Market participants are uncertain about recession and the size and scope of Fed rate cuts
September is living up to its nasty reputation as the stock market's most troublesome month, even as the Federal Reserve prepares to finally deliver a long-awaited interest rate cut the week after next.
What's eating investors is that they fear, but don't know for sure, whether the monetary easing has been a little too long-awaited.
"I think that the Federal Reserve is late in cutting interest rates, but Jerome Powell will be forgiven a lot of mistakes if he avoids a recession, which at this stage is still unknowable," said Ivan Martchev, investment strategist at Navellier & Associates, in a note, referring to the Fed chair.
The S&P 500 SPX slumped 4.3% in a holiday-shortened week after U.S. investors returned from the Labor Day holiday, while the Dow Jones Industrial Average DJIA shed 2.9% - making for the worst week for both indexes since March 2023. Technology stocks took it on the chin, with the Nasdaq Composite COMP slumping 5.8% for the worst weekly performance since January 2022.
As was the case during an earlier growth scare at the beginning of August, a run of weak economic data was blamed for the market pullback. While not uniformly gloomy, investors appeared spooked by another weak Institute for Supply Management manufacturing sector gauge, while evidence of growth in the much larger services sector did little to lift the gloom.
But the main event - Friday's August jobs report - proved inconclusive. The Fed had already signaled it was teeing up a Sept. 18 rate cut, the only question being whether it would be 25 basis points or 50 basis points. Fed watchers expected the jobs data to quickly settle the debate.
It didn't.
For those in the 50 basis point camp, nonfarm payrolls rose just 142,000 versus expectations for 161,000, while previous months saw hefty downward revisions. For those in the 25 basis point camp, the unemployment rate ticked down to 4.2% from 4.3%, while average hourly wages surprised to the upside, helping ease worries about the health of the consumer.
Fed-funds futures swung wildly as pricing around the size of a September rate cut shifted. Remarks by Fed Gov. Chris Waller were initially interpreted as signaling an openness to a supersize cut, but bets soon swung back in favor of a smaller move. At the end of the day, investors priced in a 30% probability of a 50 basis point cut and a 70% probability of a 25 basis point move, according to the CME FedWatch Tool.
Attention now turns to next week's inflation data, including the August consumer-price index, which may offer the final word. It's important because although investors have long pined for rate cuts - traders entered 2024 pricing in seven quarter-point reductions - big moves by the Fed can actually be unsettling.
A half-point cut isn't a "good omen" for markets "because I believe at that point people are starting to price in more of a recession than if the Fed can cut at a steady clip of 25 basis points for a few meetings," said Chris Graham, chief investment officer at Nationwide Financial, in an interview.
Meanwhile, the market and the economy are showing signs the Fed's round of fast, aggressive rate hikes that took the fed-funds rate from near zero in March 2022 to its current level of 5.25% to 5.5% by July 2023, are finally beginning to bite.
The most capital-intensive and rate-sensitive activities show evidence of slowing, noted Larry Adam, chief investment officer at Raymond James, in a Friday note.
In addition to a continued contraction in manufacturing activity, motor vehicle sales fell to the second lowest level of the last 18 months, he noted, while construction spending saw its first monthly fall in over 20 months.
And low-income consumers continue to feel pain, consistent with weakness reported by discount retailers in quarterly results this past week, Adam noted. Dollar Tree (DLTR) shares dropped over 21% this week after its quarterly update, while Dollar General (DG) said a slowdown in spending toward the end of each month suggested consumers were having difficulty stretching their budgets to month-end.
The bond market on Friday sent a recession signal, with the yield on the 2-year note BX:TMUBMUSD02Y closing below the 10-year Treasury yield BX:TMUBMUSD10Y for the first time since July 1, 2022. That's a return to the usual order, with the yield curve sloping upward. But the unwind of an inverted curve has tended to signal that a recession is near.
Read: The bond market just flashed a reliable recession signal. Don't panic.
That all sounds scary, but remember that September is usually a bad month for stocks. September has seen the S&P 500 post an average monthly decline of 1.2% and finish higher only 44.3% of the time dating back to 1928, according to Dow Jones Market Data.
The S&P 500 remains just 4.6% below its record close set on July 16.
Nationwide Financial's Graham argued that the stock-market action below the surface is more reassuring.
Chip maker Nvidia Corp. (NVDA), the biggest beneficiary of the artificial-intelligence boom and the pre-eminent member of the so-called Magnificent Seven megacap tech stocks, erased $406 billion from its market value on the week, the most for any U.S. company on record. The tech sector was the S&P 500's biggest loser, with a weekly loss of more than 7%.
Investors, however, have been waiting for the stock-market rally to broaden out, Graham said. While losses this week were broad, a pullback in lofty valuations for the biggest highfliers can be accompanied by a pickup in valuations for other swaths of the market.
If companies with price-to-earnings ratios in the high 20s can move closer to 21-22 times earnings, while others move from 15-16 times earnings to 18-19 times as earnings for both improve, that's a pretty favorable backdrop, he said.
Near-term growth worries aside, the economy appears to be in the soft landing that investors have long been looking for, he said, while the broader market is poised to begin reaping benefits of an AI-related productivity boost.
Adam at Raymond James said he also doubts a recession is likely despite the recent gloom and the warning flashed by the yield curve.
"Despite the yield curve's strong track record, our forecast is that we avert a recession. Why? The Fed has plenty of firepower at its disposal to cut rates to support the economy through this soft patch to keep the expansion going," he wrote.
Meanwhile, Navellier's Martchev questioned whether the distinction between a soft landing and a recession will ultimately prove meaningful.
"Right now, it looks like a soft landing for the U.S. economy, but as far as I am concerned the difference between a soft landing and a mild recession is becoming quite blurred," he wrote.
-William Watts
This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.