs hard-to-get” from the Conference Board…) are signaling additional weakness is on its way (see chart below). A weakening in the labor market should not be a surprise with the unemployment rate having been below 4% for a record 27 straight months. This foreshadows the potential that a negative inflection point is at hand which will cause investors and policymakers to closely monitor incoming labor market data.
Don’t over extrapolate what I’m saying here (the economy is not falling off a cliff), but the data is showing clear signs that activity and growth have taken a step down from the robust pace it was expanding at in the back half of 2023. This raises two important questions: Does the pace of slowing accelerate? And when/where do we trough? Oh, to know the answers to those questions would be lucrative, but no one knows. However, we do know that with the Citi economic surprise index tipping into negative territory and at its lowest level since February 2023 that it’s time to start looking at the data in a more skeptical manner.
Perhaps the lagged impacts of the most aggressive rate hiking cycle in four decades are more fully filtering their way into the economy. Not to mention the liquidity impact from the Fed’s QT program which has shrunk the size of its balance sheet by nearly $2 trillion from its peak, although the pace of QT runoff is going to moderate come June from $95 billion per month to $60 billion. Additionally, we are hearing from many consumer facing companies (Starbuck’s, McDonald’s, and Yum brands to name a few) that consumers are being squeezed and seeking out less expensive substitutes within their budgets.
Alright Corey, what does this mean for markets and investors? I don’t think it changes much for equities at the moment. As long as the labor market is still registering positive job growth the structural bid from passive flows will provide a steady tailwind of buying activity for stocks. Furthermore, corporate buybacks are ramping back up, election year seasonality is favorable, and investor sentiment has been adequately reset. If/when we see outright job losses the passive tailwind will turn into a headwind which should worry investors, but we’re not there yet. I also think we may have just put in the high in interest rates for the year last Tuesday. If yields are flat to down the rest of the year, then that is a positive for equity valuations, ceteris paribus. Furthermore, there are areas within the capital markets that I think offer better opportunities than others:
I think big-Tech continues to work and that investors need to have exposure to the Mag7 as an equity factor. Additionally, semiconductors have gone through a needed correction and is also a part of the tech space I think warrants exposure.
I continue to like parts of the energy sector namely oil, oil services, and uranium miners, but they are not the layups they were coming into the year with the XLE up +12% and uranium via URNM up +15%
Industrials, robotics, and companies that can provide efficiency solutions in the theme of an American Industrial Renaissance, onshoring, and the realignment of global manufacturing alliances is an investable opportunity with legs. Defense companies also fit this mold as all countries with the means to do so ramp up defense spending.
Emerging Asia is an area we like and allocated capital to in mid-to-late January which has performed well. Chinese equities have rallied more than 20% in the last three months, and this has pulled up other Asian markets. I still like this area, including Japan, and think it works with several tailwinds that can continue to fuel it.
Gold and copper remain my two favorite metals. Both have had very strong moves to the upside since mid-February and I’m not overly excited about chasing them here, but I wouldn’t hesitate to increase the size of our exposure should they experience a deep enough correction that allows us to size up.
Then there is bonds, which I think represent a solid opportunity for parking idle capital on the sidelines while locking in riskless returns with yields near 5% . Corporate credit and high yield don’t look as attractive to me with spreads as tight as they are, but they could see price appreciation if the general level of interest rates comes down. Otherwise, I think buying high quality bonds with a maturity range between 1- 5 years with the part of a portfolio earmarked for capital preservation is a no-brainer today.
In closing, I think we are in a favorable set up for most assets where weak data (but not too weak) will act as a positive catalyst (bad news is good news) for a time as it activates the ‘Fed Put’, but such a set up has a shelf life. Inevitably if it goes on for long enough and deep enough, bad news will be bad news for risk assets. Friday’s price action is a perfect illustration where a subpar employment report was celebrated with interest rates and equities repricing for a less tight monetary policy. I suspect we are in goldilocks environment for the next several months where economic data continues to weaken at the margin, but not too much and the downtrend in inflation reasserts itself starting with the April CPI report on May 15th. Beyond that, who knows, I have my guesses based upon our models, and will invest accordingly. But if/when I’m wrong, I’ll reassess and adjust accordingly.
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