Bullish Stock Market Window To Continue For Now

The bullish window opened up last week as the FOMC Minutes were somewhat more balanced with regard to growth and inflation than were Powell's previous comments.  In addition, almost all the US economic data kept alive the possibility that inflation could be brought under control without recession.  This week's US economic data are expected to sustain this possibility and thus keep open the bullish window for stocks.

Consensus looks for the Mfg ISM to slip to 54.5 in May from 55.4 in April.  This would continue its modest downward trend so far this year, consistent with a slowdown but not recession.  The 50+ level signals growth, not a pullback in manufacturing activity.  Note that not all evidence from other manufacturing surveys point to a decline in the Mfg ISM, so an uptick can't be ruled out -- particularly since the chip shortage constraints in the motor vehicle industry appear to be easing.  At some point, presumably, a restocking of defense-related equipment and ammunition will boost manufacturing output, as well.

The May Employment Report also is expected to show a moderation in job growth together with a steady 3.6% Unemployment Rate.  A steady Unemployment Rate would be consistent with near-trend GDP growth.  Consensus sees May Payroll slowing to a still-strong +320k m/m, versus +428k in April.  The Unemployment Claims and other evidence agree with a slowdown in May Payrolls.   Consensus expects +0.4% m/m for Average Hourly Earnings, which would be up from +0.3% in April but in line with the recent trend.  It would suggest that wage inflation is contained so far.

Anecdotal evidence suggests some companies are eliminating job openings rather than reducing payrolls in the face of Fed tightening and downside risk to the outlook.  If this is broad-based, it would be a welcome development for the Fed, which hopes to reduce excess demand for labor this way rather than by increasing unemployment.  The Fed's Beige Book or the April Job Openings Report, both due Wednesday, may pick up this downward shift in labor demand. 

Is A Bullish Window For Stocks Closed?

The window for a stock market bounce may have been closed by Fed Chair Powell's hawkish speech last week, in which he did not rule out the need for a recession to tame inflation.  But, maybe not.

To be sure, an expectation of a Fed-induced recession may continue to weigh on stocks.  The only questions are when will it begin and by how much does the Fed have to tighten to bring one on.  But, the answer to the first question is not soon.  So far, none of the US economic data indicates a recession is close, let alone here.  The market, though, may continue to treat them as old news to be ignored, as it did last week.  But, with upcoming US economic data expected to remain non-recessionary (see below), the market may decide to take a pause in its fear of recession.

A test could be seen with another Powell speech on Tuesday and the release of the May FOMC Meeting Minutes on Wednesday. Both are unlikely to contain anything new, but should underscore the Fed's serious intent to fight inflation.  A bullish surprise (and perhaps warranted) would be if Powell tries to dampen the fear of recession, for example by saying that while a recession may be needed to lower inflation that is not the Fed's baseline forecast.

Part of the problem for the market is the uncertainty regarding how much monetary policy tightening will be needed to achieve the Fed's inflation target.  With the risk that the already announced 50 BP hikes at the next two FOMC Meetings will not be the end of tightening, the burden for fighting inflation falls to the markets just in case the Fed actions are insufficient or too gradual to achieve the goal.

Powell has said the Fed does not target the stock market, but views it as one of the major channels through which monetary policy impacts the economy.  There are three major channels -- stocks, Treasury yields and the dollar.   As long as Treasury yields and the dollar continue to remain off their highs, the stock market has to bear the most weight in the fight against inflation.

With Powell saying the Fed may tolerate a recession to achieve its 2% inflation target, evidence of slower economic growth may not be enough to send an "all clear" signal.  The Fed may need to see an actual softening in inflation and its determinants -- wage rates and commodity prices -- to pause on rate hikes.  Waiting for signs of slowing inflation could lead to recession.  A soft landing in the economy was achieved in the past when the Fed was quick to pause on signs of slowdown.  A Fed-induced recession occurred when rates were hiked into the downturn. 

This week's US economic data are expected to show a strong consumer and manufacturing sector in April.  Personal Income and Consumption are seen up 0.6-0.7% m/m.  And, Durable Goods Orders are expected to climb 0.6%.  The April Core PCE Deflator is seen rising 0.3% m/m, the same as in March but still above the Fed's target.  It is reasonable to expect the PCE Deflator to be below the 0.6% Core CPI, both because of differences in composition and in their measurement of airfares.

 

A WIndow for Stocks to Retrace Losses?

The stock market is not off the hook from having to deal with the Fed's goal of slowing growth and inflation.  But, there may be an opportunity for some retracing of its recent losses over the next few weeks.

There are several reasons.  /1/ Longer-term Treasury yields appear to have stabilized for now.  /2/ The April inflation data underscored that the underlying pace is too high, but some of the culprits are likely behind us.  /3/ US economic data due over the remainder of May are mostly of minor market significance.  Most are expected to show modest gains or declines.  /4/ The Russia/Ukraine war is currently background noise from a market perspective.  This could change if Russia acts on any of its threats regarding an expansion of NATO.  But, some news reports suggest Putin will have a cancer operation soon, which could delay any action on Russia's part.  The Ukrainian prediction of victory by year end would be a positive if it happens, but it is too soon to be a catalyst for the market.

An analysis of the 0.6% m/m April Core CPI has mixed implications for bringing inflation down to the Fed's 2% target (about 0.2% m/m). 

1. Some of the increase in the Core CPI will probably slow by itself.  In particular, the extraordinary 18.6% jump in Airfares should ease up.  Fuel prices have flattened out and airline bookings are said to have fallen in response to the high fares.  Technically, most of the survey for airfares is bi-monthly, so the April jump may have reflected increases that occurred in March.  Airfares in the PPI, which are surveyed monthly, slowed in April. The jump in airfares accounted for about 0.1% point of the 0.6% Core increase.

2.  But, some parts of the CPI may be sticky.  In particular, Primary and Owners' Equivalent Rent edged up in April.  These are measured essentially as the average increase over the prior 6 months, so they risk continuing to move up as past large rent hikes get more fully captured.  Moreover, ironically, they could be boosted by a shift away from home ownership because of higher mortgage rates.  It's hard to see how Core CPI can move to a 0.2% m/m trend without rent slowing sharply.  It's somewhat less of an issue for the Core PCE Deflator, because rent has a smaller weight in its construction.

3.  Other components were mixed in terms of speeding up or slowing down from their March paces.  The jump in New Vehicle Prices was surprising, given signs that the chip shortage was easing.  Companies may be passing on increases in other commodity prices, such as Lithium, as price hikes for electric vehicles have been reported.

 4.  Commodity prices probably need to fall substantially and wages to slow to get inflation down to the 2% target.  

This week's US economic data are expected to be mixed -- more consistent with an economic slowdown than a recession.  Consensus looks for a speedup in April Total Retail Sales, but a slowdown in Ex Auto.  Both Total and Ex Auto will be boosted by higher prices.  So, the most important part will be Ex Auto/Ex Gasoline.  Another modest gain would suggest the 0.2% m/m in March was not just a typical offset to a recently strong monthly gain but that the consumer may indeed be slowing down.  Consensus looks for a strong 0.5% m/m increase in the April IP Report's Manufacturing Output.  But, there is downside risk to this estimate, based on Total Hours Worked.  April Housing Starts/Permits as well as the May NY Fed Empire State and Phil Fed Mfg Indexes are expected to slip. 

 

 

Digesting the Fed's Message

The stock market had a hard time adjusting to the FOMC message last week.  While the market first reacted positively to the less-than-feared hawkish policy stance, it more than gave back Wednesday's relief bounce on Thursday and Friday as it presumably focused on Fed's intent to slow the economy or on the risk that the Fed's announced tightening path would be insufficient to bring down inflation.  

Fed Chair Powell announced the Fed's intention to hike by 50 BPs and reduce the Fed's balance sheet at the next several FOMC meetings.  So, there is little, if any, uncertainty regarding monetary policy through the Summer.  Barring extraordinary events during this time, the main question for the markets will be whether US economic data increase the odds that the Fed will achieve its goals of moderate growth and 2% inflation without having to tighten much more.  The data will have to indicate both slower growth in aggregate demand for goods and services as well as for labor.  Most importantly, increases in labor costs and core prices need to slow further.

The Fed's approach puts a lot of weight on financial markets to reach these goals.  Powell said at his news conference that reducing the Fed's balance sheet is meant to lift longer-term yields as a channel to restrain the economy.   To the extent that higher yields hurt demand, there is less pressure on stocks or the dollar to do so.  Nevertheless, economic growth and inflation may have to fall below the targets, that is overshoot to the downside, before a sustained stock market rally is possible.

Friday's April Employment Report had a mixed message with respect to the Fed's goals.  The jobs data were strong and Total Hours Worked looked to be on a path to match the increase seen Q122.  So, this side of the Report underscored the need to apply further restraint to slow the economy.  In contrast, there were indications that wage inflation continues to be contained.  The 0.3% m/m increase in Average Hourly Earnings was less than the 0.4-0.5% seen for the most part since last Spring.  And, the Unemployment Rate held steady at 3.6%, despite the large increase in Payrolls.  The broadest measure of labor market slack -- U6 -- edged up.

The Q122 Productivity/Labor Cost Report also suggested that labor cost inflation is contained.  Compensation/Hour rose only 3.2% (q/q, saar).   This pace is well below the 5.6% seen in 2021 and in line with the pre-pandemic range.  While the Q122 Employment Cost Index was high, its fixed composition of occupations may be masking a shift by companies to use lower-paid positions to hold down labor costs -- possibly a reason for the softer Labor Cost data.  The drop in Q122 Productivity should be ignored.  It resulted from what was likely a mis-timing of imports, which depressed GDP (as I argued in last week's blog).

This week's April inflation data could add to evidence that inflation is stabilizing -- and could stabilize the markets.  Consensus looks for +0.2% mm for the Total CPI and +0.4% for Core.  A 0.4% print for Core would keep it below the 0.5-0.6% range seen from October 2021 through February 2022.  Moreover, the risk is for a lower-than-consensus Core CPI.  The Total will be held down by a drop in gasoline prices, which is one-off (so far) and old news.  Consensus also expects a slowdown in the PPI, both Total and Core.  And, April Import Prices may show the dis-inflationary effects of the stronger dollar.  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Relief After The FOMC Meeting?

The stock market may find some relief from the outcome of the FOMC Meeting, but this could depend on the latter's message.   The likely 50 BP rate hike and start of Fed balance sheet reduction would be as expected.  So would an expectation for additional aggressive tightening ahead.  What could be important is if the Fed emphasizes its desire for a "soft landing." 

Recent comments by Fed officials reveal 3 targets -- /1/ bringing down inflation to about 2% (annualized), /2/ achieving non-inflationary economic growth, and /3/ raising the Fed funds rate to a neutral 2.5% level.  The third goal is subservient to the first two.  The Fed could take its time raising the funds rate to 2.5% if inflation and growth move toward their targets.

The anti-inflation target is now the most important.  And, this will be seen by emphasizing the need for aggressive, front-loaded monetary policy tightening in the FOMC Statement or in Fed Chair Powell's post-meeting news conference.  But, this is well known and a major reason for the stock market plunge already seen.  The new information will be the extent to which the economic growth target is defended.  A desire to achieve a "soft landing" -- even if acknowledging the possibility of recession -- would suggest the Fed will pull back from tightening aggressively in the face of weaker economic data.  This relatively pro-growth stance could spur a relief rally in stocks.

The problem, however, is that the Fed may have to overshoot its growth target to the downside in order to achieve its inflation target.  The unemployment rate may need to move up to 5.5% to bring inflation down by a couple of percentage points.  But, this possibility will probably not be mentioned, if only for political reasons.  Also, such a weakening in labor market conditions might not be necessary if supply constraints ease up in the near future.  And, the already-stronger dollar should ease inflation pressures coming from import prices.

This week's key US economic data are not expected to be weak, however.  The April Mfg ISM is seen rising to 57.6 from 57.1, consistent with some other surveys.  It would remain below the 57.8 Q122 average, however, suggesting the manufacturing sector's growth has slowed a bit.  Consensus sees a solid 380k m/m increase in April Nonfarm Payrolls, versus +431k in March.  The Unemployment Rate is expected to dip to 3.5% from 3.6% and Average Hourly Earnings (AHE)  to climb 0.4% m/m, in line with the trend seen since June 2021.  Note that some evidence suggests a speedup in Payrolls from the March pace but a steady Unemployment Rate.  There is no evidence, unfortunately, for what is likely the most important part of the Employment Report -- AHE.  A lower-than-consensus print would add to evidence that inflation may be peaking.  A slower pace of AHE is needed to bring down inflation.  AHE averaged 0.2% m/m before the pandemic when inflation was low. 

It is not clear how the stock market would react to near-consensus prints for this week's key US economic data.  Real-side strength would underscore the Fed's intent to tighten aggressively ahead.  But, it also would suggest the economy could handle further increases in interest rates.   On balance, the market's reaction could be muted if Average Hourly Earnings doesn't surprise significantly. 

Even if the "official" data don't signal a sharp weakening in growth, there are early signs that a slowdown may  be in progress.  Many commodity prices are off their peaks.  Trucking rates are said to have fallen.  And, most housing data have softened.  Besides fewer sales, anecdotal evidence suggests that re-sale home prices have begun to fall in some areas.  The one exception could be the motor vehicle sector, where the chip shortage restraints may be ending.  But, a return to normal production should be accompanied by lower vehicle prices.  Note that job growth could be more of a lagging indicator than in the past, given both the need to fill the backlog of past orders and to bring headcount back to pre-pandemic levels.  This may explain why the Unemployment Claims data have not made a significant upturn but appear to be only stabilizing.  All this suggests it may take several months before market talk of a noticeable slowdown becomes pronounced.

While Q122 Real GDP fell 1.4% (q/q, saar), it may reflect a measurement problem.  A surge in imports more than offset increased demand, which doesn't fit well with employment and hours worked data.  It is possible there was a timing mismatch in the measurement of imports and demand -- either between Q421 and Q122 or between Q122 and Q222.