The “JOLT” Investors Have Been Waiting For

Both stocks and bonds rallied on Tuesday in reaction to some surprising economic data. We learned that job openings across the economy fell to 8.8 million in July, continuing a rapid descent from a high of over 12 million in March of last year and representing the lowest number since March 2021. Job openings for June were also revised lower to 9.2 million from the preliminary estimate of 9.6 million. Based on the July data, there are now 1.5 job openings for every person considered officially “unemployed.” That is down from a high of over 2.0 in early 2022.

Separately, the Conference Board reported that consumer confidence fell to 106.1 in August from a downwardly revised 114.0 last month. The August reading was well below the consensus estimate of 116.0 and reflected a sharp sequential deterioration in consumers’ attitudes with regard to both their present situation and their expectations for the future. Survey respondents also signaled their growing concerns about employment opportunities, which may have been the most surprising aspect of the report. The gap between those who thought jobs were plentiful and those who said jobs were hard to get dropped to its lowest since early- to mid- 2021. And finally, the “Quits” rate fell to 2.3%, which is the lowest rate since January 2021. Generally speaking, fewer people quit their jobs when opportunities to earn higher incomes by switching jobs start to dry up. All this data is consistent with the notion that the labor market is loosening.

The weaker-than-expected labor market data continued yesterday with the release of the ADP Employment Survey for August, which revealed that 177,000 jobs were added during the month, compared to the consensus estimate of 200,000. We also learned from the same survey that annual pay gains for both “Job-Stayers” and “Job-Changers” came in at the lowest level since 2021. Again, what’s good for workers (and prospective workers) is not necessarily what’s good for asset prices. Stocks were up a little more yesterday after a huge day on Tuesday, while bonds held their gains (yields did not reverse Tuesday’s declines).    

The Fed must be heartened by this incoming data, and the market reaction to the data confirms the notion that investors had been far more concerned about entrenched inflation (and the resulting high interest rates) than they are about a potential recession. The rationale goes like this: If the imbalance between the demand for and supply of labor continues to shrink, then workers and prospective workers will lose some of their bargaining power over wages and other benefits. As that bargaining power subsides, upward wage pressures are likely to subside as well. And if wages start to grow at a slower pace, consumers might spend less on goods and services, slowing economic growth, but also further alleviating inflationary pressures. This scenario is the opposite of the so-called “wage/price spiral” that investors and the Fed have been so worried about. We knew that the labor market has been in the Fed’s crosshairs, and so the market reaction to this data is another confirmation that investors believe the Fed is on track in bringing inflation back down through a more balanced labor market.  

Here’s the tricky part. The Fed, acting with imperfect information at best, is hoping to cool the labor market just enough to bring inflation down to its target 2% but not so much as to create the widespread job losses and other negative side effects associated with economic deceleration. At present, the voting members are contemplating a pause in interest-rate hikes so that they may better assess the lagged impact of the 5.25% cumulative increase in the fed funds rate since the rate hikes began. The markets are telling us that there is a very real possibility that the Fed can thread this needle, but is that a realistic expectation? That’s the $27 trillion question (size of the U.S. economy) that nobody knows how to answer. 

Stock prices continue to discount a favorable outcome from this economic experiment. The largest seven U.S. companies are up, on average, 98% year-to-date. The P/E ratio on the S&P 500 has risen from less than 17x a year ago to over 19x today (based on forward earnings). History suggests that the Fed can’t be successful in defeating inflation without thrusting the economy into recession. Equity investors appear to be ignoring this history lesson by piling headlong into the most expensive stocks. If we follow Warren Buffett’s advice and be fearful when everyone else is greedy, now sure seems like a good time to be defensive. As always, we remain fully invested but feel even more comfortable with our diversified portfolios, which include defensive areas such as healthcare and consumer staples.