A Santa Claus Rally?

A Santa Claus rally in stocks this week cannot be ruled out.  There is little US economic data scheduled for release and stocks may have overreacted to fears of recession in the past two weeks.  

The Claims data offer reason to think the market overreacted.  Initial and Continuing Claims both stopped rising in the past two weeks, providing hope that the economic slowdown is not snowballing.  To be sure, the Claims data (as well as some other evidence) so far support the idea of a slowdown in December Payrolls and an increase in the Unemployment Rate.  But, these prints would be consistent with a slowdown, not a recession.

Besides Claims, the other US economic report of interest this week is the Chicago PM.  It has done a good job predicting the m/m direction of the Mfg ISM since April.  Consensus looks for an increase in Chicago.  Other survey data are mixed, but none has as good a tracking record as Chicago.

If the market pulls back its fear of a near-term recession, perhaps as a result of not-so-bad prints for the December Employment Report and Mfg ISM, a sustained rally will probably depend on Q422 corporate earnings.  Right now, consensus appears to be for a slight uptick on a y/y basis, despite a sequential q/q decline.  The macroeconomic evidence (see table below) shows some negatives -- slower growth here and abroad, as well as a still strong dollar and a slowdown in oil prices.  But, profit margins may still be supportive of earnings, as prices may have climbed faster than wages (on a y/y basis).  Earnings may have to exceed consensus for stocks to climb further.

The extent and duration of a stock market rally, however, would be constrained by the Fed's intent to keep economic growth slow enough to generate slack in the labor market.  The economy would likely respond positively to an easing of financial market conditions (which include higher stocks), contrary to the Fed's desire.  So, additional Fed restraint, by further rate hikes or through tough Fedspeak, would likely serve to undermine the rally.  Until labor market slack is sufficient, e.g., with the Unemployment Rate at or above 4.8% and wage inflation slowing, the potential for an aggressively restrictive Fed will hover over the stock market.  The end result may be a cycling stock market over next year or so, possibly within a broad range.

                                Macroeconomic Evidence Regarding Corporate Earnings

                                                                                                                                           Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.5           6.0               47.1                                    

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.7% (q/q, saar). 

Recession Fears Now Dominate Stocks

The stock market did not take the Fed's message well last week, choosing to focus on the recession risks of tighter monetary policy and not on the Fed's flexibility to change policy quickly if needed -- the latter implied by the downshift to a 50 BP hike at the meeting.   Despite the Fed's intent to bring down inflation, the downshifting shows they are mindful of other considerations, as well.  At this point, the market appears to be bracing for recession.  Weak US economic data are a negative, while strong data will probably be discounted as temporary.

This one-minded reaction to soft economic data was seen in the sell-off on the decline in November Retail Sales.  The -0.6% m/m  Total and -0.2% Ex Auto, with small downward revisions to the prior two months, was treated as evidence of a weakening consumer.  But, a small decline after a large increase, as in October, is often the case.  Retail Sales are volatile and one month's change (and even 2 months') should not be treated as a trend.  

This week's US economic data for November are expected by consensus to be soft -- not good for stocks.  Housing data -- Starts, New and Existing Home Sales -- are seen falling  Total Durable Goods are expected to fall and Ex Transportation to slow.  Consumer Spending should slow.  Initial Claims are projected to rebound.  

Weak housing data should not be a surprise, as this has been the recent trend and their sensitivity to the tighter monetary policy is well known.  Weak manufacturing data, in contrast, may be more significant, as they would confirm the recent declines in the Mfg ISM and other surveys and show a broadening softening in the economy.  There already has been some confirmation.  Last week's report on November Industrial Production showed manufacturing down for the month -- consistent with Total Hours Worked data.  In particular, motor vehicle assemblies fell to its lowest level since March.  A weakening in manufacturing is continuing in December, according to early surveys.

While housing and manufacturing are feeling the effects of tighter monetary policy, they are not the entire economy.  Unemployment Claims are the broadest high-frequency data available.  They surprised to the stronger side in last week's report.  It will be of interest to see if the consensus expectation of a rebound in Initial Claims turns out correct.  A counter-consensus decline in Initial Claims would raise a question about whether weakness is in fact snowballing.   

The Atlanta Fed model's current forecast of 2.8% for Q422 Real GDP Growth presumably would be revised down if this week's US efconomic data print on the weak side.  The model forecast is well above the 1.3% implied by the Fed's Central Tendency Forecast for 2022 Real GDP.  

Despite the market's fears, a recession is no sure outcome.  Besides the Fed having downshifted (and possibly downshifting more in Q123), the huge FY23 federal spending budget should provide a boost to the economy next year.

 

 

A Relief Rally?

A relief rally by the stock market probably will require two developments: /1/ a November CPI near consensus and /2/ less-than-feared rate projections coming out of the December 13-14 FOMC Meeting.  If the markets get past these two events unscathed, then a window opens for a "Santa Claus" rally into year end if not longer.

Consensus looks for +0.3% m/m Total and Core CPI for November.  This expectation can't be dismissed, but there may be more upside than downside risk.  A consensus print would probably require /1/ Owners' Equivalent Rent coming in at +0.6% m/m, the same as in October, /2/ holiday discounting showing up in Apparel and other goods, and /3/ a further decline in Airfares.  Airline fares fell a large 5.0% m/m in the November PPI, but they are measured differently in the CPI.  Also, the decline in PPI Airfares could  be catch-up to the decline in CPI Airfares that occurred in October.

A downshift in Fed rate hikes to 50 BPs at this meeting is almost guaranteed.  This would raise the funds rate target to 4.25-4.5%.  The markets will likely focus on the endpoint projected for the funds rate in the "dot" chart and Central Tendency forecasts.  Endpoints of 5.0-7.0% have been mentioned by a few Fed officials in recent weeks.  An endpoint in the 5.5-6.0% range, implying 2-3 more 50 BP hikes, would probably be viewed favorably by the stock market.  The endpoint in the September Central Tendencies is 4.5-5.0%.

While news analyses focus on the risk of recession in analyzing the latest decline in the stock market, there is no sign as yet that one is imminent.  The Atlanta Fed model's forecast is back up to over 3.0% (q/q, saar) in Q422.  The labor market is slowing gradually, but it may be reflecting efficiency drives by companies rather than a weakening in demand for goods and services.

A continuation of solid economic growth can be attributed to several factors.  Fiscal policy is a positive.  In October, some state governments issued a large amount of tax rebates.  While they are one-time, they likely are helping to lift holiday spending.  Similarly, the stimulus-driven excess saving during the pandemic continues to be source of consumer purchasing power.  Defense restocking of armaments also may be helping some industries, as may be new incentives for investment in climate/energy projects.  Away from fiscal policy, the return of manufacturing activity from abroad is a positive, particularly if it entails large amounts of investment.

These factors are working against the Fed's goals of slowing the economy and pushing down inflation, raising the possibility that this week's endpoint forecasts may not be the last word on the subject.  But, there is time for the Fed to evaluate whether a further upward adjustment will be needed.  And, there are no signs yet of impending recession.  So, the markets might have a window in Q123 to worry less about Fed policy or an economic downturn.

November Employment Report and the Fed

The stock market could be constrained going into the December 13-14 FOMC Meeting, weighed down by fears that the stronger-than-expected November Employment Report will keep the Fed on an aggressive path.  But, the economy is slowing, which supports a less aggressive approach to policy tightening.  So, a downshift in rate hikes to 50 BPs from 75 BPs remains likely.  The economy is not slowing enough as yet, however, to ease labor market conditions sufficiently to hold down inflation on a sustained basis.  The endpoint of this tightening cycle will likely be raised as a result.

The problem with the November Employment Report was not so much that Payrolls came in stronger than expected but that wage inflation remained high.  Payrolls slowed in November relative to October, which was consistent with the implications of the Unemployment Claims data.  The latter and other evidence, including the decline in the November Average Workweek, at this point suggest Payrolls will slow further in December.  However, the November pace is still well above the desired 100k mentioned by Fed Chair Powell in his speech last week.  Moreover, Retail/Warehousing/Courier jobs fell, suggesting lower-than-normal holiday hiring that will reverse in January.

Other components of the Report also point to slower economic activity.  With the Average Workweek down last month, Total Hours Worked (THW) fell m/m.  THW look like they slowed to 0.9% (q/q, saar) in Q422 from  3.0% in Q322.  The Unemployment Rate also suggests some weakening in economic growth.  While the Unemployment Rate was steady at 3.7% in November, it remained slightly above the 3.6% Q322 average.   The Atlanta Fed model's estimate of Q422 Real GDP Growth is down to 2.8% from 4.3%.  But, even this pace may understate the degree of slowing in the economy.  The m/m trajectory of THW shows a slowdown over the course of Q422.  It enhances the possibility of slower GDP Growth in Q123.

The problem for the Fed and the markets is that wage inflation picked up in the past two months.  Average Hourly Earnings (AHE) rose 0.6% m/m in November after an upward-revised 0.5% in October (was 0.4%).  Both are above the prior 0.4% m/m trend.  The November increase was widespread, with 8 of the 13 major sectors speeding up.  Nevertheless, the overall November speedup could have resulted from the extraordinary jumps in Transportation/Warehousing and Information  (+2.5% and +1.6%, respectively).  A simple average of the AHE sectoral changes excluding these two yields +0.4% in November versus +0.5% in October.  Moreover, the Transportation/Warehousing AHE surge could reverse after the holidays.  So, there may be less than meets the eye in the large overall AHE increase in November.

In his speech last week, Fed Chair Powell cited the "uncertain lags" between monetary policy and growth and inflation.  And, wage/price inflation tends to lag policy more than does growth.  So, the combination of an economic slowdown with still high wage inflation is to be expected.  Powell also mentioned that excess demand for labor could be exerting upward pressure on wages.  And, the Fed is aiming to restore balance in the labor market.  These comments imply that economic activity has to slow even more than it already has, if not decline, to bring wage inflation under control.  The Unemployment Rate probably has to rise at least a percentage point to do so.

Nonetheless, the slowdown in economic growth, as seen in THW, should encourage the Fed's belief that the tightening to date is having an effect.  So, officials could feel comfortable downshifting rate hikes to 50 BPs from 75 BPs.  At the same time, the failure of wage inflation to respond as yet argues for the Fed to raise its expected terminal point, pointing to more rate hikes next year than it had penciled in at the September FOMC Meeting.

Looking ahead to the November CPI, due December 13, a relatively moderate but still above-Fed target print is a good possibility.  A slight speedup in the Core CPI from October's +0.3% m/m can't be ruled out.  Among the components, Used Car Prices and Medical Care Services are not likely to subtract as they did in October.  And, Owners' Equivalent Rent may not slow again: while the lagged effect of the rent slowdown should continue to pull it down, there could be a smaller subtraction from the energy adjustment in its calculation this month.  Food Away from Home and Lodging may continue to be lifted by higher wages.  AHE in the Retail and Lodging sectors sped up in both October and November.