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Weekly Market Analysis - Labor Market Slowing, Corporate Profits Growing
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Post-Pandemic Pattern for Labor and Corporate Profits Likely Reversing
Since last year, a key feature of our constructive outlook for financial markets is our belief that US corporate profits and labor markets would diverge – with profits rising and job growth slowing. This does not occur regularly.
Why would we think now is different? It is because the trend is merely reversing the unusual post-pandemic recovery pattern of weakening profits/strong labor seen in 2022/2023.
US Unemployment Rate Rises
In the latest quarter, US private employment gains slowed to 146K per month, the weakest pace since the recovery began. The unemployment rate has risen from 3.4% to 4.1%, approaching history’s largest increase outside of recession periods.
Data Points Toward a Fed Easing This Year
We don’t believe current conditions are consistent with an employment bust, but rather a “whimper.” Labor-intensive services collapsed in 2020. After a torrid rebound, US job creation is now “narrowing” in the words of Fed Chair Jerome Powell. With it, the Fed is likely to swerve toward easing this year to protect the recovery.
Summary
Employee compensation in the US slowed to a roughly 5% growth pace in the first quarter. This counts both the newly employed and the wages, salaries and benefits of those already employed in total. Preliminary data for the second quarter suggest a similar pace, decelerating through quarter end.
Meanwhile, we expect US companies to report a gain in EPS of greater than 10% in the second quarter, or double the rate of national employee compensation in coming weeks. With the US unemployment rate rising more than a half a point in the past year, wage growth decelerating and the Fed’s policy rate above the rate of unemployment (see chart), we believe that only “committee inertia” will keep the Fed on hold when its policymaking committee meets late this month.
Portfolio considerations
“Narrow” is the right description for corporate profits up until the latest quarter. The “Magnificent 7” large cap tech firms posted a 51% EPS gain in the year through 1Q while the remainder of the S&P 500 posted a 1% drop. But estimates for 2Q show this changing even with the usual downward bias in estimates just before reporting time. EPS gains are possible in 9 of 11 sectors in 2Q 2024 with reporting to begin in coming weeks. The healthcare sector in particular is worth watching after the largest EPS drop for the sector on record in 2023. EPS have skyrocketed for just 2 global pharma companies responsible for GLP-1 weight control medications. EPS plunged elsewhere in the sector. Healthcare share price performance has been similarly narrow. Estimates for 2024 suggest a broader healthcare recovery. 2Q results may help determine if this is near at hand or further off in the future.
Source: Haver Analytics as of July 9, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Post-Pandemic Pattern for Labor and Corporate Profits Likely Reversing
Employee compensation in the US slowed to a roughly 5% growth pace in the first quarter. This counts both the newly employed and the wages, salaries and benefits of those already employed in total. Preliminary data for the second quarter suggest a similar pace, decelerating through quarter end. Meanwhile, we expect US companies to report a gain in EPS of greater than 10% in the second quarter, or double the rate of national employee compensation in coming weeks.
It is not uncommon for corporate profits – the “small” difference between sales and business costs – to rise and fall much more sharply than worker compensation. As a “residual,” profits earned by companies and their shareholders are far more volatile than sales or costs. What is uncommon is for profit growth across the economy to accelerate while compensation decelerates – that is outside of the beginning periods of a new economic recovery.
US Unemployment Rate Rises
So why would the US labor market slow? The pandemic caused large and unusual swings in not just the overall economy, but the composition of economic activity. Consumer goods and housing boomed within 2020 despite social restrictions. A recovery in services activity – such as hospitality and leisure – was put off largely until 2022.
It is not uncommon for a restaurant to have more workers than a large warehouse or largely-automated factory. Between 2020 and 2022, the swing in US services employment – from collapse to boom – was the largest as a share of total employment since World War II. These industries – most heavy in head count – are slowing. While preliminary data are unreliable, government employment gains were more than a third of all job gains in June. A pattern of sharp downward revisions to earlier months suggests that reported job gains may in fact be overstated.
Data Points Toward a Fed Easing This Year
With the US unemployment rate rising more than a half a point in the past year, wage growth decelerating and the Fed’s policy rate above the rate of unemployment, we believe that only “committee inertia” will keep the Fed on hold when its policymaking committee meets late this month. By September, we would expect some likely action to move US monetary policy away from the Fed’s self-described “restrictive” stance. If so, the Fed will be doing this while corporate profits are growing.
2Q Earnings Preview
Health care stocks have been stuck in the mud since early 2023. With the exception of leading weight loss drugmakers and a handful of high-quality device makers, the sector has underperformed amidst a series of challenges from COVID overhangs, dried up funding for new drug research, and concerns around US drug price regulation.
Wall Street analysts expect that drugmaker and medical devices profits grew in Q2 relative to a year ago, potentially ending an unprecedented streak of 6 straight quarters of earnings declines. Under the hood, one-off charges have exacerbated headline growth declines over the past year. But even after excluding these two outliers, investors are looking for clear signs of positive growth for the sector.
Industrials, a highly diverse sector, tick a lot of thematic boxes as well. Within the sector we can identify firms directly engaged in providing electrical equipment and materials to power data centers running AI processes, defense shares, and companies tied to the energy transition. Our outlook for retailers, with key bellwethers reporting the week of August 12, is more of a mixed bag. While the Consumer Discretionary sector is dominated by two Magnificent 7 leaders, the average discretionary retailer has lagged in recent months amid concerns that inflation is pinching savings for middle- and lower-income individuals. US luxury and apparel shares have plummeted 30% YTD amid concerns about a buyers’ strike among the affluent. Staples retailers, meanwhile, have exhibited much lower volatility and along with healthcare may be a defensive way to play the market after a strong first half rally ahead of typically choppier summer trading.
