SUMMARY
Weak labor market data has raised the probability of further Fed interest rate cuts. We explore the implications for growth, inflation and markets.
KEY TAKEAWAYS:
The Fed will likely cut rates in response to weak US jobs growth
Further inflationary pressures from rate cuts could hit long duration bonds
Equity volatility could pick up in the months ahead
Swings in both directions in small-cap equities and housebuilders seem probable
The US Federal Reserve looks set to cut its policy rate at its meeting this month.
Disappointing labor market figures on September 5 have made this more likely. New jobs grew by just 22,000 for the month of August. Consensus expectations were for an increase of 75,000.
The nonfarm payrolls report underlined the raft of challenges facing the US economy. These include elevated interest rates, sticky inflation, and policy uncertainty.
Manufacturing jobs especially are under pressure, with 78,000 lost this year. The Fed’s Beige Book publication also highlighted tariff-related labor slowdowns across most districts last week.
When it comes to interest rate reductions, looking back at previous cutting cycles for clues about the coming months may not be helpful. Today’s situation looks different to past employment slowdowns.
The labor market is experiencing shorter supply from immigration owing to the ongoing crackdown.
Also, companies’ heavy spending on artificial intelligence (AI) may hinder any broad-based wave of layoffs.
Assuming the AI capex boom continues, demand for construction workers, electricians, engineers, software engineers, cloud specialists and others will likely stay strong.
Overall, then, we believe the Fed is set to cut rates soon. Cuts could filter into support for struggling areas of the economy such as manufacturing, construction and retail. At the same time, it could increase inflationary pressures.
In the medium term, we believe looser monetary policy could boost nominal GDP, i.e., with inflation included.
What might lower rates mean for markets?
As investors mull a potential cutting cycle and subdued labor market data, longer-term US Treasury yields have dipped lately.
This stands in contrast to what’s happened elsewhere, with European and Japanese yields having risen.
Still, we believe long rates have potential to move higher again while short rates seem set to fall. That’s because the Fed is signaling it is comfortable with inflation above 2% in the near term.
Another factor is that tariff-related inflation is still brewing while investors are looking for firm nominal GDP growth in 2026.
We stay underweight longer-duration fixed income for now, therefore.
We also retain some exposure to gold, which we see as a hedge if investors start selling risk assets again.
Why volatility might pick up
The past four months have been unusually calm for the stock market.
Since April’s tariff-induced turmoil, S&P 500 volatility – as measured by the VIX Index – has been well below historical average levels. Typically, June to August sees increased choppiness.
Notably, the S&P 500 has gone 94 sessions without a decline larger than 2% on a closing basis.
These subdued conditions have encouraged systematic investors to up their exposure, helping to support the stock market.
Because of their buying, systematic investor positioning now stands at a high for 2025.
However, were volatility to increase, the rules they follow would cause them to trim their exposure.
Given the scope for trade and other policy surprises, we see higher volatility as likely in the coming months.
So, crowded positioning looks like a bigger risk for US equities right now. By contrast, investor sentiment doesn’t look excessively bullish, going by various surveys.
Among the areas that have done well lately are small-cap equities and homebuilders.
Such shares may well benefit from interest rate cuts, in our view.
So, many investors who were speculating on price falls in these areas have closed their short positions. This short covering has helped to drive small-cap and homebuilder outperformance.
However, companies are just beginning to digest their changing cost structures. We believe that markets are still underestimating tariff-driven inflation and threats to profit margins and consumer spending.
We expect small-caps and housebuilders to experience two-way price volatility through year-end.
Legal challenges to US tariffs are ongoing and ultimately look set to go to the Supreme Court. In our view, the uncertainty is likely to lead to further volatility going into 2026.
