Macroeconomic Background Improving for Stocks

The stock market should continue to recover through month end and very possibly into the summer, as prospects for a soft landing and a downshift in Fed tightening appear to be improving.  

A slowdown is suggested by commodity prices and Unemployment Benefits Claims.  Commodity prices, for the most part, have unwound their Spring surge but remain at high levels.  They would likely be falling much further if the economy were moving into recession.  Similarly, Unemployment Claims so far are not spiking upwards, as would be the case if the economy were in recession.  Initial Claims are up moderately from their April lows and stabilized in the latest week, while Continuing have only just begun to move up.

Evidence of slowing growth and lower commodity prices should convince the Fed to downshift its tightening moves.  Instead of hiking the funds rate by 75 BPs, as in May, it may very well hike by 50 BPs at the July FOMC meeting.  This would put the funds rate at 2.25%.  An additional 75-100 BPs over the year's remaining 3 FOMC meetings would get the rate to the Fed's target of 3.0-3.25%.  This amount of tightening would require further downshifting.

Evidence of a moderation in longer-term inflation expectations supports the idea of a downshifting in monetary policy tightening at this point.  The drop in the University of Michigan's 5-Year Inflation Expectations to 3.1% in the final-June report from the very high 3.3% at mid-month is important.  The high mid-month print helped persuade the Fed to hike by 75 BPs rather than 50 BPs at the May meeting.  Its unwinding should be welcome relief to Fed officials, who expressed concern about a ratcheting up of longer-term inflation expectations.  Indeed, the final Michigan print implies a sub-3.0% average in the second half of June.  The recent flattening in the Treasury yield curve is another piece of evidence that should dampen the Fed's concern about inflation expectations.  

This is a light week for US economic data, but the risk is for further evidence of a slowdown rather than recession.  Consensus looks for small gains in May Durable Goods Orders, although the risk is to the downside.  Consensus also expects declines in May Pending Home Sales and June Conference Board Confidence.  But, the latter is still expected to be at a high level.  The second revision to Q122 Real GDP should be small and hold no surprises.  The Atlanta Fed model's latest estimate of Q222 Real GDP is 0.0% (q/q, saar).  But, there is not yet enough data to make a reliable current-quarter GDP estimate.

 

Stock Market Consolidation Possible, But Fed Fears Remain

The stock market should continue to be weighed down by fears that policy tightening by the Fed and other central banks will push the US, if not world, into recession.  The Fed's intent to fight inflation will be reiterated in this week's Congressional testimony by Fed Chair Powell.  So, while the market could consolidate over the rest of June, after the latest plunge, these fears are not likely to go away as yet.  But, Powell may discuss the possibility that a recession can be avoided, which could help the market.

Ironically, the market's recession fears are not likely to abate until there is enough evidence -- either of a slowdown or lower inflation -- pointing to an end of Fed rate hikes.  Significant evidence is not scheduled to be released until the June Mfg ISM and Employment Report in the first week of July.  Both are likely to soften, but probably not by enough to derail the Fed's tightening path.  The most important piece of the Employment Report -- Average Hourly Earnings -- is hard to predict. 

At his post-FOMC Meeting news conference, Fed Chair Powell emphasized the Fed's intent to bring down inflation, but left open the door for a modest downshifting.  He called last week's 75 BP hike extraordinary and expects a 50-75 BP hike at the July 26-27 meeting.  A downshifting to a 50 BP hike would likely provide only modest support for stocks, however, since it still would be significant tightening.  Moreover, it would not end the tightening cycle.  The Fed's expectation is for the funds rate to be raise to over 3% by year end.  There would be at least another 1 percentage point of tightening needed to achieve this if the Funds Rate were to be raised by 50 BPs in July.  

A 50 BP hike in July is beginning to appear more likely than 75 BPs, as US economic data have started to soften notably.  Initial Unemployment Claims are now above the May average, which, itself, is above the April average.  Continuing Claims have flattened out.  The early evidence is for a further slowdown in Nonfarm Payrolls in the June Employment Report.  Among the economy's sectors, housing looks to be turning down.  Along these lines, this week's data on May Existing and New Home Sales are expected to post declines.  And, manufacturing may be slowing.  Some evidence points to a decline in the June Mfg ISM.

The most important development would be if commodity prices fall significantly.   But, this has yet to be seen, despite Friday's drop in oil price.  Indeed, gasoline prices would jump about 10% m/m (SA) in the June CPI if they stay near the current level for the rest of the month.  Powell acknowledged that the Fed has little, if any, control over commodity prices when supply factors, such as the Russia/Ukraine war, are operating.  The Fed's aim is to prevent a wage-price spiral.  Labor cost data, such as Average Hourly Earnings, and measures of longer-term inflation expectations, such as the University of Michigan 5-Year Inflation Expectations, will be important in this regard.  Unfortunately, there is little, if any, evidence to predict them.  The Final-June Michigan Survey will be released on Friday.

The market is right in worrying about recession.  Besides the drag from higher yields, higher dollar and lower stocks, the surges in food and energy prices represent a tax on the consumer.  For example, the more-than-doubling $3.00 increase in the price of a gallon of gas since the depth of the pandemic amounts to a $400 Bn (annualized) reduction in consumer purchasing power.  While much of this would be offset if the oil industry used the additional revenue to increase production and drilling, this has been slow to happen because of the anti-carbon stance of the Biden administration.  The drag from higher gasoline prices also is offset to the extent that workers' compensation increase.  But, this offset would not succeed if higher wage rates are passed through to prices. 

Stocks To Face Unfriendly FOMC Meeting This Week

The stock market remains in trouble as the higher-than-expected May CPI (and jump in the University of Michigan 5-Year Inflation Expectations) should reinforce the Fed's hawkish policy stance at this week's FOMC Meeting.  This doesn't mean the Fed will decide to hike by 75 BPs rather than the pre-announced 50 BPs, although Fed Chair Powell has been known to change his policy view after the release of some problematic data.  But, the Fed's Central Tendency Projections could lift the  trajectory of the funds rate sharply.  Also, the tone of the Statement and Powell's post-meeting news conference may not hint at any relaxation in the pace of tightening ahead. 

While the 1.0% m/m May Total CPI was high, there may be less behind it than meets the eye from the Fed's perspective.   44% of the Core components had m/m changes of 0.3% or less, compared to 36% of their prior 3-month averages.  Moreover, the jump reflected to a large extent supply issues: the embargo on Russian oil, the cutoff of Ukrainian food exports, and shortages of materials and components used in motor vehicles -- either directly in food and energy prices or in pass-throughs, like airfares.  (The CPI jump also reflected a catch-up to the run-up in rents since the end of the pandemic.)  All are factors over which the Fed has no control other than by restraining aggregate demand.  And, this could have little effect if the rest of the world, particularly China, grows quickly.  Or, if OPEC cuts production as demand for oil falls.  In a sense, the Fed may be only repressing US demand to allow the rest of the world to consume more of these commodities -- netting to little change in their prices.

This world-wide, commodity-driven problem shows that what is going on is not so much an inflation story as a relative price shift event.  The surges in energy, food and other commodity prices reflect supply-demand imbalances that are being eliminated through relative price changes.  Higher prices reduce demand for these items and encourage increased supply. The widespread impact of higher oil prices, however, makes the situation look like general inflation.

From this perspective, the Fed's goal should be to prevent wage rates from climbing in response to the higher prices, that is to prevent a wage-price spiral.  This goal could be difficult to achieve, since the relationship between wage inflation and unemployment has been loose, as Fed Chair Powell, himself, has acknowledged in testimony.  So, increasing the Unemployment Rate may have only a small effect on wage inflation.  To be sure, the slowdown in Average Hourly Earnings to a modest 0.3% m/m trend since February is encouraging.  It raises the possibility that the Fed will not have to tighten much to keep wage inflation from speeding up.  But, AHE is the narrowest of the major measures of labor costs and may not be telling the whole story.  Nevertheless, Labor Costs rather than Price Inflation perhaps should become the important data by which to evaluate Fed policy. 

How far the Fed thinks it will have to slow the economy will be apparent in the Central Tendency Projections released at this week's FOMC Meeting.  The market will probably be looking to see if these projections embody a recession or close to a recession.  The March Growth Projections will certainly have to be lowered, as they looked for an above-trend pace in 2022 and 2023 (see below).

The March projections also show expectations for the year-end Fed Funds Rate of 1.6-2.4% in 2022 and 2.4-3.1% in 2022.   These projections will be raised.  A 3.5% Funds Rate for 2022 would imply a 50 BP hike in each of the five FOMC Meetings from June through December.  A 2.75% Rate for 2022 would imply 50 BP hikes in June and July and then a downshift to 25 BPs in the 3 Meetings from September through December.   Note that Fed officials have said a neutral rate is 2.5%.

These projections were made before the May CPI was released, so Powell could emphasize upward risks to them at his news conference.  The cumulative increase in the projected funds rate has become more important to the markets than the actual hike at the Meeting.  That is one reason why the market reactions have been larger than historical comparisons would suggest.

                                    Central Tendency Projections at March FOMC Meeting*

                                                2022            2023

Real GDP Growth                2.5-3.0            2.1-2.5        

Unemployment Rate            3.4-3.6            3.3-3.6            

PCE Inflation                        4.1-4.7           2.3-3.0            

Core PCE Inflation               3.9-4.4           2.4-3.0 

*  Q4/Q4 Percent Change, Except for Q4 Average for Unemployment Rate.

The May Employment Report Wasn't Bad, May CPI Next Hurdle

The stock market may continue to have difficulty climbing out of its hole this week, as it braces for Friday's May CPI.  The latter will be boosted by higher energy and food prices, although the Core is likely to slow from April's jump.  On a positive note, Fed officials will be in their "blackout' period before the June 14-15 FOMC meeting, so their hawkish comments will not hit the screens.  The market treated the May Employment Report as a negative.  But, this was probably a mistake.

The stock market's fear is that the Fed will decide it necessary to push the economy into recession to bring down inflation.  This fear has led to sharp reactions to official comments about possibly moving the funds rate above the neutral 2.5% level.  It also appears to have been behind the market's negative reaction to Friday's strong May Payroll gain.

But, this fear is mainly hypothetical and more of an issue for later this year.  The Fed is essentially locked into two 50 BP hikes to 2.0% at the June and July FOMC Meetings.  The May Employment Report is irrelevant with regard to what the Fed does at those meetings as well as after July (since there will be more Employment Reports to see).  Indeed, no one is certain how the economic landscape will change after these hikes.  If the economy slows sharply and Core inflation moderates, the Fed could decide to hike by 25 BPs in subsequent meetings.  If the Fed does downshift, it still could bring the funds rate back to neutral or higher.  But, the pace of tightening would not likely precipitate recession.

At this point, the Fed officials' threatening comments may be aimed at influencing market and business expectations in a way to achieve slower growth without actually hiking too much.  Fed officials probably just want companies to cut hiring plans, and news reports suggest such hiring restraint is happening. 

Despite the market's reaction, the May Employment Report contained a number of elements that should please Fed officials.  Job growth is slowing modestly, moving toward a "soft landing" rather than recession.  It shows the economy still has momentum that could withstand the already announced tightening.  And, even though the Employment gain was large, it was accommodated by a higher Labor Force Participation Rate that kept the Unemployment Rate steady at 3.6%.  So, the gain is not necessarily inflationary.  Indeed, the 0.3% m/m increase in Average Hourly Earnings (AHE) showed that wage inflation remains subdued despite the strong demand for labor.  The low print may not have been an aberration, since it matched the average pace seen since February.  Moreover, it is below the 0.4% m/m averages in 2018 and 2019, before the pandemic.

A sectoral breakdown of AHE reveals that the earlier post-pandemic period of high wage inflation largely resulted from huge increases in just a few industries as they re-opened.  These huge increases are now behind us.  There also has been a slight increase in the number of sectors with 0.3% or lower AHE.  Six of thirteen sectors had 0.3% m/m or lower increases in AHE in May as well as between February and May on average, compared to 5 on average from April 2021 through January 2022. It remains to be seen whether the moderation in AHE shows up in the broader measures of labor costs -- Compensation/Hour and Employment Cost Index, both due in the summer.

The subdued wage inflation could show up in the May CPI, although higher commodity prices are a driving force.  Consensus looks for +0.7% m/m Total and +0.5% Core.  The Total estimate looks reasonable as gasoline prices jumped this month.  It risks being a bit higher if food prices speed up sharply.  The Core estimate can't be ruled out, but a slightly lower print is conceivable, as well.  This would likely require significant slowdowns in airfares and new vehicle prices after their large increases in April.