Delays in the labor market continue to affect the economy

August underscored a critical reality: the job market is cooling. While the headline numbers seemed 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 often overlooked, as we will discuss, there is an undeniable link between economic activity and corporate profits.

Employment is the lifeblood of a consumer-based economy. Consumers must produce before they consume, so employment is key to corporate profits and market valuations. We’ll discuss each in turn.

Slowing job market: first red flag

August showed that job creation had slowed dramatically, particularly in key manufacturing, retail and service sectors. For months, we relied on the narrative that a strong job market could sustain the economy through tough times.

But that narrative is quickly falling apart as hiring freezes and job cuts become more common. The data trend is always more important than the actual number of employees. The message is simple: employment is declining.

However, as discussed in “,” full-time employment is a much better indicator of the economy than total employment. As noted, the US is a consumer-based economy.

What is essential is that consumers cannot consume without first producing something. Therefore, for a household to consume at an economically sustainable level, full-time employment is necessary.

These jobs offer higher wages, benefits, and health insurance to support a family, while part-time jobs do not. It is no wonder that historically, when full-time employment declines, a recession usually follows.

If full-time employment is the engine of economic growth, it is logical that stronger trends in full-time employment are necessary.

But since 2023, the economy has lost more than 1 million full-time jobs, compared to 1.5 million part-time jobs. That doesn’t scream economic strength.

Moreover, comparing the number of people in full-time employment to the working-age population shows why the US has been unable to sustain annual economic growth above 2%.

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

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

Corporate profits are at risk

Understanding how weakness labor market translates into weaker wages is essential. When companies are uncertain about future demand, they stop hiring and look for ways to cut costs. These cost-cutting measures come in a variety of ways, such as layoffs, automation, outsourcing, or increasing the number of temporary workers. Such measures may buy companies some time, but they do not solve the problem of falling revenues. When fewer people are employed or wage growth stagnates, consumer spending slows, and that hits the top line of many companies, especially in consumer-driven sectors. It is not surprising that there is a relatively high correlation between the year-over-year change in GDP and corporate profits.

So, given the fact that market participants bid up stock prices in anticipation of higher earnings and vice versa, the correlation between year-on-year earnings change and market prices is also high.

We’ve seen in past economic cycles how quickly earnings can disappoint when the labor market weakens. Analysts were overly optimistic about earnings growth, and now the reality of slower consumer demand will force them to adjust their forecasts.

As earnings expectations continue to decline, investors will need to reconsider current valuations. It’s a simple equation — lower earnings lead to lower stock prices as markets update current valuations.

Investors should brace themselves for the impact of a slowing labor market on stock prices. The market is a forward-looking mechanism and is already starting to factor in the effects of weaker employment growth.

Sectors most exposed to consumer spending, such as retail and travel, are likely to see the biggest declines in stock prices as investors adapt to the reality of lower profits.

Technology companies, which have largely driven 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 job market weakens, consumer demand for technology products and services will also decline, leading to lower profits and falling stock prices.

Implications for investors

Broader financial markets are potentially at risk “a bumpier ride” as the effects of the weakening labour market are reflected in the economy.

As we have seen in previous cycles, investors will begin to move away from riskier assets like stocks and into safer investments like Treasury bonds. This shift could exacerbate market volatility if earnings are revised down to reflect slower economic activity.

There’s also the question of how the Federal Reserve will respond. A slowing labor market often leads to lower inflation, which could allow for more aggressive rate cuts and a reversal of the current balance sheet shrinkage.

However, if it stays well above the Fed’s 2% target despite weaker job growth, the Fed’s hands could be tied. A potential market risk is that the Fed is forced to keep interest rates high while the economy slows. That would prolong the economic recession and put pressure on stock prices.

The latest employment reports show a clear trend: the job market is losing momentum. That spells trouble for the economy and the stock market. The slowdown in job creation, combined with weaker corporate profits, sets the stage for increased market volatility.

As noted, with markets still near record highs, this is an excellent time to reassess portfolio risk. Rebalancing positions in overvalued growth stocks and moving into more defensive assets may be prudent.

As we have often said, in times of uncertainty, capital preservation should be the priority. The job market indicates that uncertain times lie ahead, and investors should prepare accordingly.