by Alex Harding, CFA
Vice President
Equity Research and Portfolio Management
This week has left many wondering how all the puzzle pieces fit together. On one hand, we have a clear weakening in the labor market, yet the stock market continues to soar to new all-time highs. Toss in some mixed inflation reports and that may leave some questioning if a few of the puzzle pieces are missing from the box.
The August Consumer Price Index (CPI) report, released today, showed that inflation pressures picked up, with the CPI rising 0.4% in August after a modest 0.2% increase in July. Over the past year, prices are now up 2.9%, compared to 2.7% in July, marking the highest annual pace since January. Notably, shelter costs were the largest contributor to August’s price gains, rising 0.4% for the month, implying that tariffs are not driving inflation higher (yet) as many companies have been hesitant to pass through import costs to the end consumer. Energy costs also rose 0.7% in August, led by a 1.9% jump in gasoline prices. The core CPI, which excludes food and energy, increased 0.3% in August and sits at 3.1% year-over-year. Altogether, today’s inflation snapshot suggests persistent cost pressures in key categories leaves inflation uncomfortably above the Fed’s 2% target.
The Fed has a dual mandate: to maintain maximum employment and keep prices stable. Thursday’s weekly unemployment claims report showed a surprise spike to 263,000, 30,000 more claims than last week and the highest reading since October 2021. While the holiday-shortened week may have influenced the data, the recent revisions to U.S. payroll figures and the “low hiring, low firing” strategy employed by many companies right now are evidence the job market is weakening.
As we look ahead to the Federal Reserve meeting next week, the market expects the Fed to switch its focus from inflation to jobs - prioritizing the "maximum employment" side of its mandate. Most experts now see a rate cut as a virtual certainty at the upcoming meeting. The question isn't whether they will cut, but by how much. While a 0.25% cut is widely expected, some are even suggesting a larger 0.50% cut to address the labor market's vulnerability. The Fed's decision will be a crucial signal for the markets and the economy.
Despite the increase in inflation and the weaker jobs picture, the market is telling us to expect a soft landing (no recession) - with stocks reaching new all-time highs and interest rates declining. If the bond market was concerned about persistent inflation, long-term interest rates should be rising. Instead, the yield on the 10-year U.S. Treasury briefly dipped below 4% this week. For stocks, the outperformance of cyclical stocks (consumer discretionary companies) relative to defensive stocks (consumer staple companies) is another sign the market expects a soft landing. If investors anticipated job losses would cause an economic recession, defensive stocks should assume leadership and outperform cyclical stocks. As the chart below depicts, the stock market believes the anticipated interest rate cuts by the Fed (amongst other factors) will breathe life into the more cyclical sectors of the U.S. economy and extend the business cycle.
Takeaways for the Week:
The Fed is expected to lower their benchmark interest rate by 0.25% next week with another 0.50% of cuts expected by the market before the year-end
Cyclical stocks are propelling U.S. stocks higher fueled by the prospect of interest rate cuts
While the job market is clearly weakening, stocks and bonds are telling investors the U.S. economy will weather the storm and achieve a soft landing
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