How healthy is the U.S. labor market?

The U.S. Federal Reserve (Fed) appears almost certain to begin its long-awaited rate cutting cycle in September. Not surprisingly, global stock markets have responded positively to this news. However, it is important for investors to understand that rate-cutting cycles are not all the same.  Historically, cutting cycles accompanied by “soft landings” have tended to be very good for stock markets. But cycles accompanied by recessions have tended to be very bad for stock markets.This is why the health of the U.S. labor market is so important right now. If higher interest rates have successfully cooled inflation, but ultimately lead to a spike in unemployment, then enthusiasm over Fed cuts is likely to be short-lived. 

Fortunately, data on the health of the U.S. labor market are plentiful. Two notable reports that can be used to monitor labor market conditions are nonfarm payrolls and initial unemployment claims. Nonfarm payrolls are released on the first Friday of every month and tend to garner more attention than other labor market data. The report for July, released on August 2nd, provided a notable negative surprise that caused a sharp sell-off in the stock market over the next two trading days.However, an examination of the July data in context reveals a relatively benign picture. While job creation has eased considerably over the past three years, it has slowed from extremely high levels back toward growth that is more in line with the longer-term average. We also find it comforting that the pace of this slowdown appears to be flattening out.Weekly unemployment claims paint a similar picture. So far in 2024, we have seen a steady increase in unemployment claims. But this trend is similar to what we saw from October 2022 to June 2023, which proved to be a false alarm.  More importantly, the current level of claims is low relative to longer-term history. This further validates the theory that the weakness we’re seeing in the labor market is simply normalization, rather than the precursor to a recession.
Unfortunately, there are still reasons to be concerned about the health of the U.S. labor market, as the current weakening trend does have the potential to turn into something more severe.  
One area that bears watching are profit margins for smaller companies. These tend to be very correlated with labor market weakness because falling profit margins are often the catalyst for job losses.  

When profit margins shrink to low or even negative levels, companies often are forced to lay off workers.Broadly, profit margins across publicly listed companies remain healthy and stable. As of August 6, the net margin for the Russell 3000 Index – a benchmark for the broad U.S. stock market -- stood at 9.6%, not far below the peak of 11.5% reached in the spring of 2022.

But profit margins for smaller companies, as measured by the S&P 600 Index, have been deteriorating for more than two years now and are rapidly reaching the danger zone.  

The reason for this divergence is that small companies tend to be much more sensitive to interest rates than large companies because they typically carry higher debt burdens. The rise in interest rates over the past several years means that interest costs are taking a proportionally larger bite out of their profits.

This is potentially bad news for the labor market because smaller companies also tend to be more labor-intensive than large companies. Despite their relatively low weight in the broad equity indexes, small businesses account for the majority of jobs in the U.S. economy.  That’s also why there’s an urgent need for the Fed to start cutting rates, even though inflation hasn’t yet returned to its 2% target.

As of late August, U.S. labor market data were not flashing warning signs of a looming recession.  But, given the stress that higher interest rates have placed on smaller businesses, it will be important to keep a close eye on the data going forward. 
As a result, our Asset Allocation Committee is maintaining a broadly neutral risk profile.