The recent batch of indicators has punctured the notion on Wall Street that the U.S. economy is bulletproof and can withstand headwinds like President Donald Trump’s trade war.
That was evident in Friday’s stock market selloff as the dismal jobs report and shocking downward revisions to earlier months raised recession fears.
But not everyone was surprised, as some on Wall Street had previously sounded the alarm on overoptimism and various red flags that are associated with downturns.
In a note on Tuesday, James St. Aubin, CIO of Ocean Park Asset Management, warned that investors were leaning too heavily on the narrative of economic resiliency.
The idea of a “Kevlar economy” had fueled complacency that was showing up in stretched valuations, tight credit spreads, and an underpricing of risk, he added, referring to the synthetic fiber used in bulletproof vests.
One of the risks is political pressure creeping into the Federal Reserve’s decision-making, St. Aubin said. For months, Trump and the other White House officials have demanded Fed rate cuts, even suggesting that cost overruns on a headquarters renovation project are grounds for Chairman Jerome Powell to be ousted.
Another risk is that stock market investors viewed tariffs as a temporary speed bump that would be offset by tax cuts and the tech sector’s capital spending splurge on AI. But St. Aubin pointed out that tariffs hit businesses unevenly, with some are far more exposed than others.
“If you believe in resiliency too much, you’re not being fully compensated for the risks you’re taking,” he added. “Something always goes wrong eventually — whether it’s a risk hiding in plain sight or something you couldn’t see coming.”
Consumer spending on services
To be sure, the U.S. economy had previously demonstrated surprising durability. In 2022, after the Fed launched its most aggressive rate-hiking campaign in more than 40 years, Wall Street widely assumed a recession would follow. But it never came, and inflation cooled sharply.
And earlier this year, economists feared Trump’s tariffs would fuel a big spike in inflation. But while some import-sensitive areas have seen an uptick, the overall rate has been more muted, so far.
However, a deeper dive into some of the headline numbers revealed troubling signs. Last month, economists at Wells Fargo pointed out that although discretionary spending on goods had held up, spending on services dipped 0.3% through May on a year-over-year basis.
“That is admittedly a modest decline, but what makes it scary is that in 60+ years, this measure has only declined either during or immediately after recessions,” they wrote in a note.
Spending on food services and recreational services, which includes things like gym memberships and streaming subscriptions, were barely higher.
Meanwhile, transportation spending was down 1.1%, led by declines in auto maintenance, taxis and ride-sharing, and air travel, which had the steepest drop at 4.7%.
“The fact that households are putting off auto repair, not taking an Uber and cutting back or eliminating air travel points to stretched household budgets,” Wells Fargo said.
Housing market
In May, Citi Research recalled that the late economist Ed Leamer famously published a paper in 2007 that said residential investment is the best leading indicator of an oncoming recession.
“We would be wise to heed his warning,” Citi said.
In fact, residential fixed investment shrank 4.6% in the second quarter, according to data released Wednesday, after contracting 1.3% in the first quarter.
And overall construction spending continued to decline in June, led by a steep plunge in new single-family homes. That’s as mortgage rates remain elevated, representing a major obstacle to affordability, while home prices are still high.
“Residential fixed investment is the most interest rate sensitive sector in the economy and is now signaling that mortgage rates around 7% are too high to sustain an expansion,” Citi said in May.
Labor market
Citi economists have long been among the less bullish on Wall Street, and before Friday’s startling payroll data, they had already sniffed out signs of weakness.
In particular, they flagged a dip in the labor force participation rate, which had suppressed the unemployment rate as it meant fewer people were looking for work.
Citi downplayed the notion that Trump’s immigration crackdown was primarily responsible for the lower participation rate. Instead, economists pointed to low hiring as an indication of weaker demand for workers.
On Friday, Citi saw its prior warnings play out and predicted Wall Street would start to come around.
“Softness that had been evident in details of the jobs report is now apparent in the headline numbers,” the bank said. “Markets and Fed officials should now more closely mirror our view that a low-hiring labor market, together with slowing growth create downside risk to employment and reduce the risk of persistent inflation.”
