Unveiling the Economic Puzzle: Change in Rate Expectations, and Economic Indicators.

Over the past two weeks, a comprehensive set of economic data has provided economists and investors with a detailed understanding of the US economy. Notably, today’s market reversal was driven by a shift in market expectations for the Federal Reserve’s target rate, presenting a challenging path forward for the stock market and raising uncertainties.

The latest labor market data revealed a hint of tepidness in the June nonfarm payrolls report. Job growth of 209,000 fell slightly below consensus expectations, and revisions showed a net gain of 99,000 jobs, signaling a slower pace compared to previous months. This suggests that the ongoing reduction in the M2 measure of money is gaining traction and beginning to impact the economy. Tight monetary policy, as a result of the Federal Reserve’s hiking cycle, is starting to have an effect.

Despite the softer labor market data, it is unlikely to deter the Federal Reserve from raising short-term interest rates at the upcoming July 26 meeting. Civilian employment, including small-business start-ups, rose by 273,000, pushing the unemployment rate down to 3.6%. Average hourly earnings increased, and total hours worked saw an uptick, reinforcing the belief that the Fed perceives the need for further stabilization of the economy through additional rate hikes.

A divergence becomes apparent when shifting focus to the goods and services sectors. The ISM Manufacturing index continued its contraction for the eighth consecutive month, reflecting concerns about a slowing US economy and reduced customer demand. In contrast, the ISM Services index rose to 53.9 in June, with fifteen out of eighteen major industries reporting growth, surpassing even the most optimistic forecasts. While signs of a potential recession loom, the services side of the economy appears to be holding up for now, with business activity and new orders within the services sector remaining in expansion territory.

International trade data indicated a decline in the trade deficit for goods and services to $69.0 billion in May, accompanied by decreases in both imports and exports. This aligns with forecasts of a recession, reflecting weakened domestic demand for goods and a shift towards increased spending on services. Import numbers from China have plummeted by 24.3% compared to the same period last year, resulting in China slipping to the third-largest exporter to the US behind Mexico and Canada. Falling daily freight rates further indicate a weakened global trade environment.

The most significant market impact today was driven by new expectations for the Federal Reserve’s target rate. The provided data reveals an increasing probability, now at 92.4%, of the target rate falling within the 525-550 basis points range. This shift in rate expectations has led investors to reassess their strategies and pricing models, incorporating the potential impact on various asset classes.

Though rates off recent highs, this week's still-large backup in yields reflects fears of a more aggressive Fed and continued global tightening (though market pricing continues to forecast only a single July rate hike before the Fed pauses).

Considering the implications for the stock market, the outlook appears uncertain. The ongoing slowdown in the goods sector, coupled with reduced demand and inventory buildup, raises concerns about future factory output. Persistent inflationary pressures, as indicated by the prices index within the manufacturing sector, pose challenges for companies.

As the market adjusts to shifting rate expectations and economic indicators, caution should be exercised. The stock market may face downward pressure as it navigates these uncertainties, potentially impacting company valuations and investor sentiment. Market participants are urged to closely monitor developments, adapt investment strategies accordingly, and remain diligent in risk management.

The impact of the shifting economic landscape and changing rate expectations will mainly impact cyclical stocks, stocks particularly sensitive to economic fluctuations. Cyclical stock industries include automotive, construction, technology hardware, manufacturing, consumer durables, housing, airlines, travel and leisure. The slowdown in the goods sector, coupled with potential rate hikes, could present challenges for companies within these sectors.