Will Stocks Take A Breather?

The stock market should trade cautiously this week as it gets through several large corporate earnings releases.  Once these releases are digested, the market will face a number of positive macroeconomic factors and some potentially negative ones.  Positively, the US economic data should continue to indicate above-trend growth going into Q421, after a Q321 slowdown.  And, the Fed is committed to gradual tapering and keeping rates steady until the asset purchases are over (in middle of 2022).  Negatively, further increases oil and other commodity prices will not only filter through the various inflation measures but also serve as a tax on the consumer.  Also, at some point, the Democratic spending/tax bill could come together and be problematic for stocks.  A continuation of the stock market rally over the next few weeks could depend on whether these negative potentials turn out to be less of a problem than feared.

A number of considerations suggest further increases in commodity prices, however.  /1/ With US GDP Growth likely to speed up in Q421, demand for commodities is not likely to abate, if not go higher.   The additional transfer payments in the Democratic legislation would boost demand, as well.  /2/ Increased supply, such as higher oil production, also does not appear to be happening soon.  OPEC ministers reaffirmed their quotas at their October 4th meeting and may do the same at the November 4th meeting.  The Saudis do not appear to be inclined to bend to US requests for greater oil output, perhaps /a/ because the Biden administration had earlier sanctioned the Saudi Crown Prince over the journalist Kashoggi's murder and /b/ because the administration has moved toward Iran, the Saudi's enemy.  Domestically, US frackers apparently are reluctant to increase production, given the administration's anti-oil policy stance.  But, if oil prices rise to $90-100/bbl over the next few weeks, OPEC may very well decide to increase production at its early-December meeting.

There are three important US economic data this week -- Q321 Real GDP Growth, the September PCE Deflator and the Q321 Employment Cost Index (ECI).  The markets' responses could be muted, however.

Real GDP Growth appears to have slowed sharply in Q321, with fears of the Delta variant apparently keeping consumers from restaurants and other activities.  While the chip-shortage drag on motor vehicle production received a lot of press, the q/q decline in vehicle assemblies was modest.  Consensus looks for Real GDP Growth of 2.8% (q/q, saar), versus 6.7% in Q221.  The Atlanta Fed model is even weaker at +0.5%.   However, there are reasons why Real GDP Growth will speed up in Q421.  The Claims data are falling fast, Retail Sales data show a rebound in consumer spending over August and September, and the impact of the Delta variant appears to be waning.  So, the markets may not extrapolate Q321 weakening to Q421 and thus could have a muted reaction to a low print.  

Consensus looks for a modest 0.2% m/m increase in the September Core PCE Deflator, versus 0.3% in August.  The CPI already has shown inflation to have moderated in the past two months.  So, this is old news.  In contrast, there is some evidence, such as Used Car Prices and pass-through of higher oil and other commodity prices, that raises the risk of a higher print in October.  So, again, the market reaction to a soft September inflation report could be muted.

Consensus expects a speedup in the Q321 ECI to +0.9% (q/q) from +0.7% in Q221.  The Q3 increase would match the pace of Q121, so it could be viewed as being in a range and not signaling a significant upsurge in labor costs.  The ECI has been rising faster than the +0.4% 2020 average so far this year, but its pace is not far different from the +0.7% average in pre-pandemic 2019.  The ECI is important because, among the major measures of labor costs, it is the least affected by compositional shifts.  

 

 

 

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.

 

 

 

Contending With Higher Longer-Term Treasury Yields

The stock market will likely trade cautiously this week as it contends with higher longer-term Treasury yields even though a solid corporate earnings season begins.  There were several culprits for the rise in yields.  But, with the Democratic spending/tax bill expected to be pared down substantially (and assuming no gimmicks such as shortening the stated duration of spending programs) and the debt ceiling raised until December, the remaining culprits are /1/ fear of rising inflation, sparked in part by the further run-up in oil prices, and /2/ fear of a larger-than-expected amount of Fed tapering beginning in November.  This week's release of the September CPI could exacerbate the inflation issue, although  there are reasons why an adverse print may overstate the problem.  The FOMC Minutes should not worsen tapering fears.

The consensus estimate of +0.3% m/m for the September Total and Core CPI risks being too low -- which could trigger knee-jerk selling on the release.  Some components, such as Used Car Prices, are still susceptible to shortage-induced price hikes.  But, these will eventually unwind.  And, if the spikes are excluded, the Core will probably be benign -- which could reverse the knee-jerk selling.

The September Employment Report boosted inflation fears with the large 0.6% m/m jump in Average Hourly Earnings (AHE).   But, this jump overstated the underlying trend, as it was narrowly based.   A surge in the Education and Health Services sector (possibly related to the seasonal adjustment problem that depressed State Education payrolls) was responsible for pushing AHE above their recent 0.4% trend.  The remaining sectoral hourly earnings data were mixed between those that sped up and those that slowed down.  They were all in line with their recent trends.

The FOMC Minutes are likely to repeat the message Fed Chair Powell sent at his post-meeting news conference.  The Committee expects to begin tapering later this year and have it completed by the middle of 2022.  This timeline implies a $15 Bn reduction in Fed long-term asset purchases per month -- which has become the market expectation.  So, the Minutes could dampen fears of an even faster pace of tapering.  In addition, the Minutes should repeat the Fed's commitment to sustain strong economic growth, which is a powerful factor underpinning the stock market. 

A strong economy should help the stock market weather the rise in longer-term yields.  The September Employment Report confirmed the economy's strength, despite the sharp slowdown in Total Payrolls and the misleading news reports of a weak report.  /1/ Private Payrolls were stronger than Total, as the latter was depressed by a technically-related drop in State Education Workers.  Seasonals expected to offset a start-of-school-year jump in education jobs.  But, these jobs came in earlier than normal this summer, possibly because of the recovery from the pandemic.  So, seasonals overly boosted them then and overly depressed them in September.  /2/ The Unemployment Rate fell 0.4% pt to 4.8% almost entirely due to a jump in Civilian Employment -- not because of the dip in the Labor Participation Rate that news reports blamed.  The Rate would have been 4.9% if the Participation Rate were steady.  /3/ Total Hours Worked (THW) were strong, thanks in part to a rebound in the Workweek.  While the Atlanta Fed model estimate is a low 1.3% (q/q, saar) for Q321 Real GDP, THW point to the likelihood of a rebound in growth in Q421 -- particularly now that the Delta variant appears to be winding down.  The consensus estimate of +0.5% m/m for this week's September Ex Auto Retail Sales (2nd good-sized gain in a row) would support this likelihood.

Reasons for Stocks to Rally Back

The stock market has a window to rally back now that the Democratic spending/tax bills are on hold, the coronavirus infection rate is receding, and seasonal weakness is behind us.  /1/ Stocks risked being hurt by the bills, either because of tax hikes or to crowd out private spending to make room for the infrastructure investments.  /2/ A receding virus means the fear of the Delta variant will soon stop weighing on consumer spending.  /3/ The S&P 500 rose in October in 8 of the past 10 years.  This week's September Employment Report is expected to show a speedup in Payrolls and a decline in the Unemployment.  Even if Payrolls are not as strong as consensus expects, which is the risk, they should not stand in the way of a stock market bounce-back -- particularly if Treasury yields decline on the news.

Consensus expects Nonfarm Payrolls to speed up to +460k m/m in September from +235k in August.  But, the Claims data don't support a speedup.  Both While Initial Claims fell between August and September, showing fewer layoffs, Continuing Claims did not fall as much in September as they did in August.  The slower decline in Continuing Claims suggests a softer pace of re-hiring between the two months and argues for a smaller Payroll gain than in August.  A wild card, however, is the speed at which people who lost their extended Unemployment Benefits in early September found jobs.  The Claims data do not argue against the consensus estimate of a dip in Unemployment Rate to 5.1% from 5.2%.  So, even if Payrolls are softer than consensus, they still should be viewed as being above-trend.

Potential problems for the US economy and stock market further ahead are beginning to be apparent in Europe and Asia.  Energy shortages, stemming from weather-constrained alternative energy sources or policy-induced shifts away from fossil fuels, are showing up in parts of Germany, UK and China.  They could be precursors of what will happen in the US in coming years (having happened in Texas already).  In addition, the coronavirus has resulted in shutdowns in Viet Nam.  These developments will result in shortages that could exacerbate inflation.  

These supply effects have curious implications for monetary policy.  /1/ A supply-constrained US economy means the pre-pandemic low of the Unemployment Rate (3.5%) may not be the right target for Fed policy.  The non-inflationary level of the Unemployment Rate is substantially higher.  Policy should rein in demand to fit the slower capacity of the economy to increase production.  (To be sure, the lags and imprecision of monetary policy's impact mean the correct degree of restraint is not guaranteed to be achieved. A tighter policy could overshoot.)  /2/ If shortages abroad have little impact on US production, but result in higher import prices, monetary policy still may have to tighten to prevent spillover to prices of US-produced goods and services.  /3/ If some of the supply constraints ease, such as the chip shortage, monetary policy could ease to allow demand to move up with supply.

 

 

Stock Market Hurdles : Some Pushed Back, Some Less Than Meets the Eye

The stock market's rally may very well continue over the next several weeks, despite headlines highlighting hurdles still to be faced.  The Fed's tapering has been pushed back to November-December at the earliest.  A default on the Chinese Evergrande company's foreign bond interest payment won't be known for a month.  And, expectations for Q321 corporate earnings are high, although down from the extraordinary surge in Q221.  While a government shutdown stemming from failure of Congress to hike the debt ceiling by Friday is a possibility, it will be only temporary if it happens.  In the background, US data will likely confirm a moderation in economic growth but with inflation remaining high.  Also in the background will be the Democratic spending/tax bill.  It is not clear how this will turn out, with disagreement among Democrats about its particulars and size. 

As for increasing the debt ceiling, news reports say the Democrats could pass the necessary legislation by themselves.  But, they want the Republicans to take some of the heat from voters concerned about higher debt.  The Republicans, however, oppose suspending the ceiling for a year, presumably because doing so would hide the increase in debt needed to pay for the Democratic spending/tax bill.  So, there may be gridlock to the deadline, but it should be resolved either with or without the Republicans. 

From the little that is known so far, the Democratic spending/tax bill could be a net drag on the economy at first.  Higher taxes and increased subsidies to low-income people will hit first, while most of the infrastructure spending apparently won't begin until 2023.   The near-term effects will depend on the drag from higher taxes versus the boost from low-income subsidies.  Since this is not clear, passage of a bill similar to what the Democrats have proposed will likely have only a modest impact on the stock market initially. 

What's striking about the Democratic proposal is its similarity to the goals of Chinese President Xi.  Xi wants a more equal distribution of wealth and a breakup of the market dominance of large corporations, according to a WSJ analysis.  The means to achieve these goals are different between the two.  Xi wants the government to intervene more in the economy ("steer flows of money, set tighter parameters for entrepreneurs and investors and their ability to make profits, and exercise even more control over the economy than now") and for wealthy people to share their wealth.  He also "eliminates" people who could oppose his program.  The government would determine the direction of the economy and allocate resources accordingly.  The Democrats want to rely on higher taxes, subsidies to lower-income people, and more regulation.  The risk in both approaches is that individual initiatives will be stifled, economic growth hurt, and resources mis-allocated.

Xi may have two events in mind regarding implementation of these ideas, according to analysts.  He wants to establish his program in time for the 20th Party Conference in November 2022, where he plans to be re-elected for a third term as president.  Further ahead, he wants China to dominate the world by the 100th anniversary of the Chinese Revolution in 2049.  Both goals imply that China's actions will be an issue for the market for many years to come.

The market expects about 25% (y/y) for Q321 S&P 500 corporate earnings.  This is down from close to 90% in Q212 (helped by base effects), but is still strong.  The macroeconomic evidence supports this kind of expectation.  Real GDP slowed on a y/y basis, although is still above trend.  The Trade-Weighted Dollar is not down as much as in Q221.  Along with a moderation in non-US economic growth, it suggests earnings from abroad should not provide as much of a boost as in Q221.  Similarly, there could be some shrinkage in profit margins, as labor costs sped up.

                                                                                                                                          Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q119            3.2                -12.8                 +7.9                             3.2           2.1               51.9 
Q219            2.7                -12.2                 +5.9                             3.1           2.1               47.8    
Q319            2.1                -19.2                 +3.6                             3.2           2.3               46.4
Q419            2.4                  -3.6                 +1.7                             3.2           2.3               46.2

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            5.3 *               70.5                 -3.0                              4.4           3.7               61.0                                                    

         

* Based on the Atlanta Fed Model's latest projection of +3.7% (q/q, saar).

 

 

 

 

 

 

This Week's FOMC Meeting

The stock market has to get through a number of potentially negative events in this seasonally weak week, including the FOMC Meeting on Tuesday and Wednesday.  Expectations are that the Statement will point to a tapering start before year end.  The meeting's outcome could hit the market hard if the starting date is more immediate.  But, the latter is unlikely, given the mixed views of FOMC members and Powell's re-nomination question.  Instead, there are reasons why stocks could rally after the meeting -- /1/ the tapering should be described as gradual and /2/ the Fed is likely to emphasize its intent to keep the funds rate near zero for an extended time.  

With the possibility of re-nomination as Chair in the background, Powell presumably does not want to disrupt the markets by a tapering decision.  A sharp negative reaction in the stock market could damage his support in Washington,  particularly as it could be compared with the incompetence seen in the Afghanistan debacle.   It also could damage the Fed's reputation.  He will most likely want to make tapering as smooth as possible to avoid these results.

The speed of tapering is important because the Fed is not expected to raise the funds rate until its monthly asset purchases ($120 Bn) are finally over.  A $15 Bn reduction per month would eliminate these purchases in 8 months -- or in June 2022 if the starting date is November  A reduction of $10 Bn each month would end the program in 12 months -- or in October 2022.  So, expectations of the start of interest rate hikes would be for mid-2022 or Q422 at the earliest.   The later the better from the stock market perspective. 

This week's US economic data will highlight the importance of interest rates, as they consist mainly of housing-related releases.  Consensus sees mixed but muted data.  August Housing Starts are expected to edge up, but Permits slip.  August Existing Home Sales are seen down, but New Home Sales up.  There would be downside risk to the consensus estimate of New Home Sales if 1-Family Housing Permits fall again in August.  The latter have fallen for three straight months.  Overall, recent data suggest the housing sector has stalled.

Besides acting against a background of mixed, sluggish data, the Fed will likely be lowering its Central Tendency Projection for 2021 Real GDP Growth at this week's meeting.  It had raised its GDP Growth forecast to 6.8-7.3% (Q4/Q4) at the June FOMC Meeting (was 5.5-6.8%).  But, given the H121 Real GDP Growth Rate of 6.5% and the Atlanta Fed model's current estimate of 3.6% for Q321 Real GDP Growth, growth over the first 3 quarters of 2021 would be 5.5%.  Even, if, as is likely,  the Atlanta Fed model's estimate is ultimately raised to around 4.5%, the 3-quarter Real GDP Growth Rate would be 5.8%.  An unlikely Q421 Real GDP Growth of close to 10% would be needed to reach the Fed's lower bound of 6.8% for the year.  Nevertheless, even a lowering of the GDP Central Tendency would keep it above its 1.8-2.0% longer-run trend, so the Fed still could feel comfortable tapering.

The June Central Tendency for the Unemployment Rate looks too low, as well, but so do the Central Tendencies for the PCE Deflator.

 

Stock Market Concerns Continue

The stock market will likely continue to be weighed down by concerns over Fed tapering, a slowing economy and potentially large increases in federal spending and taxation.  But, there are reasons why sentiment could change at some point -- possibly in late September or early October:   /1/ A strong Q321 corporate earnings season is expected.  /2/ While the Fed appears to be focused on starting tapering in November, the reduction in asset purchases will likely be gradual.  Moreover, interest rate hikes would probably begin only after all the asset purchases end, putting the first hike in late 2022.  /3/ The other two concerns are not baked in the cake and could surprise. 

The Fed is expected to set the stage for tapering at the September 21-22 FOMC Meeting and then actually begin tapering at the November 2-3 Meeting, according to the WSJ.  Any weakness in US economic data leading into the September Meeting should not deter the Fed from this course.  As NY Fed President Williams said, he is more focused on the cumulative strength seen so far rather than m/m fluctuations.  In contrast, strong US economic data would likely be viewed positively by the stock market, as they would suggest economic growth will remain solid as the tapering proceeds.    

While consensus expects most of this week's real-side data to be soft, the Claims data so far have not supported the idea of slowing economic growth.  There are several explanations.  /1/ The dichotomy highlighted by Fed staff (see my prior blog) could be at play.  So, declines in August Total and Ex Auto Retail Sales (consensus -1.0% Total, -0.1% Ex Auto) would fit with the Fed staff's expectation of "an easing of the surge in demand over the first part of the year," while an increase in August Manufacturing Output, led by increased motor vehicle assemblies, would fit with the staff's expectation of an easing of supply constraints.  Overall, the economy is still growing above trend, accounting for the further downtrend in Unemployment Claims.  /2/ Some of the weakness seen in July Retail Sales and August Payrolls could be measurement error that will be revised away.  /3/ Some of the weakness in August Retail Sales, if such is the print, could be just the typical pause after strong gains (as in June).  The pause could last as long as 3 months and tends to be followed by strong sales. 

The other important data this week will be the August Consumer Price Index.  The consensus estimate of +0.4% m/m Total and +0.3% Core looks reasonable, although a lower Core cannot be ruled out.  The forces behind inflation are mixed.  /1/ Wage inflation, as measured by Average Hourly Earnings, has sped up.   But, a news report that Walmart eliminated its quarterly bonus payment to offset an increased wage rate shows that AHE overstates the increase in labor costs.  The elimination of the quarterly bonus payments will hold down the Employment Cost Index and Compensation/Hour, but not AHE -- for definitional reasons.  /2/ Some recently large price increases, like Used Car Prices, have turned down.  This fits with the Fed's view that the recent inflation surges would be temporary.  /3/ The dollar has weakened against the Chinese Yuan, which could lead to higher import prices from there (or narrower profit margins of Chinese exporters if they don't pass through the stronger Yuan).  /4/ Oil prices have flattened out, so their pass-through in a variety of other prices should settle down.