Is the rally running out of breath? Three potential paths ahead

Equity markets have staged an impressive rally since the mid-June lows, aided by weaker commodity prices, easing inflation expectations, and lower bond yields. With last week's outsized job gains suggesting that the Fed has to stay aggressive in its fight against inflation, additional near-term momentum for this rally might be difficult to achieve, and markets could be entering a choppy phase in the months ahead. Yet, the worst of the valuation declines might be behind us. We see three potential future paths for the U.S. economy and financial markets and offer our take on the blockbuster July jobs report.

Path 1: The recession is old news, the cycle has reset, and a new uptrend is underway

  • Under this scenario the bear market likely ended in June, and the most sensitive to economic growth investments, like small-cap stocks, are ready to assume leadership.
  • Our view:
    While possible, we don’t think this is a very likely outcome, as risks to growth still skew to the downside. While the economy contracted for two consecutive quarters, conditions are not yet consistent with a broad-based decline in activity, as last week's data showcased. Without any weakness in the labor market, a rise in defaults, or a decline in corporate profits, it is hard to argue that the business cycle has reset and that a new expansion is underway. The Fed is still a ways away from concluding its tightening campaign. 

Path 2: A "softish" landing is achieved, with the economy narrowly avoiding an official contraction; the cycle continues to mature  

  • Under this scenario the current growth scare proves to be a midcycle slowdown and not something worse. The gradual easing of inflation pressures does not require the Fed to overtighten, with officials pausing rate hikes early next year. Growth remains weak, inflation slowly rolls over, volatility stays high, and markets are rangebound in the coming months. This backdrop favors balanced positioning across cyclical and defensive asset classes.
  • Our view:
    The Fed does not have a great track record of tightening just enough to slow inflation without pushing the economy into a recession. However, the broad decline in commodity prices in recent months provides some relief. And the Fed's outsized rate hikes early on suggest that borrowing costs don’t have to rise much more from here. We think this scenario is reasonable, and if it materializes, it would mean that the market's low is already in and that the expectations for an early 2023 pause will be validated.

Path 3: The economy is heading toward a mild 2023 recession as Fed tightening continues to bite

  • Broad inflation pressures suggest that the Fed has more work to do in its inflation fight, while the entire effect of the existing rate hikes has not yet been fully felt in the economy. Restrictive policy drives the unemployment rate higher and corporate earnings lower, in which case the midsummer gains prove to be a bear-market rally, with major indexes heading lower.
  • Our view:
    At this time, we think a mild recession is about equally as likely as the chance for a soft landing. The signal from the yield-curve inversion and weakness in some leading economic indicators should not be dismissed. However, the strength in consumer finances and the strong momentum in the labor market provide a cushion against a sharp downturn, with unemployment rising only modestly and equity markets not matching the declines seen in past deep recessions.

The job market is heating up instead of cooling -- not what the Fed wants to see

The U.S. economy added an impressive 528,000 jobs last month, more than double what was expected, while the unemployment rate declined to 3.5%, matching the pre-pandemic low, which was the lowest since 19691. The job gains were broad-based across different industries, defying expectations for a slowdown in job creation. Meanwhile, wage growth rose more than expected, up 0.5% from the prior month and 5.2% over the past year, suggesting that wage pressure will keep services inflation elevated in the near term1. And the labor-force participation rate (the number of people in the job market either working or looking for work) declined, adding more evidence that the imbalance between the demand and supply of labor is not improving, as Fed officials have been hoping for.

While the strength in the labor market is good news for the economy, it is bad news for the Fed, as it implies that more rate hikes are needed to cool the still-tight labor market and ease inflation. In reaction to the employment data, equity markets declined and bond yields rose, as expectations for Fed policy recalibrated higher. The bond market now expects another outsized rate hike of 0.75% in September, instead of the 0.5% hike that was priced in before, with a peak fed funds rate of 3.6% in March 20231. Because part of the midsummer rally was based on the expectation of a policy pivot, with the Fed letting off the brakes, last week's data could disrupt the recent market calm. Further gains could be more difficult to achieve, as it may take time for inflation to come down and the Fed to signal the pause. However, between now and the September meeting, Fed officials will have another employment report and two more inflation readings to look at before tweaking their projections for the path of rate hikes. And the uptrend in jobless claims, along with the recent downtick in job openings, suggests that the exceptional strength on the jobs front will be hard to maintain.  

 Labor market remains remarkably strong despite other signs of economic weakness.

Source: Bloomberg, Edward Jones

The graph shows the strong monthly U.S. payroll gains that far exceed the gains needed to keep unemployment from rising


Recession - what recession? Lessons from the past

Since the release of the second-quarter advanced GDP estimate, there has been a growing debate about whether or not the U.S. economy is in a recession. A rule of thumb is that two negative GDP quarters indicate a recession. However, the NBER’s Business Cycle Dating Committee uses several criteria to declare recessions, like trends in payroll employment, personal income, consumer spending and industrial production. Last week's whopping job gains and fast-rising wages puts the recession question to bed. An economy adding more than 500,000 jobs with a historic low unemployment rate is inconsistent with a recession.

From a historical perspective it is very unusual to have two consecutive negative quarters of GDP outside of an NBER-declared recession. As shown in the table below, the only time this occurred was in 1947. Real GDP contracted in the second and third quarters, but no recession was declared for the period. Like the first half of this year, consumer spending stayed positive, while the economy continued to add jobs at a solid pace. While the S&P was down 25% by the summer of 1947, the market stayed rangebound and didn’t bottom until the economy eventually fell into a recession in 19491. Yet, the new bear-market low was only marginally lower than before, as a lot of the bad economic news was already in the price. This could be one possible way things play out under the scenario of a mild 2023 recession (path 3).

The only time there were two consecutive negative quarters of GDP, outside of a NBER-defined recession, was in 1947.  

 The only time there were two consecutive negative quarters of GDP, outside of a NBER-defined recession, was in 1947.  

Source: FactSet, Edward Jones

The table shows the periods when the U.S. economy contracted for two consecutive quarters. The strength in consumer spending and the labor market this year is inconsistent with past official recessions. In the past 11 out of the 12 cases when real GDP declined for two consecutive quarters, consumer spending and capital investment spending were negative, while the economy was shedding jobs. 1947 was the only time where inflation contracted two quarters in a row, -1.1% and -0.8%, while having no official recession. During this period, consumption and job gains where strong, similar to trends we have seen in the current economic environment.


An important lesson from past recessions and bear markets is that stocks always bottom before the end of recessions. To this point, the average recession has lasted about 12 months (ranging from two to 19 months), but the average bear market ended on month seven (ranging from month one to 15)2. Because of the market's forward-looking nature, stocks don't wait for economic data to inflect higher before finding their footing. While we expect more disappointing news on the economic front, this is why stocks have likely bottomed under scenarios one and two. But at the same time, as the 1947 experience shows, bear markets don’t end before recessions start, which is why there is likely some more downside under scenario three. 

 Bear markets bottom before the end of recessions.

Source: FactSet, Edward Jones  

The graph shows the duration of past recessions and the point in time when bear markets bottomed.


A marathon, not a sprint

As is always the case, there is no certainty about which path the economy and markets will travel. But assigning probabilities to the different outcomes can help set appropriate expectations and inform opportunistic portfolio adjustments.

We don't think that the coast is clear yet, which is why we prefer large-cap companies over their small-cap peers and high-quality domestic investment-grade bonds. The additional rate hikes will continue to pose strong headwinds for consumer spending and economic growth over the remainder of the year. But a recession shouldn’t necessarily be the only possible scenario, as economic and earnings resiliency can provide some cushion. And if we get an official recession later this year or next, it should be a mild one.

While the daily swings in markets can be uncomfortable, sticking to one's investment plan is often the best approach. With the best- and worst-performing days often found near one another, as has been the case this year, getting in and out of the market can create missed opportunities. After all, compounding over time is the most powerful tool investors have when it comes to achieving long-term goals.

Angelo Kourkafas, CFA
Investment Strategist

Sources: 1. Bloomberg, 2. FactSet, Edward Jones

Weekly market stats

Weekly market stats
INDEXCLOSEWEEKYTD
Dow Jones Industrial Average32,803-0.1%-9.7%
S&P 500 Index4,1450.4%-13.0%
NASDAQ12,6582.2%-19.1%
MSCI EAFE *1,924.07-0.7%-17.6%
10-yr Treasury Yield2.84%0.2%1.3%
Oil ($/bbl)$88.37-10.4%17.5%
Bonds$102.71-1.3%-7.9%

Source: Factset. 08/05/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 8/8/2022.

The week ahead

Important economic data being released this week will be centered around inflation in the U.S.

Review last week's weekly market update.


Angelo Kourkafas

Angelo Kourkafas is responsible for analyzing market conditions, assessing economic trends and developing portfolio strategies and recommendations that help investors work toward their long-term financial goals.

He is a contributor to Edward Jones Market Insights and has been featured in The Wall Street Journal, CNBC, FORTUNE magazine, Marketwatch, U.S. News & World Report, The Observer and the Financial Post.

Angelo graduated magna cum laude with a bachelor’s degree in business administration from Athens University of Economics and Business in Greece and received an MBA with concentrations in finance and investments from Minnesota State University.

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