Morgan Stanley: Labor Market Suggests a Bottom, Not Recession

Equity strategists at Morgan Stanley suggest that the slowing pace of job growth in the United States actually signals that the economy is nearing a bottom, rather than indicating the onset of a recession. This analysis hinges on an optimistic outlook for the US economy and its capacity for recovery.

The team, led by Mike Wilson, the bank's chief US equity strategist, argues that "unemployment will not rise rapidly/sharply, and we won't see large negative non-farm payroll numbers, unless the economy experiences another shock."

These comments came after the US non-farm payroll data for August showed an increase of just 22,000 jobs, a figure that fell short of market expectations. In addition, June's data was revised downward, while July's was revised upward. This data appears to have "sealed the deal" for a Federal Reserve interest rate cut in September.

"Last week's jobs data and revisions suggest that June was the low point in the current non-farm payroll cycle. However, other indicators we track show that job weakness was most pronounced around 'Liberation Day' – which we believe represents the trough of the rolling recession," they noted.

The Rolling Recession and Early Recovery

Wilson and his team have consistently argued that the US economic recession began in 2022 and bottomed out on "Liberation Day." They suggest that the recent jobs data provides further evidence that the economy is currently in the early stages of recovery.

They explain that the early stages of US economic recovery are led by the technology and consumer discretionary sectors – sectors that benefited significantly from COVID-19 related stimulus packages. Subsequently, most other economic sectors experienced a phase of recession at their own pace. "This is the main reason we haven't seen a typical surge in traditional recession definition indicators."

Earnings Revision Breadth Confirming Recovery

Reinforcing this view is the sharp rebound in earnings revision breadth (i.e., the number of analysts raising earnings expectations minus the number lowering them). They add that this type of upward turning point "only occurs after a recession, not before – i.e., in the early transition phase of the economic cycle," appending a related chart.

Wilson suggests that investors unnerved by the latest jobs data should remember that "jobs data is always a 'lagging' indicator; by the time it confirms the economy is in a downturn, the stock market has often already sensed it."

Short-Term Risks and Long-Term Prospects

However, the team does believe that the stock market faces a short-term risk, namely whether the Federal Reserve will be able to provide sufficient response measures.

"The Federal Reserve is still currently focused on inflation risks, and although jobs data is weak, it is 'not too bad' yet. Therefore, there is doubt in the market about the size of the interest rate cut the Federal Reserve will offer in the short term," they say.

The strategists believe that investors may see volatility in the seasonally weak period between September and October. But "given our firm belief that the economy will achieve a lasting and comprehensive recovery, any correction will pave the way for strong movements at the end of 2024 and 2026."

A Look at the Healthcare Sector

Morgan Stanley advises investors seeking defensive hedging to focus on large-cap healthcare stocks, as earnings revisions in the pharmaceuticals/biotech, medical devices, and services sectors are steadily increasing.

Wilson and his colleagues point out that the formal interest rate cut cycle may also reverse the trend of small-cap stocks. Last week, they upgraded small-cap stocks from "underweight" to "neutral." The Russell 2000 Index (RUT), a benchmark for small-cap stocks, has risen 7.2% this year, while the S&P 500 Index (SPX), a benchmark for large-cap stocks, has risen 10%.

"Given that the Federal Reserve may remain more focused on inflation than on weak jobs, the speed of interest rate cuts in the short term may not be enough to drive a sustained flow of funds into low-quality small-cap stocks," they suggest.

Although further deterioration in jobs data would prompt the Federal Reserve to take a more dovish stance – which is necessary to drive the flow of funds into small-cap stocks – "given the lagging nature of jobs data, this will take at least a few months."