The downside risks in the stock market outlook came to the fore sooner than expected last week. Central bankers highlighted the potential to tighten monetary policy in the US, Canada and Europe later this year, while the Senate's failure to pass a health care bill lowered expectations of corporate tax reform. These developments more than offset the positive effects of strong earnings by some companies. These countervailing forces are likely to continue to buffet the stock market in coming weeks. However, a renewed modest uptrend in stocks into July is conceivable, as Fed fears are tempered somewhat by softer-than-consensus US economic data next week and as more reports of strong earnings are released in the rest of the month.
Evidence points to softer-than-consensus June Mfg ISM (due Monday) and Payrolls (due Friday). The two regional surveys that have correctly predicted the m/m direction of the Mfg ISM each month so far this year are the Phil Fed Mfg Index and the Dallas Fed Mfg Index. Both point to a decline, contrary to the consensus expectation of an increase to 55.1 from 54.9 in May.
(m/m change, points)
Mfg ISM Phil Fed Mfg Dallas Fed Mfg
Jan17 +1.3 +2.1 +6.6
Feb +1.7 +19.7 +2.4
Mar -0.5 -10.5 -7.6
Apr -2.4 -10.8 -0.1
May +0.1 +16.8 +0.4
Jun na -11.2 -2.2
June Payrolls risk slowing further, based on evidence from Initial Unemployment Claims. The second difference in Initial Claims rose in June, signaling a weaker June print than May's. A slowdown would be contrary to the consensus expectation of a speedup to +177k m/m from +138k in May.
2nd Difference in
Initial Claims Private Payrolls (First Print)
Jan17 -19k +97k
Feb +2 -10
Mar +29 -138
Apr -29 +105
May +7 -47
Jun-to-date +2 na
Both the June Mfg ISM and Payrolls should still be strong enough to keep a September Fed rate hike in play. But, it might encourage the dovish Fed officials to continue to raise questions about the wisdom to stay on a tightening path at this time. These doves are not likely to prevail at the FOMC, however, as Fed officials appear to be committed to their "normalization" path of the Fed funds rate. Indeed, the banks' passage of their stress tests removed a concern about further tightening. So, only very weak evidence will likely be required to dissuade them from a September rate hike. Fed officials have said that they view Payroll gains of 75-125k in a month to be consistent with a steady Unemployment Rate. Payrolls presumably would need to print below this range to be viewed as weak.
While Fed officials are likely to emphasize that the funds rate (and Fed balance sheet) remain at accommodative levels at this stage in the normalization process, this does not undo the problematic implications of funds rate normalization for a number of asset classes, including stocks, houses, artwork, etc. Normalization would likely weigh on these asset classes to the extent that they had benefited from the prior near-zero level of the funds rate. In other words, these asset classes would "normalize" also. So, I continue to think that August-September -- after the Q217 earnings season and before the Fed rate decision -- is the real window for a major correction in the stock market. It may take a major stock market correction to keep the Fed from hiking at the September FOMC Meeting.
The one caveat is that signs of progress on corporate tax reform could allow the stock market to escape an August-September correction. Expectations of a boost to economic growth from a corporate tax rate cut would take the place of the disappearing Fed stimulus. To some extent, Trump's reversal of regulations already may be helping.
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