Stocks, the Fed and the US Economic Outlook

The stock market could stabilize this week as the Q421 corporate earnings season approaches.  To be sure, the market will have to get through Fed Chair Powell's testimony (Tuesday) and the December CPI (Wednesday), both of which are likely to underscore the need for tighter monetary policy.  How stocks respond could depend on the bond market.  Some of the latter's reaction to a ratcheting up in tightening expectations occurred last week.  So, a lower-than-consensus CPI, which is the risk, could allow for a relief rally. 

The mixed December Employment Report should not deter the Fed from its plan to /1/ end tapering by March and /2/ begin hiking and reducing its balance sheet soon thereafter.  While the increase in Payrolls was less than expected, Civilian Employment (used in the calculation of the Unemployment Rate) was strong.  The drop in the Unemployment Rate shows the economy running out of excess capacity in the labor market, which is likely behind the 0.6% m/m jump in Average Hourly Earnings.  As a result, Powell's testimony is likely to be hawkish.  

The shrinkage in labor market slack means the economy is running out of room to grow above trend.  Real GDP Growth will have to slow to about 2%, either by itself or as a result of Fed tightening.  (The Atlanta Fed model's latest projection is 6.7% for Q421.)  And, historically, an overshoot to below-trend growth (or recession) is the typical result of Fed tightening.  Market analysts will probably lower their earnings projections as this realization sinks in -- a negative for the stock market.

Another problem is that any delay in Fed tightening will put more burden on the markets to move in ways to slow the economy.  This means higher longer-term yields and lower stocks.  Ironically, these market moves could reverse once the Fed begins tightening, as the markets' burden eases.  At this point, it would seem the Fed will wait until tapering ends in March before it begins hiking rates.  Shrinking its balance sheet should come soon after the rate hikes.  Upcoming US economic data will tell whether the markets will allow the Fed this gradual approach to tightening policy.

There are a couple of developments that could give the Fed time  for a gradual approach.  A downturn in the Omicron virus' impact, as some health experts expect in late January, could lead to an increase in the labor force as more people feel comfortable getting jobs.  Also, some purchasing managers surveys suggest supply bottlenecks have begun to ease.  This could result in a pickup in production but with lower prices at some point. 

Besides Powell's testimony, this week will feature the December CPI, Retail Sales and Industrial Production.  Consensus estimates +0.4% m/m Total and +0.5% Core CPI.  Lower energy prices should hold down the Total, possibly by more than consensus expects.  The consensus' Core estimate looks reasonable.   Consensus looks for flat Retail Sales, with Ex Auto up a modest 0.2% m/m.  A near-consensus print should not be a problem, as it fits with the need for slower growth ahead.  Consensus expects 0.3% m/m Industrial Production, with Manufacturing Output up 0.4%.  The risk is to the upside, based on the jobs data, but this report typically has little market impact.