Weekly market wrap

Four Normalizations to Watch: Economy, Jobs, Fed, Markets

Key points:

• Equity markets hit fresh record highs last week on signs that the economy, labor market and central-bank policy are normalizing.
• A gentle economic slowdown is welcome to the extent that it alleviates some upward pressure on inflation. A soft-landing remains our base-case scenario. 
• Fresh data on the labor market suggest that employment conditions remain strong but are gradually loosening under the surface. We see softer hiring ahead but not a major uptick in firings.
• The ECB and BoC kicked off their rate-cutting cycles. While there is no urgency, we think that the Fed won't be far behind in starting to normalize policy as well.
• Unlike last year's very narrow gains, more sectors, asset classes and regions are starting to participate in the upside. We see more balanced portfolio gains ahead.

The onset of summer coincided with signs of a cooling economy and mixed signals in the labor market, best described as a gradual normalization rather than a sudden shift. With the economic expansion continuing, albeit better aligned with easing inflation pressures, and with two major central banks initiating a rate-cutting cycle, interest rates fell and stocks rallied to new highs¹. We think the theme of normalization across economic activity, employment growth, Fed policy and market leadership will gain importance in the second half of the year. Here are four trends to watch:

1) Economic normalization: After a period of robust expansion, growth is leveling off

Based on estimates for population and productivity growth, the U.S. economy's potential growth rate is considered to be around 1.5% - 2% over the medium to long term (without assuming any breakthrough technological advancements). Yet, despite high inflation and the Fed's aggressive tightening campaign, the economy has been able to grow above 2% in the previous six quarters up until the start of this year¹. Excess savings accumulated in the early days of the pandemic, and generous fiscal spending and mortgages with low fixed rates have helped make the economy less sensitive to the sharp rise in interest rates.

However, growing evidence suggests that high borrowing costs are slowly filtering through the economy. Low- and middle-income consumers are beginning to feel the strain and are pushing back against rising prices, as noted in management commentary from several retailers. Unlike 2021 and 2022, wage growth has been outpacing the rate of inflation over the past year, bolstering consumer spending. But with the labor market cooling and the progress on inflation stalling in the first quarter of 2024, real wage growth (adjusted for inflation) has slowed, affecting discretionary spending. Elsewhere, the recovery in housing and manufacturing activity is wobbly as of late, though the outlook for improvement remains. 

Implications: An economic slowdown is welcome to the extent that it alleviates some upward pressure on inflation. But if growth deteriorates sharply and the economy stagnates, the current narrative of "bad news for the economy is good news for the market" will change. In our view, the economic landscape remains supportive and tracking toward the soft-landing scenario where growth slows just enough to control inflation without a slump in activity or a recession. While risks exist on both sides, we consider scenarios of either a "no-landing" (where growth and inflation both accelerate) or a "hard-landing" (leading to a recession) to be less probable this year.

2) Labor-market normalization: Employment conditions are strong but no longer tight

A distinctive feature of this business cycle has been the tight labor market -- on one hand supporting the expansion, but on the other fueling inflation concerns. Last week brought fresh datapoints that suggest that the labor market remains strong but is gradually loosening under the surface.

To begin with, the U.S. economy added 272,000 jobs in May, smashing the estimates for a 180,000 gain. Health care, government, and leisure and hospitality were once again the usual suspects leading the job gains. These three sectors have accounted for almost 80% of all jobs created over the past 12 months. But that is where the good news stopped. The unemployment rate, which is derived from a separate survey, ticked up to 4% from 3.9%, the highest in two-and-a-half years, while the number of people who joined the labor force but couldn’t find a job jumped by the most since August 2021¹.

Taking in all the data, we would still characterize the labor market as healthy, just not as tight as it once was. Back in March of 2022 there were twice as many job openings as the number of unemployed, the most on record. But with job openings declining more than expected in April, the openings-to-unemployed ratio (a key gauge of labor tightness) has now dropped to 1.2 from 1.75 a year ago. This ratio is now back to its pre-pandemic level, as is the rate of people quitting their work voluntarily. A lower quits rate has historically led to lower wage growth, which is why we don't expect the acceleration in wages seen in last week's report to persist¹.

Implications: The labor-market resilience eases worries of stagflation and emboldens the Fed to keep policy unchanged this summer. However, a normalization is underway, and slack is starting to develop. We see softer hiring ahead as companies adjust to slower demand, but we don't see a significant uptick in firings. The silver lining to the cooling labor market is that it should lead to slower wage growth, a key driver of services inflation.

3) Policy normalization: Central banks kick off easing cycle

Last week the Bank of Canada (BoC) became the first among the G7 central banks to ease policy, lowering its interest rate to 4.75% from 5%. A day later, the European Central Bank (ECB) also cut its key rate by a quarter point to 3.75% from 4%. We view these moves as a measured first step in starting a multiyear rate-cutting cycle, but without committing to any particular path. Because growth in both Canada and the eurozone has been sluggish while inflation continues to ease, officials don’t want monetary policy to be more restrictive than it needs to be. The risk is that looser policy could drive higher services inflation in Europe and reignite the housing market in Canada. That's why policymakers in both banks highlighted data-dependence, taking future decisions on a meeting-by-meeting basis.

This week it is the Fed's turn to meet. The bank is widely expected to hold rates steady at 5.5%, the highest since 2001¹. The focus of the meeting will be the new projections and the "dot plot," which are likely to show one or two interest-rate cuts this year, down from three that were projected in March. The message since March has been that rates will stay higher for longer as inflation in the first quarter surprised to the upside and the economy continued to chug along. But as the labor market and economic growth moderate, further progress on inflation will likely follow, providing the Fed cover for its first rate cut possibly in September. 

Implications: Global interest rates have likely hit a peak for this cycle and will gradually move lower as various central banks pivot to rate cuts this year. While there is no urgency, we think that the Fed won't be far behind in starting to normalize policy, which is why short- and long-term bond yields may gradually move lower over the next 12 months. For those investors that have an oversized allocation to CDs and other cash investments, now might be a good time to consider the reinvestment risk (possibility that the principle might not be able to earn the same rate of return when reinvested) and diversify their fixed-income allocation into intermediate- and long-term bonds.

4) Market leadership normalization: AI leads the way, but more stocks participate in the rally 

Last week NVIDIA, the artificial intelligence (AI) industry leader at the moment, briefly joined the $3 trillion dollar club in terms of market capitalization, toppling Apple and becoming the second most valuable company. Just three stocks (Microsoft, Apple and NVIDIA) now account for 20% of the index, and their outsized gains have helped the S&P 500 reach its 26th all-time high this year¹. 

But unlike last year's very narrow gains, more sectors, asset classes and regions are participating in the upside, a positive sign for the longevity of the bull market. Many European indexes are keeping pace with the U.S. stock market, while 10 of the 11 S&P 500 sectors are up year-to-date (real estate is the only sector lower). One can contrast that with the last three months prior to the tech bubble peak in 2000, when seven sectors were lower even as the broader market kept hitting new highs¹. 

Implications: While AI may be poised for rapid growth over the next five to 10 years, we continue to find value in diversification. The benefits of this technology have so far accrued to those companies that enable the development of AI and provide the infrastructure. But the next phase could benefit those companies that apply AI to drive productivity gains. We recommend complementing growth stocks with cyclical and value-style investments.

The bottom line

A gradually normalizing economy and labor market suggest that it won't be too long until interest rates start to slowly normalize as well, which we think will keep the bull market intact and lead to more balanced portfolio gains. After all, a slight cooling in the summer months might not be a bad thing if it doesn't turn into a chill.

Angelo Kourkafas, CFA
Investment Strategist

^{Source: 1. Bloomberg}

Weekly market stats

^{Source: FactSet, 6/7/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Morningstar Direct 6/9/2024.}

The week ahead

Important economic releases this week include CPI inflation data and the FOMC meeting.

Review last week's weekly market update.