The stock market should continue to be influenced by evidence supporting two countervailing ideas -- /1/ expectations of elevated corporate earnings emanating from strong Q221 GDP growth and /2/ slower growth over the quarter that could dampen corporate earnings in Q321. The second idea is more interesting in regard to Fed policy, given that the Fed is tolerating strong growth as long as labor market slack remains. A slowdown in economic growth could keep the Fed on the sidelines even if the very high inflation seen recently doesn't end soon. But, a tolerant Fed will not necessarily be the case. On balance, expected strong Q321 corporate earnings along with an accommodative Fed could be enough to lift stocks into early July. The Fed could become more of a potential problem this summer.
The Fed views the very high inflation prints in March and April as temporary. But, there are several reasons high inflation could be stubborn for awhile. /1/ Input prices, as measured by Intermediate Materials Prices in the PPI, continued to climb sharply in April. They risk being passed through to final demand prices over the next few months. /2/ The chip shortage has hindered production of many goods, particularly motor vehicles. Prices are being hiked instead. The shortage is not expected to end soon. /3/ Labor shortages could boost the overall wage inflation rate. /4/ The dollar appears to have begun to weaken again.
The strength of demand and the insufficient response of labor can be attributed to a peculiar set of fiscal policies. The stimulus payments were far in excess of the income shortfall caused by the shutdowns, as pointed out by Larry Summers. They added to the "forced" saving that built up among households during the pandemic that is now available to be spent. The new Child Tax Credit will begin adding to this fiscal thrust in mid-July, as well. Meanwhile, the extra Unemployment Benefits made it profitable for lower-income people to stay unemployed rather than return to work. This result showed up notably in the latest Unemployment Claims data. Initial Claims fell, consistent with fewer layoffs stemming from strong growth. But, Continuing Claims rose, showing people staying on the dole despite the strength of demand for labor.
The risk to the Fed's policy approach -- and thus to the markets -- is that the combination of strong growth and labor shortages leads to higher wage inflation. This could broaden the extent of price hikes and raise concern of higher-than-desired inflation for a longer-than-desired time. The Fed could be induced to tighten sooner than it expected. But, this is why a slowdown in Q321would be important. Would the Fed tighten if it looks like "stagflation" is back? Note that if the slowdown is a result of shortages or bottlenecks, then a tightening would be warranted. It would aim to bring demand down to the level of constrained supply.
This week's US economic data are expected to show strong but slowing demand as well as higher inflation. Consensus expects April Core Durable Goods Orders to rise a decent 0.7% m/m, after climbing 1.6% in March. April New Home Sales are projected to dip but stay at a high level. The Core PCE Deflator is seen speeding up to 0.6% m/m in April from 0.4% in March. The y/y would jump to 3.0% from 1.8%, due in part to base effects. It also will be of interest to see if the University of Michigan Consumer Sentiment's 5-year Inflation Expectations stays near the high 3.1% seen in mid-month. The prior range was 2.5-2.8%.
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