"Our American friends offer us money, arms, and advice. We take the money, we take the arms, and we decline the advice." -Moshe Dayan
This morning's jobs report delivered a second day of pain in markets after a large selloff yesterday. A slowing in the labor market seems to be accelerating based on the lower-than-expected numbers. About 175,000 jobs were expected to be gained this month, but the actual number came in at 114,000 while the unemployment rate unexpectedly ticked up to 4.3%. Markets sold off in response to the negative surprise. The report showed the following realities in the labor market:
Job growth has markedly slowed and it has slowed faster than expected.
The unemployment rate is rising quickly and temporary help jobs are dropping off quickly.
Weekly hours worked is low and looks like it is slated to fall further.
Wage growth slowed from 3.9% last month to 3.6% this month and showed monthly deceleration.
Factory orders also came in weaker than expected. This was the most negative MoM change since April 2020, in the height of COVID.
The famed "Sahm Rule" was violated, which tends to suggest we are in the early phases of a recession.
The market sold off extensively, but it wasn't a complete rush for the exits. As you can see below, firms that did well on earnings reports like Exxon Mobil and Apple were still able to hold onto gains despite the risk-off sentiment from the jobs report. Treasury curves were where the report was really seen, and the curve re-inverted in some places signifying building fears of a recession.
The slowing jobs market is not the only concern. There have been some stumbles recently in Mega cap Tech earnings. Furthermore, the decline in luxury spending suggests that the wealthiest consumers who have helped keep consumption going are starting to be a little tighter with their wallets. The CBOE Volatility Index spiked to its highest level since October 2023. Unemployment hit its highest rate since October 2021. The US 10-yr also plummeted.
While the market had been jubilant after the Federal Reserve signifying cuts, now the focus is on whether or not the FOMC has committed a policy error by waiting so long to cut.
Markets are at a clear turning point because the rotation into small caps and lower quality companies in the markets had largely been based on the prospect of economic strength and a soft landing. The eye of markets is now clearly focused on recession after today's report though. This could make small caps less appealing given their relative debt loads to larger stocks in the S&P 500.
One indicator that shows how quickly the sentiment has transformed from risk-on to risk-off is the spike in chances for a 50 bps rate cut in September. Two days ago the chances of a 50 bps rate cut was 11%.
Now it is is the favored outcome as implied by futures, with markets pricing a 70% chance of a larger cut in September. The conversation has very rapidly changed from folks thinking we were in the midst of a soft landing to talk of the Fed needlessly keeping rates too high and perhaps committing a grave policy error that exacerbates coming economic weakness.
Middle East Geopolitical Risk May Be Particularly Potent at This Moment
"Hezbollah may decide that in order to restore deterrence with Israel, it needs to conduct a more significant attack that targets civilian and military areas deep inside Israel." -Institute for the Study of War
The Federal Reserve and US elections have obscured a risk that is building to global markets caused by increasing tensions in the Middle East. Spiking oil prices from a regional war would be particularly unwelcome given the deteriorating pace of economic activity. Crude prices have declined for four consecutive weeks, but a war could easily and quickly reverse that. There are indications that a direct confrontation between Israel and Hezbollah could be more protracted and bloody than earlier confrontations.
The tit for tat exchange of violence at Israel's northern border appears it may spin completely out of control. Since tens of thousands of Israelis are still not allowed to return to their homes in the north, there is also political pressure from Netanyahu's right-wing coalition to deal with Hezbollah militarily sooner rather than later.
But the main risk is the impending attack from Israel's enemies which has already been ordered by Iran's supreme leader. Two high profile Israeli assassinations, one in Tehran and one in Beirut, will almost certainly lead to a significant military response from Iran and its vast network of militias throughout the Middle East. The theocracy likely feels a need to establish real deterrence given that a guest was killed in a sanctified section of its capital.
One of the main reasons I think markets could trip over this risk is because the popular perception of Israeli military dominance may be challenged by what Iran and its allies are planning. This causes the type of uncertainty that markets love to freak out about.
On October 7th, one of Israel's biggest concerns was evacuating the Northern Border region and rushing soldiers there because it knows it is militarily vulnerable there. Some Israeli commanders have been quoted as saying that Hezbollah would have made it to Haifa if they had coordinated with Hamas on that grim day.
Luckily, Hamas operated in isolation and did not cause Israel to be threatened simultaneously on multiple fronts. However, after recent aggression, Israel's allies are coordinating a response to restore deterrence and strategic parity. The results may surprise many in a very negative way.
Given the stakes for the Israel's enemies and their increasingly respectable kinetic military capabilities, I think there is a high probability of a regional conflagration that dramatically shocks markets and the world. Even with the American air defense umbrella, Israel's adversaries have the ability to overwhelm most air defenses with a high volume of projectiles. If they choose to do this, the effect on markets and the global economy will be severely adverse.
Israel's enemies have announced that they will respond to Israel's recent assassinations in what their enemies previously perceived as safe havens. While Hezbollah has so far shown some restraint, probably partially because of the deployment of US aircraft carriers to the region, Israel's brazen actions may have forced its hand.
Israel is a very strong country with a formidable military, but it is still highly vulnerable to strengthened adversaries that it faces on multiple fronts. The market currently underestimates the risk of a protracted regional war, but I think that possibility is distinctly rising and it is doing so in the shadow of other headlines distracting the market's attention.
Wars are inflationary and the speed with which expectations for the level of rate cuts has changed shows markets are at a critical juncture. The fragile state of markets absorbing disappointing economic data may be badly exacerbated by increasing hostilities in the Middle East and the tangential economic effects it could cause.
I think the odds of a serious and shocking attack that dramatically exceeds what Iran delivered in April is much likelier than many market participants consider. In such an event, volatility could potentially spike to its highest levels since COVID given the evolving convergence of economic and geopolitical risks.
