In This Month's Issue:
Shifting Attention to the Labor Market
Mark Luschini, Chief Investment Strategist
The Kansas City Federal Reserve’s annual confab, held at the foot of the Grand Tetons in Jackson Hole, Wyoming, serves as a gathering for central bankers and other policymakers from around the world to discuss global policies and deliver speeches on working papers. It is often used as a forum for the world’s most important central banker, the Chairman of the U.S. Federal Reserve (the Fed), to deliver remarks on the closing day not to express a definitive position on monetary policy explicitly but rather to signal changes that may be under discussion or pending adoption.
Importantly, this August’s presentation by Fed Chair Jay Powell clearly set the stage for a reduction in interest rates at the upcoming mid-September Federal Open Market Committee (FOMC) meeting. Indeed, his statement that “the time has come for policy to adjust” is as explicit a signal as one could expect from the Fed Chair. Market participants expect this reduction in the rate setting, the first since the last rate hike in July 2023, to likely be followed by several more this year. Much depends on the evolution of the labor market. In his speech, Chair Powell remarked that employment conditions are “no longer a source of inflationary pressures” due to rising unemployment and falling number of job vacancies. However, he added that those at the Fed “do not seek or welcome further cooling in labor market conditions.” In other words, they hope the restrictive monetary setting they have employed has sufficiently reduced inflation toward its target of 2% without inflicting irreparable damage to the job market. In our view, not only will the state of the labor market determine the number and pace of rate cuts that the Fed will embark on, but also whether the widely held view of a soft landing (read: economic growth may slow, but a recession is avoided) is vindicated.
Among the myriad factors to consider when evaluating the health of the labor market, a couple stands out—job openings and labor supply. Job openings rose rapidly through 2021 as employers sought to re-open and hire after the COVID-induced lockdown. After reaching a peak of more than 12 million in early 2022, those unfilled positions have declined but today still exceed those who are unemployed. Indeed, while it has become harder to find available jobs, it has merely reverted to pre-pandemic levels. Furthermore, the latest data from the Bureau of Labor Statistics’ monthly Job Openings and Labor Turnover survey showed a stabilization in the number of openings. Should that continue to be the case, the risk of a surge in unemployment due to the lack of employment opportunities will remain low. The other variable to consider—labor supply—has been the binding constraint to employment growth for the past several years. Said another way, the influx of new workers seeking jobs has not overwhelmed employers looking to hire. If labor demand begins to fall, i.e., job openings drop so that a person losing a job can no longer readily find another, unemployment could rise rapidly. So far, while the unemployment rate has moved higher, it is still near historic lows and not yet so concerning to households—at least that which is being expressed in consumer surveys—that an imminent retrenchment in spending is apparent. To be sure, rising unemployment is a process that could feed on itself as employers assess their prospects when peers are shedding workers, followed by consumers’ concerns about job security bolstering savings accounts to brace for a potential stretch of financial uncertainty. Consequently, one cannot simply assume that labor conditions, while solid today, won’t change somewhat abruptly.
While we are not advocating a “brace for impact” approach to portfolio construction, we are cognizant of the historical record showing that few recessions have been avoided after an extended period of tight monetary policy, even if the Fed begins a campaign of reducing rates. That dubious track record, plus a rotation occurring in the stock market where investment is shifting beyond just the tech and tech-related industries, suggests sectors that possess defensive qualities, including Consumer Staples, Healthcare, Utilities, and Real Estate, warrant increased exposure.
Anatomy of a Rate Cut Cycle
Guy LeBas, Chief Fixed Income Strategist
The Federal Reserve (Fed) will very likely begin cutting interest rates at their FOMC meeting on September 18. Whether Fed officials, led by Chairman Jay Powell, will begin the cycle with a standard 0.25% reduction or a super-sized 0.50% rate cut remains to be seen, though we lean pretty heavily towards the standard option. Either way, the action will mark the first cut since the emergency measures the Fed took amidst the early stages of the pandemic in March 2020. While the coming cuts and the 2020 experience were both rate reductions, that is where the similarity ends. It’s been a while since the last one, but this time around, the U.S. is likely to have a very normal Fed rate-cutting cycle.
In the history of the contemporary Federal Reserve, there have been nine rate-cutting cycles (considering the early-1980s cycle as a single event). On average, the first cut of a cycle comes six to nine months after the last hike, a shorter span than one might intuitively expect. Assuming September 2024 is a done deal, this cycle would be on the longer side, with a 16-month span between July 2023’s final hike and the September FOMC meeting. One reason that periods of peak rates tend to be short is that the Fed is essentially hiking the economy into recession in order to fight inflation. As soon as that recession hits, central bankers are forced to cut quickly to protect jobs and prevent inflation from falling too far. However, the U.S. has proven surprisingly resilient to higher interest rates this time, so policymakers have seen little urgency to reverse aggressive hikes from 2022 and 2023.
As Federal Reserve Vice Chair Philip Jefferson highlighted in a summer speech, each rate cut cycle is more than a little different. Across the nine aforementioned cut cycles, the average total cuts were more than -4.00%. Therefore, from today’s levels, an “average” cycle would mean the Fed continues cutting until overnight rates hit 1.375%. That sort of outcome will not happen, barring a sharp recession, something outside of our current range of economic expectations. In rate cut cycles without a severe recession, the conditional average of cuts is closer to -1.00%. Intuitively, that seems like a better comparison for today’s environment.
There have been a handful of what Fed officials historically termed “mid-cycle corrections” over the last few decades. The most recent was in 2019, also under the stewardship of Fed Chair Powell. After raising rates into a still-fragile financial system, the Powell Fed then took overnight rates down 0.75% over six months. The 2020 pandemic later overshadowed the successful mid-cycle nature of those cuts. Prior to 2019, the Fed executed a successful series of reductions in 1998 - 1999 (the circumstances were slightly different) and prior to that in 1995 - 1996. In many ways, the 1995 experience is the most consistent with today’s, as the Greenspan Fed over-hiked to fight inflation and then reversed course when it was clear inflation was indeed declining.
Chart 1: Cycles Varied Widely in How Far Fed Cut
Mid-cycle corrections are relatively rare, but when they do emerge, they come alongside what financial media have this time around termed a “soft landing.” That phrase is vague, but our interpretation is that it refers to a period of falling inflation and slowing though still-positive economic growth. The path to that constructive outcome is still very narrow, but as the slowing effects of high interest rates fade, the path gradually widens.
Is It the FOMC or FOMO That Matters?
Gregory M. Drahuschak, Market Strategist
For 73 years, September has had the dubious distinction of having the worst average monthly performance, although in election years, the average weakness is not as much as it is normally.
However, an extremely poor market result in September in several years has led to dramatic turnarounds in notoriously volatile Octobers.
Chart 2: The 10 Worst September S&P 500 % Results and Following October
For example, in 1974, the S&P 500 fell 11.93% in September and gained 16.30% in October. A 7.18% drop in September 2011 led to a 10.77% October gain. In 2002, the S&P 500 dropped 11.00% and then gained 8.64% the next month. September 2022 produced a 9.34% loss, followed by a 7.99% October gain.
A September loss, however, is no assurance of a rapid rebound. For example, the S&P 500 in September 2008 fell 9.08%, followed by a 16.94% October loss. The comparatively small 2.42% loss in September 1987 preceded the largest October loss since 1950 of 21.76%.
The Federal Reserve Open Market Committee (FOMC) will be a key issue for the month of September, of course, along with being in the midst of a presidential election campaign. The FOMC was in a comparable situation when it met on September 16, 2020, to decide on its credit policy. Conditions in 2020, which were vastly different than they are now, prompted the FOMC to keep the target range for the federal funds rate at 0 to 25 basis points (0.00% to 0.25%). On September 21, 2016, the FOMC chose to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The September 13, 2012, decision again showed no change as the FOMC kept the target range at 0 to 25 basis points. On September 16, 2008, there was no change in the 2.0% target range.
“No change” has been the FOMC favored phrase in many September FOMC meetings, but this year, the market seems disposed to believe that the Federal Reserve will break with precedent by reducing the federal funds rate. The only disagreement seems to be whether the cut should be 25 or 50 basis points.
The key question for equity investors will be how this might affect stocks. Counter-intuitively, in absolute terms, a month after the first rate cut often sees the S&P 500 move slightly lower, and then it improves three, six, and 12 months later. Historically, the Technology sector has had the worst drop in the month after the first rate cut. Somewhat surprisingly, the Staples sector often has had the best gain a year after the first rate cut. It is important to remember that post-rate cut market movement is highly contingent on whether the rate cut will occur in an overall recessionary environment. The most recent GDP report dispelled concerns about a recession when the recent GDP growth estimate came in at 3.0%, driven by increases in consumer spending, private inventory investment, and nonresidential fixed investment.
Chart 3: Average S&P 500 Election Year Result (1952–2020)
After a nearly vertical move in the first two weeks of August, the S&P 500 was stymied through the second half of the month within less than one percent of its all-time high set on July 16, 2024. Surpassing that level might allow the S&P to move higher quickly until it reaches an extremely overbought condition that likely would blunt the move for a time. Seasonality could become an inhibiting factor as the second half of September is a notoriously weak period. Election jitters are expected in the two months before Election Day, but in the 18 election years from 1972 through 2020, the S&P 500 has posted gains 11 times in September and nine times in October.
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