Is A Growth/InflationTrade-Off Right?

The stock market should get relief from this week's July CPI Report, which could print below the already low consensus estimate.  But, it may not be enough to preclude another 25 BP Fed rate hike at the September 19-20 FOMC Meeting.  Friday's July Employment Report kept open this risk, although it argued against a more aggressive policy tightening.   Nonetheless, there is a way to interpret the jobs data in a favorable way regarding the inflation outlook that could hold back the Fed at some point.

Consensus looks for +0.2% m/m in both Total and Core CPI.   This would be close to the Fed's annualized 2.0% target for the second month in a row.  Moreover, a 0.1% print for both can't be ruled out.  Owner's Equivalent Rent needs to rise no more than 0.5% (as in June), used car prices and airfares fall, and hotel rates flatten out.  For a below-consensus Total, food at home prices need to fall, as well, which is suggested by recent softness in PPI food prices.  

Whether a low CPI is enough to persuade the Fed to hike once and pause or to pause in September could depend on its view of the labor market.  Friday's Report showed the latter to be still tight, with the Unemployment Rate slipping to 3.5% and wage inflation remaining high at 0.4% m/m.  It keeps open the door for a September hike.  However, the latter is still not a foregone conclusion, since the Fed will see the August Employment Report before the September meeting.  And, the BLS will release its estimate of the Benchmark Revision to Payrolls on August 23 -- possibly revising down the trend in job growth.

In any case, there may be a way to interpret the latest data to draw a more positive view of the inflation outlook.  More than half of the Payroll gain was in Health, Education and Government.  While their demand for workers helps to keep wage inflation high, other sectors look like they are trying to economize on high-cost labor by cutting jobs and the workweek.  These efforts should help offset higher wage rates and hold down prices.  And, they may not reduce output if offset by higher productivity of the retained workers.  

Last week's Q223 Productivity Report was encouraging in this regard.  The 4-quarter trend in Productivity is now 1.3%, up from -0.2% over 2021-202 and close to the pre-pandemic pace (1.6% over 2017-19).  With the latest Atlanta Fed model's estimate of Q323 Real GDP Growth at 3.9% (q/q, saar) and July Total Hours Worked only 0.3% (annualized) above the Q223 average, another strong increase in productivity seems possible in Q323. 

Strong Productivity offsets the impact of fast wage growth on price inflation.  Unit Labor Costs  (Compensation Growth Less Productivity Growth) averaged only 0.9% (q/q, saar) over the past 3 quarters.  It may be one reason why core inflation could be slowing.  The large wage increases could be viewed as labor capturing part of the productivity gain and not requiring a pass-through to prices.  In this view, the Fed could tolerate the high pace of wage increases and pause in its tightening. 

Stock Rally Continuing in August?

The stock market's rally may be slowed by August's seasonal weakness, but it should not be derailed.  The supportive macroeconomic themes of moderate growth and inflation should persist.  Further ahead, stocks could face a problem if growth and inflation do not abate and the Fed becomes more aggressive in tightening.  With this in mind, there are some upside risks to the key data released in August.  Their implications for Fed policy, however, will be mitigated by the fact that another set of key data will be released before the next FOMC Meeting in September.

At this point, it seems likely that the funds rate will be hiked another 25 BPs at the September 19-20 FOMC Meeting.  Economic growth doesn't appear to be slowing.   And, a hike would be consistent with the Fed's Central Tendency forecast.  For both reasons, the market could take the hike in stride.  What could be a more significant negative for the market would be if the Fed raises its endpoint of tightening.  And, unless July-August inflation data slow further, this is a good possibility.  At his post-FOMC news conference last week, Powell opened the door for a string of rate hikes ahead.

Powell essentially said the Fed will keep tightening until it becomes clear that inflation will settle down at 2% for an extended period.  When this will happen is not known.  He said that while monetary policy tightening may stop before 2% inflation is achieved, Fed officials will need to have a good sense that this goal will be realized soon thereafter.  He was not specific about which data points would be persuasive, but presumably a softening in labor market conditions is one of them.  The latest Unemployment Claims data don't suggest this is happening now.

Powell mentioned one factor that presumably makes officials comfortable with their gradual pace of tightening -- the real funds rate is above its historical average.  He didn't say this, but there are reasons why a high real funds rate is now appropriate and should not be reversed soon.  Defense restocking, shifting production back to the US from abroad, and rebuilding the US energy system are providing thrusts to economic activity.  A high real funds rate is needed to crowd out other economic activities, given how tight the labor market is, if these developments are not to further ignite inflation.    

Failure to accomplish a significant enough amount of crowding out may be the most important downside risk to the stock market.  Fed officials could become frustrated with their gradual 25 BP tightening approach and opt for a larger hike at some meeting -- similar to what happened in 1994.  

Consensus estimates of this week's key US data do not suggest these macroeconomic issues will be resolved soon.   Labor market data are expected to show continued above-trend job growth with little, if any, easing in labor market tightness.  Payrolls are seen up 200k m/m, about the same as in June (+209k), with the Unemployment Rate steady at 3.6%.  Job Openings are estimated to fall to 9.62 Mn in June from 9.82 Mn in July --  in the desired direction, but still well above the 7.5 Mn pre-pandemic trend.  Average Hourly Earnings are seen at 0.3% m/m, welcome after printing 0.4% in the prior two months but one month does not make a trend.  

Note that the Claims and other evidence don't rule out a speedup in Payrolls.  Consensus expects Private Payrolls to speed up, but to be offset by a decline in Government Jobs after the latter jumped in June.  Timing or seasonal adjustment issues may have caused the jump and could reverse in July.  Strikers will subtract only a minor amount this month.

Consensus estimates of the Mfg and Non-Mfg ISMs are mixed.  The Mfg ISM is seen edging up to 46.8 in July from 46.0 in June -- a somewhat better level but still in recession territory.  The Non-Mfg ISM is seen slipping to 53.0 from 53.9. 

Stock Market Caution In Face of FOMC and ECI

The stock market may trade cautiously this week, as it faces the possibility of a hawkish FOMC Meeting and key inflation/labor cost data.  Moreover, the market soon will be facing the risk of seasonal weakness in August.  To be sure, the market may take the FOMC Meeting in stride, as a 25 BP rate hike and threats of at least another hike ahead are well expected.  The US economic data, as well as corporate earnings, may be more important.  As for the data, consensus expectations are friendly regarding the PCE Deflator but somewhat disappointing regarding the Employment Cost Index.  The latter would underscore the likelihood of another Fed rate hike ahead.

Consensus expects the Core PCE Deflator to slow to +0.2% m/m in June from 0.3% in May, the same as what was seen in the Core CPI.  The y/y is seen falling to 4.2% from 4.6%.  This seems like a reasonable expectation.  While it should be welcomed by the Fed, there likely needs to be more months of 0.2% or lower core inflation to convince officials that their fight against inflation has been won.   With oil prices up, Ukraine wheat exports on hold, and the dollar softer, the Fed has to remain cautious about the inflation outlook.

The consensus estimate of a 1.2% q/q increase in the Q222 Employment Cost Index (ECI) implies no softening in labor cost inflation.  It keeps the pace in its recent range, as did the speedup in Average Hourly Earnings (AHE) in Q22 (see table below).   Although the ECI is a broader measure of labor costs than AHE, both have risen by similar amounts in recent quarters -- up about 5.0% (annualized).  However, the broadest measure of labor costs -- Compensation/Hour -- has been softer, rising only 3.0% over the year ended in March 2023.   This broadest measure does not keep the composition of jobs constant, unlike the ECI.  This is often viewed as a drawback.  Allowing for compositional shifts, however, may be a better way to understand the impact of labor costs on price inflation if companies are shifting their labor force composition to hold down costs.

The other important data this week will be Unemployment Claims.  While Initial Claims fell in the latest week, Continuing Claims rose.  As they stand now, Initial show fewer layoffs in July than in June.  But, Continuing Claims have risen and suggest a slowdown in July Payrolls.  One more week's data are needed to finalize the implication of Continuing for July Payrolls.

               (percent change over the quarter)

                          AHE                        ECI      

Q223                1.1                            na                       

Q123                0.9                            1.2                 

Q422                1.2                            1.1

Q322                1.1                            1.2

Q22                  1.1                            1.3  

Q122                1.3                            1.4 

Corporate Earnings and FOMC Meeting Won't Likely Derail Rally

 The stock market will be focusing on Q223 corporate earnings and the message coming out of the July 25-26 FOMC Meeting over the next few weeks.  Both will not likely derail the rally.  Earnings may not pose a problem, as the macroeconomic data don't fully support the weak consensus expectations.  The FOMC Meeting, to be sure, should not be market friendly.  A 25 BP rate hike seems to be in the cards.  And, the Fed will probably leave open the door for at least another rate hike ahead.  However, both are widely expected.  And, further tightening is far enough away that it could be put on the back burner. 

Consensus estimates a large 7% or more y/y drop in Q223 S&P 500 corporate earnings.  The macroeconomic evidence is not altogether weak, however, suggesting consensus may be too downbeat (see table below).  Negatives among the evidence include a drop in oil prices (reflecting a spike in Q222) and softer economic growth outside of the US.  But, the dollar is not as strong on a y/y basis as it has been, so it is less of drag on earnings from abroad.  Another negative appears to be a decline in profit margins, as the CPI slowed by more than Average Hourly Earnings.   In contrast, a speedup in Real GDP Growth could save the day for corporate earnings.

The Fed can point to the latest CPI report to justify its recent downshift in tightening.  Although it will likely emphasize that one report does not make a trend, and therefore leaves open the door for further tightening ahead, the inflation trend does appear to be down.  Excluding Used Car Prices and Shelter, the Core CPI was flat in June and registered its fifth month of deceleration.  Moreover, Used Car Prices should fall over the next few months and Owners' Equivalent Rent (the largest component of Shelter) may be in the process of slowing, as it did in June.  Nevertheless, the Fed cannot take its foot off the brake while the Unemployment Rate is so low.  A speedup in economic growth, as well as in commodity prices, could reignite inflation.  Ironically, the Fed may have to overshoot in its tightening to create enough slack in the economy to allow for faster, non-inflationary growth.

The next round of key US economic data may illustrate the problem.  Early evidence points to a speedup in July Payrolls (particularly adding back strikers).  And, the recent upturn in oil prices could feed through to core prices.  

This week's US economic data are expected to be mixed, but consensus risks being too low for some.  Consensus looks for a speedup in June Retail Sales, which seems reasonable.  But, its estimate of flat Manufacturing Output in the June Industrial Production Report risks being low.  While consensus expects a drop in June Housing Starts, this could be due to volatility or the weather.  Permits are expected to rise.  Consensus sees some improvement in the July Phil Fed Mfg and Empire State Mfg Indexes.

                                Macroeconomic Evidence Regarding Corporate Earnings                                                                                                                                            Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level) 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.9           6.0               47.1    

 

Q123            1.9                -15.0                 +3.0                              4.5           5.5               47.9 

Q223            2.5                -30.0                 +0.5                              4.4           5.2               44.7

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.3% (q/q, saar).

 

Macro Evidence Remains Stock Market Friendly

The macroeconomic background should continue to support the stock market this week.  Last week, the June Employment Report pointed to decent economic growth going into Q323.  The risk this week is for the June CPI to show even more of a softening than consensus expects.  The Fed still is likely to hike by 25 BPs at the July 25-26 FOMC Meeting, but that is already built in by the markets.  

The sharp slowdown in June Payrolls to +209k m/m Total and +149k Private is the second of the past three months when job growth -- particularly Private -- moved close to the pace consistent with the Fed's goal.  Nevertheless, the Report bodes well for Q322 economic growth.  Cyclical sectors -- manufacturing and construction -- posted gains.  And, with the Nonfarm Workweek rising, Total Hours Worked jumped in June.  The latter's level is 1.0% (annualized) above the Q222 average -- a good take-off point for Q322.  

Wage inflation may be less of a problem than suggested by the 0.4% m/m increase in Average Hourly Earnings in May and June.  Both rounded up from 0.35% -- so they were "low-side" headlines.  In June, speedups and slowdowns relative to the prior 3-month average were split almost evenly among the sectors.   More than half of the sectors posted wage gains of 0.3% or less.  They are consistent with the Fed's 2% price inflation target, taking account of productivity growth.

The moderate wage inflation may help hold down the June CPI.  Consensus looks for +0.3% m/m for both Total and Core, the latter a slowdown from the +0.4% in April and May.  Unlike in these earlier two months, Used Car Prices should not jump.  Instead, the risk is that they fall, catching up to the declines seen at the wholesale level in the past few months.  Along with the possibility of subdued increases in other components, a below-consensus print for both Total and Core cannot be ruled out.

The June Employment Report provided more reason to be cautious about placing much weight on private surveys.  The slowdown in Payrolls made mockery of the +495k ADP Estimate.  The latter has not been a consistently good predictor of Payrolls.  Total Hours Worked in the Manufacturing Sector point to another increase in Manufacturing Output in the June Industrial Production Report.  Hard data on manufacturing have consistently been stronger than the weakness seen in Mfg ISM and similar surveys in recent months. 

Economic News Encouraging the Stock Market

The stock market contended with hawkish Fedspeak last week and quickly dismissed it for now.  The market was encouraged by evidence of modest economic growth -- not recession -- and contained inflation.  This week's US economic data are expected to signal the same.   So, the market may very well see further gains after possibly unwinding some quarter-end window dressing that lifted it on Friday.

Consensus looks for the June Employment Report to show a slowdown in Nonfarm Payrolls, a downtick in the Unemployment Rate and moderate 0.3% m/m increase in wage inflation.  Payrolls are seen rising 223k m/m, after climbing 339k in May.  A slowdown would be consistent with the implications of the Unemployment Claims data.  But, the consensus estimate, as well as the Claims data, suggest that job growth still is too high from the Fed's perspective.  A sub-100k jobs increase would be consistent with an easing in labor market conditions to the Fed's liking.  Moreover, the consensus estimate of a dip in the Unemployment Rate to 3.6% from 3.7% is in the wrong direction for the Fed.  Fed Chair Powell said last week that the motivating factor behind current Fed tightening is the very tight labor market.  

Powell's comment is another way of saying that the problem for the Fed is not the pace of economic growth, but the level of economic activity.  The level of demand is too high relative to potential supply.  The Fed would like to solve the problem by having economic growth stay below its longer-term trend, thereby allowing population and productivity growth to lift potential supply.  An alternative and faster solution would be for the Fed to tighten enough to precipitate a recession -- thereby knocking demand down to or below potential supply.  So far, the Fed has not opted for this alternative solution -- hinted by Powell's reiteration of the Fed's dual mandate of full employment and low inflation.  The risk, however, is that the Fed may become frustrated with the slow progress against inflation and resume aggressive tightening.  This happened in 1994, when Greenspan abandoned a measured approach to tightening and opted for surprise jumps in the funds rate target.  At the minimum, Fed rhetoric has to stay hawkish (which should be seen in this week's release of the June FOMC Minutes)  to counter the inherent dynamism of the US economy.  Economic growth would probably accelerate if the Fed eased off the brake.

A sustained slowdown in core inflation could mollify the Fed.  And, a deceleration in core inflation to 0.2% m/m is not out of the question.  Housing rent would probably need to slow sharply from the recent +0.5% pace for this to happen.  It remains to be seen.

Consensus estimates of this week's other key US economic data should be market friendly.  Consensus expects an uptick in the Mfg ISM to 47.0 in June from 46.9 in May.  Despite the expected increase, this level would remain in recession territory and not scare the Fed.   While the evidence is mixed, it is tilted toward supporting the consensus estimate.  

Consensus  also looks for a decline in Job Openings to 9.9 Mn after the surprising increase to 10.1 Mn in April.  A decline would signal an easing in excess demand for labor, but excess demand would remain with Job Openings still exceeding the 7.5 Mn pre-pandemic level.  A consensus-like print would not persuade the Fed to end its tightening path.

 

US Economic Data Not Soft Enought For Fed So Far

The stock market has to contend with speeches by Fed Chair Powell and other Fed officials this week, in which they will likely continue to threaten further rate hikes ahead.  Their emphasis on more hikes makes for a high hurdle to prevent one at the next FOMC Meeting.  Indeed, last week's US economic data-- Unemployment Claims and Housing data -- were not soft enough to argue for another pause.  This week's calendar contains the important May PCE Deflator, which risks printing softer than consensus.  However, a soft print is probably not enough to stop the Fed from hiking in July.  An extremely weak June Employment Report may be required, as well.

Consensus expects +0.4% m/m for the May Core PCE Deflator -- the same as the increase seen in the Core CPI.  This estimate risks being too high for reasons mentioned in last week's blog.  In particular, a jump in Used Car Prices accounted for more than 0.1% pt of the Core CPI's increase.  Used Car Prices, however, do not enter the PCE Deflator significantly.  A low Core PCE Deflator print, by itself, would probably not be enough to dissuade the Fed from tightening, as a one-month print is not a trend.  Moreover, a 0.3% print still would be above the Fed's target.

The Fed will probably need to see signs that a recession has begun.  Data released so far don't say this.  The Unemployment Claims data say the labor market has weakened, but the weakness is not snowballing.  Initial Claims stayed high in the latest week, but unchanged from the prior week.  Despite the high level of layoffs, Continuing Claims fell.  The latter suggests hiring remains strong.  To be sure, the Claims data still point to a slowdown in June Payrolls (one more week's data is needed for a complete picture).  However, they do not hint at a sub-100k print, which is what may be needed to get the Fed to consider pausing. 

Last week's Housing Starts/Permits data clashed with Fed Chair Powell's depiction of the housing sector as being hurt by past rate hikes.  His depiction may be rear-view.  The increases in May Starts and Permits -- both for 1-Families and Multis -- raised the possibility that the impact of past rate hikes on this sector is no longer dominant.  Underlying factors, such as population growth and household formation, may be reasserting themselves in housing demand.  While the Starts/Permits jumps may be one-off in terms of magnitude, 1-Family Starts have now risen in each month since February.

The manufacturing sector also may not be as weak as some surveys suggest.  The decline in the Markit US Mfg PMI to 46.3 in June may be just catch-up to the levels seen in the Mfg ISM in prior months.  Evidence for the June Mfg ISM so far is mixed.  Hard evidence regarding manufacturing will be seen in this week's report on May Durable Goods Orders.  Consensus looks for -1.0% m/m for Total, but this is just an unwinding of the +1.1% jump in April.  Ex Transportation Orders are seen slipping 0.2%, which would just extend a modest descent similar to the -0.1% in April.  The Fed's Industrial Production Report shows Manufacturing Output up 2.4% (saar) in April-May over Q123 -- clearly not a sign of recession in this sector.

Overall, the Atlanta Fed model's estimate of Q223 Real GDP Growth is now 1.9% -- in line with the long-term trend estimated by the Fed.