Investors are freaking out that the Fed is too late to save the economy
Stocks had a pretty bad day after the unemployment rate unexpectedly jumped in July.
The US consumer is the engine of the domestic – and the global – economy. The US consumer needs jobs and income growth to spend money and propel corporate profits and the stock market higher.
Right now, the outlook for that to continue is being called into question. The S&P 500 closed down 1.8% on Friday after the July US non-farm payrolls report showed that fewer than anticipated jobs were added as the unemployment rate unexpectedly jumped to 4.3%, continuing the trend of underwhelming labor market data.
For now, investors are no longer embracing the idea that data showing cooling activity means that the Federal Reserve will step in to put a floor under growth and the labor market. That’s poised to upend some dominant market narratives and relationships between asset classes.
“The playbook on how to trade stocks around economic data prints that we have been using for most of 2024 has officially flipped as we head into the jobs print,” wrote John Flood, managing director at Goldman Sachs in a note to clients on Thursday morning. “We are no longer in a bad data is good for stocks environment.”
Flood’s words proved prescient within hours, if not minutes. First, US initial jobless claims rose much more than anticipated. Then, the ISM Manufacturing purchasing managers’ index (which surveys factor execs on conditions in the sector) had an awful print. The production and employment sub-indexes posted their worst readings since 2020 – and if we strip out the pandemic period, the employment numbers were the worst since the 2009 financial crisis.
The S&P 500, initially buoyed by positive earnings, turned from up 0.8% to finish down 1.4% in their most volatile session of the year to date.
It’s a similar story on Friday. The S&P exchange-traded funds that track the consumer discretionary, tech, financials, energy, and industrials sectors all fell more than 2%.
Heading into the jobs data, traders priced about a 33% odds of a 50 basis point cut at its September meeting. This Wednesday, the Fed Chair Jerome Powell said a cut that large to kick off the easing cycle was “not something we're thinking about right now.” The odds of that broke above 80% in the minutes following the July jobs report.
The silver lining amid the stock damage is that at least US government bonds are rallying as traders price in more Fed cuts. This likely marks an end to the positive stock-bond correlation that’s persisted for most of the two years.
Why have we reached a limit on how much lower rates can be viewed as a positive for the stock market? Because the bond market has already priced in a lot of interest rate cuts from the Fed – more than 100 basis points through year-end and nearly 175 basis points over the next 12 months.
For the Fed to cut rates more than traders currently expect, we’d likely need to see more ugly macroeconomic data, and the kind of damage to the labor market that would get investors even more worried about the outlook for consumer spending and corporate profits. Over the past 50 years, there’s only been one instance of the Fed cutting rates by 150 basis points or more in a year that wasn’t associated with a recession (the mid-80s).
Both the Citi Economic Data Change Index, which measures data versus its one-year average, and the Citi Economic Surprise Index, which tracks how data evolve relative to analysts’ forecasts, are still in negative territory. Neither seems to be decisively trending higher, which may be a prerequisite for more durable breadth in the equity market.
A separate economic surprise index produced by Bloomberg is also in negative territory, with the labor market subindex at its lowest level since August 2021.
There’s another key ramifications of a return to a more traditional “risk-on, risk-off” regime, according to Dean Curnutt, founder of Macro Risk Advisors. That is, an environment in which stocks go up and bonds go down on good economic news, and vice versa on poor data.
And it’s that correlations between stocks should pick up, because a common driver for all companies – Americans having jobs and being able to spend more and more money – is now in focus for all the wrong reasons.
“Every stock in the S&P is related to the economy,” he said. “If the economy is truly slowing, that’s going to slow corporate profits and it’s really hard to emerge from that unscathed, as a stock.”
Over the past month, the realized correlations between the biggest stocks in the market have exceeded what investors bet they’d be a month ago. The so-called “dispersion trade” – a strong winner since the COVID-induced bear market ended in 2020 – is looking much more precarious.
Correlations and overall volatility for major stock market benchmarks are closely related. In other words, prepare for the big swings between pockets of the market and individual stocks that defined the first half of the year to begin to creep into the overall stock market, and show up as large daily changes in the S&P 500.
To that end, 5 of the S&P 500’s 10 largest moves this year have come in the past 13 sessions. And four of those days have been losses.
Updated with closing prices on Friday.
