Schwab Market Perspective: Connecting the Pieces

A softening job market has helped bring U.S. inflation down to 2.6%, close to the Federal Reserve's 2% goal. This supports potential Fed interest rate cuts as soon as this fall; however, it's important that job weakness not lead to outright economic deterioration. In the Treasury market, expectations for the timing of a rate cut versus concerns about the U.S. government's ongoing expansive fiscal policy have kept yields bobbing up and down. Meanwhile, the surprising outcomes of elections in the U.K. and France have potential implications for markets, especially for the Energy sector.

Despite several supply shocks and an aggressive rate-hiking campaign by the Federal Reserve over the past several years, the U.S. labor market has remained relatively resilient since the post-pandemic recovery began. The sharp rebound in payroll growth, coupled with soaring demand for labor on the part of companies, helped drive the market to an incredibly tight position. That in turn was consistent with strong wage growth and a surge in inflation.

Fortunately, inflation has continued to trend lower as the labor market's tightness has unwound. That has largely happened without major general, or "headline," damage, but much of the real story is being told below the surface. As shown below, even though nonfarm payroll growth is still in healthy territory when it comes to growth over the past year, full-time employment (measured via the household survey) is contracting. It's unusual to see a spread this wide between both series, but key to keep in mind is that they measure different populations, the household survey tends to be more volatile, and nonfarm payrolls are subject to revisions in the future.

Further weakness in payrolls wouldn't be a surprise given the corroborating evidence from other data points. As shown in the chart below, the employment component in the ISM Services Purchasing Managers Index fell deeper into contraction (below 50) in June. That doesn't guarantee that services payrolls are about to fall into recessionary territory, but with the services sector having been a key pillar of support over the past couple of years, any wider cracks would be increasingly detrimental to economic growth.

Softening in the labor market is ultimately a feature of the Fed's goal in bringing down inflation, simply because a slowdown in job creation tends to be consistent with weaker earnings growth and spending power—thus, in theory, slower inflation. The key moving forward is monitoring whether subsurface cracks widen and lead to outright deterioration.

Cracks are also visible in the foundation of the stock market. One of the more notable trends this year has been the underperformance of the equal-weight S&P 500 index (which assigns each of the 500 component stocks a fixed weight of 0.2% of the index) relative to the market-capitalization-weight version of the index. As shown in the chart below, the ratio of both indexes has fallen to its lowest level since the end of 2008. That doesn't necessarily mean the equal-weighted index has done poorly since then—it just hasn't kept up with the cap-weighted index's marked gains.

We think that might start to become an issue if investor sentiment continues to grow more euphoric and market breadth—the ratio of rising to falling stocks—falters. Exuberant investor sentiment, at extremes, can be a contrary indicator. To be sure, frothy sentiment in and of itself is not a good market-timing tool, but if there is a strong negative catalyst, indexes are in a more vulnerable position today—especially because of the waning strength down the market-cap spectrum.

Ten-year Treasury yields have declined over the past month, but the path hasn't been smooth. While the pace of inflation and economic growth has slowed, shifting expectations about the timing of a potential Federal Reserve rate cut along with concerns about ongoing expansive fiscal policy have kept yields bouncing around within a range. This is a pattern we expect to continue in the second half of the year.

For the remainder of 2024, the outlook for returns to fixed income investors looks positive. Starting yields are high in both nominal and inflation-adjusted terms, and inflation is getting closer to the Fed's 2% target, increasing the likelihood of rate cuts starting in the fall. The Fed's preferred inflation measure, the deflator for personal consumption expenditures excluding food and energy, or "core" PCE, has resumed its downward trend. It fell to a 2.6% year-over-year pace in July, which is below the Fed's projection of 2.8% for the end of the year. At the current pace, it could reach 2%, the Fed's inflation target, by early 2025.

The labor market is also showing signs of cooling off—a precondition for the Fed to ease policy. The unemployment rate has risen from a cyclical low of 3.4% to 4.1%, with the pace of job growth slowing. Wage growth has edged lower, reducing concerns about inflation stemming from too much consumer demand.

Consequently, we continue to expect that the Fed will begin a series of rate cuts at its September meeting. Fed Chair Jerome Powell may use the late-August meeting of central bankers in Jackson Hole, Wyo., to indicate the shift in policy.

The inverted Treasury yield curve already reflects expectations of rate cuts, with long-term yields still well below short-term rates. Based on federal funds futures trading, the market has built in the likelihood of two rate cuts in 2024 and another four in 2025, which would bring the federal funds rate down to about 3.75% from its current target range of 5.25% to 5.5%.

With the likelihood of rate cuts on the horizon amid easing inflation, prospects for returns in the second half look positive. We continue to favor extending duration to capture current yields for the intermediate to long run. However, with the Treasury yield curve already inverted, we suggest investors consider other fixed income asset classes when adding duration. Yield curves in other fixed income markets are flat to upward-sloping, offering incrementally more yield with longer maturities.

High-credit-quality bonds such as investment-grade corporate bonds and agency mortgage-backed securities (MBS) offer yields of more than 5% out to maturities of 10 years. The yield on the Bloomberg Aggregate Bond Index is 5.0% with a duration of 6.1 years. For investors in high tax brackets, the after-tax yields on investment-grade municipal bonds are attractive, as well. We would be more cautious on lower-credit-quality bonds.

Through the volatility, we see the opportunity for investors to benefit from the current level of yields.

Sweeping changes resulted from the U.K. election on July 4, and the final round of French voting on July 7, as voters railed against incumbents after a period of weak economic growth and high inflation. In the U.K., the Labour Party pushed out the Conservative government in a landslide, while France's far-left New Popular Front (NFP) won the most seats in the legislature, prompting the resignation of the prime minister.

The election in the United Kingdom gave the Labour Party a large majority and total number of seats, very close to beating the party's best result, seen in the 1997 general election. Yet the potential for sweeping change is highly constrained by fiscal realities that likely mean little near-term impact on policy and markets.

New U.K. Prime Minister Keir Starmer's main challenge will be working with already extended budget deficits that leave no room for new spending priorities combined with a pledge not to raise taxes (income, payroll or the value-added tax, or VAT—although modest revenue could be raised via increases to capital gains and inheritance taxes) and a debt-to-gross domestic product path that is not on a sustainable footing. The election doesn't seem to change the near-term U.K. economic outlook. Still, the clarity of the election outcome may lift business sentiment. The Purchasing Managers' Index (PMI) for June fell slightly as the comments in the flash release revealed businesses adopted a wait-and-see approach ahead of the election. The clear result may lead to a modest rebound in the PMI in July.

What may be of most importance to investors in U.K. stocks is the outlook for the Energy sector. Two oil companies make up nearly half the earnings of the MSCI United Kingdom Index, contributing to the relative performance of the U.S. and U.K. stock markets tracking the performance of the world's Information Technology and Energy sectors, as you can see in the chart below. While Labour has indicated it won't revoke existing oil and gas licenses, it has vowed not to issue any new ones as it focuses on green-energy projects. No immediate changes to policy may mean the U.K. Energy sector continues to outperform the overall market, as it did in the first half of the year as Brent crude oil prices climbed.

Given the plans laid out by France's far-right and far-left parties, France's second-round election on July 7 had the potential to reshape the country's economic and fiscal policies and widen the budget deficit that is already in breach of European Union rules. In June, as the elections approached, French stocks fell and the risk premium on French debt widened. But the far-left New Popular Front (NFP) and centrist Ensemble coalitions coordinated in three-party runoff races to block the far-right National Rally (RN) from winning a majority. The NFP picked up the most seats, while President Emmanuel Macron's Ensemble came in second and RN third, but each fell far short of a 289-seat majority.

The outcome may mean any major legislative changes are unlikely as the leaders of all three groups have vowed not to work together on domestic policy. Macron remains in charge of France's international relations and trade policy. Markets began to reverse June's losses after the first round of voting on June 30, as the margin of victory by the National Rally appeared insufficient to claim a majority in the second round. But the surprise outcome leaves some uncertainty as to what comes next, which may weigh on France's markets.