Stock Rally To Continue For Now

The stock market should extend its post-midterms rally, possibly through the rest of the year, thanks to three developments suggested in part by last week's data: /1/ inflation may have peaked, /2/ labor market is softening, and /3/ a divided government remains a possibility.  The first two point to a downshift in Fed tightening to 50 BP hikes and possibly a not-so-large increase in the expected end-point.  The third point suggests the possibility of actions to reduce the Federal deficit.

The 0.3% m/m increase in the October CPI reflected slowdowns in a number of components that fundamentals suggest may persist.  New Vehicle Prices finally may be beginning to react to an easing in production disruptions.  Increased vehicle supply has been evident in Industrial Production data, and could be seen to have continued in October in this week's IP report.  The decline in Used Car Prices also reflects this improved demand/supply situation.  And, the CPI's measure of housing rent finally may have begun to pick up the declines seen in recent surveys.  But, declines in other components, like airfares and medical services, may be one-off.  So, while the October CPI is encouraging regarding a peaking in inflation, the problem may not be resolved satisfactorily as yet.   

The Claims data show a modest softening in labor market conditions.  Both Initial and Continuing Claims are moving up from their September lows.  In particular, the jump in Continuing in the latest week suggests that hiring has slowed.  A couple of more weeks of data are needed to determine whether they point to a slowdown in November Payrolls.  A sustained pickup in economic growth without re-triggering inflation requires substantially more slack in the labor market.

Republican control of the House has not been resolved yet, although control remains a possibility at this point.  Such a result could be positive for the stock and Treasury markets, particularly if it pushes the Administration to work with Republicans to pass legislation reducing the Federal deficit.  Even an announced intention to do so would likely lower the medium- and long-term Treasury yields -- a positive for stocks.  Note that anti-deficit talk from the Clinton administration had these market effects in the 1990s.

These developments are likely to persuade the Fed to downshift to 50 BP rate hikes at the December FOMC Meeting, as suggested by recent Fed officials' comments.  They also could hold down upward revisions to end-point estimates of the funds rate in the Fed's Central Tendency forecasts.  But, the market moves -- higher stocks, stable to lower Treasury yields, and lower dollar -- could lead to a renewed speedup in economic growth and inflation that could put more aggressive Fed tightening back on the table at some point.  So, what we may be going through is a cycle rather than a straight uptrend in the economy and markets.