• It looks like stock markets could get the best of both worlds: falling inflation and a continued strong economy.
• This month, investors briefly panicked after weak jobs data was released, fueling fears of a recession.
• However, current economic data suggests that a soft landing is in sight.

The best-case scenario for the stock market got a second chance this week.

This is likely to come as a surprise to investors who panicked earlier this month after the labor market turned out to be weaker than expected in July and unemployment rose to its highest level since the pandemic.

Investors have since recovered those losses and more, with a strong rally on Thursday fueled by the latest economic data that breathed new life into Wall Street’s dream of cooling inflation and a stable, growing economy.

“The extreme swings in sentiment reflect exaggerated recession worries,” Tim Hayes, chief investment strategist at Ned Davis Research, said in a note. “In the U.S. and globally, pessimism has given way not only to the realization that recession fears were overblown, but also to expectations of a more dovish Fed that will almost certainly follow other central banks and cut rates next month.”

Wall Street strategists are taking comfort from four recent pieces of data that suggest the economy will make a soft landing.

Inflation is definitely declining

Consumer prices approached the Fed’s 2% target last month, rising 2.9% on an annual basis in July, the Bureau of Labor Statistics said. That’s less than the 3% annual increase economists had expected and also less than the 3% annual increase recorded in June.

“The bottom line is that inflation has slowed significantly but is probably still within a comfortable range for the Fed to initiate a series of rate cuts,” Charlie Ripley, a senior investment strategist at Allianz Investment Management, said in a note this week.

Investors have been waiting for interest rate cuts all year, and if the Fed does loosen monetary policy, it could potentially trigger a 1995-like rally, the head of global investment strategy at Wells Fargo said this week.

“The CPI report is a green light for the Fed to cut interest rates in its next decision,” said Bill Adams, chief economist at Comercia Bank, this week.

Comercia expects the Fed to decide on a 25 basis point cut at its next four monetary policy meetings, with cuts of 150 basis points over the next 12 months.

Investors are expecting an even more rapid easing of monetary policy. According to the CME FedWatch tool, the markets are pricing in a 41 percent probability that the Fed could cut the key interest rate by 100 basis points by the end of the year.

Unemployment figures at five-week low

The number of jobless claims was lower than economists expected. According to the Labor Department, the number of new claims for unemployment benefits fell to 227,000 last week compared to the previous week.

Initial jobless claims hit a yearly high in early August, but the sharp rise could be due to severe weather such as Hurricane Beryl, some strategists say.

“The decent growth in activity indicators in July suggests that the increase in unemployment this month is not due to a slowing economy. More likely, it reflects the impact of Hurricane Beryl on the Texas labor market and perhaps an increase in the labor force due to immigration and college graduates entering the job market,” said Comercia’s Adams.

“Today’s retail sales and unemployment data provide further evidence that the risk of recession in the U.S. remains low, even as the economy deviates from unsustainably strong levels of growth,” added Ronald Temple, chief market strategist at Lazard, in a note.

Consumer spending saw a surprising increase

Retail sales recorded their largest increase in over a year in July, rising 1 percent compared to an estimated 0.3 percent.

These results are consistent with a “soft economic outlook,” Bank of America analysts said in a note this week, adding that they expect the Fed to cut interest rates twice this year, each by 25 basis points.

“Retail sales in July benefited from consumer spending, which experienced a tailwind in mid-summer, providing another solid piece of data indicating that the economy remains on an expansionary path,” added Jim Baird, CIO of Plante Moran Financial Advisors.

“Consumers have become more selective about their spending as they continue to face higher prices and borrowing costs, but the latest retail sales data show a continued willingness to spend,” Lydia Boussour, a senior economist at EY, said in a statement, adding that the firm does not see a “consumer downturn” on the horizon.

Small businesses are more confident

According to the latest survey from the National Federation of Independent Business, small business confidence rose to its highest level since February 2022, just before the Fed announced its first interest rate hike.

The number of small business owners planning to invest in inventory in the coming months rose four basis points in July, the first positive reading since October 2022.

The percentage of owners expecting higher real sales volume also rose four basis points to its highest level this year, according to the survey.

“The NFIB’s SMB optimism index hit its highest level in nearly two and a half years, and new data this week shows a slowdown in inflation, suggesting that the recent sharp rise in recession fears was unfounded,” John Caplan, CEO of financial firm Payoneer, told Business Insider.

Despite renewed hope for a soft landing, some forecasters warn there is still some likelihood of recession, depending on whether the labor market and economic activity continue to slow. Economists at the New York Fed believe the economy could fall into a 56 percent recession by July next year, according to the central bank’s latest forecasts.