The stock market should continue to trade up in the last two weeks of December, sustained by the more balanced stance of Fed policy mentioned by Fed Chair Powell in his post-FOMC news conference. He said the Fed was now weighting growth and inflation more evenly in its set of goals. However, the markets' focus on the Fed's forecasts of rate cuts in 2024 risks being disappointed. Stronger US economic data could be the factor that sparks a stock market correction early next year.
The Fed's Central Tendency Forecasts include 2-4 25 BP rate cuts next year. Although Powell continues to insist these forecasts are not cast in stone and should not be viewed as necessarily indicative of the actual path of policy, they are important for two reasons. First, they influence the markets' expectations of future monetary policy, so in a sense they are an additional policy tool to the actual changes in the funds rate. Second, the overall Central Tendency Forecasts put future rate decisions in the context of expected economic growth and inflation. They indicate what combination of them would be compatible with the Central Tendency rate forecasts.
The Central Tendency forecasts are for slow economic growth, higher unemployment and lower inflation next year:
2024 2023
Real GDP Growth * 1.2-1.7 2.5-2.7
Unemployment Rate ** 4.0-4.2 3.8
PCE Deflator * 2.2-2.5 2.7-2.9
Core PCE Deflator * 2.4-2.7 3.2-3.3
* Q4/Q4 percent change
** Q4 Level
In other words, next year's Real GDP Growth needs to slow to a pace below the Fed's 1.7-2.0% estimate of longer-run trend and result in an increase in the Unemployment Rate. At the same time, inflation has to slow by about 0.5% pt on a y/y basis. The Real GDP Growth forecast could be difficult to achieve. Ironically, the markets' anticipation of this expectation may prevent it from happening, as the drop in longer-term yields, higher stock market and weaker dollar all work to stimulate aggregate demand. Moreover, the Bideneconomic thrust from defense restocking, alternative energy investments and re-shoring of manufacturing from abroad remains largely in force -- to be sure, the auto companies' retrenchment of EV production helps curtail the thrust of the Administration's policy. Finally, the economy still has good momentum. The Atlanta Fed models' forecast of Q423 Real GDP Growth was revised up sharply to 2.6% from 1.2% after last week's data releases. Overall, the Fed's forecast for 2024 may not work out.
Even if the forecast for slow economic growth turns out to be wrong, one factor may serve to lower inflation. If housing rent, particularly the measure of Owner's Equivalent Rent, slows to 0.2% m/m from its current trend of 0.5%, the Fed's 2% inflation target may be met. Since the CPI's measure of housing rent lags actual rent by 6 months or so, it conceivably may slow sharply during H124 as it catches up to the flattening already seen in private surveys of housing rent. Also, the decline in
longer-term yields may help hold down rents -- lower yields encourage
new residential construction, thereby lifting the supply of housing. The issue could become whether the Fed will cut rates with inflation in check even though economic growth remains robust.
Based on this analysis, weak US economic data should not be a problem for the stock market, as they would reinforce expectations of Fed policy easing ahead. Economic weakness would be viewed as temporary. Strong US economic data, however, would be a problem if they raise doubt about rate cuts in 2024. And, if they are so strong as to suggest the Fed will renew tightening, they would be a significant problem for stocks. Not only would yields be higher, but the economic strength would be viewed as temporary.
Much of this week's US economic data are housing related. Consensus expects them to weaken slightly. Soft prints most likely will be ignored, given the latest drop in yields. The Purchase Component of Mortgage Applications could begin to get market attention instead.
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