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.