The US economy may be on ‘thinner’ ice than investors think

Investors are
increasingly confident
the US economy will achieve a “soft landing,” a scenario in which higher interest rates lead to lower inflation without a major hit to economic growth.

On the surface, it appears all signs point to that outcome. Inflation
has eased
. The economy
is still expanding
. Consumer confidence
has risen
. Retail sales
are healthy
. Corporate profits
remain strong
. And stocks continue to hover at record highs, with the Federal Reserve on tap to cut interest rates as soon as its next meeting on Sept. 18.

But one strategist warned on Yahoo Finance’s
“Stocks in Translation” podcast
that there are cracks under the surface.

“We’re skating on ice that’s a bit thinner than a lot of people presume,” said Michael Darda, chief economist and macro strategist at Roth Capital Partners.

Darda pointed to a rising unemployment rate and elevated earnings expectations, both of which contributed to
the stock market routs
seen at the start of August and September.

“It’s not unprecedented to have a slowdown period that looks like a soft landing, and then a recession ends up taking shape,” he said. “That’s sort of unexpected now because many have been lulled into this idea that the soft landing is going to be a permanent state of affairs for the business cycle. Equity market valuations reflected that coming into the summer.”

“But there’s been some cracks in the business cycle,” he cautioned, noting expectations for the economy, corporates, and the stock market have remained at “super high” levels.

To that point, the S&P 500
shed 2%
on Tuesday, dragged down by the tech sector after Nvidia (
NVDA
) earnings
didn’t deliver enough of a beat
to satiate investors’ appetites. Stocks
seesawed
in the subsequent days as markets struggled to find their footing following the sell-off.

“What’s unfolding now actually makes a lot of sense to me,” Darda said of the pullback. “We’re seeing companies that had been soaring off of repeated beats on either revenues or earnings not do so well in this most recent period.”

The recent drawdowns point to how the current market — one in which investors consistently chase hot stocks and hot areas like artificial intelligence — can be a “dangerous” game, according to Darda.

“What that tells me is that the expectations have just gone up so much. It’s impossible to beat expectations indefinitely. Eventually they’ll catch up,” he said. “We’re in a bit of a frenzy here. And if things start to go wrong, whether it’s the earnings not living up to expectations or the business cycle faltering, that’s when you see stock markets roll over in potentially a material fashion.”

‘Choppy waters’

But it hasn’t just been earnings. The jobs market is also telling a particular story.

Last month, the July jobs report spooked markets after unemployment
unexpectedly rose to 4.3%
, its highest level in nearly three years. The move higher also triggered a closely watched recession indicator known as the Sahm Rule.

The rule, which has accurately predicted recessions 100% of the time since the early 1970s, measures the three-month average of the national unemployment rate against the previous 12-month low. It’s triggered when unemployment rises 0.5% from that level.

Traders instantly panicked that the economy was slowing more than anticipated. But then the debate ensued: Why was unemployment suddenly seeing an uptick?

Economists and strategists began to lay out the possible scenarios, including a theory that
above-trend immigration
is driving up labor force participation rates, therefore pressuring unemployment as more workers enter the jobs market. This eased investor fears
as stocks rebounded to finish August
with wins across all three major indexes.

But Darda said the rise in unemployment is still “a bit concerning.” And he’s not completely sold on recent bullish commentary that
higher unemployment doesn’t really matter
as long as the economy keeps growing.

“4.3% is still an incredibly low unemployment rate level that looks quite good in the historical context,” he explained. “The problem, if there’s a problem, is that we’re up to 4.3% from a cyclical trough of 3.4%.”

“Those kinds of movements and the level tell us that the economy, if it’s still growing, is growing below trend or below the growth rate of potential,” he said. “There’s an exceptionally fine line between that and an actual recession.”

Investors will receive another update on unemployment Friday with the August jobs report on deck. Darda said that report could likely lead to even more market volatility in the weeks and months ahead.

“I do think we’re probably in an environment now where volatility is going to stay elevated,” he surmised. “The risk of a more material pullback and/or correction is quite high.”

Ultimately, his view is one of caution: “With what we saw for the last two years with this market backdrop, from 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 little bit.”

Alexandra Canal
@allie_canal

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