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The U.S. economy delivered exactly the kind of labor market report investors spent much of last year hoping for. Unfortunately, markets were not in the mood to celebrate yesterday.
Stocks fell sharply due, in part, to a surprisingly strong payroll report, which reignited concerns that inflation could remain stubborn in 2026 and force the Federal Reserve to keep interest rates higher for longer. The S&P 500 posted its first weekly decline since March, while the Nasdaq led losses with a 4.7% drop as technology and semiconductor stocks came under heavy pressure. The Russell 2000 also struggled, while the Dow Jones Industrial Average held up relatively well with only a modest decline.
The selloff is channeling a notable shift in market psychology that’s been bubbling behind the scenes. For much of the past year, investors viewed signs of economic weakness as justification for future rate cuts. Now, stronger economic data is creating the opposite problem. A healthier economy reduces the need for Fed support at a time when inflation risks remain elevated.
Treasury yields moved higher as investors increased expectations that the Fed may need to raise rates rather than cut them. Markets are now pricing in at least one rate hike by year-end, a dramatic shift from expectations earlier this year.
The Labor Market Finds Its Footing
Aside from the market volatility, the labor market story was undeniably positive.
The U.S. economy added 172,000 jobs in May, significantly exceeding expectations, on top of upward revisions to prior months. Even more encouraging, hiring gains were broad-based rather than concentrated in only a handful of industries. Construction, manufacturing, mining, professional services, transportation, retail, leisure, and hospitality all contributed to job growth.
Unemployment held steady at 4.3% and is now flat year-over-year. Broader U-6 unemployment fell to 8.1%, up only 0.3 percentage points from May 2025.
Perhaps most importantly, this improvement is not a one-month anomaly. Private payroll growth has accelerated throughout 2026, with the three-month average reaching its strongest level in more than three years. More than half a million jobs have been created during the first five months of the year, nearly double the total generated during all of last year.
This improvement comes at an important time for consumers. Higher energy prices have squeezed household purchasing power, and recent spending has been supported in part by tax cuts and reduced savings. A stronger labor market may start to provide a more sustainable source of income growth, although that has yet to show up in the data. Hourly earnings growth fell to 3.4% year-over-year, below headline inflation, and earnings growth is likely to fall further behind in May.
It’s a sign that the economy isn’t at risk of overheating, but it presents bigger problems for household financial security. While high(er) income households are still holding inflation-beating earnings growth, low(er) income households are seeing nearly a full percentage point of real earnings declines.
Markets prefer a minor chord
Over the past year, one of the strongest arguments for lower interest rates was that labor market conditions were deteriorating. That argument has now largely disappeared, although there is still plenty of nitpicking over the industries seeing the most growth or losses.
Job openings are rising, payroll growth is accelerating, and unemployment remains stable. Through it all, inflation pressures have proven persistent enough to push long-term inflation expectations to uncomfortably high levels. The NY Fed 5-year median inflation expectation was 3.8% in April (the highest since data collection started in Jan 2022).
The situation becomes even more complicated when geopolitical risks are added to the equation. In the longest-ever game of two-card monte, hopes for a peace agreement between the United States and Iran faded once again last week. This leaves the Strait of Hormuz closed and further prolongs the disruptions to global energy markets. As long as oil prices remain vulnerable to supply shocks, inflation risks will be elevated.
I expect that the Fed will leave rates unchanged for now, but the balance of risk tilts heavily toward inflation becoming unmoored. The Fed will try to look through the energy-driven inflation unless it becomes clear that broader price pressures overtake the supply-driven pressures. The possibility of future rate hikes can no longer be realistically dismissed, particularly if inflation continues moving higher or geopolitical tensions stretch into the fall.
Technology starts to squirm
Earlier, I said that the strong labor data was only part of the reason for the market reaction. Before the payroll data hit, there were a few cracks developing in the AI narrative, and it set the market on edge.
Technology stocks have dominated much of the rally this year, fueled by both enthusiasm surrounding artificial intelligence and massive infrastructure spending. Two uncomfortable pieces of news left the market running short on vital enthusiasm this week. Broadcom’s disappointing outlook weighed heavily on semiconductor stocks, while concerns surrounding new equity issuance to fund AI investments added additional pressure across the sector.
On the precipice of the SpaceX IPO, the rush by tech giants to front-run money-raising events isn’t a positive sign. Google launched an $85B raise, and there are rumors that Meta is planning one soon.
The result of all of this was a notable rotation. Defensive sectors such as consumer staples, utilities, health care, and real estate outperformed, while equal-weight indexes held up better than their market-cap-weighted counterparts.
To be clear, this does not signal the end of the AI story. The economic benefits of AI investment remain significant, and the broader growth story remains intact. However, investors may start to recalibrate expectations or price in added risk as debt and equity deals to fund capex start to pile up. Given current conditions, it will be healthy to look beyond the narrow group of technology leaders toward companies benefiting from the stronger economic fundamentals.
The bond market, always the adult in the room, may have delivered a more rational response than equities. Higher yields reflect stronger growth and the possibility of a more persistent inflation environment. While long-bond longs might grimace, rising yields create more attractive income and diversification opportunities, especially for retiree savers. Shorter-duration Treasuries appear particularly appealing, offering improved yields without taking on excessive interest-rate risk.
What this means for investors and what’s next
The coming week will test whether last Friday’s selloff was a temporary reset or the beginning of a more extended consolidation. Wednesday’s CPI data and Thursday’s PPI data should be closely watched for clues about whether pricing pressures are becoming more entrenched. Every signal that might impact Fed officials is going to needle the market between now and the June meeting.
Source: Cleveland Federal Reserve
Despite the volatility, the broader message from this past week’s data remains constructive. The economy is creating jobs, hiring is broadening, and growth appears durable enough to dodge the ever-present recession calls.
While higher interest rates may create short-term challenges for richly valued growth stocks, stronger economic fundamentals will ultimately provide support for corporate earnings and the broader market in the long term. If you haven’t already, adjust your thinking toward the possibility of a higher-for-longer rate environment. A strengthening labor market is one of the most welcome problems we could have.
Friday, June 5th Market Performance
2026 is below average for volatility at this point in the year.
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Friday was the worst single day return for the S&P 500 in 2026
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It was the worst day since October 10th 2025 (-2.71%)
Courtesy of OddStats. He (it?) is a great follow if you’re on X.
“This is only the 4th time in the history of the market that VIX opened under 16 and closed over 20 in the same day. None of the other 3 events got especially messy and SPX was higher 2 weeks later in all 3 instances.”
From James Altucher:
“So I put together a chart of all of the times the VIX (the “fear index” of the market) was up over 30% in a day (like today) in the past ten years.”
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