The labor market will be a key determinant of what happens in 2026: Brent Schutte

Key Concepts

• GDP Nowcast: A high-frequency economic indicator estimating current U.S. GDP growth (currently >5% according to the Atlanta Fed).
• ADP Employment Report: A monthly report estimating private sector employment changes in the U.S.
• Challenger Job Cuts Report: A monthly report tracking announced job cuts by U.S. employers.
• Basis Points: A unit of measurement used in finance to describe percentage changes in interest rates (1 basis point = 0.01%).
• Russell 2000: A stock market index representing approximately 2,000 small-cap U.S. companies.
• S&P 500: A stock market index representing 500 of the largest publicly traded companies in the U.S.
• MAG 7: Refers to the seven largest companies within the S&P 500 (typically Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta).
• AI Boom: The current period of rapid growth and investment in artificial intelligence technologies.
• Market Rotation: A shift in investment preference from one sector or asset class to another.

Economic Outlook and Labor Market Analysis

The discussion began with the observation that the Atlanta Fed’s GDP Nowcast is currently exceeding 5%. Fred Shoety, CIO of Northwest Mutual Wealth, cautioned against drawing definitive conclusions from a single month’s data, particularly regarding a potential economic rebound. He highlighted a mixed picture in the labor market: jobless claims remain low, indicating a low firing environment, but hiring rates are also subdued. December saw a positive job addition of 41,000 according to ADP, but the 3, 6, and 9-month average is only 20,000. Challenger reported 35,000 job cuts for the month, bringing the yearly total to 1.2 million – the highest since 2020 (previously 2009). Shoety expressed hope for labor market improvement but stressed the need for continued monitoring, emphasizing that the labor market’s performance will be a key determinant of economic outcomes in 2026.

Federal Reserve Policy and Interest Rate Impact

Shoety noted the Federal Reserve has cut rates by 1.75% over the past two years. He observed a key difference between the 2024 rate cuts and previous cuts: in 2024, the 10-year Treasury yield decreased following rate cuts, whereas in 2024 it increased. He interprets this as evidence that monetary policy remains stimulative. He believes lower interest rates are contributing to a broadening of economic activity, with small and mid-cap stocks performing well in recent weeks. This broadening is expected to continue as the interest rate environment stabilizes or moves lower, leading to more widespread earnings growth.

Small and Mid-Cap Stock Potential

A central argument presented was the potential for outperformance in small and mid-cap stocks. Shoety pointed out that this is a recurring theme among investment professionals. He drew a parallel to the year 2000, during the dot-com boom, where a narrow economy was driven by a single sector (technology). He argues that the current AI boom is creating a similar dynamic, with the broader economy lagging. He predicts that, mirroring the post-2000 period, small-cap stocks will perform well over the next seven to eight years, even if the dollar doesn’t strengthen. He stated, “It’s not a precursor or something that needs to happen for small caps to move higher. To me, it’s broadening out, and interest rates remaining lower which is where the impact for the past few years on the economy has been.” He specifically highlighted the positive impact of lower rates on housing, smaller companies reliant on bank loans, and the manufacturing sector.

Sector Rotation and the "MAG 7"

The conversation shifted to a potential rotation in investment preferences, away from large-cap stocks (like those in the S&P 500) and towards sectors that have been out of favor for the past two to three years, such as real estate, industries, and energy. Shoety expressed some concern about being “consensus” in his view, acknowledging that many others are now advocating for this rotation. He noted that only 30% of S&P 500 companies have outperformed the index in each of the last three years, compared to a historical average of 50%. He also pointed out that approximately 40-50% of the S&P 500 is now concentrated in the “MAG 7” stocks, heavily tied to the AI trade. He emphasized the importance of diversifying portfolios beyond the S&P 500 to gain exposure to more economically sensitive areas.

Historical Parallels and Market Dynamics

Shoety referenced the late 1990s, specifically 1998 and 1999, as a comparable period where the market broadened out following Federal Reserve rate cuts after a recession. He argued that a similar dynamic is unfolding now, with previously underperforming sectors poised for a comeback. He stated, “You’re going to see a lot of those trades you just talked about which have been out of favor for two or three years come back into favor, and they are more correlated.”

Notable Quote

“To me, it’s broadening out, and interest rates remaining lower which is where the impact for the past few years on the economy has been.” – Fred Shoety, regarding the potential for small-cap stock outperformance.

Synthesis/Conclusion

The discussion suggests a cautious optimism regarding the economic outlook. While acknowledging the mixed signals in the labor market, the prevailing view is that lower and stable interest rates will drive a broadening of economic activity and a rotation in investment preferences. Small and mid-cap stocks are positioned to benefit from this shift, potentially outperforming large-cap stocks, particularly those heavily concentrated in the AI sector. Diversification beyond the S&P 500 is recommended to capture the benefits of this broadening economic recovery. The historical parallels drawn to the year 2000 and the late 1990s provide a framework for understanding the potential trajectory of the market.