Weekly Stock Market Update | Edward Jones

Is the rally running out of breath? Three potential paths ahead

Equity markets have staged an impressive rally since the mid-June lows, aided by weaker commodity prices, easing inflation expectations, and lower bond yields. With last week’s outsized job gains suggesting that the Fed has to stay aggressive in its fight against inflation, additional near-term momentum for this rally might be difficult to achieve, and markets could be entering a choppy phase in the months ahead. Yet, the worst of the valuation declines might be behind us. We see three potential future paths for the U.S. economy and financial markets and offer our take on the blockbuster July jobs report.

Path 1: The recession is old news, the cycle has reset, and a new uptrend is underway

  • Under this scenario the bear market likely ended in June, and the most sensitive to economic growth investments, like small-cap stocks, are ready to assume leadership.
  • Our view:While possible, we don’t think this is a very likely outcome, as risks to growth still skew to the downside. While the economy contracted for two consecutive quarters, conditions are not yet consistent with a broad-based decline in activity, as last week’s data showcased. Without any weakness in the labor market, a rise in defaults, or a decline in corporate profits, it is hard to argue that the business cycle has reset and that a new expansion is underway. The Fed is still a ways away from concluding its tightening campaign.

Path 2: A “softish” landing is achieved, with the economy narrowly avoiding an official contraction; the cycle continues to mature

  • Under this scenario the current growth scare proves to be a midcycle slowdown and not something worse. The gradual easing of inflation pressures does not require the Fed to overtighten, with officials pausing rate hikes early next year. Growth remains weak, inflation slowly rolls over, volatility stays high, and markets are rangebound in the coming months. This backdrop favors balanced positioning across cyclical and defensive asset classes.
  • Our view: The Fed does not have a great track record of tightening just enough to slow inflation without pushing the economy into a recession. However, the broad decline in commodity prices in recent months provides some relief. And the Fed’s outsized rate hikes early on suggest that borrowing costs don’t have to rise much more from here. We think this scenario is reasonable, and if it materializes, it would mean that the market’s low is already in and that the expectations for an early 2023 pause will be validated.

Path 3: The economy is heading toward a mild 2023 recession as Fed tightening continues to bite

  • Broad inflation pressures suggest that the Fed has more work to do in its inflation fight, while the entire effect of the existing rate hikes has not yet been fully felt in the economy. Restrictive policy drives the unemployment rate higher and corporate earnings lower, in which case the midsummer gains prove to be a bear-market rally, with major indexes heading lower.
  • Our view:At this time, we think a mild recession is about equally as likely as the chance for a soft landing. The signal from the yield-curve inversion and weakness in some leading economic indicators should not be dismissed. However, the strength in consumer finances and the strong momentum in the labor market provide a cushion against a sharp downturn, with unemployment rising only modestly and equity markets not matching the declines seen in past deep recessions.

The job market is heating up instead of cooling – not what the Fed wants to see

The U.S. economy added an impressive 528,000 jobs last month, more than double what was expected, while the unemployment rate declined to 3.5%, matching the pre-pandemic low, which was the lowest since 19691. The job gains were broad-based across different industries, defying expectations for a slowdown in job creation. Meanwhile, wage growth rose more than expected, up 0.5% from the prior month and 5.2% over the past year, suggesting that wage pressure will keep services inflation elevated in the near term1. And the labor-force participation rate (the number of people in the job market either working or looking for work) declined, adding more evidence that the imbalance between the demand and supply of labor is not improving, as Fed officials have been hoping for.

While the strength in the labor market is good news for the economy, it is bad news for the Fed, as it implies that more rate hikes are needed to cool the still-tight labor market and ease inflation. In reaction to the employment data, equity markets declined and bond yields rose, as expectations for Fed policy recalibrated higher. The bond market now expects another outsized rate hike of 0.75% in September, instead of the 0.5% hike that was priced in before, with a peak fed funds rate of 3.6% in March 20231. Because part of the midsummer rally was based on the expectation of a policy pivot, with the Fed letting off the brakes, last week’s data could disrupt the recent market calm. Further gains could be more difficult to achieve, as it may take time for inflation to come down and the Fed to signal the pause. However, between now and the September meeting, Fed officials will have another employment report and two more inflation readings to look at before tweaking their projections for the path of rate hikes. And the uptrend in jobless claims, along with the recent downtick in job openings, suggests that the exceptional strength on the jobs front will be hard to maintain.

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