Did the Stock Market Overreact?

The stock market will likely continue to be weighed down by fears of aggressive Fed tightening as the May 3-4 FOMC meeting approaches.  But, some snapback from last week's plunge is conceivable.

Fed Chair Powell's comments last week underscored that fighting inflation is now the Fed's primary target and that front-loaded aggressive moves would be appropriate in this fight.  However, the markets may have exaggerated the implication of his comments, particularly after St Louis Fed President Bullard (a hawk) had suggested the possibility of a 75 BP hike.  Cleveland Fed President Mester was more even-handed, saying only 50 BP hikes (aiming for a 2.5% Fed funds target by year end) would be needed as she did not want the Fed to disrupt the economic expansion.  Her view is probably representative of the Fed leadership -- although Powell's comments were focused mainly on fighting inflation.  Her comments could spark a stock market snapback early this week.

To be sure, front-loading Fed tightening is the standard result of an "optimal control" solution to the Fed's econometric model of the US economy if the goal is to bring down inflation while keeping unemployment low over time -- which I showed in my PhD dissertation (see below).  The idea is that pushing up the unemployment rate quickly will not only depress wage inflation and thus price inflation but also inflation expectations.  The latter, along with greater labor market slack, will help hold down wage inflation in the future and thereby allow for a renewed decline in the unemployment rate in a non-inflationary way.  Ironically, Janet Yellen, when she was Fed Chair, used optimal control results to argue for continuing low interest rates.  The optimal control solutions depend not only on the Fed's goals regarding unemployment and inflation, but also on the conditions facing the economy.

A front-loaded, aggressive tightening in monetary policy risks going too far and pushing the economy into recession.  But, this is not necessary.  In the past, a major difference between Fed tightenings that resulted in recession and those that did not is how quickly the Fed reacted to signs of economic weakness.  When the Fed continued to tighten in the face of weaker data, the economy fell into recession.  When it stopped tightening or even eased, a short-lived slowdown occurred.  These growth pauses generated labor market slack that permitted growth to pick up without igniting inflation.  So, from a stock market perspective, the end of "Fed Fear" will be when Fedspeak shifts to recognizing a significant slowing in economic activity -- suggesting a downshift if not an end of tightening is in sight.

Upcoming key US economic data are not likely to show a significant, if any, slowing, however.  The Unemployment Claims data remain low -- suggesting a solid gain in April Payrolls --  and a number of manufacturing surveys picked up in April -- suggesting an increase in the Mfg ISM.    

This week's US economic data will feature the first print of Q122 Real GDP Growth, the Q122 Employment Cost Index and the March PCE Deflator.  Consensus looks for a sharp slowdown in Q122 Real GDP to 1.0% from the out-sized 6.9% in Q422.  The Atlanta Fed model's estimate is 1.3%.  Much of the slowdown may reflect a drop in inventory investment, which the market will likely view as a signal for stronger growth in Q222.  Consensus expects +1.1% q/q for the Q122 Employment Cost Index, versus +1.0% in Q421.  Not all evidence points to a speedup, but the print should exceed the pre-pandemic pace of about 0.7%.  Consensus looks for +0.3% m/m March Core PCE Deflator -- same as the CPI.  There may be upside risk, however, since the drop in Used Car Prices that held down the CPI is much less important in the PCE Deflator.

P.S.  An optimal control solution shows how monetary policy should move to result in the lowest unemployment rate and inflation during a period of time, where monetary policy, unemployment and inflation are tied together in a model of the economy.  Technically, it is a maximization problem subject to constraints, where the function being maximized includes the unemployment and inflation rates and the model the constraints.  A solution shows the path of the Fed funds rate that, according to the econometric model (the constraints), will result in the lowest combination of unemployment and inflation during the period of time, say two years.

 

 

Corporate Earnings Could Help, But ...

The stock market could be helped by a slew of strong corporate earnings reports over the next few weeks.  But, it risks remaining under pressure as long as the Fed threatens to tighten aggressively to fight inflation.   (This risk could be headlined as Fed Chair Powell speaks this week.)   Moreover, Russia/Ukraine fighting is setting up to worsen, which could put further upward pressure on commodity prices and exacerbate shortages.  

The Fed's aggressive anti-inflation talk is problematic for both the Treasury and stock market.   By identifying a problem (high inflation) and then not acting immediately, these markets take on more of a role in solving this problem.  Stocks fall and Treasury yields rise more than they would if the Fed had begun tightening aggressively sooner.  Ironically, Treasuries and stocks could recover somewhat when the Fed actually begins tightening by 50 BPs.  

Meanwhile, last week's March CPI offered some hope that inflation fears may be overdone.  But, it did not suggest the problem is over.  The drop in Used Car Prices underscored the Fed's prior view that some of the high inflation prints resulted from temporary, shortage-induced pressures.  More unwinding of these pressures may eventually be seen -- particularly since motor vehicle production jumped in March and there is evidence from the Industrial Production Report that the chip shortage may be ending.  The March CPI also showed a slowdown in Housing Rent, to 0.4% m/m from 0.5-0.6% in the prior two months.  This may be a fluke, but it also suggests there is a limit on how high prices can go before consumers push back.  Nonetheless, the March pace for Rent is still too high if CPI inflation is to fall to the Fed's 2% (annualized) target.  

Even if Q122 corporate earnings are strong, they may not provide a lasting boost since they could be viewed as temporary in the face of a potentially sharp slowdown in economic activity.   While there are signs that economic growth is slowing, they are not conclusive.  Retail Sales Excluding Autos and Gasoline slowed sharply over February and March.  But, their slowdown could be just the typical pause after a strong month (January).  The Claims data were mixed in the latest week, with Initial up a bit and Continuing down.  The manufacturing sector looks to be in good shape.  The Empire State Manufacturing Index rebounded in April.  And, March Manufacturing Output posted a large increase for the second month in a row.  This week's housing-related data could provide clues as to whether this sector has begun to react to higher long-term yields.  Consensus looks for small declines in March Housing Starts/Permits and Existing Home Sales. 

Implications of Fed Hawishness

Last week's  hawkish shift in Fed officials' comments and the March FOMC Minutes pulled forward the financial market impact that had been expected from the May 3-4 FOMC Meeting.  The stock and Treasury markets now should trend in ways that support the Fed's goal of bringing down inflation.  This means that stocks will fall and Treasury yields rise further if it doesn't look like the economy is moving in a direction that will lead to a decline in inflation. 

Interpreting real-side economic data could be tricky, however, because of the supply-constraints holding down production.  A weak print may reflect these constraints rather than a softening in demand.  For example, shortage-induced auto plant shutdowns could result in an increase in Initial Claims for Unemployment Insurance Benefits, so the latter should not be viewed as an easing in the underlying demand for labor.  Similarly, a lack of sufficient inventory, not a weaker consumer, could depress retail sales.  To be sure, some of the fundamentals behind the consumer have weakened -- lower saving rate, higher energy/food prices.  Despite this, consensus looks for a speedup in Retail Sales to +0.6% m/m in March from +0.3% in February.  At least some of the speedup reflects higher-priced gasoline sales  The more important part of Retail Sales will be Ex Auto/Ex Gasoline.

If shortages and supply disruptions are holding down economic growth significantly, it doesn't get the Fed off the hook.  It will likely have to aim for an even slower pace of growth than otherwise to bring demand down to the restrained production level, possibly to well below its 1.8-2.0% estimate of longer-run GDP trend.  The result would feel like recession, even if technically not.

Given the difficulty of correctly discerning the import of real-side data, the best evidence to track the Fed's success or failure should be inflation-related measures, themselves.  Besides the CPI and PPI, labor costs and commodity prices will be telling, since they feed into the determination of final goods/services prices. 

The consensus estimate of this week's March CPI does not allay fears of high inflation, with Total expected to jump 1.1% m/m and Core rise 0.5%.  But, there are caveats.  A surge in energy prices, particularly gasoline, is largely behind the jump in Total.  Moreover, there is upside risk to the consensus estimate of the Total as a result.  But, retail gasoline prices already have fallen, and should result in a much more subdued increase in Total in the May Report.  Because of the volatility in energy prices, the Core CPI will be the more important part.  And, while the consensus estimate looks reasonable, a smaller increase can't be ruled out.  Stocks could bounce on a below-consensus print for Core, even if Total comes in higher than consensus.  But, a 0.4-0.5% m/m increase in the Core CPI still would be too high from the Fed's perspective.  So, its hawkish stance should remain.

Has The Macroecomomic Background Improved for Stocks?

The stock market recovery should continue this week, as the macroeconomic background may have begun to improve.  Lower oil prices have eased the inflation threat somewhat.  And, the March Employment Report contained hints of a moderation in labor demand and wage inflation.  If these hints are realized, they could persuade the Fed to pursue a less aggressive tightening path than currently feared (as seen in the jump in the 2-year Treasury yield on Friday).  Moreover, strong corporate earnings are expected to be reported over the next few weeks.

The drop in oil prices should take some sting out of a high print for the March CPI (due April 12).  Not only does it point to a decline in gasoline prices in the April CPI, but it suggests that a moderation in transportation costs will filter through to other goods and services prices over time.  While a 50 BP rate hike at the May 3-4 FOMC Meeting is still the risk (which could be discussed in this week's release of the March FOMC Minutes), an easing in inflation could dampen the subsequent pace of tightening -- particularly if labor demand begins to ease noticeably, as well.    

The March Report hinted at a moderation in demand for labor.  Besides the slowdown to an albeit still strong 431k m/m increase in Nonfarm Payrolls, there appears to have been a shift toward part-time work.  The Household Survey showed that the number of people with part-time jobs for economic reasons rose for the second month in a row.  Such a shift may have been at least partly responsible for the decline in the Nonfarm Workweek and flat m/m Total Hours Worked.  The latter could be setting the stage for slower job and economic growth at some point in Q222.  Note, however, early evidence does not rule out a speedup in Payrolls in April (due May 6).

The possibility of an economic slowdown this Spring also was hinted by the declines in the March Mfg ISM and some Asian Mfg PMIs.  Disruptions caused by the Chinese anti-Covid lockdowns and  Russia/Ukraine war are restraining economic activity, according to these surveys.  These developments could have even bigger effects as they drag on into the Spring.  Slow growth in Q222 could make it difficult for the Fed to tighten aggressively, although in truth supply-constrained growth should require a greater degree of demand restraint than otherwise to prevent a pickup in inflation. 

The March Employment Report had some good news regarding inflation.  The Report contained hints of a stabilization in wage gains.  Despite the Unemployment Rate essentially back to its pre-pandemic low, wage inflation does not appear to be accelerating on a sequential basis -- in contrast to the concern raised by the speedup in Average Hourly Earnings (AHE) in December and January.  The 0.4% m/m increase in March AHE matched the m/m pace seen in 5 of 6 months between June and November 2021.  It follows a slight 0.1% increase in February. 

Consensus looks for about +5.0% (y/y) for Q222 S&p 500 Corporate Earnings, despite tough year-ago comparisons.  This would be an impressive gain, as it is the first quarter when the year-ago pandemic drag falls out significantly.  The macro evidence supports the expectation of a positive y/y but lower than in Q421 (+27%).  Real GDP Growth and Oil Prices slowed in Q122.  And, softer non-US economic growth and a stronger dollar should hurt earnings from abroad.   Perhaps the biggest boost could come from an improvement in profit margins, as the Core CPI rose faster than Average Hourly Earnings.  

                                                                                                                                         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            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

Q122            4.3  *              64.3                +2.7                              5.4           6.4               58.0                                                       

                                                                           

* Based on the Atlanta Fed Model's latest projection of +1.5% (q/q, saar).