Stocks in Trouble After Powell's Speech, But...

The stock market is in trouble after Powell's hawkish speech at Jackson Hole, particularly in this seasonally weak period.  His comments suggest that Fed tightening won't stop until the Unemployment Rate climbs and Wage Inflation falls.  The market faces the prospect of either a recession or much higher rates.  But, there is a caveat.  Stocks could stabilize if wage inflation slows without a sharp weakening in the economy.

Powell emphasized three developments that are needed to bring down inflation: /1/ A softening in labor market conditions, /2/ below-trend GDP growth, and /3/ low and stable longer-run inflation expectations.  Recent evidence is favorable in terms of the second two developments.  But, not the first.  So, at this point, a 75 BP rate hike at the September 20-21 FOMC Meeting is in play.

Regarding recent evidence:

1. The Atlanta Fed model's 1.6% early estimate is below the 1.8-2.0% long-run trend estimated by the Fed -- a positive from the Fed's perspective, but arguable not low enough.

2. The 2.9% 5-Year Inflation Expectations in the Final-August University of Michigan Consumer Sentiment Survey keeps this measure within its recent range --  a positive from the Fed's perspective.

3.  But, the Claims data have begun to suggest that the recent softening in labor market conditions may be ending.  If Claims continue to be steady or lower, they will reinforce the Fed's view that the labor market is solid and too tight. 

Consensus estimates of this week's key US economic data are not expected to be particularly soft.  If so, they should keep open the door for a 75 BP hike.  Consensus looks for a 0.7 pt dip in the August Mfg ISM to 52.0, pointing to decent growth in the manufacturing sector.  It has to fall below 48.7 to signal contraction.  The fundamentals behind this sector are mixed.  The strong dollar and weaker growth abroad should weigh on exports.  But, the motor vehicle sector seems to be getting out of the chip shortage situation, as assemblies rose in July.  

Consensus expects a moderately strong August Employment Report.  Nonfarm Payrolls are seen slowing to +285k m/m from the huge +528k in July.   But, Payrolls need to rise by less than 100k m/m to be consistent with an increase in the Unemployment Rate.  So, it is not surprising that consensus looks for a steady 3.5% Unemployment Rate.  Moreover, consensus sees Average Hourly Earnings (AHE) rising 0.4% m/m, down from 0.5% in July and in line with the trend in H122.  But, AHE needs to slow to 0.3% or lower to be consistent with the Fed's 2% price inflation target.  

A low AHE print would be a positive market surprise.  And, there is a possibility that wage inflation will slow without a sharp rise in the Unemployment Rate.  There are several reasons.  /1/ The relationship between the level of the Unemployment Rate and Wage Inflation has become tenuous over the past 20-30 years.  Globalization of the labor force may have been the cause, as US workers knew they would risk losing their jobs to imports if wages were hiked too much.  If this factor is still important, the recently strong dollar and surge in immigrants could hold down wage inflation independently of the Unemployment Rate.  /2/  The recent flattening in the Unemployment Rate and decline in commodity prices could slow wage inflation.  The standard Wage Equation has the Change in the Unemployment Rate (as well as its level) and lagged inflation as significant determinants of wage inflation.

 

 

The Bad And The Good In The July FOMC Minutes

The July FOMC Minutes had good as well as bad news for the markets.  Bad News -- The Fed is intent on reducing inflation by tightening further.  Good News -- Although officials acknowledge the possibility of overshooting, their data-dependent approach to policy decisions would enable them to respond quickly by adjusting the pace and magnitude of tightening.   It suggests there could be a "Fed put" at some point.  

These ideas could be repeated by Fed Chair Powell and other Fed officials at this week's Jackson Hole meeting.  So, the "bad" implications of the Minutes may continue to weigh on stocks, particularly in this seasonally weak period.  But, the market could shake off its fear of tightening if upcoming US economic data, such as this week's July PCE Deflator, argue for a downshift in rate hikes to 50 BPs from 75 BPs. 

The July FOMC Minutes had three main messages for the markets -- /1/ rates will continue to be hiked until sustainable 2% inflation is achieved,  /2/ the pace of tightening would likely slow at some point once the cumulative effect of past rate hikes starts to bite the economy, and /3/ rates would likely be held steady at that point in order to ensure that 2% inflation is sustainable.  

The Fed's hope is to achieve its inflation target without a recession.  The Minutes, however, contain a fairly detailed analysis of the inflation problem that raises doubts on whether a sustainable 2% inflation rate can be obtained without a hard landing, that is recession.  Fed staff, as well as officials, acknowledge that the economy is operating at a level above its long-run potential.  Growth has to fall below its long-run 1.8-2.0% trend to bring the economy to a level that does not precipitate inflation.  Although the Minutes don't say this explicitly, the Unemployment Rate has to rise significantly -- which could entail a recession.  

To be sure, there could be mitigating factors helping to push down inflation without the need to boost unemployment.  The Minutes list /1/ competitive pressures that restrain price increases, /2/ "the apparent absence  of a wage-price spiral, " /3/ the tightening of monetary policy outside of the US, /4/ an easing of supply constraints, and /5/ the dollar's appreciation holding down import prices.  While lower commodity prices should continue to help lower inflation in the next few months, Fed officials view commodity prices as a "potential source of upward pressure on inflation."  Moreover, even with the mitigating factors, they think that "a slowing in aggregate demand would play an important role in reducing inflation pressures."

Although monetary policy aimed at slowing the economy is not good for the stock market, the Minutes indicated that officials would try to avoid going too far in trying to restrain the economy.  Many participants agreed that the tightening could be "more than necessary to restore price stability."  They believe, however, that the Fed's "data-dependent approach" to tightening will be an important element helping them mitigate that risk.  Presumably, this means the Fed will stop tightening or possibly ease if the economy's weakening appears to be excessive.  This possibility should cushion the impact of upcoming  monetary policy tightening on the stock market.

This week's US economic data are likely to leave open the possibility of a downshift in Fed tightening.   Consensus looks for a 0.3% m/m July PCE Deflator, the same pace as the Core CPI.  And, there is downside risk to the consensus estimate, based on the different compositional weights in the two inflation measures.  Housing data are expected to weaken further, with July Pending Home Sales and New Home Sales falling.  Manufacturing data, however, are expected to increase, with July Durable Goods Orders up modestly.

FOMC Minutes and Data Should Not Derail Stock Rally

The stock market should rally further this week, now that the low July CPI undercut fears of very aggressive Fed tightening ahead.  This week's US economic data will likely sustain expectations of a 50-75 BP hike at the September FOMC Meeting rather than the possibility of 75-100 BPs that was raised by the strong July Employment Report.  Moreover, the data should be more consistent with a slowdown than recession.

The release of the July FOMC Minutes on Wednesday should reaffirm the Fed's commitment to bringing down inflation to its 2% target.  The Minutes will probably be vague on the magnitude of the next rate hike, as was Powell at his news conference.  He had indicated that future Fed policy would be data-dependent and not constrained by forward guidance.  What may be important would be if the Minutes reiterated the Fed view that a recession is not its most likely expectation.  It would suggest the Fed will be measured in its tightening path, trying to avoid a sharp move that could lead to an abrupt downturn in the economy.

Whether the Fed will succeed in achieving  a "soft landing," and thus avoid recession, remains to be seen.  The July CPI was held down by a number of "special" factors, such as the drop in gasoline prices and airfares, that might last for only a few months.  High wage inflation is still a problem that could keep price inflation above the Fed's target after these special factors flatten out.  The possible need for a recession to bring down wage inflation has not gone away, but it is not imminent.

This week's US economic data are expected to point to slow growth in Q322.  Consensus looks for a slight 0.1% m/m increase in July Retail Sales, with Ex Auto 0.0%.  The low prints largely reflect the drop in gasoline prices.  So,  it will be important to look at Ex Auto/Ex Gasoline Retail Sales.  It could very well slow from the strong 0.7% June gain --  but this could be explained as the typical pattern after a strong month.  To be sure, higher prices will boost food sales, which are in Ex Auto/Ex Gasoline.

Consensus risks being too low in its forecast of +0.3% m/m July Industrial Production, with Manufacturing Output 0.0%.  Total Hours Worked in Manufacturing point to an increase in the latter.  This would be important, since the output declines in the prior two months were hinting at recession -- their being one of the pieces of evidence used to date business cycle turns.   Other positive manufacturing evidence would be seen if consensus is right that the Phil Fed Mfg Index will move up to -5 in August from -12.3 in July.  A rebound in the Phil Fed Index is the risk, as it appeared to be too low relative to the Mfg ISM in July.

Some of this week's Housing data are expected to stabilize.  The rate of decline is expected to ease for July Housing Starts.  Consensus looks for -1.2% m/m versus -2.0% in June -- and a stronger print can't be ruled out given the revised uptick in June Housing Permits.  The August Homebuilder Index is seen at a steady 55.  But, July Housing Permits are expected to decline.

Strong Payrolls Versus Slower Growth

The stock market could have trouble rallying further this month, as the possibility of a 75-100 BP hike at the September 20-21 FOMC Meeting is back on the table after the strong July Employment Report.  Nevertheless, this week's July CPI Report could be important in determining the market's near-term path.  A higher-than-expected print could prompt talk of a 100 BP hike if not an inter-meeting hike, a big negative for stocks.  A lower-than-expected CPI could give the rally some breathing room.

The +528k surge in Payrolls and 0.1% pt dip in the Unemployment Rate to 3.5% seemed to defy recent data, such as Unemployment Claims and Q222 Real GDP, that suggested a softening in economic growth.   But, a combination of slower economic growth and strong job gains can be explained as a difference between levels and rates of change:

What may be happening is that companies need to expand employment because /1/ the current level of economic activity is still too high relative to the level of jobs or /2/ the level of demand is greater than what is being produced.   Put another way, the earlier stimulative fiscal and monetary policies pushed demand and output to higher levels than they did Payrolls.  Now, Payrolls are catching up -- that is, closing the gap.  That gap could be about 3.5 Mn jobs, based on Job Openings data.  In this case, Payrolls could continue to post large gains for a number of months.

The strong job growth then reflects companies' efforts to catch up to an already strong level of demand.  So, most companies are not at a point of having to eliminate workers in response to a slowdown.  They need the additional workers just to meet current demand.  As a result, from the Fed's perspective, a slowdown in growth may not be enough to reduce labor market pressures sufficiently.  A recession that lowers the level of economic activity may be needed to bring equilibrium back to the labor market. 

A reconciliation of a slowdown in GDP Growth and an almost independent speedup in Payrolls results in a decline in Productivity.  It is an offset to the increases in Productivity in 2020-21.  This outcome is not good for the inflation outlook.  A decline in Productivity would boost Unit Labor Costs just as Average Hourly Earnings shows no sign of slowing wage inflation.

This week's calendar of US economic data will highlight inflation.  Consensus looks for +0.2% m/m Total and +0.5% Core for the July CPI.  The drop in gasoline prices will hold down Total.  The risks are probably balanced with regard to Core.  A pass-through of lower gasoline prices would hold down some prices.  And, there is anecdotal evidence that inventories are being reduced through price discounting.  But, higher labor costs could lift prices.  And, housing rents could speed up further, as they lag reports of slowing rents.

The other important inflation report this week will be the University of Michigan's 5-Year Inflation Expectations for Mid-August.  They were 2.9% in July, staying within their recent range.  But, the final monthly number was above the 2.8% mid-month read.  This means that Expectations were likely closer to 3.0% in the 2nd half of July.  So, the risk could be for an uptick from the July level.