The Labor Market
Inflation Trend & The First Rate Cut
The first requirement for achieving the mythical “soft landing” was to bring inflation rates down to the Fed’s target of 2%. The most recent data showed that Personal Consumption Expenditures (PCE), the Fed’s preferred inflation measure, is running at 2.2%. This is close enough for the Fed to demonstrate confidence that the downward trend is persistent. The Fed has what is referred to as a “dual mandate”: 1) Price Stability (inflation control), and 2) Supporting the conditions for maximum employment. With price stability on track, the Fed turned its attention to the labor market and instituted a rate cut of ½ of 1% in September.
Why Now?
The casual market observer may have been confused by the Federal Reserve’s decision to cut short-term interest rates by 0.50%. Since the Fed started using short-term interest rates as the main policy tool in the early 1980s, a rate cut this size has only occurred a handful of times. Two such rate reductions came when the economy was already in a recession (1991 and 2001). One came when the economy faced the prospect of the banking system seizing (2007). The last example was the Pandemic (2020). Large rate cuts usually occur when something is going badly wrong.
By most aggregate measures the US economy is humming along nicely. Troublesome inflation has cooled, and the stock market has been setting all-time highs most of the year. Household wealth is the highest it has ever been. Sure, the labor market has softened, with unemployment moving from a low of 3.4% to 4.2%, but that was a requirement to bring down overall inflation. It’s cool comfort to those looking for work, but the rise in unemployment has been mainly due to rapid growth in the labor force, not from layoffs and job cuts. So where is this labor market weakness that caused the Fed to cut interest rates by 0.50% when inflation is still above its goal and there are no signs of market distress?
Inside the Numbers
Well, the first thing to realize is that labor market readings are lagging indicators, meaning that if the Fed waited for unemployment to move to a more concerning level before acting, it could be too late. Historically, once downward unemployment trends start gathering even a little momentum, a recession is close at hand. With short-term interest rates near 15-year highs, the Fed has room to maneuver, to get ahead of a softening labor market without much risk to the inflation trend.
The second, and perhaps more important aspect of preemptive policy shifts from the Fed, is the level of distrust in current labor market data. Fed Chairman Powell even commented on this idea in the September press conference.
The main report on the health of the labor market from the Bureau of Labor Statistics (BLS) is primarily based on surveys of employers and households. As with nearly all statistics since COVID, surveys are increasingly imprecise. This is a significant issue affecting more than just economics. Fewer people participate in surveys, and even when they do respond, the results tend to be colored by political views. We recommend “Partisan Bias, Economic Expectations, and Household Spending” by Atif Mian, Amir Sufi, and Nasim Khoshkhou in The Review of Economics and Statistics, 2023, for an excellent review of this issue.
In addition to the increasing imprecision of surveys, the labor report generally does a poor job finding inflection points in the data. This is largely due to calculation issues. For example, the employer report (also known as the “establishment report”) must adjust for the number of businesses being started or closing in each month. This is known as the “birth/death model” which is currently adding ~110k jobs to the establishment report each month. The model is backward looking and only updated annually. From the revisions to the initial data release that use state level tax filings, we know that the birth/death model is overestimating the number of new jobs created by around 80k per month on average for the past three months.
We’re not highlighting the shortcomings of the Bureau of Labor Statistics to spawn conspiracy theories. The data has always involved a bit of guesswork and patience. The BLS acknowledges that fact. Though more about the need for modernization, a warning cry from two former commissioners of the BLS about bureau underfunding was published in the Wall Street Journal on Friday October 4th. The article is titled: “Can We Still Trust the Unemployment Rate”.
According to the BLS, you can say with 90% confidence that in August of this year anywhere between 7,600 and 276,000 new jobs were created. The headline figure of 142k is just the middle of the range. The final revision to the August 2024 labor market data will be available in February—not this coming February—February 2026, eighteen months after the first report. Like we said, patience is required to know exactly where the data will end up, but action is required by the Fed in real time to prevent a labor market decline from gathering momentum.
Other Measures
Since Fed officials know that BLS data is likely to be revised lower, other measures of labor market health have taken on prominence. Surveys of consumers’ attitudes about their ability to find a job, the number of people quitting, the number of job openings, and wage growth are all examples of secondary datasets that cast light into the labor market. Further, the Federal Reserve produces the Beige Book, a standardized report from each of the Federal Reserve districts that summarizes economic activity on an anecdotal basis.
Labor Market Conclusion
Most, if not all, labor market data shows a recent downshift. By dropping short-term interest rates, the Fed hopes to motivate employers to hire new employees in order to catch the labor market before it falls.
A Change in the Growth Engine
Since the 80s the biggest driver for economic growth has been debt financing, for both consumers and businesses. The housing bubble years were the textbook example of this. Over that timeframe, consumers in aggregate had a negative savings rate and financed their spending with home equity loans and other less savory housing related debt. To put it lightly, this type of growth isn’t ideal as it leads to crisis if left unattended.
Things are different now. Maintaining a healthy labor market is always important for the strength of the economy, but this business cycle has been driven more by wage growth than has been normal for the past fifty years. The demographic shift of Baby Boomers out of the workforce and into retirement has meant that skilled labor is in short supply. Currently, wages are growing by 5%, down from a recent peak but still at the fastest rate in nearly 25 years. The Boeing machinist strike is a good local example of labor’s rediscovered leverage over employers and their ability to earn concessions.
Profit margins for all companies in the US, not just publicly traded, have been at a nearly 70-year high since 2021. Employers can pay higher wages and still invest in their businesses. This is the virtuous cycle of capital investment and a strong labor market that has eluded the US for too long.
Knowing that the Federal Reserve is willing to adjust policy to improve economic conditions well before any problem arises was received well by the equity markets, with the S&P 500 posting its largest one-day gain in years. Investors should be excited. A more proactive Federal Reserve makes equity markets less risky by lowering the odds of a recession.
Market Outlook
Revised GDP data, released in September, showed that the economy was stronger than initially thought in 2022 and 2023. The revised data indicate an increase in the size of the US economy by $354 billion, or about the size of the GDP of the state of Connecticut. With revisions, the US economy is larger and importantly, consumers have more savings than previously thought. This means that the expansion that started in the second quarter of 2020 is among the best since the aftermath of World War II.
When we talk about the economy slowing down, that’s relative to one of the best periods of economic growth in the past eighty years. That said, the economy is slowing down to more sustainable levels. For the reasons listed above, the possibility of a recession in the near term remains low. The valuation of the equity market reflects this opinion.
We’ve discussed different equity valuation tools over the years. It’s time to introduce yet another, affectionately called the “Hopes and Dreams” indicator.
This model comes from Cameron Crise at Bloomberg. Cameron was a hedge fund manager during The Financial Crisis and ran “Macro Man”, one of the few insightful and timely blogs at the time. It was a great resource for those of us trying to understand the market in that difficult period. His metric captures the proportion of the index value not comprised of the net present value of the next three years of corporate earnings plus the book value (assets minus liabilities) of all the companies in the S&P 500. The difference between the model value and the index value represents investor’s hopes and dreams for a better-than-expected future.
Cutting to the chase, the S&P 500 is currently in the 99.7% of observations since 2004. The market has only been more optimistic about the future 0.3% of the time in the past twenty years according to this model. The economic underpinnings for this rosy view are in place and the market has bought this argument hook, line and sinker.
Valuation metrics are terrible timing tools and sometimes offer conflicting results. All we should take away from this observation is that the outlook for the economy is strong, and the equity market is priced accordingly. However, when equities are expected to perform very well, they need to deliver. For example, last quarter AI darling Nvidia reported massive 200% revenue growth over the prior year and the market responded by sending shares 5% lower—the tyranny of high expectations at work.
Consequently, this past quarter we adjusted our investment models for accounts in custody at Charles Schwab & Co. marginally away from richly priced technology stocks to more pedestrian value stocks. This means a little less Nvidia and more Berkshire Hathaway and United Health Group, etc. Sectors outside of technology are showing more attractive earnings trends, analyst sentiment and better relative value metrics for the first time in a few years.
Politics
The fundamentals are there for the equity markets to move higher. Regardless, investor sentiment in the short-term can push the market away from whatever long term “fair value” may be. As human beings, we are subject to emotional reactions, even when we know the situation calls for objectivity. The upcoming election may trigger a bout of market exuberance, or trepidation, or both, to say nothing of the potential emotional impact of two ongoing wars.
As such, we’re likely to experience elevated market volatility in the first week of November. The equity derivative market is pricing a 3% swing (up or down) for November 6th, the day after the election. The market had similar volatility expectations 30 days out from the 2020 election, so this figure isn’t as extreme as one might assume.
Whatever the election result, the market will adjust. Barring some type of extreme, unforeseen outcome, we’d argue that the election is less important to the capital markets than the rhetoric suggests. However, from our client conversations we know firsthand that some are anxious. For those seeking to understand which configuration of White House and Congress tends to produce the best market outcomes, or indeed whether it makes any difference at all, spoiler alert, the party of the President is almost immaterial. Historically, the best market returns have come with a divided congress, with a republican congress a close second.
From Vanguard: Numerous variables influence the political climate in a presidential election year, making it difficult to base market strategy on a single factor. Vanguard research dating to 1860 finds no statistical relationship between the performance of a 60% equity/40% bond portfolio in presidential election and non-election years, as shown in the first chart that follows.
Markets efficiently "price in" current events. It's difficult to predict volatility or blame it on one specific cause, because there are dozens of potential factors. Market reactions reflect changes in economic expectations and efficiently "price in" current events, including elections. (Presidential Elections Matter but Not So Much When It Comes to Your Investments, September 5, 2024)
From Fidelity: Although popular myths sometimes suggest that one party or the other is “better” for market returns, the historical data does not bear out these theories.
“Markets are nonpartisan,” says Gaggar, “so it’s very important not to base your investment strategy on the outcome of elections.”
The S&P 500 has historically averaged positive returns under nearly every partisan combination, as the chart below shows. And in fact, there’s some evidence that divided government has historically correlated with stronger market returns—perhaps because government gridlock creates less policy uncertainty. (Investing in an Election Year, October 3, 2024)
From US Bank: Results of the analysis contradict conventional wisdom that a Republican or Democratic “sweep” of the presidency and Congress is most likely to cause market disruption. In fact, historically there has not been a statistically significant relationship between single-party control of both the White House and Congress and market performance.
Rather, the data uncovered three divided-government outcomes with a statistically significant relationship to market performance.
Two scenarios corresponded to positive absolute returns in excess of long-term average returns:
- Democratic control of the White House and full Republican control of Congress.
- Democratic control of the White House and split party control of the Senate and House.
One scenario corresponded to positive absolute returns modestly below long-term average:
- Republican control of the White House and full Democratic control of Congress.
(How Presidential Elections Affect the Stock Market, September 6, 2024)
As a fiduciary investment advisor firm, PIM’s responsibility is to maintain objectivity and a dispassionate approach to investing and financial planning. This we have always done and will continue to do. For those seeking to express their political views through their investment portfolios, we have some flexibility to accommodate. But we politely suggest that there are more effective ways to have a positive impact than applying restraints to investment policy.
Conclusion
Assuming inflation falls to acceptable levels and remains there, the stability of the equity market, and the economy at large, depends upon a healthy labor market.
In previous soft landings engineered by the Fed, the labor market responded with increased hiring in the months immediately following the first rate cut. This is what we hope to see in the October and November data. If the labor market does not deliver, the Fed may cut rates another 0.50% before the year is out.
Elections certainly have consequences. But the presidential election, one can argue, has less impact on equity markets than congressional elections. Expect some volatility in November but for things to settle down shortly thereafter.
We hope you all had a lovely summer and are looking forward to the approaching holiday season.