Higher Stock Market Into July?

The stock market will likely stay on an upward trajectory into July, as expectations of a strong Q217 earnings season are partly offset by evidence of a modest slowdown in economic growth.   The evidence still suggests softer June Mfg ISM and Payrolls, due in two weeks.  Potentially major events for the stock market are more likely later this summer.  They include decisions by the Fed, BoE and ECB whether to hike rates or not and potential progress on corporate tax reform.  How these events play out are far from certain, and could be either positive or negative for stocks depending on their resolution.   As a result, stocks are likely to trade more cautiously once the boost from Q217 profits ends in mid summer.  

The consensus estimate for Q217 Corporate Profits is about 11% y/y.  This is a bit softer than the near +15% in Q117, but still strong.  The double-digit gain in part reflects favorable base effects -- GDP data show that Corporate Profits fell q/q in Q216.  The decline in profits then makes a y/y comparison easier now.   But, base effects turn unfavorable for y/y comparisons in H217, as profits rose q/q over H216.  Combined with slower economic growth, the positive influence of profits on the stock market may reverse after the upcoming earnings season.

Macro evidence is not as supportive for Q2 Corporate Profits as it was for Q1 Profits.  Although Real GDP at this point is expected to accelerate on a y/y basis, other factors have softened (see table below).  Oil prices slowed their y/y gain, impacting that sector's profits (but helping others, like airlines).  The trade-weighted dollar sped up relative to last year, which should hurt the translation of earnings abroad.   And, profit margins appear to have shrunk, as prices slowed by more than wages.  In contrast, non-US economic growth sped up in Q217, which should have helped profits earned abroad.  (The speedup is apparent in the Markit Eurozone Composite PMI, which rose q/q in Q217.  But, this Index fell in June to 55.7, joining US evidence pointing to slower growth into Q317.)   The overall softer macro background already may be built into the market consensus. 

Meanwhile, forecasts of Real GDP Growth are coming down.  The Atlanta Fed model now projects 2.9% (was 3.2%) for Q217 Real GDP Growth, while the NY Fed model projects 1.9% (was 2.2%).  The NY Fed model lowered its Q317 Real GDP forecast to 1.5% from 1.8%, as well. There is still a lot more data to see before a final estimate of Q217 Real GDP, so these forecasts can change.  At the moment, both model forecasts for Q217 are above the long-term trend of about 1.5% and thus still portray relatively strong growth.  The first release of Q217 Real GDP is due July 28.
                                                                    
                                                                                                                                          Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q316            1.7                 -3.4                    2.2                              2.6          2.2
Q416            1.9               +16.4                   3.9                              2.7          2.2
Q117            2.0                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.2-2.4          +13.1                  3.1                             2.5          1.8                56.8

Will the Fed Skip September?

Some market economists are raising the possibility that this Wednesday's widely expected Fed rate hike will not be followed by another hike at the September FOMC Meeting.  Some cite the possibility of a federal government shutdown in August if the debt ceiling is not raised.   Others point to the absence of an acceleration in wage/price inflation, in line with the most recent comment by the dovish Fed Governor Brainard.  Another risk that would argue against a September rate hike is a renewed slowing in economic activity.  All three risks are positives for Treasury prices but negatives for stocks and the dollar.

The ECRI Leading Indicator, indeed, points to slower GDP growth ahead.  It has been on a flat to slightly down trend since February.   A slowdown could be modest, however, as Financial Market Conditions remain accommodative.  The NY Fed's model projects GDP to slow to 1.8% in Q317 from 2.3% in Q217.  The Atlanta Fed's model is now down to 3.0% for Q217 GDP Growth, suggesting that some of the forces behind a slowdown are already coming into play -- weak April Wholesale Inventories accounted for some of the downward revision to the Atlanta Fed's projection (see below).

ECRI Leading Index (level)
 

The latest Claims data hint at a softening in the labor market.  Initial Claims averaged  250k in the past two reports, putting them in the upper end of this year's range.   To be sure, the latest report was for a week that contained a holiday (Memorial Day), so it could have been distorted by difficult seasonal adjustment.  It will be important to see if Initial Claims stay high in this Thursday's report.  It also will be important to see if Continuing Claims begin to move up, as well.

                          Initial Claims (level, 000s)
       Latest 2 Weeks                     250
       May Avg                              240
       Apr Avg                                241
       Q117 Avg                             243
       Q416 Avg                             256

The shift toward on-line shopping could be a significant factor behind a slowdown in GDP Growth -- an unusual reason for a slowdown.  Consumption could be hurt through less "impulse" buying and ancillary buying, eg, at restaurants situated near stores.  Also, the decline in retail jobs will hold down income growth.  Even if consumption is unaffected by the shift, the latter could reduce the amount of inventory as retail stores close.  Besides the unwinding of the stock of goods at these stores, there could be a reduction in the inventory-sales ratio.  In other words, warehousing inventory could lead to efficiencies, as less inventory per dollar of sales is needed.  Business Inventory Investment would fall or stay low, thereby holding down GDP Growth.  Note that higher short-term interest rates also could hurt inventory investment, since inventories tend to be financed short-term.  So, the Fed tightening would be partly responsible for a slowdown in inventory investment. 

Note that Wednesday's FOMC Statement accompanying will probably be backward looking, just as was the May FOMC Statement.  It should cite a speedup in economic growth this Spring, while the May Statement pointed to slow growth in Q117.     


 

May Payrolls Disappoint, But...

The May Employment Report was a disappointment relative to yesterday's ADP Estimate, but essentially in line with the evidence discussed in my prior blog -- the ADP Estimate was more of a surprise than this Report.  The Report is consistent with the Fed's expectation of above-trend GDP Growth and further labor market improvement, but it also keeps alive the Fed's budding concern about low inflation.  The real-side part of the report is strong enough to ensure a Fed rate hike at the June 13-14 FOMC Meeting, but the absence of wage inflation evidence leaves open the door for skipping a rate hike in September.  The Report should be a positive for stocks and longer-term Treasuries, but a negative for the dollar.

The +138k m/m increase in Payrolls, after large downward revisions to +174k from +211k in April and to +50k from +79k in March, is consistent with my earlier expectation that job growth would moderate after one-off factors boosted it in January-February.  In contrast, GDP Growth should speed up in Q217 after one-off factors held it down in Q117.   Abstracting from this volatility points to an underlying 1.5-2.5% pace for Real GDP Growth -- enough to keep the Unemployment Rate in a downtrend.

While the May Payroll increase was far less than +253k ADP Estimate and somewhat less than the +173k consensus, the gain was still above the 75-125k pace viewed to be consistent with a steady Unemployment Rate.  And, the latter indeed fell to 4.3% from 4.4%.

There is still no evidence that the lower Unemployment Rate is leading to a speedup in wage inflation.  The 0.2% m/m increase in Average Hourly Earnings was a "low" 0.2%, as it rounded up from a modest 0.15%.   The y/y was steady at 2.5% (2.46% unrounded).  To be sure, calendar considerations work toward a higher print in June, closer to 0.3% m/m that could push the y/y up to 2.6% -- but this y/y pace is still below last year's 2.9% pace.