A Weaker Economy Is Good Until It Is Not

It was another top-heavy market on a shortened trading session before the 4th of July holiday, with technology leading the way, as Nvidia (NVDA) and Broadcom (AVGO) both rallied more than 4% on news that Nancy Pelosi disclosed purchases in both names in her most recent filing. She has a large following of investors who closely watch what have been prescient stock-picking moves in the past. Given the outsized weighting of both names, the S&P 500 and Nasdaq Composite rose to new all-time highs again.

I asserted at the beginning of this week that investors would shift their focus from inflation to a slowing rate of economic growth, which could increase market volatility and instigate a pullback in the major market indexes to refresh the uptrend. That hasn’t happened yet. Instead, investors appear to be welcoming a string of weaker-than-expected economic reports on the basis that it increases the likelihood that the Fed will start reducing rates sooner rather than later. I am happy to be wrong on that count, but I still think the stock market needs to consolidate recent gains, and I think investors need to be mindful of how weak the economy could become before the Fed begins its rate-cut cycle. While weekly unemployment claims have held steady around 238,000, the number of continuing claims has broken out to the upside at 1.86 million, which is the most since November 2021. This means the unemployed are having more difficulty finding jobs.

According to ADP, the private sector added 150,000 jobs last month, which is the smallest increase in five months. That is not a bad number, but most of them (63%) were in the leisure and hospitality sector at hotels, bars, and restaurants. The good news is that wages grew 4.9% over the past year, which is the smallest increase in three years and a focal point of Chairman Powell’s. We need wage growth to slow to further the disinflation that is bringing us closer to the Fed’s inflation target of 2%. Clearly, the labor market is showing multiple signs of softening, which is when landing the economy softly becomes very difficult. The Fed needs to start becoming less restrictive as it sees these early signs of weakness.

A more troubling sign of weakness came from the Institute for Supply Management’s survey of purchasing managers in the service sector, knows as known as the ISM Non-Manufacturing Purchasing Manager’s Index (PMI). It fell five points in June to 48.8, which is the lowest level in four years, moving it back into contractionary territory for the second time in the past three months. It was led by sharp drops in production and new orders.

This would be extremely concerning if not for the fact that S&P Global’s similar survey resulted in its Services PMI rising to 55.3, which indicates the sharpest rate of expansion since April 2022. As I pointed out with their manufacturing surveys, these two research firms survey different companies in a variety of sub-industry groups. Therefore, we must look at both in aggregate to get the best idea of what direction the service sector is headed.

Chairman Powell and several other Fed officials have been making public comments to the effect that they can wait for additional confirmation that disinflation is well entrenched because the economy is so strong. I think they will be changing their tune at the next Fed meeting on July 30-31 because the rate of economic growth will have likely weakened demonstrably be then. In fact, we may see the possibility of a July rate cut increase significantly from what is just 8% today, according to CME Fed Fund futures.

The labor market continues to soften, and we are now seeing early signs of consumer fatigue in the ISM survey. This is more of a runny nose than a full-blown cold for the US economy, but it is a leading indicator telling the Fed that the rate of economic growth is slowing meaningfully, and the rate of inflation will follow. Once economic activity starts to rollover, it typically doesn’t reverse course. That is why disinflation should continue. Additionally, there is not a lot of runway left for the Fed’s preferred inflation gauge to fall from 2.6% to 2%. While the softer economic data is welcomed now in the context of disinflation, the Fed needs to lead it with less restrictive monetary policy no later than September.