A Potential Recession, But More Aggressive Fed?

The stock market may remain sensitive to evidence of a potential recession this week, after the Mfg ISM and Employment Reports surprised on the weak side.  There are few data releases this week, but a counter-consensus decline in the July Non-Mfg ISM could hurt the market.  The market may stay under stress until the Fed gives a clear signal that it will ease aggressively.  Fed Chair Powell will have such opportunity at the Jackson Hole Conference on August 24-26.  He could open the door for multiple or large rate cuts ahead.

The July Employment Report raised the risk of recession, but did not mean one is at hand.  In either case, the Report contained a number of elements that could encourage the Fed to ease more often than just in September or start with a 50 BP rather than 25 BP cut without fear of stoking inflation.  Whether the Fed chooses to begin with a 50 BP rate cut could depend on what prints in the August Employment Report, due September 6.  It's too soon to estimate, but a speedup is conceivable to the extent bad weather temporarily hurt job growth in July.

Although the market viewed the below-consensus +114k m/m increase in July Payrolls to be particularly weak, the truth is it is consistent with trend labor force growth based on a steady Participation Rate.  The Fed is probably happy with this pace of job growth, seeing it not recessionary but sustainable in the long run.

Indeed, the composition of the m/m change in Nonfarm Payrolls raises the possibility that weak demand was not the main reason for the modest overall increase.  Most of the weakness was outside of cyclical sectors -- instead, in service-producing sectors, such as professional and business services (particularly accounting and administrative), finance and insurance, and private education.  Cost cutting and maybe the substitution of AI for workers may have been behind the job cuts.  If so, productivity (and earnings) will likely improve.

A decline in Total Hours Worked (THW), thanks to a lower Nonfarm Workweek (possibly weather related), suggests Real GDP Growth should be under the long-term trend 2.0% in Q324.  THW in July are 0.5% (annualized) below the Q224 average.  Even if THW don't bounce back in August and September, productivity growth could keep GDP Growth positive.  So, the data don't necessarily mean a recession is imminent.

The 0.2% pt jump in the Unemployment Rate to 4.3% is consistent with sub-trend economic growth if not recession.  The jump, however, largely resulted from an increase in the Labor Force Participation Rate.  The Participation Rate rose in both June and July after dropping in May, and the July level is back to that seen in the Spring.  The 3-month swing could be just volatility, but the recovery in the Participation Rate should assuage any concern Fed officials might have had about the potential growth of the economy.  And, the higher level of the Unemployment Rate means the Fed has less to fear of stoking inflation by stimulating the economy.

The below-trend 0.2% m/m increase in Average Hourly Earnings supports Powell's comment, made at the post-FOMC Meeting news conference, that the labor market is not a significant source of inflation pressures.   Eight of thirteen sectors posted sub-0.3% increases, 0.3% being the recent trend.  The low pace needs to be seen in coming months, as well, to conclude that trend in wage inflation has ratcheted down.

Consensus looks for a rebound in the Non-Mfg ISM to 51.0 in July from 48.8 in June.  Perhaps, consensus is based on the idea that the survey would catch up to the bounce-back in Retail Sales in June.  In contrast, bad weather could depress it.  Also, the decline in the July Mfg ISM suggests downside risk.  However, the m/m correlation between the Non-Mfg ISM and Mfg ISM is not solid.  From the most recent experience, both moved in the same direction in 5 of 6 months in H124, suggesting a counter-consensus decline in the Non-Mfg ISM.  They did not track as well last year, though.  They moved in the same direction in only 7 of 12 months in 2023.  So, while the decline in the July Mfg ISM suggests downside risk to the consensus estimate, it is not necessarily reliable.