Stocks Too Optimistic?

The stock market probably has room to climb further this week, but the rally risks stopping soon for a couple of reasons.  Last week's positive reaction to Powell's comments may have been overly optimistic.  While the Fed might prefer an economic slowdown than recession to bring down inflation, a downturn may be necessary to generate enough slack to cut it.  The market will be facing possibility of recession for some time (if it already hasn't begun).  If US economic data don't weaken sufficiently to point to increased slack, the market will face the prospect of further aggressive tightening by the Fed.  If the data weaken too much, stocks would have to deal with recession.  Technically, stocks tend to be weak in August-September.   

The key to the degree of Fed tightening is twofold.  The labor market has to weaken significantly, with the Unemployment Rate rising to at least 4.5-5.0% by sometime next year.  And/or, Total and Core Inflation needs to fall toward the Fed's target of 2%.  This week's US economic data (for the most part) are expected to move in these directions, but the consensus estimates are not weak enough to conclude that further aggressive Fed tightening is out of the picture.   

The July Employment Report is expected to show a slowdown in Nonfarm Payrolls and a steady Unemployment Rate.  Consensus looks for +250k m/m in Payrolls and a 3.6% Unemployment Rate.  A slowdown in Payrolls makes sense, considering the decline in Q222 Real GDP.  The weakness in Final Demand and Inventories would seem to suggest companies overly expanded employment during H122.  But, the consensus estimate is likely the maximum jobs pace that would make the Fed comfortable.  A Payroll gain of less than 100k would be more comforting, as it would match the anemic growth rate of the US population and thus not tighten the labor market further.  To be sure, an increase in the Labor Force Participation Rate would raise the comfort level for job gains.

The consensus estimate of a steady 3.6% Unemployment Rate is consistent with the Insured Unemployment Rate from the Unemployment Claims data.  But, it is far from signaling an easing in labor market conditions.   

Consensus stuck near the 0.3% m/m trend for its estimate of Average Hourly Earnings (AHE), as there is no evidence on which to base an estimate.  However, last week's release of the Q222 Employment Cost Index -- a broader measure of labor costs that is less affected by compositional shifts -- showed a slightly larger q/q increase than AHE.   So, the latter loses some significance for the Fed.

From a stock market perspective, near-consensus Employment Report prints could raise warning signs for corporate earnings.  A combination of weakening demand and increasing labor costs is not a good recipe for profits.

This week's other important report is the July Mfg ISM.  Consensus looks for a dip to 52.0 from 53.0 in June.  But, there is some evidence suggesting a sub-50 print.  Although the markets are trained to view sub-50 as signaling recession, statistical evidence says that the recession cutoff for this Index is 48.7.  In other words, the Mfg ISM has to fall below 48.7 to signal recession in the overall economy.