Signals From the Sidelines
GUEST BLOG / By Craig Fehr, a Principal and Investment Strategist with Edward Jones Co.--After a batch of softer employment figures two weeks ago, data last week offered a still-bright picture of the economy, with productivity and ISM services figures both consistent with ongoing growth.
A steepening of the yield curve and outperformance by cyclical investments in recent months are additional trends that support the case for a broader bull market. We don't think the coast is completely clear, and the combination of employment and inflation trends will govern Fed policy ahead, which in turn will govern near-term market moves.
This week's upcoming consumer price index (CPI) report should confirm that inflation pressure remains on a path of moderation. However, rising oil prices and persistent shelter costs could complicate the falling inflation story, and thus serve as a catalyst for market swings.
There has been plenty of motion to evaluate of late, but if we boil it down, there are two primary factors quarterbacking the financial markets: the labor market and inflation. Essentially, investors are rooting for the former to rise and the latter to fall, however, reality isn't that simple, and these two trends are not mutually exclusive.
Two weeks ago, a batch of employment data indicated the labor market is softening. Rates fell and stocks rose on the premise that this would be helpful for inflation, and thus Fed policy. Last week, markets ran toward the other endzone as incoming reports painted a healthier jobs picture, and the spotlight shifted toward potential implications for inflation ahead, with a fresh read on the CPI due out this week.
In the same way that a quarterback gets the bulk of the credit for both wins and losses, it's appropriate that markets are tightly tethered to employment and inflation developments. That said, here are a few trends playing out that, while getting less fanfare at the moment, offer additional signals about the state of the market:
Rising productivity adds to potential economic resilience
Chart [above] description
--Data out last week showed productivity rose by 3.5% last quarter, the strongest since 2020, and when excluding the distortions from the pandemic, the highest reading since the third quarter of 2017.
--Stronger productivity should provide upward support to GDP, particularly if accompanied by growth in the labor force, which was particularly evident in the most recent jobs report. Expansions in the late-1990s and after the 2008 financial crisis saw rising productivity, which, if replicated ahead, would be a source of sustained GDP growth that could help the economy weather the headwinds of tighter monetary policy.
--To that end, further productivity gains could actually help the Fed insofar as rising productivity can have a dampening impact on inflation, especially in a moderating wage-growth environment, which is currently the case.
--We've been pleasantly surprised by the economy's resilience thus far in 2023. We're not convinced that productivity will fully sustain the growth rate enjoyed last quarter, but further strong productivity gains would, in our view, add additional support to an outlook in which inflation can come down at the same time that the economy enjoys ongoing growth.
The steepening yield curve reflects potential for a soft landing
Chart [above] description
--The worsening inversion of the yield curve (when short-term rates are higher than long-term rates) that took shape through 2022 and the early part of 2023 was driven by aggressive Fed tightening pushing the short end of the yield curve dramatically higher. After the bank crisis offered a reprieve as rates fell, a string of better-than-expected economic readings sent short rates to their 2023 highs this summer.
--More recently, the yield curve has begun to steepen, with short-term rates falling back slightly as the end of Fed rate hikes grows closer, while longer-term yields ticked higher on economic growth prospects. This is notable, as it reflects two components that we believe will be necessary for a sustained bull market: 1) a growing economy that supports rising corporate profits and 2) an end to the Fed's rate-hiking cycle.
--A steepening yield curve does not take the prospects of an economic downturn off the table. In fact, the yield curve bottomed and began to steepen in advance for the 1990, 2001 and 2008 recessions. However, a meaningful steepening of the yield curve is typically associated with the bottoming of a bear market and the beginning of a new bull market for stocks.
--Ultimately, as part of a sustained market expansion, we'll need to see the yield curve un-invert (short-rates drop back below long-rates), which will probably not take shape until the Fed can move closer to rate cuts, something we doubt will become realistic until later in 2024.
Cyclical-sector outperformance signals improving investor sentiment
Chart [above] description
--Cyclical investments turned the corner midyear, starting a phase of outperformance after the fears of the banking crisis began to subside, reflecting greater risk appetite and optimism supported by resilient economic and corporate-profit growth. After an early-August pullback that was accompanied by a rally in the more defensive areas, cyclicals have outperformed again recently.
--The broader stock market (S&P 500) has gained 7% since the start of May, in which the more economically sensitive sectors took the lead. Cyclical leadership offers a good signal that equity-market gains are being powered by a more positive outlook for growth. Admittedly, leadership has been rather narrow for much of this year, as mega-cap technology names have logged extremely sharp gains. Nevertheless, it would be a more worrisome signal if defensives were powering the market, as this would reflect brewing underlying concerns.
--Solid market returns in 2013 and 2016-2017 were underpinned by outperforming cyclicals, so the recent trend potentially offers another hashmark in the optimism column. This doesn't warrant the "all clear." Far from it. We think the economy will show signs of slowing as we finish out 2023, but this is an indication that market fundamentals are not dramatically deteriorating under the surface, with this year's market gains validated by a more favorable cyclical outlook.
Ending mid-September Market Stats