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.