Cooling labor market a "bigger worry" than the U.S. shutdown

Capital Economics analysts highlight a cooling U.S. labor market, evidenced by a surprise September decline in private payrolls, as a more significant concern for financial markets than a government shutdown. This labor market softening has prompted a reassessment of the Federal Reserve's policy outlook, leading to a 20 basis point drop in the terminal rate discounted in money markets, a 30 basis point fall in 10-year U.S. Treasury yields, and a 2.5% depreciation in the dollar, while the S&P 500 has gained 5%. Despite these shifts, analysts maintain a "half-glass full" view, expecting the U.S. economy to hold up and suggesting that the recent declines in interest rate expectations and the dollar may be "somewhat overdone," potentially rebounding in the coming months.

Analysis

According to research from Capital Economics, the cooling U.S. labor market presents a more significant risk to financial markets than the ongoing U.S. government shutdown. This view is substantiated by a surprise decline of 32,000 in U.S. private payrolls for September, as reported by ADP, a figure gaining prominence due to the likely delay of official government labor statistics. This labor market softening has already influenced monetary policy expectations, contributing to a 20 basis point drop in the discounted terminal rate over the last two months. Concurrently, the 10-year U.S. Treasury yield has fallen by 30 basis points and the dollar index has depreciated by 2.5%, while the S&P 500 has risen approximately 5% and corporate credit spreads remain exceptionally tight. Despite these signs of economic slowing, analysts maintain a "half-glass full view," projecting that the U.S. economy will remain resilient. They also posit that the market's recent pricing, particularly the decline in interest rate expectations and the U.S. dollar, is "somewhat overdone" and may be due for a rebound in the coming months.

Key Decisions for Investors

• Investors should re-evaluate short-dollar and long-duration Treasury positions, as analysts believe the recent fall in the dollar and interest rate expectations may be overdone and could rebound.
• Given the divergence between a weakening labor market and a rallying S&P 500, it is prudent to review equity exposure and hedge against potential market complacency.
• Pay heightened attention to incoming labor market data, as it is now the primary catalyst for Federal Reserve policy decisions and has superseded government shutdown news as the key market driver.
• Consider maintaining exposure to the artificial intelligence theme, as analysts suggest the AI-driven rally has further room to run despite broader macroeconomic concerns.