A Risk-Off Tone

Recent developments on the labor front are weighing on investor sentiment, with the monthly U.S. jobs report showing a gain of only 73K during the month of July, substantially undershooting the forecast of roughly 110K. More concerning, however, are revisions to the May and June reports, which were deeply negative. While we always expect revisions to this important report, these adjustments are noteworthy: May was initially reported as a gain of 144K, adjusted to only 19K, and June was revised downward from a gain of 147K to only 14K.

For July, despite the weak jobs report, the unemployment rate rose only slightly, to 4.2% from June’s 4.1%, likely reflecting the sharp slowdown in the growth of labor supply due to constrained immigration. Some additional details in the July report bear watching: The job gains were highly concentrated in healthcare and social assistance, so the breadth was very narrow, with most other sectors (manufacturing, retail, construction and professional services) showing little or no employment growth, or even outright losses. On the wage front, average hourly earnings rose by 0.3% month-over-month to a 3.9% year-over-year gain. The recent trend of slow hiring and slow firing seems to be entrenched, suggesting rising labor market vulnerabilities.

The FOMC met this week and held interest rates steady as expected, but, below the surface, dissent continues. While the Fed kept rates steady for the fifth straight policy meeting with a fed funds rate of 4.25-4.50%, the decision passed with a 9-2 vote. Governors Michelle Bowman and Christopher Waller dissented, with each voting for a 25-basis point cut. Notably, this was the first time we have seen two dissents in over 30 years. While the FOMC did acknowledge that economic growth has moderated in early 2025, the committee continues to characterize the labor market as solid and notes that inflation remains elevated, with risks skewed to the upside.

In an interesting change, the official statement noted that “uncertainty about the economic outlook remains elevated,” which replaced prior, more optimistic language. Of course, Fed Chair Powell reiterated the data-dependent approach, the risks to how tariffs may influence the shorter-term outlook for inflation, and the continued positive economic momentum as strong supportive reasons behind the decision to hold the course. The dissenting members noted that labor market conditions can change quickly, and the risk of being late to ease policy may drive the need for more acute action in the future. After the meeting, market implied odds of a September rate cut fell sharply, from 65% to under 50%. Those odds have changed measurably after the disappointing unemployment report, however, and at the time of publication on Friday the market is assigning an 84% probability of a rate cut in September. We continue to see a high likelihood of one cut to the fed funds rate likely in late 2025.

While the full brunt of tariffs is certainly yet to be felt, we are seeing inflation creeping up,  including core PCE year-over-year at 2.8% — above target and stubbornly so. It is worth noting that this is year four of “inflated inflation,” and the implications of the new trade deals, at least over the near term, suggest an unhappy and upside surprise may be arriving in the near future. This stubborn and sticky inflation will continue to pressure the Fed to remain on pause, and may guarantee that policy will be late to adapt to a slowing economy, particularly given that the Fed is data dependent in a period when the data has proved susceptible to significant revision. Exhibit A is the monthly nonfarm payroll report, with meaningful downward revisions to the May and June data. 

The fundamentals are strong: This was a big week for tech earnings, and results continue to support the secular AI growth story. Microsoft’s Azure growth beat analyst estimates handily, and Meta results revealed AI tailwinds to both engagement and ad revenues. The second quarter earnings period for the S&P 500 has been strong overall so far, with blended earnings expected to be up 4% from last quarter to a robust 10%. Over 80% of companies reporting have bested consensus estimates, with earnings surprising to the upside by more than 8%. The trade deals this week, while onerous on importers, remove an additional layer of uncertainty for investors. Adding to positive sentiment is what seems to be the early stages of a resurgence in M&A activity, with Union Pacific set to acquire Norfolk Southern; Palo Alto Networks to acquire CyberArk; and Baker Hughes to acquire Chart Industries. Rounding out the bullish news is the successful Figma IPO, which was 40X oversubscribed. 

In the bearish category, we are seeing extended positioning as investors have piled into risky assets, extremely high valuations for U.S. stocks that reflect significant optimism, and some soft economic data suggesting a slowdown may be already underway. We can anticipate that risk asset markets may be entering more of a digestive phase, leading to higher volatility and periodic drawdowns as investors continue to assess the impacts of policies on fundamentals.