Investors are increasingly confident that the U.S. economy can achieve a “soft landing,” a scenario in which higher interest rates would lead to lower inflation without a major impact on economic growth.
At first glance, it seems likely that this will be the case. Inflation has declined. The economy continues to grow. Consumer confidence has increased. Retail sales are healthy. Corporate profits remain strong. And stocks continue to hold at record highs, with the Federal Reserve poised to cut interest rates as early as its next meeting on September 18.
But one strategist warned on Yahoo Finance’s “Stocks in Translation” podcast that there are cracks beneath the surface.
“We’re skating on a little thinner ice than many people realize,” said Michael Darda, chief economist and macroeconomic strategist at Roth Capital Partners.
Darda pointed to rising unemployment and high earnings expectations, both of which contributed to the stock market woes seen in early August and September.
“It’s not uncommon to see a downturn that looks like a soft landing and then a recession takes shape,” he said. “This is rather unexpected today, because many have been lulled into thinking that the soft landing is going to be a permanent fact of life for the business cycle. Equity valuations have taken note of this as we head into the summer.”
“But there have been some cracks in the economic cycle,” he warned, noting that expectations about the economy, businesses and the stock market remained at “very high” levels.
So far, the S&P 500 has lost 2% on Tuesday, dragged down by the technology sector after Nvidia’s (NVDA) results failed to satisfy investor appetite. Stocks have swung around in the days since as markets struggle to find their footing after the plunge.
“What’s happening now makes perfect sense to me,” Darda said of the pullback. “We’re seeing companies that had strong growth with above-average revenue or earnings are not doing as well in the most recent period.”
The recent declines show how the current market – one in which investors are constantly chasing hot stocks and fields like artificial intelligence – can be a “dangerous” game, Darda said.
“What that tells me is that expectations have risen so much that you can’t go beyond expectations indefinitely. They’re going to catch up with us eventually,” he said. “We’re in a bit of a frenzy. And if things start to go wrong, whether it’s earnings that don’t meet expectations or a business cycle that falters, that’s when the stock market can crash in potentially significant ways.”
“Rough waters”
But it’s not just about income. The job market also tells us a particular story.
Last month, the July jobs report spooked markets after unemployment unexpectedly rose to 4.3%, its highest level in nearly three years. The increase also triggered a closely watched recession indicator known as the Sahm rule.
The rule, which has been 100% accurate in predicting recessions since the early 1970s, measures the three-month average of the national unemployment rate relative to the previous 12-month low. It is triggered when unemployment rises by 0.5% from that level.
Traders immediately panicked, thinking the economy was slowing more than expected. But then the debate began: why did unemployment suddenly spike?
Economists and strategists began to map out possible scenarios, including a theory that above-trend immigration would lead to higher labor force participation rates, putting pressure on unemployment as more workers entered the job market. That eased investor fears as stocks rebounded to end August with gains on all three major indexes.
But Darda said rising unemployment is still “a little bit concerning.” And he’s not entirely convinced by recent optimistic comments that rising unemployment doesn’t really matter as long as the economy keeps growing.
“4.3% is still an incredibly low unemployment rate, which looks pretty good in historical context,” he said. “The problem, if there is a problem, is that we’ve gone from a cyclical low of 3.4% to 4.3%.”
“These kinds of movements and the level of the economy tell us that if it continues to grow, it is growing below trend or below potential growth,” he said. “There is a very fine line between that and a full-blown recession.”
Investors will get another update on unemployment on Friday with the August jobs report. Darda said that report could likely lead to even greater market volatility in the weeks and months ahead.
“I think we’re probably in an environment where volatility is going to remain elevated,” he said. “The risk of a larger pullback and/or correction is quite high.”
Ultimately, his view is one of caution: “With what we’ve seen over the last couple of years in this market environment, from these valuation levels, and based on where I think we are in the economic cycle, I think we’re going to be in choppy waters for a while.”
Alexandra Canal is a senior journalist at Yahoo Finance. Follow her on X @allie_canal, LinkedIn, and send her an email at alexandra.canal@yahoofinance.com.
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