The impact of the labor market on the stock market

August’s jobs report highlighted a critical reality: the labor market is cooling. While the headline numbers looked decent, the underlying data reveals clear warning signs that demand for workers is slowing. Investors should pay attention because the link between employment and its impact on the economy and the market is undeniable. Although it is often overlooked, as we will discuss, there is an undeniable link between economic activity and corporate earnings. Employment is the engine of a consumption-based economy. Consumers must first produce before consuming, so employment is critical to corporate earnings and market valuations. We will discuss them in order.

The labor market slowdown: the first red flag

The August jobs report indicated that job creation slowed dramatically, particularly in the crucial manufacturing, retail trade and services sectors. For months, we’ve been banking on the narrative that a strong labor market could support it the economy through heavy spots. But that narrative is quickly unraveling as hiring freezes and job cuts become more frequent. The trend of the data is always more critical than the actual number of employees. The message is simple: employment is weakening.

However, as discussed in “Sahm ​​Rule”, full-time employment is a much better measure of the economy than total employment. As mentioned, the US is a consumption-based economy. Critically, consumers cannot consume without first producing something. As such, full-time employment is necessary for a household to consume at an economically sustainable rate. These jobs offer higher wages, benefits and health insurance to support a family, while part-time jobs do not. Not surprisingly, historically, when full-time employment declines, a recession usually follows.

If full-time employment is an engine of economic growth, it stands to reason that more robust trends in full-time employment are needed. However, since 2023, the economy has lost more than 1 million full-time jobs, compared to a gain of 1.5 million part-time jobs. That does not scream economic power.

Furthermore, a comparison of full-time employment with the working-age population shows why the US cannot sustain annual economic growth rates above 2%.

Since the turn of the century, as the US has increasingly integrated technology and outsourcing to reduce the need for domestic labor, full-time employment has continued to decline. If fewer Americans work full-time as a percentage of the labor force, the ability to consume at higher rates declines as disposable income declines.

Because corporate income depends on economic activity, companies continue to adopt technology and other productivity-enhancing tools to reduce the need for labor. If slower economic demand starts to weigh on corporate profit margins, earnings forecasts will be revised down in the coming months.

Corporate profits are at risk

Understanding how the slack in the labor market translates into weaker earnings is critical. When companies are uncertain about future demand, they stop hiring and look to cut costs. These cost-cutting measures come in many ways, such as layoffs, automation, outsourcing, or increased temporary employment. Such measures may buy companies some time, but they do not solve declining revenues. When fewer people have jobs or wage growth stagnates, consumer spending slows, and this hits a tipping point for many companies, especially in consumer-driven sectors. Unsurprisingly, there is a relatively high correlation between the annual change in GDP and corporate earnings.

As such, given that market participants bid up stock prices in anticipation of higher earnings and vice versa, the correlation between the annual change in earnings and market prices is also high.

In past economic cycles, we’ve seen how quickly earnings can disappoint when the labor market weakens. Analysts were too bullish on earnings growth, and now the reality of slower consumer demand will force them to adjust their projections. As earnings expectations decline, investors will need to rethink current valuations. This is a simple equation – lower earnings lead to lower stock prices as markets revise current valuations.

Investors should brace for a slowdown in the impact of the labor market on stock prices. The market is a forward-looking mechanism and is already starting to price in the effects of weaker job growth. Sectors most exposed to consumer spending, such as retail and travel, are likely to see the sharpest declines in share prices as investors adjust to the reality of weaker earnings.

Technology companies, which have driven much of the stock market’s performance this year, will also be vulnerable. These companies rely on high growth expectations to justify their high valuations. If the labor market weakens, consumer demand for technology products and services will also decrease, leading to earnings losses and lower stock prices.

Implications for investors

Broader financial markets are potentially at risk of a “bumpier ride” as the effects of the weakening labor market ripple through the economy. As we have seen in previous cycles, investors will begin to move away from riskier assets such as stocks and into safer investments such as Treasuries. Such a shift could exacerbate market volatility if earnings are revised lower to reflect slower economic activity.

There is also the question of how the Federal Reserve will respond. A slowdown in the labor market often leads to lower inflation, which could allow the Fed to cut interest rates more aggressively and reverse the current reduction in its balance sheet. However, if inflation remains well above the Fed’s 2% target despite weaker job growth, the Fed could find its hands tied. A potential market risk is when the Fed is forced to keep rates high while the economy slows. This would prolong the economic downturn and increase share price pressure.

Recent employment reports show a clear trend: the labor market is losing momentum. That means trouble for the economy and the stock market. Slowing job creation, coupled with weaker corporate earnings, set the stage for increased market volatility.

As mentioned, with markets still near all-time highs, it’s a great time to reassess portfolio risk exposures. Rebalancing positions in overvalued growth stocks and moving to more defensive assets may be prudent. As I have often said, capital preservation should be the priority in times of uncertainty. The labor market indicates that uncertain times lie ahead, and investors should prepare accordingly.

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Editor’s note: The abstracts for this article were chosen by the editors of Seeking Alpha.