How the labor market slump will burden the economy in the coming months

The August data revealed a key development: the labor market is beginning to cool noticeably. Despite solid headline numbers, the underlying data point to a slowdown in demand for labor – a potential harbinger of future economic challenges.

Investors should take this seriously, as labor market performance is closely linked to overall economic activity and market movements. Although this connection is often overlooked, the link between economic growth and corporate profits is of considerable importance, as we will discuss later.

Employment plays a central role in a consumption-driven economy. Production must take place before consumption can take place, and therefore employment is a key factor in corporate profits and market valuation. We will analyze these points in detail below.

• A notice: Do you want to know how the most successful investors structure their portfolios? InvestingPro gives you access to the strategies and portfolios of top investors. In addition, you will receive over 100 stock recommendations every month based on AI-powered analysis. Curious? Click here for more information.

Slowdown in the labor market: The first warning signal

The August jobs report points to a significant slowdown in job creation, particularly in the key manufacturing, retail and services sectors. For months, we have relied on the strength of the labor market to carry the economy through challenging times.

However, this assumption is increasingly being called into question as hiring freezes and job cuts are becoming more frequent. The trend in the data is often more meaningful than the absolute employment figures. The message is clear: the strength of the labor market is declining.

As already described in the article “The Sahm Rule”, full-time employment is a better indicator of economic health than total employment. The US economy is based primarily on consumption.

The crucial point, however, is that consumption is not possible without prior production. Only with stable full-time employment can households consume at a sustainable level.

Full-time jobs typically offer higher wages, benefits, and health insurance, which part-time jobs often do not. Historically, a decline in full-time employment has often been followed by a recession.

If full-time employment is the backbone of economic growth, stable trends in this area are essential.

Nevertheless, the economy has lost over 1 million full-time jobs since 2023 while gaining 1.5 million part-time jobs – a development that does not indicate economic strength.

In addition, the comparison between full-time employment and the working population makes it clear why the United States cannot sustain economic growth of more than 2% per year in the long run.

Since the turn of the millennium, as the United States has increasingly used technology and outsourcing to reduce the need for domestic labor, full-time employment has declined. When a smaller share of the U.S. labor force is employed full-time, disposable income falls, which directly affects consumption power.

Companies whose profits depend on economic activity are increasingly turning to technologies to increase productivity and reduce labor requirements. If the weakening demand for products and services weighs on companies’ profit margins, a downward revision of profit forecasts is to be expected in the coming months.

Corporate profits are at risk

It is crucial to understand the impact of a weakening labor market on corporate profits. In times of economic uncertainty, companies often forgo hiring and focus more on cost cutting to protect their margins. These measures may include layoffs, automation, outsourcing, or increased use of temporary workers. While such strategies provide short-term relief, they do not address the underlying problem of falling revenues. Lower employment and stagnant wage growth inevitably lead to a rejection of consumer spending, which leads to noticeable declines in profits, especially for companies in consumer-oriented industries. It is therefore not surprising that there is a close correlation between gross domestic product and corporate profits.

While market participants drive up stock prices in anticipation of higher profits and vice versa, the correlation between the subsequent change in profits and market prices is high.

We’ve seen in previous economic cycles how quickly earnings can deteriorate when the labor market loses momentum. Analysts tend to be overly optimistic in their earnings forecasts, but the reality of slowing consumer demand often forces them to revise their estimates.

Falling earnings expectations require a revaluation of current stock prices. The causality is simple: best earnings lead to falling stock prices as soon as the market is revalued.

Investors should be prepared for the consequences of a slowdown in the labor market on stock prices. The market is a forward-looking mechanism and always immediately begins to price in the effects of weaker employment growth.

Sectors that rely heavily on consumer spending, such as retail and the tourism industry, are expected to be particularly hard hit as investors prepare for the scenario of weaker earnings.

Technology companies, which have contributed significantly to the positive market performance this year, could also be vulnerable. These companies often justify their high valuations with optimistic growth expectations.

If the labor market weakens, this will lead to a trend in demand for technology products and services, which will negatively impact earnings and stock prices.

Priorities for investments

Financial markets are likely to enter a potentially volatile period as the negative effects of a slowing labor market increasingly spread to the economy. As in past cycles, investors are expected to gradually shift away from riskier assets such as equities and instead invest more in safer assets such as government bonds. This rotation could further fuel market volatility, especially if corporate earnings are revised downward in the face of slowing economic momentum.

A key question is how the Federal Reserve will respond to these developments. A weaker jobs market could lead to falling inflationary pressures, giving the Fed more room to cut interest rates more aggressively and reverse its balance sheet reduction. However, if inflation remains above the Fed’s 2% target despite weaker job growth, the central bank may be forced to keep interest rates high. This could prolong the economic downturn and put further pressure on equity markets.

The latest employment data shows a clear trend: the labor market is losing momentum, which is expected to have a negative impact on economic growth and the stock market. Slower employment growth combined with weaker corporate earnings could further increase market volatility.

Against this backdrop and given that markets are still close to all-time highs, it is advisable to critically examine the risk positions in the portfolio. A shift from highly valued growth stocks to more defensive investments seems sensible.

In times of increased uncertainty, capital preservation should be the priority. The labor market is signaling a difficult phase for which investors should prepare now.