Stocks traded sharply lower Friday as the September employment report showed the labor market remains too hot for the Federal Reserve (Fed) to re-evaluate its policy of higher interest rates. This is a classic example of good economic news being bad news for the stock market. The incoming economic data remains consistent with an economy that is still growing and creating jobs. This continues to put upward pressure on inflation, which the Fed is trying to tame.

The Fed has been aggressively raising interest rates to cool the economy and labor market to bring inflation back towards its long-term objective of 2%. Unfortunately, the Fed’s monetary policy acts with a lag—interest rate hikes this year will have their biggest impact on the economy next year. The more the Fed must raise rates this year, the bigger the impact on the economy in the future.

While a path to a soft economic landing still exists (see last week’s note for a discussion on this), the higher the Fed raises rates and the longer it keeps them there, the higher the likelihood of recession. We anticipate stocks remaining volatile until they sense that the Fed can pivot from its hawkish stance of higher interest rates. In addition to labor market data, we are watching incoming inflation readings closely for signs that inflation is headed back toward the Fed’s 2% objective. Thursday’s Consumer Price report for September will be the next major signpost for this.

Incoming Economic Readings Consistent with Further Growth

In addition to the labor market report at the beginning of the month, we get important business surveys that provide a timely snapshot of economic health. Importantly, these surveys remain consistent with a growing economy and provide leading inflation indicators, which suggest lower future inflation.

The ISM Services PMI (a monthly service economy survey) showed that services activity continued to expand at a robust pace in September, although it has moderated over the course of this year. Given that services account for most of the economic activity, this survey supports the assessment that the economy is not currently in recession. While the ISM Manufacturing PMI fell to its lowest level since the start of the pandemic recovery, it is still consistent with economic expansion.

Inflation Leading Indicators Encouraging

The ISM business surveys also provide important inflation leading indicators. The manufacturing survey showed new orders falling to the lowest level since May 2020 while inventories accumulated at a faster pace (new orders relative to inventories is an important inflation leading indicator). Order backlogs barely grew, while the supplier deliveries index fell to its lowest level since December 2019, indicating significant alleviation in supply-chain stress. All of this contributed to lower cost pressures, with the ISM Price Index falling to its lowest level since June 2020, historically consistent with only modest inflation pressures.

The ISM Services Prices Index fell for the fifth consecutive month, to its lowest level since January 2021. It shows a significant moderation in cost pressures since the peak in this index at the end of last year, although it is still higher than pre-pandemic. Along with the decline in its manufacturing counterpart, this strengthens the argument that inflation has peaked in this cycle.

Labor Market Still Hot

Nonfarm payrolls expanded by 263,000 in September, which was in line with consensus estimates. However, the unemployment rate came in below all expectations, falling to 3.5% as the labor-force participation rate disappointingly ticked back down to 62.3% from 62.4%. A participation rate rising back toward pre-pandemic levels would play a critical role in alleviating labor market stresses.

As a result of this still tight labor market, interest rate markets are assigning about an 80% probability of another 0.75%-interest-rate hike at the November Fed meeting. We are maintaining our neutral stance toward stocks and are looking toward lower inflation readings for the sustainable uptrend in stocks to resume.

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