Investors are increasingly confident that the U.S. economy will make a “soft landing,” a scenario in which higher interest rates lead to lower inflation without significantly affecting economic growth.
At first glance, all signs point to this happening. Inflation has declined. The economy is still growing. Consumer confidence has risen. Retail sales are healthy. Corporate profits remain strong. And stocks continue to hover at record highs, with the Federal Reserve poised to cut interest rates when it next meets on September 18.
But a strategist warned on Yahoo Finance’s “Stocks in Translation” podcast that there are cracks beneath the surface.
“We are skating on ice that is thinner than many people think,” said Michael Darda, chief economist and macro strategist at Roth Capital Partners.
Darda pointed to rising unemployment and high profit expectations, both of which contributed to the stock market declines in early August and September.
“It’s not unprecedented to have a period of slowdown that looks like a soft landing, and then a recession takes shape,” he said. “That’s a little unexpected now because many have been lulled into the idea that the soft landing is going to be a permanent state of affairs for the business cycle. The equity market valuations reflected that as the summer came around.”
“But there are some cracks in the business cycle,” he warned, noting that expectations for the economy, companies and the stock market remained at “super high” levels.
To that point, the S&P 500 lost 2% on Tuesday, dragged down by the tech sector after Nvidia’s (NVDA) earnings report wasn’t enough to satisfy investor appetite. Stocks wobbled in the days that followed as markets struggled to recover from the selloff.
“What’s unfolding now actually makes a lot of sense to me,” Darda said of the pullback. “We’re seeing companies that have been shooting up on repeated wins or revenue gains not doing as well in this most recent period.”
According to Darda, the recent declines show that today’s market, where investors are constantly chasing hot stocks and hot sectors such as artificial intelligence, can be a “dangerous” game.
“What that tells me is that expectations have just gone up so much. It’s impossible to exceed expectations indefinitely. Eventually they’ll catch up,” he said. “We’re in a bit of a frenzy here. And when things go wrong, whether it’s earnings not meeting expectations or a business cycle going wrong, you see equity markets turn in potentially material ways.”
‘Choky water’
But it’s not just about income. The labor market also tells a special story.
Last month, the July jobs report rattled markets after the unemployment rate unexpectedly rose to 4.3%, the highest level in nearly three years. The rise also triggered a closely watched recession indicator known as the Sahm Rule.
The rule, which has predicted recessions 100% of the time since the early 1970s, measures the three-month average of the national unemployment rate relative to its previous 12-month low. It is triggered when the unemployment rate rises 0.5% from that level.
Traders immediately panicked as the economy slowed more than expected. But then the debate arose: why did unemployment suddenly rise?
Economists and strategists began to paint possible scenarios, including a theory that above-trend immigration is pushing up labor force participation rates, putting pressure on unemployment as more workers enter the labor market. That eased investor fears as stocks rallied, ending August with gains on all three major indexes.
But Darda said the rise in unemployment is still “a bit concerning.” And he’s not entirely convinced by recent optimistic comments that higher unemployment doesn’t really matter as long as the economy keeps growing.
“4.3% is still an incredibly low unemployment rate that looks pretty good in the historical context,” he explained. “The problem, if there is a problem, is that we’re at 4.3% after a cyclical low of 3.4%.”
“Those moves and the level tell us that the economy, if it’s still growing, is growing below trend or below potential growth rate,” he said. “There’s an exceptionally fine line between that and an actual recession.”
Investors will get another update on unemployment on Friday with the August jobs report. Darda said the report could likely lead to even more market volatility in the weeks and months ahead.
“I think we’re probably in an environment now where volatility is going to remain high,” he surmised. “The risk of a more material pullback and/or correction is quite high.”
Ultimately, he is cautious: “Given what we’ve seen over the last two years in this market environment, with these valuation levels, and based on where I think we are in the business cycle, I think we’re going to be in choppy waters for a while.”
Alexandra Canal is a Senior Reporter at Yahoo Finance. Follow her on X @allie_canal, LinkedIn, and send her an email at alexandra.canal@yahoofinance.com.
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