Stock Market Rally to Continue This Week, Then...

The stock market should continue to rally this week, helped by favorable corporate earnings releases.  While the Fed will begin tapering in November, a modest $15 Bn per month reduction in asset purchases, as is likely, should allow the market to take it in stride. The Treasury market already seems to have discounted the tapering, as longer-term yields are off their highs even after the FOMC Minutes pointed to a November tapering start.  Evidence of above-trend economic growth (and possibly more strong corporate earnings) should continue to be supportive of stocks in coming weeks, but the market may have to contend with further increases in commodity prices, particularly oil, and a possible Democratic spending/tax bill.  So, an upward path could be uneven.

Last week's US economic data point to a pickup in economic growth in Q421.  /1/ The 0.7% m/m increase in September Ex Auto/Ex Gasoline Retail Sales was an impressive gain after an even stronger August.  Typically, sales are soft after surging in a month.  In particular, Department Store and Restaurant Sales climbed further, suggesting a dissipation of Delta variant fears.  /2/ The Claims data -- large declines in both Initial and Continuing Claims -- suggest above-trend economic growth at the start of Q421 and also raise the possibility of a speedup in October Payrolls. 

The inflation data suggested that the pickup in core inflation is moderating.  News headlines have featured the high y/y rate of change  (4.0% for Core).  But, this measure is not the right way to look at the evolution of inflation.  The y/y measure reflects past high m/m prints.  The more recent m/m prints, in the 0.1-0.3% range, translate into a slowdown in the annualized 3-month rate of change to 2.7%.  To be sure, some of components that are directly impacted by supply/demand imbalances -- such as Used Cars and Airfares -- still risk being subject to large swings in coming months.  Also, the CPI's measure of housing rent has begun to capture the speedup highlighted in the news.  But, September Import Prices showed a moderation in the components that relate directly to core inflation.  And, the September PPI moderated, as well.  At this point, a core inflation trend just above the Fed's 2.0% target looks possible.  Nevertheless, a reduction in the markets' fear of inflation will probably require substantial pullbacks in oil and other commodity prices.

The overall situation of strong economic growth and higher inflation raises the issue whether a fast recovery is preferable to a slow recovery.  A fast recovery that produces demand/supply imbalances and thus higher inflation could prompt the Fed to tighten sooner and more aggressively than it would in a slow recovery in which inflation stays muted.  So, while a low Unemployment Rate could be achieved more quickly in a fast recovery, it may not last for long.  A Fed tightening could lead to a slowdown to below-trend growth or downright recession (the V-shaped 1980 recession/recovery is an example of the latter, as aggressive Fed tightening during the recovery led to the deep 1981-82 recession).  In contrast,  a low Unemployment Rate would be attained later but last longer in a slow recovery.  There is no clear answer to which speed of recovery is preferable in principle -- although a repetition of the 1980 experience would not be good.  At this point, with the Fed desiring to taper gradually, such a repetition is not likely.