Forget Rate Cuts. Bad News Could Finally Be Bad for Stocks.

A scene on the floor of the New York Stock Exchange on Sept. 3. (Spencer Platt/Getty Images)

Key Points

About This Summary

• Investors could soon shift their focus from inflation to economic growth concerns after weak labor market data.
• Jobless claims surged to a four-year high, overshadowing largely in-line inflation data.
• The bond market reflects growth worries, with a flattening yield curve.

Stock investors appear poised to quickly shift their focus, worrying about economic growth, rather than inflation, following a series of readings that suggest a notably weaker labor market heading into the final months of the year.

The Bureau of Labor Statistics published inflation data Thursday that was largely in line with Wall Street forecasts, even as the headline reading for the gain in August relative to June was modestly faster than expected at 0.4%. The closely tracked core reading showed prices rising at a 0.3% pace, with the annual gain pegged at 3.1%.

Despite the Federal Reserve’s mandate to fight inflation, those results will likely give the bank scope to start the first of multiple interest-rate cuts next week in Washington. The CME Group’s FedWatch Tool, in fact, now sees the central bank’s benchmark lending rate falling to between 3.5% and 3.75% by the end of the year from 4.25% to 4.50% today.

The problem is that the Labor Department’s update of weekly jobless claims, published alongside the inflation data, showed the largest number of Americans filing for first-time unemployment benefits in four years. The total came in at 263,000 people, compared with Wall Street’s consensus forecast of 235,000.

That sign of weakness in employment chimes with news earlier this week that the Bureau of Labor Statistics now estimates that the U.S. economy added 911,000 fewer jobs in the 12 months through March than it had reported. Given last Friday’s miserable employment report for August, the data could challenge the market’s assumption that the domestic economy is in line for solid growth over the coming quarters.

“For the first time in a long time, CPI is being overshadowed on its release day by another data series,” said Josh Jamner, senior investment strategy analyst at ClearBridge Investments. “While investors may cheer the prospect of rate cuts, if the pickup in initial jobless claims is sustained in the coming weeks, they may turn more cautious on the economic outlook.”

The Atlanta Fed’s GDPNow forecasting tool, which tracks data on economic growth in real time, suggests the economy is expanding at a 3.1% annual clip. That is in line with the pace it achieved in the three months through June.

For now, solid GDP gains and expectations they will continue, plus bets that the Fed will cut interest rates, are propelling stocks higher. Wall Street firms keep raising their calls on how far the S&P 500 will rise by the end of the year.

In a research note published this week, Deutsche Bank analysts led by Binky Chanda set a 7000-point target for the S&P 500 by the end of December. That would amount to a 7% advance from current levels.

The bank cited above-trend GDP growth, solid corporate earnings, a limited impact on profit margins from tariffs, and supportive moves from the White House.

“The consensus sees U.S. growth slowing near term before picking up next year,” Chanda and his team said. “But it also looked for growth to slow in Q2, and when that did not materialize,” stocks ultimately headed higher.

The more the jobs data worsens, however, the more likely the market is to stop seeing bad economic news as a signal that rate cuts are coming. Instead, it could see it as indicating that the economy is slowing down, which would hurt corporate earnings, and stock prices.

The bond market is already beginning to reflect worry about growth. After the jobless-claims data, the yield on benchmark 10-year Treasury notes yields briefly fell below 4% for the first time since April, while two-year yields were little changed at 3.52%.

That so-called flattening of the yield curve typically signals concern about GDP growth.

However, Seema Shah, chief global strategist at Principal Asset Management, isn’t convinced that the labor market is weak enough to trigger growth concerns just yet. She says that although the data will “inject some urgency” into the Fed’s decision-making, “an emergency sized rate reduction isn’t required.”

“Jobless claims have jumped but are still quite low compared to 2021 levels, while the broader economic activity data and earnings reports don’t signal an economy that is approaching a recessionary tipping point,” Shah said.

Write to Martin Baccardax at martin.baccardax@barrons.com