A Stock Market Correction? What About Corporate Earnings?

The big question now is whether the stock market will correct in January -- and, if so, to what extent.  Those looking for a correction see anywhere between a 3-10% decline in the S&P 500.  All, however, view a pullback as a buying opportunity -- which argues for only a modest decline if this is generally believed.  While corporate earnings expectations do not appear particularly troubling, a high Price/Earnings (P/E) Ratio is a concern.  Stocks may have outrun fundamentals.  A trigger for a correction could be soft key macro-economic data in early January.  At this point, evidence points to a sub-50 December Mfg ISM and a smaller increase in December Payrolls than November's +266k.

Corporate Earnings
The Q419 earnings season, which will begin in a few weeks, should not precipitate a correction.  The consensus estimate has moved up.  Although it is still negative, it is less so than the y/y decline seen in Q319.  Macro evidence supports expectations of an improvement in earnings from Q319.  Further ahead, expectations are for strong earnings growth in 2020. 

According to Insight, consensus expectations for Q419 Corporate Earnings are now -1.4% (y/y), better than the -2.3% in Q319 and the Q419 consensus estimate of -2.5% made at the end of Q319.   FactSet says that while downward revisions for some companies have been relatively large, the percentage of companies making downward revisions was smaller than normal.  

The macro evidence supports expectations of better corporate earnings in Q419 than in Q319.  Real GDP Growth has sped up on a y/y basis, using the Atlanta Fed model's 2.3% estimate for Q419.  Oil prices have flattened out after sinking by double-digit rates in the prior 3 quarters.  Profit margins may have improved, as wage inflation slowed while price inflation was steady.  Oil profits should benefit from an easing in price deflation.  And, earnings from abroad should be better, as the slowdown in non-US economic growth stabilized as has dollar weakness. 

                                                                                                                                         Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q117            1.9                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.1                +13.1                  3.1                              2.5          1.8                56.8
Q317            2.3                 +6.0                 -1.9                              2.5           1.7               57.4
Q417            2.5               +12.7                 -4.1                              2.5           1.7               59.7

Q118            2.6               +21.5                 -6.6                              2.7           1.9               59.1
Q218            2.9               +41.0                 -1.8                              2.7           2.2               55.9
Q318            3.0               +45.4                 +5.1                             2.8           2.2               54.3
Q418            3.0                 +6.7                 +6.5                             3.3           2.2               51.7

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                  -3.8                 +1.7                             3.1           2.3               46.2

FactSet says that consensus now looks for a 9.6% y/y increase in corporate earnings in 2020, which would be above the 9.1% 10-year average.  However, the Price/Earnings Ratio still would be high, with the S&P 500 expected to rise to 3430.  The forward 12-month P/E ratio would be 18.0, which exceeds the 5-year average of 16.6 and the 10-year average of 14.9.   A corrective decline in the S&P 500  to 3000 (-7.4% from Friday's 3240 level) would put this P/E ratio at 15.7.   This level would likely be viewed low enough to allow for a renewed rally.

P.S.    I just published a book that analyzes the theology of the Old Testament. The book's title is "Finding Judaism in the Torah" and is on amazon.com. While it does not involve economics or the markets that I write about on my blog, it uses the same objective analytical approach I apply to understanding the import of economic data.

Two Issues Facing the Markets in 2020

The two biggest issues facing the markets in 2020 will be /1/ whether US/global economic growth picks up enough to generate higher inflation and /2/ whether the left-wing Democratic presidential contenders will win the nomination and election.   An affirmative outcome to either would be a major negative for the stock market.  At this point, however, neither appears relevant for the next couple of months. 

US economic growth in Q419 is slightly above trend, according to the Atlanta Fed model's latest Real GDP Growth  estimate of 2.1%.  Longer-run trend is viewed to be between 1.8-2.0%.  The decline in the Unemployment Rate over October-November supports this above-trend depiction of Q419 GDP Growth.  However, the Unemployment Claims data have worsened so far in December.  Their higher prints may have resulted from seasonal adjustment distortions in this holiday period.  Or, a pickup in layoffs might have been a lagged response to the slower growth seen in the prior two quarters.  Then again,  they may, in fact, stem from an actual slowing in economic activity.  Boeing's stoppage of Max 737 plane production beginning January could be a significant drag on Q120 Real GDP Growth.  Anticipatory layoffs in supplier industries may have contributed to the increase in the Claims data.

While there has been some modest improvement in European and Chinese business survey data, they are still at low levels.  Germany seems to be particularly soft.  German manufacturers may be particularly hurt by softer demand from China.  Also, it is conceivable they have lost a competitive edge to the US and other European countries because of higher electricity prices that resulted from its shift to renewable energy supplies.  The German Markit PMI is well below those of other European countries.   The loss of a competitive edge within the euro area cannot be offset by a weaker currency.

Meanwhile, US inflation remains low.  The Core PCE Deflator slowed to 1.6% y/y in December.  Possibly even more troubling to the Fed is the University of Michigan 5-Year Inflation Expectations, which fell to a new low of 2.2% in December.

Regarding the presidential race, the left-wing candidates -- Warren and Sanders -- are trailing the more moderate candidates.  The first major test will be on Super Tuesday, March 3, when 14 states (representing 1/3 of the population) hold primaries.  Until then, the presidential election will be more in the background for the markets. 

A Weaker Dollar

Last week saw the resolution of 3 major issues that had weighed on the stock market -- US/China Phase 1 trade agreement, likelihood of near-term Brexit after Boris Johnson's election victory, and clarity on the Fed's expectations for monetary policy in 2020.   All three resolutions are positive for the stock market.  And, a Christmas rally that persists into January seems likely.  But, they all have one implication that is negative for Treasuries (in terms of price) -- a weaker dollar.

While analysts may debate whether the US/China trade resolution is meaningful or not, it does eliminate for now the risk of a worsening trade war.  So, there should be an unwinding of a "flight to safety" demand for dollars.  Also, any expected widening of the US trade deficit as a result of the reduction in tariffs will put downward pressure on the dollar.

The euro and pound already have begun to strengthen as a result of Johnson's victory.  The reduced likelihood of an abrupt dropping out of the UK from the Euro Area is a positive for the business outlook there, which should help lift these currencies versus the dollar.

The Fed's expectation are for steady monetary policy in 2020 despite an expectations for above-trend GDP Growth  and higher inflation.  This inflationary policy stance should hurt the dollar. 

The Fed's policy stance and the weaker dollar have inflationary implications.  So, they are negatives for the long-end of the Treasury curve and could result in a further steepening in the  yield curve.  

While the Impeachment Inquiry is a non-event for the markets, as it is expected to be defeated in the Senate, the decline of Elizabeth Warren and Bernie Sanders in the polls already may have contributed to the steepening of the medium-term Treasury yield curve.  Their disruptive policy ideas have become less likely to be put into effect during the next 5 years.

With longer-term Treasury yields already back up, and with the risk that they will rise further next year, any strength in this week's housing-related data releases will likely be ignored as temporary.  November Industrial Production also should be largely discounted as one-off -- it should jump as motor vehicle output bounces back from the GM strike.  European Markit PMIs need to rise by more than the modest increases seen by consensus to be significant.

More important for the outlook will be whether forward-looking manufacturing-related data improve, due a week later.  In particular, increases in Core Durable Goods Orders (Non-defense Capital Goods Excluding Civilian Aircraft) would show that the drag from the trade war is dissipating and would move in a direction that eliminates one of the negative risks -- weak capital spending -- in the outlook seen by the Fed.  Higher oil prices also should work not only to lift inflation but to spur increased oil drilling -- which feeds into Business Investment in GDP.

Long-Standing Hurdles About to be Resolved?

Some of the long-standing hurdles for the markets --Brexit and US/China negotiations -- potentially will be resolved this week.   Stock-market friendly outcomes are possible.  The question is whether the pickup in US economic growth now occurring will override the impact of negative outcomes.  My guess is that it will, so any market pullback on the news could be short-lived and a buying opportunity.

UK Elections and Brexit
The outcome of Thursday's UK elections will determine whether an orderly Brexit will proceed.  The latter at this point would seem to be likely, since polls show Boris Johnson in the lead.  In contrast, if the election outcome suggests otherwise, any negative impact on the UK or Euro area economies will probably be met eventually by BoE and ECB policy easing.  So, the market's knee-jerk negative reaction could reverse.

US/China Negotiations
This week should see one of three outcomes -- /1/ a Phase 1 agreement, /2/ Postponement of the December 15 tariffs and continuation of talks, or /3/ a breakdown with both sides saying further talks will await the outcome of next year's Presidential election.  The December 15 tariffs would go into effect.

The market reactions would be:

First Outcome --  Stocks would jump and Treasuries sell off sharply.

Second Outcome -- Stocks might sell off on the announcement, but then quickly resume the rally.

Third Outcome -- Stocks would sell off sharply and Treasuries rally moderately.

The Treasury market move will be partly a reaction to the stock market and partly to the implications for inflation.  Regarding the latter, note that a paring of US tariffs as part of a Phase 1 agreement would likely weaken the dollar.  This would lift import prices and possibly more than offset the direct decline in the prices of tariff-targeted goods.  Similarly, the imposition of new tariffs on December 15 should boost the dollar, which will hold down import prices.

The stock market should interpret an outcome in terms of the impact on US and global economic growth.  The third outcome would be viewed as the most likely to drag down growth.  Even in this case, the recession risks may very well be downplayed by Street economists, given the improving momentum in the US economy and the potential of a Fed easing if economic activity slows sharply.  So, a knee-jerk drop in stocks will be probably be short-lived.

FOMC Meeting
This meeting will probably be a non-event.  The FOMC Statement should underscore the Fed's desire to keep policy steady for the foreseeable future.  At the same time, either the Statement or Powell's post-meeting press conference will likely continue to suggest policy is now pro-growth as inflation remains below target and that officials remain focused on "global developments."  Note that the outcomes of the UK elections and most likely US/China negotiations will not be known at the time of the meeting.

Key US Economic Data
The November Retail Sales and CPI Reports are expected to show a solid consumer and benign inflation.  Consensus looks for +0.4% m/m Ex Auto Retail Sales and +0.2% Core CPI  (with a steady 2.3% y/y).  While Thanksgiving was late this year, there was a lot of retail discounting ahead of the holiday, which might have resulted in earlier-than-usual shopping.  This could "fool" seasonal adjustment.  So, the risk is for the prints to come in lower than consensus for the Core CPI and higher than consensus for Ex Auto Retail Sales.  

The Atlanta Fed model's estimate of Q419 Real GDP Growth is now up to 2.0%.  This is still likely too low relative to the Total Hours Worked data.  An upward revision on strong prints this week would not be a surprise when the model's estimate is updated on Friday. 

November Employment Report Argues for Above-Trend Growth With Little Inflation

The November Employment Report provides more evidence that economic growth is speeding up through Q419.  It suggests GDP Growth is already above trend.  Payrolls surged and the Unemployment Rate moved down.  Nevertheless, wage inflation still looks to be in check.  So, the Fed should remain on the sidelines for awhile.  This situation is a big positive for stocks and a moderate negative for longer-term Treasuries.

The +266k m/m surge in Nonfarm Payrolls, with upward revisions to October (to +156k  from +128k) and September (to +193k from +180k), puts the 3-month average at +205k -- the first time over 200k since January 2019.  (The 3-month average eliminates the boost by the 44k net returning strikers in November, as the latter is offset by the corresponding drag in October.)  The gains were mostly in services, particularly in health care (with a jump in ambulatory personnel).  Manufacturing jobs were up even excluding the 46k returning GM strikers.  Ex returning strikers, these jobs rose 8k.  Construction jobs rose only 1k, but this was after an upward-revised 14k in October (was 10k) -- they still show only a modest uptrend in this sector.  Retail jobs edged up 2k, with a 22k jump in general merchandise more than offsetting an 18k drop in apparel stores. 

The dip in the Unemployment Rate to 3.5% from 3.6% (rounding down after rounding up in October) argues for above-trend GDP Growth in Q419.  The October-November average is 3.5% versus 3.6% in Q319.  The Labor Force Participation Rate dipped to 63.2% from 63.3%, but remains in the higher range seen since August.

Total Hours Worked also argue for above-trend GDP Growth in Q419.  Their November level is 2.3% (annualized) above the Q319 average.  They suggest that the Atlanta Fed model's estimate of Q419 Real GDP Growth will be revised up from 1.5%.   The consensus of Street Economists also will likely be revised up.

Wage inflation remains subdued.  Average Hourly Earnings rose 0.2% m/m after an upward-revised 0.4% in October (was 0.2%).  The y/y slipped to 3.1% from an upward-revised 3.2% (was 3.0%) in October.

Caution Up, But So Is Economy

Two of the three areas of concern for the market -- US/China negotiations and the impeachment inquiry -- risk exerting downward pressure on the stock market in the next couple of weeks.  US legislation supporting the Hong Kong protestors could be a stumbling block for a resolution ahead of the December 15 trigger of new US tariffs.  And, the House looks to be heading for a vote on impeachment at some point this month.  Meanwhile, US and global economic data are turning stronger, which is a positive for stocks.  This positive development may not be enough to offset the negative effects of these two areas of concern near term.

Ironically, the stronger economic data conceivably could tempt the US and China to dig in further to their positions, making a resolution more difficult to achieve.  The official Chinese PMI moved above 50 in November.  And, the risk is for the Mfg ISM to increase for the 2nd month in a row in November.  Consensus looks for it to rise to 49.2 from 48.3 in October.  The risk is for an even bigger increase, given that the figure measures the number of companies seeing steady to better performance regardless of the magnitude of of the improvement.  Most other surveys rose in November, including the Markit US Mfg PMI, Phil Fed Mfg Index and the Chicago PMI.

An increase in the November Mfg ISM (and a consensus-like increase in October Construction Spending) on Monday should boost the Atlanta Fed model's estimate of Q419 Real GDP Growth.  Last week's data already boosted it to 1.7% from 0.4%, bringing it better in line with the Total Hours Worked data in the October Employment Report.  GDP Growth of around 2.0% is around trend and should not cause a bit hit to Treasuries.  Longer-term yields should rise a bit but not so much as to undermine the stock market uptrend.   Much stronger economic growth that brings a Fed tightening back in the picture is what would derail the stock market uptrend.

Besides the US Mfg ISM, the other key report this week will be the November Employment Report.  Payrolls will be boosted by about 44k net returning strikers (GM workers).  Workers laid off in supplier companies because of the strike should return, as well.  Consensus expects +180k m/m for Total Payrolls, but the risk would seem to be on the higher side.  The Claims data argue for a stronger print than the +128k in October.

Although the returning strikers will not impact the Unemployment Rate, the underlying job gains are strong enough to suggest a further decline.  Consensus looks for a steady 3.6%, however.  Calendar considerations and possibly the inclusion of high-paid auto workers point to a 0.3% m/m print for Average Hourly Earnings, in line with consensus.  The y/y would be 3.0-3.1%, versus 3.0% in October.

Holiday Cheer Among Caution

The markets may continue to trade cautiously this holiday week as they await resolution of 3 key items: /1/ US/China negotiations, /2/ strength of US economic speedup, and /3/ Impeachment Inquiry.  However, the tone should be positive for stocks, ahead of Black Friday, as sales estimates are moving up for the holiday season.

US/China Negotiations
These negotiations should always have been seen as difficult to close, as the US demands require China to make fundamental changes to their economic/political system.  But, the Chinese appear to be changing slowly, with the latest being new laws regarding intellectual property.  An interesting development is the Congressional bill in support of Hong Kong protestors.  The question is whether it will push the Chinese to acquiesce to a greater extent than it has been willing to do in exchange for Trump not signing the bill.  Chinese officials apparently already invited top US officials to Beijing to discuss the negotiations.

Strength of US Economic Speedup
The evidence so far suggests the weakest part of the slowdown is behind us, but the re-acceleration is modest at best.  The Flash Markit Purchasing Managers Indexes improved in November, but their levels are still relatively low.  The Unemployment Claims data have moved up in the past 2-3 weeks, suggesting either that the labor market is catching up to earlier economic slowing or that growth remains subdued.  Indeed, the Atlanta Fed model still puts Q419 Real GDP Growth at a meager +0.4% (q/q, saar).  To be sure, this estimate could be overly influenced by the low October Mfg ISM.  If so, it should move up if the Mfg ISM increases in November.

This week's data are mostly minor.  The most interesting -- October Durable Goods Orders -- may not be recent enough to accurately portray whether there has been an improvement in demand for manufactured goods.  They still may be reflective of the weak part of the slowdown.

Impeachment Inquiry
The Inquiry is on hold for the next couple of weeks while Congress is in recess.  Some commentators think the Democrats will gauge the sense of the electorate during this break before deciding how to proceed.  While a number of Republican commentators are pushing for censure rather than impeachment, the Democrats may be too far committed to the latter to do so.  Whatever they decide, it still looks as if the Senate will not go along with removing Trump from office. 

Black Friday and Holiday Season
Stocks should be optimistic about the holiday season.  Besides there being easy year-over-year comparisons, analysts have been raising their estimates of holiday sales.  The National Retail Federation now thinks sales could exceed the upper end of the 3.8-4.2% y/y range that it had estimated in October.

A Wait-And-See Mode in the Markets and a Bi-Partisan Way-Out

The markets are likely to be in a wait-and-see mode over the next few weeks, neither moving up or down decisively.   Besides the outcomes of the impeachment inquiry and US/China negotiations, they will be waiting for evidence that US and global economic growth are speeding up.  Although last week's US economic data were soft, they did not derail expectations of a speedup in growth following a US/China trade agreement.  These expectations should continue to support the stock market rally.   Meanwhile, Treasury yields no longer look excessively high after the intermediate-/long-end shed about 10 BPs last week.

Treasury yields may very well stay near these lower levels for awhile. Some considerations suggest the recent weakness is over, but early evidence does not suggest a sharp recovery.   Manufacturing Output should rebound in November now that the GM strike is over.  Moreover, retail sales could speed up in the holiday season, after a pullback in spending by the strikers and other strike-impacted workers may have weighed down sales in October.   But, the Claims data so far do not point to a sharp acceleration in growth (see below).  So, the Atlanta Fed model's estimate of Q419 Real GDP is likely to move up in coming weeks, after it was lowered to a meager 0.3% from 1.0% as a result of last week's data.  But, it may not get to 2.0% soon.

This week's US economic calendar is light, with perhaps the most important being the Claims data and Markit PMIs on Thursday and Friday, respectively.  Last week's Claims release did not support expectations of a speedup in growth.  Initial Claims jumped 10k w/w to 225k, their highest level since June.  While Continuing Claims fell, they remained in the upper end of the range seen since last April.  Consensus looks for Initial to reverse the jump but for Continuing to stay high in this week's report. 

Consensus looks for the Markit Flash Mfg PMI to edge up to 51.5 from 51.3 for the Services PMI to rise to 51.2 from 50.6.   Both estimates keep the PMIs at relatively soft levels.  But, this would be the 2nd m/m increase in a row for the Mfg PMI.  It has led the Mfg ISM this year, so another increase would bode well for the Mfg ISM.

The Markit Flash PMIs for European Mfg, due Friday, may be the most important of the week's releases.  The Euro Area and German Mfg PMIs have been particularly weak, so even a 1-2 point increase would keep them at a soft level.  But, it would be an encouraging sign that global growth is about to pick up.  Note that PMIs measure the number of companies seeing better or worse variables such as production, orders, and employment.  So, the PMI would increase if more companies see improvement even if the extent of improvement is slight.

A Bi-Partisan Way Out of the Impeachment Inquiry
A conceivable way-out of this partisan-skewed Inquiry is for the House Intelligence Committee to recommend a reprimand, or censure, of President Trump rather than impeachment.  Many Republicans have expressed disapproval of Trump's attempt to get the Ukrainians to investigate Biden and his son.  So, they may go along with a Congressional reprimand.  Although this would fall short of impeachment, Democrats might go along since the result would be bi-partisan.  It would probably have minimal impact on the Presidential election next year, since Trump's many inappropriate actions are pretty much acknowledged by both sides.  From a market perspective, it would be a positive for stocks.

Have Treasury Yields Risen Too Much?

The most striking market action last week was not the new record highs set by the stock market but the sharp rise in intermediate- to long-term Treasury yields.  They rose 12 to 22 BPs, with the 10-year ending the week just shy of 2.00% at 1.94%.  An increase in these yields was expected, for the the reasons I gave in last week's blog, but the extent risks being overdone for now.  There is still no confirmation of the October Employment Report that economic growth is speeding up,   Indeed, the Atlanta Fed model's early estimate of 1.0% Q419 Real GDP Growth is very low.  And, inflation still seems to be subdued, despite the ominous sign from Compensation/Hour -- the broadest measure of labor costs -- which were up 4.5% (y/y) in Q319, well above the near-3.0% pace seen in other labor cost measures (e.g., Average Hourly Earnings and Employment Cost Index). 

This week's US economic data will probably not change the macro picture by much.  The consensus estimate of +0.4% m/m for October Ex Auto Retail Sales probably has to be combined with an upward revision to September's -0.1% to notably boost the Atlanta Fed model's estimate of Q419 Real GDP Growth.  The latter assumes consumption will slow to 2.1% from  2.9% in Q319.  Some upward revision to the model's 1.0% estimate is likely, since it is too low relative to Total Hours Worked in the October Employment Report.  But, it will probably take more than an upward revision in consumption to pull the model estimate up to around 2.0%.  A pace below that would argue against the run-up in Treasury yields seen last week.

The consensus estimate of -0.4% m/m for October Industrial Production risks being too high, given the larger drop in Total Hours Worked in Manufacturing that month (see last week's blog).  But, IP should rebound in November, now that the GM strike is over.   So, a weak print for October should be dismissed.

Meanwhile, even if Q419 Real GDP forecasts are raised from very low early figures, a near-trend 0.2% m/m in the October Core CPI, as consensus expects, would keep the y/y steady at 2.4% and signal no significant inflation pressures.  There are some downside risks to the consensus estimate, to boot.  For example, apparel prices could fall again, or at least stay soft, as a result of bi-monthly sampling.  And, airfares could fall, following the decline in oil prices.

Economic Data Back in Focus

Many of the hurdles faced by the stock market have fallen by the wayside.  Corporate earnings are better than expected, the Fed is on hold, a Brexit resolution has been delayed to January, and the "first phase" US/China agreement appears to be on track.  The House Impeachment Inquiry remains, but at this point Trump's removal would seem a long shot.   With Pelosi expecting a House vote by Thanksgiving, how it will play out in the Senate will likely be known by then.  Until that is fully resolved, the markets will probably be more focused on whether the US and global economies will soon be speeding up.

Evidence on economic growth so far is mixed.  Most Purchasing Manager Surveys moved up in October, but they are still at weak levels.  Construction Spending was up for Residential and Public activity in September, but business-related construction fell further.  The most positive data were the surge in October Payrolls (adding back GM strikers) and the concomitant increase in Total Hours Worked.  THW in October were 1.2% (annualized) above the Q319 average.  This is a strong start, considering they rose 1.0% in Q319.  They raise doubt on the Atlanta Fed model's early estimate of 1.1% (q/q, saar) Q419 Real GDP Growth.  The risk is that the model's estimate will move up as more data come in.

The most important economic development would be signs manufacturing weakness is ending.  This will not be seen in the October Industrial Production Report, due November 15.  Manufacturing Output should drop, as THW in Manufacturing fell 0.7% m/m last month.  However, this should be followed by a bounce in November, if only because of a rebound in motor vehicle production now that the GM strike is over.  Any positive impact from a US/China trade resolution would presumably be seen in data over the next few months, as well.

The markets should move to help sustain economic growth.  The dollar should fall further as the US/China dispute gets resolved.  Elimination of the threat of more tariffs should lift the expected trade deficit, putting downward pressure on the dollar.  In addition, stocks should continue to rally in anticipation of better economic growth now that the dispute has wound down.  While the longer-term Treasury yields should rise, they may not rise much given Friday's October Employment Report showing a higher Labor Force Participation  Rate.  The latter means faster growth need not be inflationary

Until signs of manufacturing improvement appear, the Fed remains a backup.  Although the October FOMC Statement dropped the phrase "will act as appropriate to sustain the expansion, " Powell's comment that the the Fed will act ahead if it sees evidence requiring a "material re-assessment of its outlook" essentially means the same thing.  The Fed should be viewed as being in the background to keep the economy growing if needed.

October Employment Report is Strong

The October Employment Report is strong.  The underlying Payrolls are stronger than the +128k print, and the uptick in the Unemployment Rate shows greater participation in the labor force not softer demand.

 While Nonfarm Payrolls printed +128k m/m, they were held down by two one-off factors: 46k GM strikers and 17k fewer census workers.   Excluding these two factors, Payrolls would have risen 191k.  Moreover, there were layoffs outside of GM that resulted because of the strike.  They, too, should be temporary.  The composition of the Payroll gain shows notable increases in Construction (both residential and nonresidential) and Retail (possibly setting up for the holiday season).

The uptick in the Unemployment Rate to 3.6% from 3.5% resulted from an increase in the Labor Force Participation Rate.  This caused Labor Force to climb by more than the very decent +241k increase in Civilian Employment.  A rising Participation Rate -- which runs counter to the demographically-driven downtrend in the Rate (as more older people retire) -- boosts the potential growth rate of the economy.

The Nonfarm Workweek was steady at 34.4 Hours.  This, too, is a strong showing, sine it could have been negatively impacted by the GM strike.   The workweek in manufacturing, indeed, fell m/m.

The 0.2% m/m increase in Average Hourly Earnings also is stronger than it appears.  Calendar considerations and the compositional impact of the GM strike could have held it down by more.  Along with the upward revision to September to +0.4% from +0.3%, the y/y was steady at 3.0% -- still in line with trend.

This Week's Key Developments

Besides important corporate earnings announcements, this week contains 3 main macro-economic items: /1/ the October 29-30 FOMC Meeting, /2/ Q319 Real GDP release, and /3/ the October Employment Report.  All three should have at most transitory effects on the stock market.

Optimism on the US/China trade negotiations should override the significance of these items and continue to support the market leading up to a possible signing of an agreement at the Asia-Pacific Economic Cooperation meetings on Nov. 16 and 17.  The market will likely react positively to a "phase 1" agreement even if it does not contain much concession on the part of the Chinese.  All that is needed may be a sense that the worst result, a total breakdown between the two countries, has been averted.  After this sense is fully built into the market, the focus will likely shift to the outcome of the House Impeachment Inquiry.  This could weigh on the stock market until there is clarity over the final resolution -- which could be positive or negative (see my prior blog).

FOMC Meeting'
Some market economists, like those at Goldman Sachs, expect the same result as I had outlined in last week's blog.  The Fed will likely cut by 25 BPs, but suggest it will be the last for awhile.  GS economists believe the Statement will drop the phrase "will act as appropriate to sustain the expansion."  While this expectation is a long shot -- since it is difficult to see the cost to the Fed of keeping the phrase and, in fact, it is highly appropriate -- its elimination would likely elicit a negative knee-jerk negative reaction by the stock market.  Such reaction could reverse if Powell emphasizes that its removal represents the Fed's more optimistic outlook as "downside risks" seem to be ending.

But, if the Fed drops the phrase and appears desirous of keeping policy steady for the near future, the burden of reacting to the ups and downs of the economic outlook will fall increasingly on the medium- to longer-end of the Treasury yield curve.  Longer-term yields will react more to the strength or weakness of upcoming US economic data.  

Q319 Real GDP
Both consensus and the Atlanta Fed model have essentially the same forecast for Q319 Real GDP -- 1.7% consensus and 1.8% Atlanta Fed.  This growth rate is in line with the Fed's 1.8-2.0% estimate of the longer-run trend growth rate.  The Unemployment Rate supports this forecast --  the Rate was 3.63% in both Q219 and Q319, suggesting GDP growth was near trend in Q319.  Of course, if the Fed's view of longer-trend trend is too low, as is quite possible, then there is upside risk to the 1.7-1.8% Q319 forecast.  Moreover, with the Rate falling to 3.5% in September, it raises the possibility that economic growth picked up above the longer-run trend as Q3 ended. 

October Employment Report and Mfg ISM
This Report could be difficult to demonstrate that economic growth has sped up, as it will be impacted by the GM strike.  The strike will subtract 46k workers directly from Nonfarm Payrolls.  Workers laid off in supplier industries as a result of the strike will subtract, as well, but the number will not be readily identifiable.   These spillover layoffs could add to the Unemployment Rate, as well.  The Nonfarm Workweek could be held down, too.  And, the absence of the relatively high-paid strikers could push down Average Hourly Earnings.  This would be on top of calendar considerations, which argue for a low 0.1% m/m print for October AHE.   The y/y would be 2.8-2.9%, versus 2,9% in September.

The October Mfg ISM also could be negatively impacted by the GM strike, although the survey is not generally dominated by the motor vehicle industry.  Consensus looks for an uptick to 48.8 from 47.8 in September.  The evidence is mixed.   The Markit Mfg PMI rose, but the Phil Fed Mfg Index fell.

Potential Stock-Supportive Developments, But...

While much uncertainty still hangs over key issues, potential for positive outcomes should keep the stock market in a range over the next few weeks.  Agreements on Brexit and the US/China Trade Negotiations may be reached by late-October to mid-November.  Johnson is still aiming for a Brexit agreement before October 31 and Trump wants a US/China agreement signed at the Asia-Pacific Economic Cooperation meetings that take place in Chile on Nov. 16 and 17.  Even as uncertainty regarding these outcomes persist, the possibility of a Fed rate cut at the October 29-30 FOMC Meeting should support the market.  These developments, however, may not be enough to allow stocks to move decisively through resistance, as the Impeachment Inquiry moves toward resolution.  

With Fed officials still citing downside risks, but saying policy decisions will be made "meeting to meeting," the most important new information leading up to the FOMC Meeting will probably be the Markit PMIs.  The Euro and German Flash estimates, due this Thursday, likely need to move close to 50 to raise the possibility officials will change their assessment of downside risks.  And, officials may take their cue  on the significance of downside risks or the need to cut further by the  Treasury yield curve, which has built in a 25 BP cut in October  (see my blog of September 8).

Even if the Fed cuts by 25 BPs in October, the market may very well take it to be the last one for awhile.  The Treasury yield curve looks to have built in a low probability of further cuts for the next few years.   As a result, any anticipatory run-up in stocks may be given back if the Fed signals the cut is likely to be followed by a pause.  However, the yield curve is still pointed down slightly over the next 5 years, probably reflecting in part the possibility of an economically disruptive election of a Democrat president. (see my blog of September 22).  

US economic data related to manufacturing, like this week's September Durable Goods Orders and the following week's October Employment Report, may be negatively impacted by the GM strike.  So, weak prints should be discounted.  While the GM strike continues to be a drag this month, it will reverse and be a positive for growth once workers return to their jobs -- motor vehicle production will climb to make up for the lost output during the strike.

The Impeachment Inquiry could weigh on stocks if it gathers steam.  Headlines and predictions of impeachment or not may become market-important.  If it looks like the Senate will not go along, then the House deliberations and vote will be meaningless unless they are seen affecting the probability of the 2020 elections.  If the Senate looks like it will vote against Trump, it will be a big negative for the stock market.

Phase 1 on China, Brexit and the Fed/Stock Market

A Fed rate cut at the October 29-30 FOMC Meeting is still a good possibility, even with Trump's "Phase 1" deal with China and movement toward Brexit.  The latter two move toward ending the downside risks to the economy identified by Fed Chair Powell.  But, the main consequence of these risks -- global economic slowdown -- remains.     

Evidence that global growth has turned up may be needed to persuade the Fed to stop easing.  There has been some tentative evidence of improvement in Chinese manufacturing survey data.  But, any bottoming in China has not been strong enough to help its major trading partners.  European manufacturing surveys, particularly Germany's, continued to weaken through September, as have those for South Korea and Japan.  This week, consensus looks for further weakness in Germany's October ZEW Economic Sentiment Index and China's Q319 Real GDP reports. 

The short-end of the Treasury market is still building in a 25 BP rate cut in October.  A sell-off there would be the clearest signal that evidence has firmed enough to forestall a Fed rate cut.


This background should be supportive of the stock market.  If the short-end of the curve sells off, it will send a message that the economic risks have improved significantly.  If it does not sell off, the likelihood of a Fed rate cut should cushion and limit the market effects of any negative corporate earnings news.  Moreover, the easing of threats from US/China and Brexit suggest some of the earnings weakness is temporary.   And, the lower threats work to weaken the dollar, which make earnings abroad more valuable in dollar terms.  Even though some analysts point out that the US still may impose new tariffs in December, this is probably too far ahead to be a near-term concern.

Last week's speech by Powell made some important points that bear on monetary policy and politics.  He discussed 3 items -- /1/ The possibility that Productivity is higher than now measured.  /2/ The US macro-effects of oil prices.  /3/ Measuring labor market tightness.  The Productivity issue impacts both monetary policy and political discussions.

Productivity Measurement
Powell focused on the inability of GDP and thus Productivity to capture the technical impact of the internet and free applications on it.  Fed staff work so far developed a simple way of measuring it, using volume of data flow.  It implies that GDP Growth is understated by about 0.5% pt per year since 2007 and by 0.25% pt/year in the prior couple of decades.   A redefinition of GDP along these lines would make the data more in line with common sense observations about the impact of the internet on people's lives.

A redefinition of GDP has significance for the political discussion of income growth and distribution.  Much political angst has spewed forth on the failure of the median household income to rise with economic growth.  This problem will be at least partly eliminated by capturing the technical advances of the internet.  Since the boost is larger after 2007, the inter-temporal comparisons will improve.

A redefinition of GDP is not important for monetary policy.  This is because both measured and potential GDP Growth should be boosted by the same amount.  So, the relationship between the two would not change.  In other words, measures of labor market and economic slack would be unaffected.

More important for monetary policy is the possibility that the trend in productivity growth has improved.  Powell acknowledged the speedup in Productivity Growth over the past couple of years.  He said the Fed is still not sure if it will persist.  But, if officials begin to be convinced that it will, this would be a big positive for the stock and Treasury markets.  It would mean the Fed's view of Potential GDP Growth is higher than the current 1.8-2.0% estimate.  So, officials would be more willing to permit stronger GDP Growth than now.  It also would likely lead the Congressional Budget Office to lift its estimate of longer-run growth, which would make budget projections less troublesome.

Powell highlighted the positive effects of Greenspan's insight into the implications of the technological revolution of the late 1990s -- suggesting it is an important insight into current Fed thinking.  It suggests the Fed will be very tolerant of stronger growth until a noticeable pickup in inflation occurs.

"Chairman Alan Greenspan famously argued that the United States was experiencing the dawn of a new economy, and that potential and actual output were likely understated in official statistics. Where others saw capacity constraints and incipient inflation, Greenspan saw a productivity boom that would leave room for very low unemployment without inflation pressures. In light of the uncertainty it faced, the Federal Open Market Committee (FOMC) judged that the appropriate risk‑management approach called for refraining from interest rate increases unless and until there were clearer signs of rising inflation. Under this policy, unemployment fell near record lows without rising inflation, and later revisions to GDP measurement showed appreciably faster productivity growth."

Oil Prices
Powell acknowledged that the surge in US domestic oil production means that a rise/fall in oil prices will have a little impact on US GDP.  This is in contrast to the past when the US was a large net consumer of oil.  Then, for example, a rise in oil prices had a significant negative impact on the economy as the consumer was hit by essentially a large tax hike.  Now, the hit to the consumer would be offset by a price-induced increase in domestic oil production.

To be sure,there still could be net negative effects on the US economy through the exchange rate -- although not mentioned by Powell.  Higher oil prices boost world demand for dollars, since oil is traded in dollars.  An increase in dollar demand would result in a higher dollar exchange rate, which would hurt US net exports.

Measuring Labor Market Tightness
Powell said the Fed is working with ADP to construct a new measure of job growth.  It was more accurate regarding  job losses during the Great Recession than official data at the time.  But, he was not more specific than that.  He acknowledged that the recent BLS estimate of the benchmark revision to Payrolls would lower m/m Payroll growth.  But, he said the pace would still be strong enough to tighten the labor market:

"Based on a range of data and analysis, including our new measure, we now judge that, even allowing for such a revision, job gains remain above the level required to provide jobs for new entrants to the jobs market over time."

More Hurdles for the Stock Market

The stock market is about to face another hurdle, with the start of the Q319 corporate earnings season.  Earnings are expected to be soft, with consensus about -3.5% y/y for the S&P 500 (see my September 22 blog).  Besides earnings, the market should continue to react more significantly to news on the US economy and US/China negotiations than the impeachment inquiry.  Any market reaction to the latter will likely be temporary.

Last week's US data tripped the stock market but did not undermine the rally.  The September Employment Report was strong enough to blunt the market's recession-interpretation of the weak 49.1 Mfg ISM (see below).   This coming week's economic news is centered on inflation measures -- the September PPI and CPI.

Both the Core PPI and Core CPI are expected to be benign.   Consensus looks for a benign 0.2% m/m increase in both, keeping the y/y at 2.4% for the Core CPI and 2.3% for the Core PPI.  Both printed 0.3% in August.  Lower-than-consensus print cannot be ruled out.  For the more important Core CPI, health services prices could flatten after an out-sized increase in August.  Owners' Equivalent Rent may stay low at 0.2%.  And, Apple's inclusion of a free year's streaming service with a new phone could be captured as a price decline by BLS.  However, some prices could be boosted by a pass-through of tariffs.  Whatever prints is not likely to stand in the way of an October Fed rate cut.
The Minutes of the October FOMC Meeting should be a non-event.  Fed Chair Powell has said many times the Fed will do what is needed to maintain economic growth in the midst of many downside risks.  And, I have argued that it will likely be persuaded to cut again or not by how the markets react to upcoming data (see my September 8 blog).  So far, global economic data remain weak, and the markets are building in a 25 BP rate cut at the October 29-30 FOMC Meeting. 

US/China negotiations are scheduled to resume late this week.  An agreement to continue talking may be more likely than a real breakthrough, since the underlying issues are fundamental to China and not easy to resolve.  And, news reports suggest China is not ready to agree to the reforms desired by the US.

The markets overreacted to the soft September Mfg ISM last week, believing it to be signaling recession.  Historically, the Mfg ISM tends to be well below 50 when the overall economy goes into recession.  According to ISM,  "A PMI^® reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally declining. A PMI^® above 43.2 percent, over a period of time, indicates that the overall economy, or gross domestic product (GDP), is generally expanding; below 43.2 percent, it is generally declining."

Sep Employment Report Does Not Confirm Markets' Drastic Reaction to Mfg ISM

The September Employment Report does not confirm the markets' drastic take on the sub-50 Mfg ISM earlier this week.  It confirms a slower trend in job growth, but one that is still strong enough to push down the Unemployment Rate.  Despite the tighter labor market, wage inflation remains in check -- although technical factors likely helped depress Average Hourly Earnings.  If the markets force the Fed to ease at the October 29-30 FOMC Meeting, the Report argues that it would do so by only 25 BPs. 

The +136k m/m increase in September Nonfarm Payrolls is well below the +171k 3-month average ending in August.  Excluding government jobs, Private Payrolls rose 114k versus the 135k prior 3-month average.  But, both the September and recent trend job gains are above the near-100k m/m needed to keep the Unemployment Rate steady (assuming no increase in the Labor Force Participation Rate).  Moreover, the cyclical components -- construction, manufacturing and mining -- were altogether up slightly m/m in September and do not confirm the markets' fears of recession.  In particular, the September Industrial Production Report should show flattish Manufacturing Output excluding the GM Strike-related drop in motor vehicle production.  (Manufacturing jobs rose 2k, excluding motor vehicle jobs).

The Report supports expectations of modest Real GDP Growth in Q319, and does not rule out stronger growth in Q419.  Total Hours Worked (THW) rose 0.8% (q/q, saar) in Q319.  Adding 0.5-1.5% for Productivity Growth shows that 1.5-2.5% range is not an unreasonable expectation.  To be sure, the GM strike in H2 of September will subtract from Q319 GDP, so a print in the lower end of the range may have a better chance of printing.  But, THW's take-off point for Q419 is good.  The September level is 0.8% (annualized) above the Q319 average.  So, at this point, a speedup in Q419 Real GDP Growth cannot be ruled out.

The drop in the Unemployment Rate to 3.5% also argues that GDP Growth is above trend.  Even the broader U-6 measure of labor market slack fell to 6.9% -- only the 2nd time since the series began in 1994 when it reached that level.  The decline in Unemployment resulted from a jump in Civilian Employment more than offsetting a moderate increase in the Labor Force.

The 0.0% m/m September Average Hourly Earnings was the risk, based on calendar considerations and some unwinding of August's out-sized +0.4%.  The y/y fell to 2.9% from 3.2%.  Calendar considerations suggest a 0.1-0.2% print in October, which should put the y/y at 2.9-3.0%.  Note, however, that AHE is the narrowest of the major measures of labor costs.  So, the low prints may not tell the whole story. 

What's Important -- Impeachment Inquiry or Fundamentals?

The markets are not likely to be significantly affected by the news regarding the House's Impeachment Inquiry near term.  Most of it will likely be politically motivated and not offer a complete interpretation of the "facts."  The markets will probably see them as background noise, with the only important question being whether they change the odds of next year's Presidential election or perhaps of passage of the US/Mexican and US/Canadian trade agreements.  News regarding the US/China negotiations and key US economic data should be the main focus of the markets.

This week's key US economic data include the September Mfg ISM and Employment Report.

Consensus looks for a rebound in the September Mfg ISM to 50.4 from 49.1.  But, the evidence is mixed.  A variation of the Chicago PM and the Markit Mfg PMI argue for an increase.  They have relatively good tracking records.  The variation of the Chicago PM was correct in 6 of past 8 months.  The Markit Mfg PMI was correct in 5 of 8 months this year.  Most regional surveys point to a decline, however.  This is the case with the Phil Fed Mfg Index, correct in 6 of 8 months this year -- a good tracking record.  But, some, like the Richmond Fed Index, appear to be catch-up after they missed the decline in the August Mfg ISM.

Consensus expects a speedup in Nonfarm Payrolls to +162k m/m from +130k in August.  Continuing Claims point to a speedup, correct in 7 of 8 months so far this year.  This month, it is probably more important to look at Private Payrolls (Total less Government) than Total Payrolls.  Private Payrolls rose only 96k in August, well below the +179k prior 3-month average.  Whether a speedup is viewed as strong or weak could depend on how it compares with this 3-month average.

Total Payrolls could be boosted by the hiring of temporary federal government workers in preparation for the 2020 census.  They accounted for 25k of the 130k August increase.  While this was a large increase by the Census Department, it is well below the hiring pace seen in 2009 ahead of the 2010 census.  Then, about 100k census workers were hired in April-June.  So, it is conceivable that census hiring will speed up in September.

Average Hourly Earnings should be benign.  Calendar considerations suggest 0.1-0.2% m/m, which would push the y/y down to 3.1% from 3.2% in August.  Such a print also could be payback for the higher-than-trend 0.4% jump in August.  Consensus is +0.3% m/m (the same m/m increase as in June and July) and 3.2% y/y.

Meanwhile, the Atlanta Fed model's latest projection of 2.1% (q/q, saar) is slightly above the Fed's 1.8-2.0% estimate of the longer-run trend.  And, Friday's data on the Core PCE Deflator shows the y/y moving up toward the Fed's 2.0% target, but the m/m slowing.  The y/y is backward looking, so the recent slowdown is more significant.  Low inflation is seen in the decline in the University of Michigan 5-Year Inflation Expectations to 2.4% from 2.6%, as well.  The combination of near-trend real growth and low inflation keeps a Fed easing bias in place.  But, it does not scream for another rate cut.





 

Stock Market Faces Some Hurdles in Coming Weeks

The stock market will face a number of hurdles in the next few weeks that could keep it in a trading range.  Q319 corporate earnings are expected to be soft in the aggregate.  US/China negotiations may very well remain on edge, as the major issues (whether China will change its business/government practices) are not easily reconcilable and the US does not appear to want a partial settlement.  Key US economic data risk strengthening in early October, which could reduce the odds of further Fed easing this year.

Corporate Earnings 
Macro evidence supports the consensus expectation of a y/y weakening in Q319 corporate earnings.  Consensus appears to be -3.7% y/y for Q319, versus an actual -0.4% in Q219.  Slower growth in the US and abroad are partly responsible.  Also, oil company earnings should be hurt by the larger y/y drop in oil prices.  A mitigating factor appears to be that profit margins may have improved, as the Core CPI sped up by more than Average Hourly Earnings.  Another mitigating factor is that the dollar did not appreciate as much as in Q219 on a y/y basis, so that the currency-related drag from earnings abroad lessened.

Earnings weakness, however, could be dismissed as temporary in the aggregate, based on evidence that US economic growth is picking up.  And, the consensus estimate now appears to be for a y/y increase in Q419 corporate earnings.
                                                                                                                                         Markit
                                                                                                                                          Eurozone              Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q117            1.9                +65.3                  2.3                              2.7          2.2                55.6
Q217            2.1                +13.1                  3.1                              2.5          1.8                56.8
Q317            2.3                 +6.0                 -1.9                              2.5           1.7               57.4
Q417            2.5               +12.7                 -4.1                              2.5           1.7               59.7

Q118            2.6               +21.5                 -6.6                              2.7           1.9               59.1
Q218            2.9               +41.0                 -1.8                              2.7           2.2               55.9
Q318            3.0               +45.4                 +5.1                             2.8           2.2               54.3
Q418            3.0                 +6.7                 +6.5                             3.3           2.2               51.7

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            2.3                -19.6                 +3.5                             3.2           2.3               47.3

Upcoming Key US Economic Data
Some evidence points to a rebound in the September Mfg ISM and a speedup in September Nonfarm Payrolls, both due in the first week of October.   A variation in the Chicago PM has done a good job predicting the direction of the Mfg ISM, and it points to an increase in the next Mfg ISM report.  Unemployment Insurance Claims data -- the broadest high-frequency measure of economic performance -- have moved down so far in September.  They point to a speedup in September Payrolls.  The rebound in the August Nonfarm Workweek supports one, as well.  The GM strike began after the September Payroll Survey Week, so it should not subtract from this month's print.

Fed and the Treasury Yield Curve
Stronger key US economic data will temper any expectations of further Fed easing this year.  But, they won't eliminate them.   The Fed is focused on downside risks, not current US economic performance.  This week's release of Flash September Markit Mfg Purchasing Manager Indexes (PMIs) will provide evidence whether European economic growth is improving, as was hinted in the August data.  They probably have to improve a lot (with the EU and German PMIs moving above 50) to have a significant impact on Fed views of the risks.

While Powell has been highlighting downside risks to the outlook stemming from weak global economic growth and uncertainty from the US/China negotiations, a bigger downside risk may be the outcome of next year's US Presidential election.  A Democratic victory could lead to large disruptions in the structure of the economy that require very easy Fed monetary policy to offset.  This risk may help explain why the Treasury yield curve declines through 5-year maturities -- through the first term of the next Administration.  A Trump victory has the opposite risk.  He could push the economy so hard as to boost inflation.

Fed Should Pause After This Week's Rate Cut

Last week's Treasury market sell-off is a signal to the Fed that monetary policy should take a breather after a 25 BP cut at this week's FOMC Meeting.  Parts of the yield curve reversed their inversion (longer-term yields lower than shorter-term yields), suggesting some of the downside risks to the outlook have eased.

News stories suggesting some kind of breakthrough in US/China trade negotiations in October reduce the downside risk to the US economic outlook.  And, the ECB rate cut works against the downside risk from the global slowdown.  As for other risks, the Saudi shutdown of 50% of its oil output after the drone attack has mixed implications for the US economy and, on balance, should have a small impact.

A 25 BP cut this week is probably still in the cards, despite the optimistic news regarding US/China and higher inflation data for August.  It is still not clear whether the negotiations will be concluded.  And, the higher August core inflation prints were narrowly based.  Historically, the Fed tends to overshoot when either easing or tightening -- possibly a requirement to be effective.

Core inflation may have bottomed, as the Core CPI rose an above-trend 0.3% m/m in the past two months and pushed the y/y up to 2.4%.  But, the speedup was not widespread.  Large increases were registered in Hospital Services, Health Insurance Premiums and Airfares.  Most other components were little changed or lower.  And, some important components, like Owners' Equivalent Rent, in fact, slowed.  So, the run-up in core inflation may be temporary.

To be sure, Non-Fuel Import Prices were flat in July-August, after falling in 5 of 6 months in H119.  So, they may be less of a drag on inflation ahead.  Also, Average Hourly Earnings posted a high 0.4% m/m increase in August.  But, some of the strength likely reflected calendar considerations that should moderate in September.

The real-side of the economy is rising moderately.  It does not justify Fed easing, but does not stand in its way.  Q319 Real GDP Growth, at 1.8% according to the Atlanta Fed model's latest forecast, is in the range estimated by the Fed to be the economy's long-run potential growth rate.  It is neither too high or too low.  While job growth slowed sharply in August, early evidence points to a speedup in September.   

The cutback in Saudi oil production has mixed implications for the US economy.  Oil prices are expected to jump by as much as $10/bbl, depending on the length of time of the cutback.  This would translate into as much as 23 cents/gallon for gasoline.  Along with higher heating costs, consumers will have to pay an additional $35 Bn (annualized) directly with a $10/bbl jump.  Total US spending on petroleum products would climb by as much as $75 Bn (0.4% of GDP).   But, more than half of this spending would be on domestically-produced oil, which should climb (both production and drilling) in response to the higher prices if they look to be in effect for some time.  So, the net effect of the higher oil prices on US GDP should be minor.

The "dots" chart to be released at this week's FOMC Meeting probably loses importance after last week's Treasury market sell-off.  The FOMC members' rate projections were done a couple of weeks earlier.  So, they might have incorporated concerns about downside risks to the outlook that now look less threatening according to the market (see my last week's blog).

Fed Policy After a 25 BP Cut

With a 25 BP rate cut by the Fed at the September 17-18 FOMC Meeting a near-certainty, the markets will be looking for any hint that this is the last easing for awhile.  This will be found in the "dots" chart, which will be updated along with the Fed's economic projections at this meeting.

The chart shows what the FOMC participants -- board members and district bank presidents -- expect the funds rate to be in 2019-2022.  It is an explicit statement of what officials think the most likely path of the funds rate will be.  Nevertheless, the chart is no guarantee of being a correct prediction.  For example, at the December 2018 meeting, it showed expectations for an upward path of the funds rate over the next 3 years.  The Fed stopped tightening the following month.

Because the Fed is now basing monetary policy on downside risks to the outlook, there is even greater-than-normal uncertainty about the reliability of the dots chart.  These risks are difficult to ascertain, as they can be subject to the eyes of the beholder.  Powell and other Fed officials have been citing downside risks at the same time as portraying economic growth to be solid.  The latter view could seem to undercut the significance of the former.  And, he has varied the litany of downside risks over time.  So, as the headlines and data shift, the question will be whether the Fed's perception of downside risks have changed enough to affect their policy decision. 

The key to answering this question may be the markets' own behavior.   Since officials, themselves, are likely unsure how to evaluate the significance of any specific data or event in terms of downside risk, they may continue to rely on the markets' reaction to make policy decisions.  If longer-term yields climb and the curve steepens in response to new information, the Fed could pull back from its concerns about downside risks.  A breakthrough in the US/China trade talks or new German fiscal stimulus are potential examples where yields could rise (led by European yields in the latter case) and the dollar falls.  The extent and persistence of these moves presumably will be important regarding their impact on Fed decision making.  But, if such developments do not result in these market moves, then further Fed easing may remain a good possibility.  If the markets don't think an event or data significantly affect the risks to the outlook, why should the Fed. 

This week's US economic data are not expected to affect the Fed's concerns about downside risks.  Consensus looks for a small 0.1% m/m increase in August Ex Auto Retail Sales, which would be decent after the 1.0% jump in July and the likelihood of some unwinding from "Prime Day" in July.  Consensus also looks for a moderate 0.2% m/m increase in the July Core CPI, with the y/y edging up to 2.3% from 2.2%.

US economic data will be important in 3 cases.  One, if they show that GDP Growth is well above or below the 1.8-2.0% long-run potential pace for an extended period.  Two, if core inflation is very high or low relative to the Fed's 2% target.  Three, if Fed officials shift to viewing 3.0% growth as a long-run potential pace rather than their current estimate of 1.8-2.0%.  To date, they have not done so.

August Employment Report Shows Business Caution, But...

The August Employment Report shows business hiring caution but has positive elements regarding the outlook.  The hiring caution is seen in the Payroll slowdown and jump in part-time workers.  The positive elements are the rebound in the Workweek and the further increase in the Labor Force Participation Rate. The Report should not stop the Fed from cutting rates by 25 BPs at the September 17-18 FOMC Meeting.

The +130k m/m increase in Nonfarm Payrolls, with Private Payrolls up only 96k, shows sluggish growth in many industries and continued decline in Retail Jobs.  Curiously, manufacturing-related data were better than survey and anecdotal evidence suggested: manufacturing jobs rose 3k (although most industries cut jobs), the workweek rose (including overtime), and temporary jobs rose (viewed as mostly manufacturing jobs).  Industrial Production should rise smartly this month.   Construction jobs also sped up, with the gains in residential and non-residential.  Mining jobs fell, however, possibly as oil drilling activity reacted to the lower oil prices.

Total Hours Worked rose a solid 0.4% m/m, thanks largely to the rebound in the Average Workweek.  They stand 1.1% (annualized) above the Q219 average.  So, they support estimates of 1.5-2.0% Q319 Real GDP Growth, although the relationship between THW and Real GDP Growth is variable as Productivity Growth can fluctuate.

The Household Survey data were the most interesting in the Report.  Civilian Employment and Labor Force both surged over 500k m/m.  More than half of the job growth was in part-time jobs.  But, the important point is that the Labor Force Participation Rate continued to climb, raising the possibility that potential trend growth is higher than the Fed's 1.8-2.0% estimate.  The increased workforce participation is possibly in response to higher wage rates.   While the 0.4% m/m increase in Average Hourly Earnings was probably partly a consequence of calendar considerations, it also could reflect the tight labor market.  The headline Unemployment Rate was steady at 3.7%, but unrounded it slipped to 3.69% from 3.71%.  The decline was concentrated in African-American, Latino Ethnicity, Teen-Age and Women Unemployment Rates.

Focus on the September FOMC Meeting

Over the next few weeks, the markets are likely to focus on the likelihood of a Fed rate cut at the September 17-18 FOMC Meeting.  With Fed officials emphasizing downside risks in their policy decision making, upcoming US and non-US economic data may not be relevant in their decision making.  The downside risks will remain even if some data strengthen.  And, the evidence suggests the key US economic data risk being mixed, in any case.  So, at this point, a 25 BP cut at the Meeting looks probable.

Although some Fed officials have stated recently that more rate cuts are not needed, a decision not to ease at the September meeting was made more difficult by former NY Fed President Bill Dudley's op-ed piece on Bloomberg last week.  It argued the Fed should refrain from easing in order to make it difficult for Trump to be re-elected.  The piece opens the door for more accusations of political motivation if officials decide not to ease.  The Fed is already being attacked by Trump (see last week's blog).  And, Dudley's piece gives him ammunition.  In principle, Fed officials, current and former, should emphasize that Fed actions always aim to achieve the goals of full employment and low inflation and are not politically motivated.

The evidence is mixed for this week's key US economic data.  While an increase in the August Mfg ISM cannot be ruled out, there is some evidence that August Payrolls will slow.

Consensus looks for a dip in the August Mfg ISM to 51.0 from 51.2 in July.  But, an increase cannot be ruled out.  While none of the other mfg surveys has done a consistent job predicting the m/m direction of the Mfg ISM, they are mixed this month.  Markit Mfg PMI and Phil Fed Mfg fell in August, but Richmond Fed and Chicago PM rose.  Even a variation of Chicago PM, that had been correct in most prior months, missed the July decline in Mfg ISM, which suggests a reverse miss (and increase) in August.

Consensus looks for a slight slowdown in August Payrolls to +159k m/m from +164k in July.  The Claims data show that layoffs remain low, but suggest that hiring has slowed.   On balance, they suggest a smaller Payroll gain in August than in July.  Calendar considerations point to a consensus-like 0.3% m/m increase in Average Hourly Earnings.  But, these considerations underestimated July, so could overestimate in August.

The consensus August Payroll estimate and July's print are in line with the +165k H119 average pace.  This is the correct comparison, even though both don't take account of the large downward revision in the BLS benchmark estimate.  Last week, the BLS released its estimate of the benchmark revision to March 2019 Payrolls.  It showed the currently printed level of Payrolls is 501k too high.  This benchmark revision will be incorporated into the data in early February 2020 with the January Employment Report.  What it means is that the currently reported +165k H119 average is too high, possibly by about 40k.  The benchmark revision also could mean that Productivity is higher than currently measured.  It will depend on the GDP benchmark revision, due next July.

The best measure of the labor market is the Unemployment Rate.  It is independent of Payroll measurement issues.  If it falls, then job growth is above trend.  In other words, the labor market is strengthening.  If the Rate rises, then job growth is below trend and the labor market is weakening.  If the Rate is steady, then so are labor market conditions. 

July Construction Spending, due Tuesday, will be of interest.  Although not typically a market-mover, this report will show whether Public Construction remained weak at the start of Q319 after it dropped in June.  A further weak print would work against any rate-induced increase in Residential Construction in terms of boosting Q319 GDP Growth.  It could mean that labor or material shortages are holding back construction activity -- suggesting that easier Fed policy will not be particularly effective in stimulating the economy.

Trump's Beef With the Fed and "Order" Re China

Trump's public beef with the Fed is reprehensible -- political interference with a central bank is bad for the latter's credibility and the economy.  Nevertheless, there are a couple of important issues that may have motivated his outbursts.   First, is Trump right that more aggressive Fed stimulus (i.e., 50 BP cut) is needed to offset negative fall-out from his fight with China.  The trade-off between short-term pain and long-term gain would be mitigated.  And, stronger US economic growth could give him more leverage against China by giving him additional time to press his case.  Second and more basic, is he right in thinking the Fed is incorrect believing that 3.0% growth would exceed the economy's long-run potential growth rate and be inflationary.

Is Trump right on these two issues?  As for the first, aggressive easing offset to the negative fall-out from the trade war is not now needed because Real GDP Growth is still exceeding its estimated long-run potential pace, if the Fed is correct about the latter pace being 1.8-2.0%.  Although Powell and the Fed moved toward Trump's demands by citing downside risks in the outlook and cutting the funds rate by 25 BPs in July, the subsequent dissent against further easing by some FOMC members stems from the still strong growth rate.  Trump's more basic argument for aggressive Fed easing comes down to a belief that the Fed is too conservative in its 2% view of what is sustainable non-inflationary growth.  Whether core inflation picks up or not will determine who is right.

The question of what GDP Growth Rate is sustainable and non-inflationary may take time to get resolved.  The latest evidence throws doubt on Trump's belief that the Fed is aiming for too low a growth rate.  The Core CPI has risen an above-trend 0.3% m/m in the past two months.  And, Compensation/Hour --the broadest measure of labor costs -- sped up sharply in H119.  The tight labor market may be finally exerting upward pressure on labor costs, and Powell should not have been so quick to agree that the Phillips Curve is dead in his Semi-Annual Monetary Policy Testimony. 

Not all factors point to an inflation speedup ahead, however.  The dollar has continues to strengthen, which, along with weaker economic growth abroad, should hold down import prices -- although the tariffs should boost some prices.  And, lower oil prices should feed through to items like airline fares.   Which factors will dominate should become clearer this Fall.

The next important inflation report is the July Core PCE Deflator this coming Friday.  Consensus looks for +0.2% m/m and an increase in the y/y to 1.7% from 1.6%.  Both the m/m and y/y risk being 0.1% pt higher.  Calendar considerations raise the risk of a high 0.3% m/m increase in August Average Hourly Earnings, due September 6.

This week's US economic data will bear on the risks the Fed sees in the outlook.  The consensus estimates argue that the fall-out from the downside risks is limited and overall economic growth still is good.  July Durable Goods Orders, on Monday, will show whether the June bounce in Ex Transportation Orders is sustained.  Consensus believes that it will, as it looks for +0.1% m/m.  The August Consumer Confidence Index, on Tuesday, should reaffirm a strong consumer.   Although consensus looks for a decline to 130.0 from 135.7 in July, the level would be high.  The Claims data are expected to give back some of the prior week's declines.  But, they would remain in their recent range.

Trump's explosive "order" for US companies to rethink their operations in China would appear to reflect frustration that the Chinese are not bending on the fundamental issue in the negotiations, namely for China to play by Western rules.  Trump's prior tariff imposition was meant to push China to acquiesce on this issue.  China's response by imposing 10% tariffs on some US goods shows it does not want to tackle this fundamental issue.  The 10% tariff is minor and a parry in the fight.   While Trump's "order" was ridiculed by some, it is in line with what may be the ultimate outcome of this battle -- a separation of two spheres of influence.  Or, perhaps fear of such separation could eventually persuade the Chinese to come to grips with more significant changes to their business practices. 

Focus Back on the Fed

This week's market focus will be primarily on the July FOMC Minutes (due Wednesday) and Fed Chair Powell's speech at the Jackson Hole Conference (Friday).  Neither should diverge from Powell's message at the post-FOMC meeting news conference -- economy is strong, Fed sees some downside risks, it has moved in response to these risks, and stands ready to do so again if needed.  Now that the markets are less concerned about a near-term recession, a reiteration of this message should be a positive for the stock market, in contrast to the sell-off following Powell's comments at the press conference.

Last week, the markets had some solace over the US economic outlook from the strong July Retail Sales report.  July Housing Starts also showed underlying strength, even though Total Starts fell.  (The apparent responsiveness of 1-Family Permits and Starts to lower mortgage rates argues against those analysts who say easing monetary policy won't work to boost the economy under current circumstances.)  The Atlanta Fed model's Q219 forecast moved up to 2.2% from 1.9% after these reports.  The forecast now exceeds the Fed's 1.8-2.0% estimate of the long-run potential growth rate.

Ironically, the markets ignored some softer data.   Unemployment Claims bounced toward their recent highs in the latest week, after they had been signaling economic strength through the recession-fear moves in the stock and Treasury markets,   In addition, Manufacturing Output Excluding Motor Vehicles unwound their June bounce, showing that this sector remains under pressure from global economic weakness.  The bright spot in manufacturing is now Motor Vehicles, which appear to be past their Spring inventory correction.  Assemblies rose further in July,  the 3rd consecutive monthly increase.

In total, last week's real-side data underscored the Fed's perception of the US economy.  Growth remains acceptable, but downside risks from weak global growth are showing up in some areas.  This narrow area of softness in economic activity for now justifies the Fed's cautious approach to easing.

Another justification is the risk that inflation finally may be beginning to move up.  The Core CPI rose 0.3% m/m in the past 2 months.  Labor Compensation/Hour (the broadest measure of labor costs) surged over H119, according to revised data.  The 4.3% y/y in Q219 is a post-recession high and well above the near-3% range seen in other labor cost measures.  This is high even taking account of strong productivity gains.  Unit Labor Costs are up to 2.5% (y/y) in Q219, well above the 1.0% in Q418.  The Phillips Curve may not be dead after all.

To be sure, global real-side data are expected to remain soft, as well.  Consensus looks for dips in the Markit European "Flash" Purchasing Managers Indexes (PMIs), due Thursday.  However, soft European PMIs could have a neutral to positive impact on stocks and the euro if they bolster expectations for German fiscal stimulus, as was suggested in a report on Friday.  The prospect that European fiscal policy will finally act to counter economic weakness there also takes pressure off the Fed to ease in response to downside global risks.   It is a negative for Treasuries.

US/China Battle and This Week's US Economic Data

The markets are once again primarily focused on the battle between the US and China.  The concern is that the battle will lead to a global recession.  This week's US economic data could influence this concern, as real-side data are likely to be soft.

There are two aspects of the battle that should be kept in mind:  /1/ The battle will not be resolved quickly.  The US wants China to conform to the rules of the global trading system.  China wants to follow its own rules of conduct.  At issue is which country will dominate world trade.  Since neither country seem willing to concede, the markets are likely to face continued headline risks for an extended period.  To be sure, there could be positive surprises, such as the North Korean president's letter to Trump raising the possibility of ending missile testing and resuming talks.  /2/ The Trump Administration is not entirely correct in blaming the recent dollar strength on Chinese FX intervention.  US tariffs have the effect of boosting the dollar because they lower the expected trade deficit.  And, bond arbitrage between Europe and the US also serves to lift the dollar.  

US economic data will remain important for two reasons.  First, they influence the probabilities of a negative fall-out from the US/China battle.  Second, they influence the probabilities of another Fed rate cut.  Weak data would not be stock-market friendly because of the first reason.  But, the market impact would be mitigated because of the second.

At this point, there is evidence that caution is creeping into private economic decision making.  The July Employment Report showed a dip in the Average Workweek, suggesting firms are pulling back on hours worked without cutting jobs significantly.  The Claims data show companies are not in the aggregate firing workers in response to economic uncertainties.  Initial Claims fell to 209k in the latest week, putting them below the 212k July average and the 218k Q219 average.  But, hiring may have slowed,  as suggested by Continuing Claims staying high.  Continuing Claims fell to 1.684 Mn in the latest week, putting them slightly below the 1.687 Mn July average.  But they remain just above the 1.680 Mn Q219 average.  The low point was April.  Continuing Claims need to fall further to suggest hiring has picked up.

The Atlanta Fed model's latest forecast is 1.9% for Q219 Real GDP Growth.  This is in line with the longer-run potential growth rate as estimated by the Fed.  But, there is not enough available data for the model's forecast to be reliable now.

This week's US real-side economic data risk being soft.  /1/ The consensus estimate of +0.4% m/m July Retail Sales may be overly optimistic.  Some of the gain may reflect higher-priced gasoline.  If so, the more important Ex Auto/Ex Gasoline Retail Sales would be softer.  Also, a pause after several months of strong gains in Ex Auto/Ex Gasoline would be typical.  /2/ The consensus estimate of +0.1% m/m in July Industrial Production, with Manufacturing Output -0.1%, is not out of line with the flattish Total Hours Worked in Manufacturing Production Workers seen in the Employment Report.  Such prints would underscore sluggish activity in that sector.  /3/ Consensus looks for a decline in the August Phil Fed Mfg Index to 10 after it jumped to 21.8 in July.  But, the latter missed the declines seen in the Mfg ISM and Markit Mfg PMI that month.  So, it would be just catch-up.

The July CPI could be problematic for the markets.  Consensus looks for the Core CPI to return to 0.2% m/m after +0.3% in June.  Friday's release of the July PPI supports the idea of an easing of inflation pressures: the underlying PPI -- PPI Ex Food/Energy/Trade Services  -- was -0.1% m/m in July after 0.0% in June.  But, there are upside risk to the Core CPI from other sources.  Apparel Prices could be up again, after +0.8% m/m in June -- as a result of bi-monthly sampling for this component.  And, Owners' Equivalent Rent risk continuing to print 0.3% m/m or even 0.4%.  A 0.2% m/m print for the Core CPI would keep the y/y steady at 2.1%.  A high print for the Core CPI would temper expectations of a Fed rate cut, making it less of a mitigating factor regarding the US/China battle.