Strong Corporate Earnings Should Sustain Stock Market Rally

A strong Q421 corporate earnings season should sustain the stock market rally in January.  It should help the market overcome selling typically seen early in the month after a "Santa Claus" rally.  In addition, Fed policy should not change, even if some of the upcoming key US economic data are above target.  The Fed should want to give its latest two sped-up taperings time to work.  And, it will probably want to keep policy steady soon after Powell's renomination hearing this month, trying to avoid undermining his credibility.  While there are reasons to expect above-target prints for December Payrolls and CPI, there are other reasons to believe they will be followed by more moderate prints in the following month or so (see last week's blog).  So, the Fed should be patient if high December prints turn out to be the case.

Consensus looks for about a 20% (y/y) increase in Q421 corporate earnings, versus 39% in Q321.  Although this would be the lowest quarterly increase for the year, it still would be historically high.  Most of the macroeconomic evidence, indeed, point to a larger y/y increase in Q421 than in Q321.  A pickup in Real GDP Growth and an improvement in profit margins, as prices sped up relative to wages, would appear to have lifted domestic profits.  Similarly, higher oil prices should boost profits in this industry.  But, a stronger dollar (thanks to easier year-ago comparison) and softer economic activity abroad should hurt earnings outside of the US.

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

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            4.9                  72.7                 -3.4                              4.2           4.1               60.9

Q421            5.7 *               80.3                +1.0                              4.6           5.0               58.2                                                                                                    

* Based on the Atlanta Fed Model's latest projection of +7.6% (q/q, saar). 

The latest Unemployment Claims data point to a speedup in December Payrolls, but hint at a slowing in labor market improvement over the month.  Both Initial and Continuing Claims are below their levels in the November Payroll Survey Week.  But, Initial Claims have flattened out over the past several weeks. 

 

 

Fear of the Fed

Besides fear of the Omicron variation of the virus, stocks may continue to grapple with the implications of the Fed's (and other central banks') increased emphasis on targeting inflation.  While there are some reasons to expect the currently high inflation to abate at some point, a sustained ratcheting down requires a slowdown in economic growth to the near-2% long-run trend -- given the already low unemployment rate.  The larger the extent of slowdown in H122, the less there will be to fear aggressive Fed tightening.

At this point, a GDP slowdown in Q122 is highly likely after its rebound in Q421.  The Atlanta Fed model estimates the latter to be 7.0% (q/q, saar), similar to the 6.9% implied by the Fed's Central Tendency forecast.  Part of the Q421 strength is just a bounce-back from the virus-impacted 2.1% Q321 pace.  This should not carry  into Q122.   Moreover, the boost to consumption from fiscal transfer payments already has begun to abate.  But, the issue is how much of a slowdown will occur.  Early evidence suggests a speedup in December Payrolls -- in the wrong direction if looking for a slowdown.  But, what will be more important is whether Initial and Continuing Claims stop falling.  Their flattening would signal a steadiness in the unemployment rate, which, in turn, would signal near-trend GDP growth.

Inflation may stay high in the next couple of months, but then could turn lower -- independently of economic growth.  /1/ Seasonals look to offset holiday discounting in December and post-holiday promotions in January.  This price cutting likely happened to a smaller extent than seasonals expect because of the supply problems.  So, seasonals risk boosting components like apparel in the next two CPI reports.  But, then seasonals look to offset the ending of this discounting by pulling down prices.  And, since this discounting was likely small, so should the rebound -- so seasonals should depress these prices in the CPI.  /2/ Start-of year price hikes could boost the January CPI -- one-off price increases.  /3/ The stabilization of oil prices may soon help to hold down transportation costs, which could be reflected in the prices of many products (and airfares).  /4/ Motor vehicle prices -- both for new and used vehicles -- could come down once the chip shortage abates.  But, this development seems well ahead in the future.  The November Industrial Production Report showed only a slight increase in motor vehicle production, so the chip shortage is still significant.  Used Car Prices continued to rise in first half of December, according to the Manheim Survey.

Some of these factors may help explain the combination of above-trend growth and slower inflation seen in the Fed's Central Tendency forecasts for 2022.  The Fed looks for 3.6-4.5% Real GDP Growth and 2.2-3.0% PCE Deflator Inflation.  Its forecast of a decline in the Unemployment Rate to 3.4-3.7% (consistent with the above-trend GDP forecast) should be accompanied by faster inflation unless there are non-economic factors holding it down.  Whether the non-economic factors will hold down inflation prints will be clearer by early Spring.  This will be after the Fed's asset purchases end and the markets become even more focused on whether the Fed has to hike by more than 3 times in 2022.  If inflation does not come down by then of if economic growth does not slow sharply, the Fed may have to aim for slower growth than what was behind its 3-hike projection.

 

Five Reasons for Stocks To Rally Into January

The stock market should rally to new highs into January for a number of reasons.  /1/ Economic growth is strong.  /2/ The Fed's shift to fighting inflation, although not yet through higher rates, reduces the significance of currently high inflation,  The markets can treat it as temporary.   /3/ The risk of Russian armed aggression against the Ukraine and of China against Taiwan may be more significant in the Spring. /4/ The Senate vote on the tax/spending bill may be pushed back further.  /5/ Strong Q421 corporate earnings are expected. 

The economy's strength is seen in the downtrend in the Unemployment Claims data.  While still early, there's reason to think they will point to a speedup in December Payrolls. The 4-week average of Initial is 219k, well below the 273k going into the November Payroll Survey Week.  This week's US economic data should flesh out the picture of solid growth.  In particular, consensus looks for +0.8% m/m Total November Retail Sales and +1.0% Ex Auto Sales.  This would be impressive after the 1.7% jump in October.  And, it could argue that monthly sales were, indeed, better than suggested by the Black Friday experience.  But, they may have to print even stronger to match the expectation for consumer spending built into the Atlanta Fed model's 8.6% Q421 Real GDP forecast.

The Fed is likely to increase the speed of tapering at this week's FOMC meeting.  There's no reason to think officials will not match market expectations of doubling the monthly tapering to $30 Bn from the current $15 Bn.  This will eliminate the expansion of the Fed's holdings of Treasuries and Mortgage-Backed Securities by February-March.  It will not mean the Fed will begin hiking rates at that point.  But, even if it does, the market rule of thumb is that 3 hikes are needed to turn down the stock market.  To be sure, the rule might not work this time, given the rate hikes will have been preceded by the tapering -- which, in effect, is like a tightening.  Meanwhile, the markets will likely view potential rate hikes as undercutting the likelihood that currently high inflation prints will last for long.

There are a couple of reasons to think a Russian/Ukraine or China/Taiwan conflict is not imminent.  /1/ Winter weather was a problem in the Napoleonic and German invasions of Russia.  Knowing this, Putin may want to wait to Spring.  /2/ China will probably not initiate an attack ahead of the February Olympics.  One curious thought is that Russia and China could act at the same time, making a US/European response even more difficult.

News reports are raising the possibility that Senator Manchin may be even less enamored with the Building Back Better bill after the November CPI underscored his concerns about its inflationary implications and the CBO estimated  a $10 Tn cost (over 10 years) if the short-term measures in the bill are subsequently made permanent (and not offset by even higher taxes).   Biden will speak with him on Monday.   So, headlines regarding this meeting could hit the markets.

Consensus looks for about +20% (y/y) in Q421 corporate earnings.  This would be the 2nd quarter in a row that y/y growth slowed, as the boost from pandemic-related easy year-ago comparisons unwinds.  But, it is still historically strong.

 

 

A Potential Speedup in Fed Tapering Now Takes Top Billing (Along With the Virus)

Besides fear of the virus, the stock market will have to contend in the next week and a half with the need for Congress to hike the debt ceiling and the likelihood of a Fed decision to speed up the pace of tapering.  The former will probably be a nail-biter as the December 15 deadline approaches, but should be resolved in time.  The latter, also due on December 15, could have significant implications for the timing of Fed rate hikes, but this issue is more for next year than now.

Friday's November Employment Report should not derail a speedup in Fed tapering, although it could argue for a smaller-than-otherwise degree of faster tapering.  While November Payrolls were weaker than expected (which was the risk), a rebound in the Nonfarm Workweek helped boost Total Hours Worked.  The latter suggests strong Real GDP Growth in Q421, as the October-November average is  up 4.7% (q/q, saar) from Q321.  Moreover, the drop in the Unemployment Rate to 4.2% indicates above-trend economic growth.  And, the Rate's level and the politically sensitive Black and Hispanic Rates are less than 1% pt from their prepandemic lows.  So, there is ample reason for the Fed to speed up tapering.  But, there is also reason to temper the speedup, found in the deceleration in Average Hourly Earnings.  The 0.3% m/m increase in AHE is below the recent 0.4% trend and suggests that wage inflation is contained.  

The Fed began tapering by cutting the $120 Bn/month purchases of long-term Treasuries and Mortgage-Backed Securities by $15 Bn last month.  With $105 Bn left, an increase in tapering to $20 Bn would end these long-term purchases in 5 months (April-May).  An increase to $25 Bn would end it in 4 months (March-April), while $30 Bn would end it in 3.5 months (February-March).  An ending of these purchases will not automatically mean the Fed will begin hiking rates, but it will open the door for it, based on officials' comments.

Even with wage inflation apparently in check, this week's print for the November CPI risks being high.  Consensus looks for +0.7% m/m Total and +0.5% Core.  The risks of higher or lower prints appear balanced.  Used Car Prices are likely to play a noticeable role in boosting the CPI again.  These will eventually reverse, but now signal the production constraints that limit the supply of new vehicles.  When Fed Chair Powell says that "temporary" is no longer a useful characterization of the observed higher inflation, he essentially means the Fed must lower its estimate of non-inflationary growth to account for these on-going constraints.  So, the Fed has boosted the significance of the outsized moves in Used Car Prices.

   

  

Renewed Virus Fears and Other Market Concerns

Fears of the Omicron virus variant pulled ahead and telescoped the stock market decline that risked unfolding in H1 of December in anticipation of faster Fed tapering at the December 14-15 FOMC Meeting.   The markets' reactions may have been overdone on Friday, however, since news reports say /1/ drug companies are already testing vaccines against the new virus and /2/ the symptoms seem to be mild for vaccinated/healthy people.  But, if these mitigating factors are seen as significant, a decision to speed up tapering at the December meeting can reassert itself as a downside risk.  So, the stock market could stay under pressure until then, particularly given expectations of strong November Employment and CPI reports and the need to raise the debt ceiling.

At this point, because of the emergence of the Omicron virus, the probability of an increase in Fed tapering at the next meeting has receded.  By then, the Fed may not yet have a handle on the effectiveness of vaccines against this mutation, since a sense of the latter is expected to take several weeks to develop.  Moreover, from the Fed's perspective, the mutation underscores the downside risk to the its economic forecast, mentioned in the FOMC Minutes.  Along with the sharp market reactions, this downside risk may persuade the Fed not to change the pace of tapering.   Even if the November Employment and CPI reports are strong, Fed officials could agree to be patient and wait to see what effects the Omicron virus might have and if its baseline forecast of a moderation in inflation bears out.

However, this week's testimony by Fed Chair Powell and speech by Vice Chair Clarida (both on Tuesday) will probably keep open the door for a faster pace of tapering at the December meeting.  They could mention the Omicron virus as a downside risk to the outlook, but likely balance it with the risk that inflation may not slow as quickly as desired.  A policy shift most likely needs to await a full consensus of members at the FOMC Meeting.

The drop in oil prices, nonetheless, supports an expectation of slower inflation ahead, even if some of the plunge reverses in the next week or so.  This is because the oil price drop may not fully reverse -- it could reflect more than the possibility of a renewed virus-related slowdown in global economic growth.  OPEC officials are reported saying the release of oil reserves by the US and other countries will result in a global oil glut early next year (and suggests this week's OPEC meeting will not result in any significant production increase).  Moreover, US domestic oil production continues to climb.  The Baker-Hughes Oil Rig Count rose again the latest week.  Lower oil prices will feed through to non-oil prices that are impacted by fuel costs.

Besides the possibility of continuing virus and tapering fears, fear of a debt ceiling crisis in mid December could weigh on stocks in the next few weeks.  This latter fear is typically overdone, however.  While there tends to be a lot of noise and blame out of Washington ahead of a debt ceiling deadline (December 15), an extension almost always is approved by Congress.  A short-term extension will likely be the compromise again.  A longer extension, if at all, likely will await resolution of the spending/tax bill.

This week's November Employment Report should be strong, but the consensus Payroll estimate may be too high.  Consensus looks for +550k m/m Payrolls, versus +531k in October.  Some evidence, however, such as Unemployment Claims, points to a smaller jobs increase in November than in October (although to a further decline in the Unemployment Rate, as well).   One possible reason for a larger November increase, however, is a surge in holiday-related retail, warehousing and delivery jobs.  Seasonals look to offset such increases, to be sure.  But, if they don't fully do so, a compositional shift toward lower-paid workers could push down Average Hourly Earnings below the consensus (and near-term trend) of 0.4% m/m. A low AHE print could soften the market impact of a large Payroll gain.

Stocks and The Risk of Faster Fed Tapering

The stock market should be supported this week by President Biden's announcement of the next Fed Chair -- regardless of whether it will be Powell or Brainard.  Both are highly capable, and the decision would remove some uncertainty.  Also, the market tends to do well in the Thanksgiving week.

But, stocks are likely to turn cautious, if not turn down, over the first half of December on fears the Fed will decide to increase the speed of tapering at the December 14-15 FOMC Meeting.  Fed Vice Chair Clarida raised the possibility in last week's speech, making one wonder whether Biden asked both Chair candidates to do something to bring down inflation.  If that were the case, there may not be much new information regarding tapering in this week's release of the October FOMC Meeting Minutes.

The November Employment and CPI Reports (due December 3 and 10, respectively) -- risk exacerbating the market's fear of faster tapering.  The data may have to be particularly soft to persuade the Fed to stick to its announced $15 Bn per month tapering path.  This will not likely be the case.

Early evidence does point to a smaller m/m increase in Nonfarm Payrolls in November than October's +531k.  But, the pace will likely remain above trend, as the Insured Unemployment Rate so far suggests another decline in the Civilian Unemployment Rate.  If Average Hourly Earnings prints above 0.3% m/m, as it has in the past 7 months, the Fed could feel the need to respond to growth-related inflation pressures stemming from a too-tight labor market (unemployment rate below NAIRU as discussed  in last week's blog).

Both Total and Core CPI risk printing high.  Retail gasoline prices rose in November, with seasonals exacerbating the increase again.   Also, there is a risk the higher Used Car wholesale prices in September and October will show up in retail Used Car Prices in the November CPI. 

A pullback in the stock market could be short lived, however, for several reasons.  /1/ Economic growth should remain solid next year, even with a faster pace of tapering.  In part, growth could be boosted by an easing of the chip shortage and other supply disruptions.  /2/ Q421 corporate earnings, due in January, should be strong.  The Atlanta Fed model's latest estimate is +8.2% (q/q, saar) for Q421 Real GDP Growth.  /3/ Inflation may ease.  Supply-related price hikes over the past several months, such as for motor vehicles, could reverse.  Also, oil prices may fall further.  Their decline could help hold down a slew of goods and services prices.

While the increased risk of faster Fed tapering may have contributed to last week's drop in oil prices, there are fundamental reasons for the latter to continue to stay low, as well.   /1/ US Domestic oil drilling and production have begun to move up sharply.  (Perhaps the Biden Administration has quietly signaled a positive message to the industry?)  The October Industrial Production data show a 9.3% m/m jump in oil and gas drilling.   And, the Baker-Hughes Oil Rig Count rose in November after plateauing in October.  Both pieces of evidence are in line with the International Energy Agency's prediction that Non-OPEC oil production will finally make a noticeable move up in Q421, with US production accounting for a good deal of the increase.  /2/ The partial shutdowns in Europe and China also should temper increases in demand for oil in the immediate future.

Stocks Can Handle Inflation For Now

The stock market should continue to recover from last week's inflation shock be for several reasons.  /1/ The Fed is likely to remain on its gradual tapering path, which could be reiterated by some Fed speakers this week. One inflation report will not change Fed policy.  And, Powell will likely want to maintain a stable policy while Biden is deciding whom to nominate as Fed Chair.   /2/ Economic growth is strong.  Even if growth moderates ahead, which is a possibility, it would be positive for stocks by holding down inflation.  /3/ Much of the jump in the October CPI is attributable to temporary factors.  And, a main underlying culprit -- oil prices -- appears to have stabilized for now.  So, the Fed can wait and see.  Nevertheless, the inflation risk remains as long as economic growth is above trend and pushes down the Unemployment Rate.

The very high October CPI likely overstated the trend in inflation.  About half of the 0.6% m/m jump in the October Core CPI resulted from /1/ Used Car Prices (+2.5%), /2/ New Vehicle Prices (+1.4%), /3/ Medical Care Services (+0.5%) and /4/ Recreational Services (+0.8%).  The run-up in car prices should reverse once the chip shortage abates.  Medical Care Services Prices are volatile on a m/m basis.  And, the jump in Recreational Services reflected an 8% jump in Admissions to Sporting Events, which is not likely to be repeated in coming months.

In addition to the easing of temporary factors, a moderation in price inflation is conceivable considering the underlying reasons for the speedup:

 /1/ Some of the increase in inflation could be just a one-off adjustment to the re-opening of the economy -- and this factor should end soon.  The shortages and bottlenecks stemming from the speed of recovery should work themselves out in coming months. 

/2/ The pass-through of higher transportation costs -- reflecting higher fuel costs and a trucker shortage -- is likely a major reason for the run-up in food and other prices.  Oil prices rose sharply as OPEC held back production relative to demand and as the Biden Administration pushed against lifting US domestic oil/natural gas output.  The Administration may have influenced the OPEC decision, as well, by moving against Saudi Arabia in a number of ways and moving favorably toward Iran, Saudi's enemy.  The OPEC decision could have been in retaliation or a snubbing of the US.   Oil prices have stabilized at this point.  But, some Saudi officials have been reported seeing the potential for these prices to climb to $150/bbl.  Perhaps the possibility of a cold winter is behind this potential.

/3/ The extended Unemployment Benefits most likely kept some people from taking jobs, thereby pushing up wage inflation.  While the Democrats might think boosting low-paid workers' wage rates was a good result, the pass-through of these higher wages to prices undercut the real benefit -- as reflected in the drop in the University of Michigan Consumer Sentiment Index.  With the extended Unemployment Benefits expired, labor costs could moderate in coming months and hold down price inflation. 

But, the risk of higher inflation remains as long as economic growth is above trend.   At 4.6%, the Unemployment Rate already may be below the Non-Accelerating Inflation Rate of Unemployment (NAIRU) -- the level of the Unemployment Rate below which inflation accelerates steadily.  NAIRU had been estimated to be in the mid-5% range before the Trump years.  But, even if NAIRU is lower, the Fed is aiming for the Unemployment Rate to fall to the pre-pandemic low of 3.5%.  A further tightening of the labor market will likely move the Rate closer to if not below NAIRU and boost wage inflation. 

 

 

 

Stocks Should Weather This Week's Inflation Reports

The stock market's rally should not be derailed by this week's inflation reports (October PPI and CPI), even if some are higher than expected.  High inflation prints, at this point, will not deflect the Fed from its gradual approach to tapering and thus should not damage stocks significantly.   What would be a more important negative for stocks is if oil prices break out of their recent range to the upside.   The passage of the infrastructure bill should not be a problem for stocks.  The bill's impact on economic activity will not likely be seen soon, possibly at least a year from now.  So, it can be put on the back burner from a market perspective.  But, a year from now, the bill's economic boost could be a factor pushing the Fed to raise rates.

The consensus estimates of +0.6% m/m Total PPI and +0.5% Core PPI risk being too high.  The Trade Services component could be lifted again by higher gasoline prices.  But, it has slowed in the past two months.  And, it could be offset by lower airfares, as was the case in September.  Moreover, intermediate prices, which lead finished prices, have slowed in each of the past 4 months.

Consensus expects +0.6% m/m Total CPI and +0.3% Core CPI.  While the consensus estimates have a good chance of being right, there is upside risk to the Core CPI.  Owners' Equivalent Rent should remain high, as it catches up to the large increases in rents reported in the press.  Used Car prices at the wholesale level surged over the past two months and could begin to show up in the Core CPI.  But, Used Car Prices should be ignored.  They will probably fall sharply once motor vehicle production becomes unhindered by the chip shortage.  This may be happening sooner than many expect.  Ford already said that the chip shortage is becoming less of a problem in Q421.  And, the jump in motor vehicle jobs in October seems to support this possibility.

Last week's reports muddied the picture regarding Labor Costs -- the primary determinant of price inflation.  While the Q321 Employment Cost Index had broken to the upside, the two latest reports -- Compensation/Hour and Average Hourly Earnings -- did not confirm the breakout.  Compensation/Hour slowed to 2.9% (q/q, saar) in Q321 from 3.5% in Q221.  The average pace so far this year is 2.6%, which is below the pre-pandemic trend (3.7% over 2019).  Unlike the ECI, compositional shifts toward lower-paid workers could be behind the slowdown.  But, Compensation/Hour is the most comprehensive measure of labor costs, so should not be entirely dismissed.

The 0.4% m/m increase in October Average Hourly Earnings was back to the rate seen from June through August.  It suggests that while wage inflation is higher than its pre-pandemic pace, it is not snowballing.  The components were mixed relative to their recent trends and split almost equally between a speedup and slowdown from September.

 

Stock Market Positives Dominate So Far, But...

The stock market rally should be supported this week by the two positive factors mentioned in last week's blog -- evidence of above-trend growth in Q421 and the announcement of a modest pace of Fed tapering .  The negatives -- higher oil prices and the Democratic tax/spending proposal -- so far have stalled, but they are not out of the picture yet: 

/1/ Although the Democrats hope to vote on the tax/spending/infrastructure bills on Tuesday, this remains to be seen.  And, even if they pass the bills, it could be a non-event.  Not only has the tax/spending bill been pared down, the effects may take time to be seen.  

 /2/ This week's FOMC meeting should be a non-event.  As expected, the Fed will likely announce the start of tapering, putting it at a $15 Bn reduction in asset purchases a month.  Powell will likely be pressed to explain his view on inflation at the post-meeting news conference.  He will probably stick to the idea that much of the recent pickup is temporary although could last longer than had been expected.  But, a spillover to higher wage inflation is problematic (see below) and could be an issue for Fed policy and the market ahead.

 /3/ OPEC ministers are not likely to agree to boost output at its meeting this week.  So, the risk of a renewed run-up in oil prices remains.

This week's US economic data should point to above-trend growth.   The October Mfg ISM, Payrolls and Unemployment Rate are all expected to be strong.

While consensus looks for a dip in the Mfg ISM to 60.5 in October from 61.1 in September, the level would remain historically high.  Moreover, there is some evidence pointing to another increase in the Index.  For example, the Phil Fed Mfg Survey components rose this month.  

Consensus looks for a speedup in Payrolls to +413k m/m in October from +194k in September.  Even Private Payrolls (Total less Government Jobs) are seen up 400k, versus 317k in the prior month.  The Claims data, as well as other evidence, support the idea of a speedup in October Payrolls.

The consensus estimate of a decline in the Unemployment Rate to 4.7% in October from 4.8% in September also is supported by the Claims data.  The Insured Unemployment Rate dropped to 1.7% from 2.1% between the two months' survey weeks.  

The market could get some solace if the consensus estimate of a slowdown in Average Hourly Earnings to +0.4% m/m from +0.6% is right.  The increase would be back to the pace seen from June through August.  But, Labor Costs are becoming more problematic with regard to the inflation outlook.  Last week's release of the Q321 Employment Cost Index showed a speedup even excluding sales commissions.  The ECI Ex Commissions rose 1.1% q/q versus 0.7% in Q221 (which also was the pre-pandemic average). 

Will Stocks Take A Breather?

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

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

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

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

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

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

 

 

 

Stock Market Rally to Continue This Week, Then...

The stock market should continue to rally this week, helped by favorable corporate earnings releases.  While the Fed will begin tapering in November, a modest $15 Bn per month reduction in asset purchases, as is likely, should allow the market to take it in stride. The Treasury market already seems to have discounted the tapering, as longer-term yields are off their highs even after the FOMC Minutes pointed to a November tapering start.  Evidence of above-trend economic growth (and possibly more strong corporate earnings) should continue to be supportive of stocks in coming weeks, but the market may have to contend with further increases in commodity prices, particularly oil, and a possible Democratic spending/tax bill.  So, an upward path could be uneven.

Last week's US economic data point to a pickup in economic growth in Q421.  /1/ The 0.7% m/m increase in September Ex Auto/Ex Gasoline Retail Sales was an impressive gain after an even stronger August.  Typically, sales are soft after surging in a month.  In particular, Department Store and Restaurant Sales climbed further, suggesting a dissipation of Delta variant fears.  /2/ The Claims data -- large declines in both Initial and Continuing Claims -- suggest above-trend economic growth at the start of Q421 and also raise the possibility of a speedup in October Payrolls. 

The inflation data suggested that the pickup in core inflation is moderating.  News headlines have featured the high y/y rate of change  (4.0% for Core).  But, this measure is not the right way to look at the evolution of inflation.  The y/y measure reflects past high m/m prints.  The more recent m/m prints, in the 0.1-0.3% range, translate into a slowdown in the annualized 3-month rate of change to 2.7%.  To be sure, some of components that are directly impacted by supply/demand imbalances -- such as Used Cars and Airfares -- still risk being subject to large swings in coming months.  Also, the CPI's measure of housing rent has begun to capture the speedup highlighted in the news.  But, September Import Prices showed a moderation in the components that relate directly to core inflation.  And, the September PPI moderated, as well.  At this point, a core inflation trend just above the Fed's 2.0% target looks possible.  Nevertheless, a reduction in the markets' fear of inflation will probably require substantial pullbacks in oil and other commodity prices.

The overall situation of strong economic growth and higher inflation raises the issue whether a fast recovery is preferable to a slow recovery.  A fast recovery that produces demand/supply imbalances and thus higher inflation could prompt the Fed to tighten sooner and more aggressively than it would in a slow recovery in which inflation stays muted.  So, while a low Unemployment Rate could be achieved more quickly in a fast recovery, it may not last for long.  A Fed tightening could lead to a slowdown to below-trend growth or downright recession (the V-shaped 1980 recession/recovery is an example of the latter, as aggressive Fed tightening during the recovery led to the deep 1981-82 recession).  In contrast,  a low Unemployment Rate would be attained later but last longer in a slow recovery.  There is no clear answer to which speed of recovery is preferable in principle -- although a repetition of the 1980 experience would not be good.  At this point, with the Fed desiring to taper gradually, such a repetition is not likely.

 

 

 

Contending With Higher Longer-Term Treasury Yields

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

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

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

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

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

Reasons for Stocks to Rally Back

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

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

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

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

 

 

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

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

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

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

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

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

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

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

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            5.3 *               70.5                 -3.0                              4.4           3.7               61.0                                                    

         

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

 

 

 

 

 

 

This Week's FOMC Meeting

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

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

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

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

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

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

 

Stock Market Concerns Continue

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

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

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

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

 

 

Cautious Market This Week?

The stock market will likely trade cautiously this week for two reasons. /1/ It will continue to digest the risks highlighted by the August Employment Report -- a slowdown in economic growth, possibly resulting in part from the Delta virus variant, and higher wage inflation.  /2/ Threats of increased taxes to pay for the Democratic spending bills.  But, these risks are not a foregone conclusion.  So, a market pullback would probably be modest.  

Not all the components of the August Employment Report pointed to slower growth.   Total Hours Worked in August are 4.7% above the Q221 average, the same as their q/q growth in Q221, but are only modestly above the July-August average.  They need to climb by more to point to good-sized growth in Q421.  The Atlanta Fed Model's estimate of Q321 Real GDP Growth was lowered to 3.7% from 5.3% after the Report, but the new estimate seems too low relative to THW.  So, the risk now is for upward revisions to the model estimate after it was to the downside before.  Indeed, the 0.2% pt decline in the Unemployment Rate to 5.2% in August raises doubt about a sharp slowdown in growth.  And, the latest Unemployment Claims data keep alive the possibility that the Rate will fall further in September.

The composition of August Payrolls sheds light on the driving forces in the economy.  Hotel jobs were essentially flat while restaurant jobs fell in the month -- after both had rebounded sharply in the prior few months. Fears of the Dela variant could have undercut the recovery of these sectors.  Or, there could have been a natural pause to "take stock" of the situation after having recovered so sharply.  In contrast, motor vehicle jobs jumped, suggesting the chip shortage is abating somewhat, despite news headlines to the contrary.  The dichotomy fits with the Fed staff's outlook (as reported in the July FOMC Minutes) -- "in the second half of 2021, an easing of the surge in demand seen over the first part of the year was expected to be largely offset by a reduction in the effects of supply constraints on production, thereby allowing real GDP growth to continue at a rapid pace." 

The August Employment Report did highlight the risk of a speedup in wage inflation.  The 0.6% m/m jump in Average Hourly Earnings follows 0.4% increases in the prior two months.  Moreover, about half the sectors saw speedups in the month.   But, of the three major measures of labor costs -- AHE, Employment Cost Index and Compensation/Hour -- AHE is the narrowest.  And, speedups in all of them can be offset by faster productivity growth thereby reducing their import for price inflation.  For example, in Q221, most of the 3.4% increase in Compensation/Hour (q/q saar) was offset by a 2.1% increase in Productivity.  Besides wages, final demand pressures could impact price inflation.  And, the risk is that softening demand for hotels, airfares and restaurants because of the Delta variant fear could result in price declines.  This week's report on August PPI will provide evidence on airfares.  

The decline in the Unemployment Rate and higher wage inflation in the Report should keep a Fed tapering at year-end in play.  But, with the Black Unemployment Rate having risen and Payroll gains slowing, the stock market could be supported by an increased possibility of a delay in the tapering.

 

The August Employment Report and Fed Tapering

The stock market's rally should not be dented by this week's August Employment Report, even if it as strong as consensus expects.  This is because a strong Report may not be enough to trigger a Fed decision to start tapering.  In contrast, a soft Employment Report could push the market's view of the start of tapering into next year.

Both Fed Chair Powell and Fed Vice Chair Clarida highlighted the need to see further progress in labor market improvement, particularly a significant decline in the Unemployment Rate -- which is not likely to be fully realized in the August Employment Report.  The Rate has a long way to fall before reaching pre-pandemic levels.  The Total as well as almost all its sub-components were about 2 percentage points above these earlier levels in July.  It could take several months to make a sufficient dent in this spread to warrant saying "substantial progress has been made."  That may be why Powell and Clarida both seemed to indicate a late-Q421 start to tapering. 

Consensus looks for +728k m/m Nonfarm Payrolls, a strong gain even though less than the +943k in July.  Some evidence supports the idea of an even larger gain than July's.  /1/ The Claims data argue for a speedup, as Continuing Claims fell much more sharply between July and August than between June and July.  /2/ State & Local Education jobs could jump even more than in July as the school year began in parts of the country.  

But, there is other evidence suggesting a smaller gain in August than in July.  /1/ The Claims data missed the speedup in July Payrolls, so they may not be a reliable indicator in August.  August Payrolls could see payback for the surge in July Payrolls, making the 2-month change more consistent with the Claims data.  /2/ In 5 of 7 months so far this year, Payrolls sped up when the ADP Estimate was larger than the (first-print) Payroll print in the prior month and slowed when the ADP Estimate was smaller than the Payroll print in the prior month.  ADP was 330k in July while Private Payrolls was 703k.  If the relationship holds, August Payrolls should slow relative to July.  Consensus for August Private Payrolls is +610k, consistent with this evidence.

Consensus expects the Civilian Unemployment Rate to fall to 5.2% from 5.4%.  The Insured Unemployment Rate, calculated from the Claims data, supports this estimate.  The Insured rate fell 0.3 percentage point between the July and August Employment Survey Weeks.  This is only suggestive, however, since there is no exact relationship between the Insured and Civilian Unemployment Rates (see table below).  One reason for the inexactness is that the Civilian Rate is based in part on the Labor Force while the Insured Rate is not.  Note that even if the consensus estimate is correct, the Civilian Unemployment Rate still would be well above its pre-pandemic low of 3.5%.

                         Level in Survey Week (percent)
    Insured Unemployment Rate            Civilian Unemployment Rate 

Jan21          3.4                                            6.3
Feb             3.1                                            6.2
Mar            2.7                                            6.0
Apr             2.6                                           6.1
May            2.6                                           5.8
June            2.5                                           5.9
July            2.4                                           5.4
Aug            2.1                                           na        

Consensus also looks for a dip in the Mfg ISM -- the other key data this week -- to 58.5 in August from 59.5 in July.  Most other mfg surveys fell in August, although some could be catch-up after missing the decline in the July Mfg ISM.  A near-consensus print would still be a strong level, but the pullback could underscore problems in the supply chain.  A modest decline would not likely be enough to dissuade the Fed from beginning tapering later this year.

Tapering Here We Come?

The stock market could trade cautiously ahead of Fed Chair Powell's speech at the August 26-28 Kansas City Fed conference at Jackson Hole.  But, there is reason to think the recovery from the initial sell-off on the release of the July FOMC Minutes will continue.  

Initially, the market sold off on news headlines highlighting the Minutes' sentence that "many participants" could see the appropriateness of beginning to taper by year end.  But, a near-term start is not a given.  The news reports did not emphasize the conditionality of this view nor the lack of unanimity among the participants regarding the timing.   (One of the "hawks," Dallas Fed President Kaplan, already has said he may have to adjust his position on beginning tapering in October if the Delta variant significantly impacts the economy.)  Moreover, Biden's decision whether to re-appoint Powell as Fed Chair -- a decision expected to made this autumn -- conceivably could play a role in the timing of the tapering. 

There were 3 key sentences in the Minutes:

1. "Looking ahead, most participants noted that, provided that the economy were to evolve broadly as they anticipated, they judged that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee's 'substantial further progress' criterion as satisfied with respect to the price-stability goal and close to being satisfied with respect to the maximum-employment goal."

    a.  This is the sentence cited in news stories.

But, this was followed by sentences indicating differences of opinions among participants:

2. "Various participants commented that economic and financial conditions would likely warrant a reduction in coming months."

 3. "Several others indicated, however, that a reduction in the pace of asset purchases was more likely to become appropriate early next year because they saw prevailing conditions in the labor market as not being close to meeting the Committee's 'substantial further progress' standard or because of uncertainty about the degree of progress toward the price-stability goal." 

Given the lack of unanimity in the FOMC, Powell's speech is unlikely to be precise about when tapering will begin.   It could discuss the conditionality of the decision, but again not in a precise way (as he has done in is post-meeting news conferences).  He will probably emphasize the Fed's intent to maintain the funds rate at its currently low level for a long time.  Indeed, the need for a low interest rate as a catalyst to economic growth takes on more importance if tapering begins.  The markets' view of tapering could soften if this idea takes hold.  Stocks could have a relief rally after the speech.

Nevertheless, with the Claims data suggesting another strong Payroll gain in August, the next Employment Report will probably support the "hawks" at the September FOMC Meeting.   But, a large jobs gain may not be enough to satisfy the "doves."  They could still be concerned about the large shortfall in jobs relative to the pre-pandemic peak (5.7 Mn in July) and the 2% pt spread between the current Unemployment Rate and the pre-pandemic low (total as well as sub-groups).  The latter could be particularly important from a political perspective, given that Powell has committed the Fed to lowering the Unemployment Rate for Blacks and Hispanics.   So, while the September FOMC Statement will likely open the door for a tapering, it could leave the starting date dependent on further improvement in the labor market. 

The choice of the next Fed chair could influence the timing of tapering.  News reports suggest that Biden already is being pressured by progressive Democrats not to re-nominate Powell because he is not pushing the Fed hard enough in the direction of bank regulation, income inequality, and climate change.  Fed Governor Brainard is said to be the progressives' choice.  Biden may be forced to show his hand in September, since he could nominate Brainard for Fed Vice Chair, which will be vacant in October.  If Brainard is chosen to be Fed Chair instead, Powell could join the "doves" in pushing for a start to tapering in Q421, if only to make it easier for his successor.  If he is chosen, he could hold out against tapering until the Unemployment Rate spread shrinks by more -- avoiding a problem with Democrats in his confirmation hearings.

Besides the discussion on tapering, the FOMC Minutes contained an insightful summary of the Fed staff's economic outlook.  Fed staff said that "in the second half of 2021, an easing of the surge in demand seen over the first part of the year was expected to be largely offset by a reduction in the effects of supply constraints on production, thereby allowing real GDP growth to continue at a rapid pace."  Last week's US economic data fit this scenario -- July Retail Sales pointed to a flattening in their trend and housing data suggested a softening trend beginning in the 1-Family sector, but Industrial Production showed an upturn in the chip-constrained motor vehicle production.  This compositional shift has a curious implication for the inflation outlook -- slower demand will put downward pressure on prices, but so will an increase in supply as shortages ease.  The economy could be moving into a period of moderate, but uneven, growth and slowing inflation.  Ironically, this scenario could make it difficult for the Fed to justify tapering.

Bracing for the Fed

The stock market will likely trade cautiously ahead of the Kansas City Fed's Jackson Hole Conference on August 26-28.  The Fed Chair's speech at this annual conference sometimes announces intentions to change monetary policy.  So, the markets will probably brace for an announcement about an intention to taper in the near term.  They will be looking for hints to this effect in this Wednesday's release of the July FOMC Meeting Minutes -- although they are not likely to find much, given that Fed Chair Powell's post-meeting conference did not provide any new insights.  In the background, concern about the negative effects of the Delta virus variant could weigh on stocks.  But, this concern should be mitigated if upcoming US economic data continue to point to strong growth.

This week's US economic data releases will touch on the consumer, manufacturing and construction sectors.  Consensus looks for -0.3% m/m Total and +0.2% Ex Auto Retail Sales for July.  A small decline or increase is typical after a strong Sales gain as in June (+0.6%Total, +1.3% Ex Auto).  So, any commentary attributing a soft print to the virus should be viewed dubiously.  The July Employment Report showed job gains in most Retail categories, suggesting Retail Sales remain in an uptrend.  

Consensus looks for a +0.5% m/m increase in July Industrial Production and, within it, Manufacturing Output.  The risk is for an even larger gain in the latter, as the consensus estimate does not appear to take account of a productivity gain this month -- the expected Output increase equals the increase in Total Hours Worked in manufacturing.  What could be important for the stock market if this report suggests the chip shortage is ending in the motor vehicle sector.  The clue will be whether Motor Vehicle Assemblies increase m/m.

Consensus expects a dip in July Housing Starts but an increase in Permits.  A dip in Starts could be just a lagged reflection of the decline in Permits in June.  So, if Permits rebound in July, the decline in Starts should be dismissed as temporary. That said, the housing sector has a problem.  The Affordability Index (based in part on Existing Home Prices) has been declining all year because of the surge in home prices.  Since March, the Index has dropped to its lowest  level since 2018 despite the benefit of lower mortgage rates.  The risk is for a shift to rentals from 1-Family purchases, which could hurt construction activity.  Higher rents will eventually show up in the CPI, while home prices could soon be coming down.

Door Open for Fed Tapering

The strong July Employment Report increases the risk of the Fed cutting back its bond buying program before year-end.   Economic growth and the labor market are on solidly positive paths, allowing Fed officials to say they're seeing "substantial further progress" toward their "maximum employment" goal.  Officials will have many speech opportunities to inform the markets of a policy shift in coming weeks, as the next FOMC meeting is on September 21-22.  But, with the Unemployment Rate still well above pre-pandemic lows and inflation looking as if it will soon come off its extraordinary high pace, a Fed rate hike is likely a long way off.  Indeed, the increased chances of tapering could put additional downward pressure on commodity prices.  The markets' reactions to tapering will likely be muted as a result.

The July Employment Report was strong.  The +943k m/m surge in Nonfarm Payrolls is mostly attributable to Leisure & Hospitality (+380k) and State & Local Education Jobs (+231k).  But, even without these post-pandemic bounce-backs, Payrolls rose a strong 332k.  Moreover, June and May Payrolls were revised up.  The surge in jobs was also seen in the 1.0 Mn jump in Civilian Employment.  This swamped the moderate increase in Labor Force, so the Unemployment Rate dropped to 5.4% from 5.8%.  Total Hours Worked in July stand 4.3% (annualized) above the Q221 average, pointing to another strong Real GDP Growth in Q321.  The Atlanta Fed model's latest projection is 6.0% (q/q, saar), similar to the 6.5% growth rate in Q221.

While it is too soon to draw a conclusion about the risks to the August Employment Report, the early evidence from the Claims data suggests another strong report.  Specifically, the -366k w/w drop in Continuing Claims to 2.930 Mn, a new low for the move down, suggests a speedup in hiring.

Despite the strong growth, inflation may be moving down toward the Fed's target of 2%.  Consensus looks for +0.4% m/m Total and +0.5% Core in this week's July CPI report.  They are about half the June pace (+0.9% each).  Some of the culprits for the recent large increases -- used car prices, gasoline prices -- have begun to flatten.  The July report may be too soon to see the full extent of the flattening, however.  So a further deceleration in coming months is a good possibility.

Labor Costs are moving up, but they too may be starting to moderate.  Although Average Hourly Earnings were higher than expected in July, +0.4% m/m after an upward-revised 0.4% in June (was +0.3%), they were slower than the 0.5-0.7% seen in April and May.  Wages rose the most in sectors with labor shortages -- Leisure & Hospitality and Transportation/Warehousing sectors.  Wage pressures in these sectors may begin to ease in September when the ending of supplemental Unemployment Benefits may induce an increase in labor supply.  This week's report on Q221 Unit Labor Costs will show whether Productivity Gains are offsetting the higher wage inflation.  Consensus looks for a slowdown in ULC to 1.2% (q/q, saar) from 1.7% in Q121, which is in the right direction from an inflation perspective.