Are Recent Economic Trends Good Enough for the Fed?

The stock market rally should remain intact if consensus estimates of this week's key US economic data are correct.  They would ratify a slowdown and support expectations of Fed rate cuts in 2024.  However, stronger-than-consensus prints for some, such as December Payrolls, are the risk, which could dent the market rally.   A potential problem ahead is that an economic slowdown will not be sufficiently weak to convince the Fed to cut rates in 2024.  However, it is too soon for this issue to be resolved, so the Fed's forecasts of rate cuts in 2024 should still dominate thinking.  

A way to evaluate upcoming economic data in the context of the Fed's Central Tendency forecasts is to compare the data with their recent trends, which at the moment could be considered consistent with the slightly above-trend 2.3% Q423 Real GDP forecast of the Atlanta Fed model.  If so, the data have to weaken relative to these trends to pull GDP growth closer to the Fed's expectation of sub-trend GDP growth in 2024.  

As you can see from the table below, consensus estimates of this week's US economic data are mixed relative to the recent trend.  Job Openings, ADP Estimate, Markit US Mfg PMI and Total Nonfarm Payrolls are expected to soften relative to trend.  In contrast, Construction Spending (for November), Private Payrolls, and Non-Mfg ISM are forecast to be slightly stronger than their recent trend.  So, consensus-like prints shouldn't close the door either way regarding slow-enough economic growth in 2024.

The most important are the labor market indicators.  The expected payroll gain -- both Total and Private -- is still too high relative to the Fed's sub-trend 2024 forecast.  It needs to be sub-100k.  Also, the Unemployment Rate would need to break above its recent range (3.7-3.9%).  So, consensus prints would indicate the Fed is not yet getting what it wants in the labor market. 

A technical change in the January Employment Report, due early February,  could have a bearing on the Fed's view of the economic outlook.  In the January Report, BLS will incorporate revisions to the measurement of the US population.  An upward revision would lift the Labor Force and presumably its growth rate.  The latter could boost the Fed's estimate of the longer-run trend in GDP growth, assuming a higher labor force growth is not offset by lower productivity growth.  A higher trend would allow the Fed to tolerate faster economic growth with less fear of boosting inflation.  The only technical change in the December Employment Report is for revised seasonal factors in the Household Survey.  These typically do not change the Unemployment Rate.

The evidence regarding the December Employment Report is mixed:

1.  Upside Risk to Payrolls:  As mentioned in last week's blog, Initial Unemployment Claims fell modestly since the November Payroll Survey Week, indicating a slight decline in layoffs, while Continuing Claims have stabilized if not dipped from their levels around the November Week.   Both suggest a speedup in Payrolls from November's pace. 

2. Upside Risk to Unemployment Rate: The Claims data, however, also suggest the Unemployment Rate may rebound after falling sharply in November -- and a 3.9% print can't be ruled out.  But, the Claims data are not a reliable predictor of the Unemployment Rate.  

3.  Upside Risk to Average Hourly Earnings: Some lagged boost from the UAW contract is conceivable.  Also, if seasonal factors look to offset softer wage rates of holiday-related temps, the factors may boost them too much if stores hired fewer-than-normal temps this year. 

There is no reliable evidence for the Mfg and Non-Mfg ISMs.  Nonetheless, some surveys suggest a dip in the Mfg ISM -- Markit US Mfg PMI, Chicago PM and Phil Fed Mfg Index.  Evidence is mixed for the Non-Mfg ISM  -- Markit US Services PMI up, Chicago PM down.

                                                         Consensus Estimate        Oct-Nov Avg

Construction Spending                             0.5%                            0.4% m/m

Job Openings                                              8.8 Mn                         9.0 Mn 

ADP Estimate                                            100k                             108k m/m                   

Markit US Mfg PMI                                 48.2                                50.1

Mfg ISM                                                   47.1                                46.7

Nonfarm Payrolls                                     158k                                175k m/m      

Private Payrolls                                         120k                               118k  m/m      

Unemployment Rate                                  3.8%                              3.8%                

Average Hourly Earnings                          0.3%                               0.3% m/m

Non-Mfg ISM                                           52.5                                52.3

RIsk To Stock Market Rally in Early January?

The stock market should continue to climb into year end, before some consolidation in early January is reasonable to expect.  The latest economic data should support the market rally immediately ahead.  They point to slower growth and inflation.  They even suggest the Fed's 2% inflation target is being met.   But, with the market having run up so much and possibly overshot fundamentals, it is vulnerable to a pullback at some point.  In early January, the risk is that a stronger December Employment Report triggers some profit taking.

Last weeks' November Personal Income Report pointed to both slower consumption growth and inflation.  Real Consumption in November was 2.5% (annualized) above the Q323 average, compared with the 3.1% q/q pace in Q323.  The pace is below the prior estimate in the Atlanta Fed model's forecast of Q423 Real GDP Growth.  The latter was revised down to 2.3% from 2.7% as a result.  Meanwhile, the PCE Deflator, both Total and Core, is running close to the Fed's 2% target on a 6-month basis.  The 6-month annualized change is 2.0% for Total and 1.9% for Core.

The lower Atlanta Fed model's projection, however, still suggests economic growth may be faster than desired by the Fed, as it is above the Fed's Central Tendency 1.2-1.7% Real GDP Growth forecast for 2024.  A continuation of solid growth next year could dissuade the Fed from cutting rates.  The next important piece of evidence with this in mind will be the December Employment Report (due January 5).

Early evidence suggests the Report could be problematic.  The Claims data so far suggest the December Nonfarm Payrolls may speed up (excluding strikers).  Initial Claims averaged 211k over the 4 weeks ended in the December Payroll Survey Week, versus 221k ending in the November Survey Week.  They indicate that layoffs have fallen.  So far, Continuing Claims are down slightly since the November Survey Week.  However, Continuing Claims don't rule out the possibility of  rebound in the Unemployment Rate after November's surprising decline to 3.7%.  The Rate may have to rebound to at least the most recent high of 3.9% to prevent being dismissed as "noise."

This week's calendar of US economic data is light.  House Prices and Chicago PM should be of only modest interest to the markets.  The Unemployment Claims data will be the most important. 

Betting On The Fed's Forecasts

The stock market should continue to trade up in the last two weeks of December, sustained by the more balanced stance of Fed policy mentioned by Fed Chair Powell in his post-FOMC news conference.  He said the Fed was now weighting growth and inflation more evenly in its set of goals.  However, the markets' focus on the Fed's forecasts of rate cuts in 2024 risks being disappointed.  Stronger US economic data could be the factor that sparks a stock market correction early next year.

The Fed's Central Tendency Forecasts include 2-4 25 BP rate cuts next year.  Although Powell continues to insist these forecasts are not cast in stone and should not be viewed as necessarily indicative of the actual path of policy, they are important for two reasons.  First, they influence the markets' expectations of future monetary policy, so in a sense they are an additional policy tool to the actual changes in the funds rate.  Second, the overall Central Tendency Forecasts put future rate decisions in the context of expected economic growth and inflation.  They indicate what combination of them would be compatible with the Central Tendency rate forecasts.

The Central Tendency forecasts are for slow economic growth, higher unemployment and lower inflation next year:

                                                 2024            2023

Real GDP Growth *                1.2-1.7        2.5-2.7

Unemployment Rate **           4.0-4.2        3.8

PCE Deflator  *                       2.2-2.5        2.7-2.9   

Core PCE Deflator *               2.4-2.7        3.2-3.3

* Q4/Q4 percent change

**   Q4 Level

In other words, next year's Real GDP Growth needs to slow to a pace below the Fed's 1.7-2.0% estimate of longer-run trend and result in an increase in the Unemployment Rate.  At the same time, inflation has to slow by about 0.5% pt on a y/y basis.  The Real GDP Growth forecast could be difficult to achieve.  Ironically, the markets' anticipation of this expectation may prevent it from happening, as the drop in longer-term yields, higher stock market and weaker dollar all work to stimulate aggregate demand.  Moreover, the Bideneconomic thrust from defense restocking, alternative energy investments and re-shoring of manufacturing from abroad remains largely in force -- to be sure, the auto companies' retrenchment of EV production helps curtail the thrust of the Administration's policy.  Finally, the economy still has good momentum.  The Atlanta Fed models' forecast of Q423 Real GDP Growth was revised up sharply to 2.6% from 1.2% after last week's data releases.  Overall, the Fed's forecast for 2024 may not work out.

Even if the forecast for slow economic growth turns out to be wrong,  one factor may serve to lower inflation.  If housing rent, particularly the measure of Owner's Equivalent Rent, slows to 0.2% m/m from its current trend of 0.5%, the Fed's 2% inflation target may be met.  Since the CPI's measure of housing rent lags actual rent by 6 months or so, it conceivably may slow sharply during H124 as it catches up to the flattening already seen in private surveys of housing rent.  Also, the decline in longer-term yields may help hold down rents -- lower yields encourage new residential construction, thereby lifting the supply of housing.  The issue could become whether the Fed will cut rates with inflation in check even though economic growth remains robust. 

Based on this analysis, weak US economic data should not be a problem for the stock market, as they would reinforce expectations of Fed policy easing ahead.  Economic weakness would be viewed as temporary.  Strong US economic data, however, would be a problem if they raise doubt about rate cuts in 2024.  And, if they are so strong as to suggest the Fed will renew tightening, they would be a significant problem for stocks.  Not only would yields be higher, but the economic strength would be viewed as temporary.

Much of this week's US economic data are housing related.  Consensus expects them to weaken slightly.  Soft prints most likely will be ignored, given the latest drop in yields.  The Purchase Component of Mortgage Applications could begin to get market attention instead.    

Stock Rally Should Survive This Week's FOMC Meeting

The stock market rally should survive this week's FOMC Meeting.  The Fed is likely to keep steady policy and retain its message that further tightening is possible if the trends in economic growth and inflation speed up.   Consensus estimates of this week's key US economic data may underscore this message, although a friendlier Core CPI can't be ruled out.

The November Employment Report did not contain evidence that would persuade the Fed to change its stance.  Excluding the direct effects of strikers, Private Payrolls (Total less Government jobs) rose 112k, a bit slower than the 115k increase in October.  Both increases are in line with estimates of job gains that are consistent with trend economic growth.  Although the Household Survey showed jumps in both Civilian Employment and Labor Force, these figures likely reflect the small sample bias of this Survey.  This bias is eliminated in the calculation of the Unemployment Rate.  And, while the Rate fell to 3.7% from 3.9%, it equals the August-September average.  A steady Rate also is consistent with trend-like economic growth.  Total Hours Worked are on track for 1.0-2.0% Real GDP Growth in Q423.  The Atlanta Fed model's latest projection is 1.2%.

Wage inflation was a bit on the high side in November, with Average Hourly Earnings up 0.4% m/m. But rounding made it look worse than what it was.  The unrounded increase is 0.35%.  Also, the one-off UAW settlement may have added a bit to AHE this month.  The 2- and 3-month averages of AHE are both 0.3%, which is consistent with the Fed's 2% inflation target, taking account of productivity growth.  However, it could be disconcerting to the Fed that moderation in wage inflation is not widespread among sectors.  AHE rose 0.3% or less in only about half of the major sectors.  The absence of a widespread acceptable pace of wage gains argues for the Fed to keep a hawkish tilt in its rhetoric.

The Fed's Central Tendencies will be updated at this meeting.  They are likely to show faster Real GDP Growth, lower PCE and Core PCE Deflator inflation, and no change in the Unemployment Rate forecasts than those made in September.  These changes would be stock market friendly.  The Fed's forecast of rate cuts in 2024 and 2025 will probably not change much, if at all.

Consensus estimates for this week's key November US economic data, however, are somewhat unfriendly.  It looks for 0.0% m/m Total (a good print) but +0.3% Core CPI (slightly higher than desired). A 0.2% print for Core can't be ruled out, but it likely would require substantial holiday discounting and a slowdown in Owners' Equivalent Rent.  Heavy discounting may be behind the consensus estimate of -0.1% m/m  for both Total and Ex Auto Retail Sales.  If so, the soft prints would understate the "real" gains in consumption.  Consensus expects a 0.3% m/m increase in Industrial Production, including a 0.5% rebound in Manufacturing Output.  They reflect the end of the UAW strike, so overstate trend. 

Stocks Uptrend Intact

The stock market should stay in an uptrend, as this week's key US economic data are not expected to change the macroeconomic picture of slower growth/inflation and its implication for steady Fed policy ahead.  

Consensus looks for another sub-200k m/m increase in Nonfarm Payrolls for November.  Total is seen up 170k and Private up 131k.  These estimates include 38k net returning strikers (returning less new strikers), so the underlying pace is even weaker -- 132k Total and 93k Private.  And, they show a slowdown from October's data excluding strikers of +180k and +129k, respectively.  The Unemployment Rate is expected to be steady at 3.9%.  

Evidence from the Claims data point to a slowdown in Payroll growth as well as an uptick in the Unemployment Rate, although questions about their reliability in this holiday season suggest caution in relying on them.  Layoffs appear to have picked up in November, as Initial Claims were 221k in the four weeks ending in the Payroll Survey Week, versus 206k in October.  And, it may have become harder to be rehired, as Continuing Claims rose 144k in November versus 118k in October.  The Insured Unemployment Rate rose by 0.1% point in November, as it did in October -- when the Civilian Unemployment Rate rose to 3.9% from 3.8%.

Consensus looks for a slight speedup in Average Hourly Earnings to +0.3% m/m from +0.2% in October.  This higher pace is still below the +0.4% trend seen earlier in the year.  And, it is consistent with the Fed's 2% inflation target after taking account of productivity growth.  An uptick could result from the new UAW contract.

A recession does not seem imminent, however, despite the increase in Unemployment Claims.  Consumer Spending appears to be holding up, although slowing.  October Consumer Spending set the stage for 2+% (q/q, saar) consumption growth in Q423.  And, reports of holiday sales in November were strong.  Housing demand may have responded already to the pullback in longer-term yields, as mortgage applications have moved up steadily since making a low in late October.  The Atlanta Fed model's latest estimate of Q423 Real GDP Growth is 1.8%.  This pace is in line with the Fed's estimate of longer-run growth and not weak enough to argue for monetary policy easing.

Indeed, the rallies in the stock and Treasury markets, as well as the weakening in the dollar in the FX market, could be laying the groundwork for a speedup in economic growth in H124.  They essentially act as "built-in" stabilizers.  In addition, spending on defense, alternative energy and re-shoring of manufacturing should continue to provide forward thrust to the economy in the background.  A growth speedup could be problematic for the Fed, particularly if there is not much slack in the labor market.   This possibility could become the most consequential downside risk for the stock market ahead.

Stocks In An Uptrend

The stock market is likely to stay in an uptrend this week, helped by soft inflation data.  Other US economic data are expected to be mixed, but on balance point to modest economic growth in Q423.  The combination of low inflation and modest growth should sustain expectations of steady Fed ahead in the near future.  Powell's speech this week should not disabuse these expectations.  Month-end buying and hope for a "Santa Claus" rally in December could help the stock market this week, as well.

With the Israel/Hamas hostage deal lifting hope that the Middle East will soon return to normalcy, risk premiums in the markets could subside.  However, one of the reduced risk premiums appears to be in a weaker dollar in the FX market.  The latter also could reflect a reduced fear of Fed tightening.  Nevertheless, a weaker dollar could become a problem for the Fed next year.  First, a weaker dollar boosts US exports and import substitution -- helping to lift economic growth.  Second, it boosts import prices and thus inflation.  Right now, the weaker dollar is not a dominant concern in the stock and Treasury markets.  However, it is important to keep an eye out for how it behaves ahead.

The most important US economic data this week is the October PCE Deflator.   Consensus looks for +0.1% m/m Total and +0.2% Core, in line with the soft CPI already reported.  The y/y is expected to fall for both, although staying above 3.0%.  This would be welcome news for the Fed.  But, officials have said one, or even a few, low prints would not be enough to end the tightening policy bias.

Another important data are Unemployment Claims.  They are expected to rebound somewhat after dropping in the prior week.  The latter changed their implications for the November Employment Report, no longer suggesting a further slowdown in Payrolls.  However, seasonal adjustment of the Claims data is not reliable in this holiday season.  So, they may be less useful in providing clues about the monthly jobs data.

Other US economic data are expected to be mixed.  October New Home Sales are expected to dip and Consumer Spending to slow.  An expected decline in the November Conference Board Consumer Confidence Index would underscore a softening consumer, as well.  But, the November Mfg ISM is expected to tick up, although remain sub-50.  And, October Construction Spending is expected to remain in an uptrend, reflecting the recent increase in Housing Starts and strength in non-residential building. 

Stocks Helped by Holiday Shopping

The stock market is likely to continue to move up in this Thanksgiving week.  Although US economic data releases will be few, news reports regarding holiday sales and price discounting should underscore expectations that the economy will avoid recession and that inflation will fall further.  The consumer is expected to remain solid in this holiday season, helping to prevent recession.  And, large price discounting may be highlighted.  To be sure, high-frequency data -- Unemployment Claims and commodity prices -- suggest the US economy already is slowing.  

Surveys, such as one conducted by Deloitte and National Federation of Retailers (NFR), suggest holiday spending will remain robust.  NFR estimates holiday sales will increase 3-4% y/y.  Deloitte sees average spending per person exceeding the pre-pandemic level for the first time.  However, spending on heavily discounted items, such as those offered on Black Friday and Cyber Monday, is expected to be more prevalent than in 2022.  Deep discount promotions would help hold down the CPI.   

A still solid consumer would mitigate fears of recession, even as the economy slows.   The labor market already appears to be weakening.  Unemployment Claims moved up in early November and suggest that not only have layoffs increased but hiring has slowed.  If these trends continues over the next couple of weeks, it will point to an even weaker Employment for November than October's (adjusting for the impact of strikers -- subtracting in October and adding in November).  

Commodity prices also continue to point to softening economic activity.   Some major indices -- CRB and S&P GSCI -- have fallen further in November.  Others -- SSE Consumer Commodity Index -- flattened out after falling in October.  

With these weak high-frequency indicators flashing soft economic activity, the Atlanta Fed model's early estimate of 2.0% (q/q, saar) for Q423 Real GDP seems too high.  This estimate is near trend and inconsistent with the increase in the Unemployment Rate seen in September and October.  The model's estimate risks moving down as more data become available.   

Stock Rally To Survive This Week's Economic Data and Events?

The stock market rally will probably survive this week's key US economic data if the data print as consensus expects.  And, more market-friendly prints than consensus estimates can't be ruled out.  The November 17 Federal Budget deadline could present a problem, but how it will be resolved remains an open question.  Moody's downgrade of the US may spur some fiscally conservative decisions regarding the budget. If it looks like the Democratic proposal to expand social programs will not pass, the outcome could be a market positive even if the government shuts down for a few days.

Fed Chair Powell scared the markets last week by keeping the possibility of renewed tightening on the table.  He stipulated that the Fed needs to see solid evidence of a downtrend in inflation to end the tightening cycle.  He said this would take more than just a few months of low inflation prints.  From an economist's perspective, what will likely be needed to mollify the Fed is a significant weakening in GDP growth and a large increase in labor market slack.  An overshooting to the downside in economic growth may be needed to establish the conditions for good, non-inflationary economic growth ahead.  An overshoot could be problematic for the stock market at some point.

There already is evidence that economic growth is slowing and the labor market loosening up.  Unemployment Claims have moved up in the past couple of weeks.  If they stay at these levels in the next few weeks, they would point to another slowdown in November Nonfarm Payrolls and possibly a higher Unemployment Rate.  The renewed softening in commodity prices also attests to a slowing economy.  

This week's release of October Retail Sales and Industrial Production are expected to be soft.  Although a slowdown in Retail Sales could be just the typical pause after a strong month and a decline in Industrial Production could reflect in part the auto strike, near-consensus prints may very well be positives for the markets.  They would support the idea that the Fed may get the slowdown it wants.

If signs of a slowdown accumulate, the markets could view still-high inflation data as temporary.   Consensus looks for a benign Total but still-high Core CPI for October.  Total is seen at +0.1% m/m and Core at +0.3% (same as in September).  A 0.2% Total or a 0.2% Core can't be ruled out.  The latter would likely be a big positive for the stock market, while a consensus print for Core could be a small negative.

 

Further Stock Market Rally On The Favorable US Economic Data

The stock market should continue to climb in response to last week's favorable US economic data.  The data point to slower economic growth in Q423 and subdued wage inflation.  They support the idea that the Fed's rate hiking cycle is over.  As a result, concerns about the Fed are on the back burner for now, so that Fed Chair Powell's speech this week, which should repeat what he said at the post-FOMC news conference, will likely have little market impact.  Moreover, strong demand at this week's Treasury auctions of longer-dated securities -- reflecting the more subdued outlook for Fed policy -- could help lift stocks.

The October Employment Report is good news for the Fed and markets.  It points to slower growth in Q423 and reduced labor market pressures (including wages). 

The Report contains a number of signs that economic growth is slowing.  /1/ The +150k m/m increase in October Payrolls (+185k excluding strikers) was below this year's trend (+249k).  /2/ The Nonfarm Workweek slipped to 34.3 Hours, putting it below the 34.4 Q323 average.  /3/ Total Hours Worked (THW) fell 0.3% m/m, putting the October level flat relative to the Q323 Average.  In contrast, THW rose 1.4% (q/q, saar) in Q323.  /4/ The uptick in the Unemployment Rate to 3.9% put it at the upper end of the Fed's Central Tendency forecast of 3.7-3.9% for Q423.

The Report suggests that wage inflation remains in check.  The 0.2% m/m increase in Average Hourly Earnings shows a broad-based acceptable pace among sectors -- that is, a pace consistent with the Fed's 2% price inflation target, taking account of trend productivity growth.  Ten of the thirteen sectors had an increase of 0.3% or less in both October and the 3-month average.  This is better than September's seven of thirteen sectors with an acceptable pace of wage increase. 

Looking ahead,  the October CPI, due November 14, may not fully be in line with the Fed's goal.  The Total should print below September's +0.4%,  thanks to the decline in gasoline prices.   However, it is not clear whether the Core CPI will slow from September's +0.3%.  Nevertheless, a modestly high print may be ignored by the market, given the signs of a slowing economy.

Stock Market Stabilization This Week?

The stock market has a chance to stabilize this week, although this will likely require highly favorable prints for key US economic data.  With the Fed likely keeping rates steady and repeating its "wait and see" stance at this week's FOMC Meeting, the markets have become the vigilantes to make sure the Fed's goal of 2% inflation is achieved.  The strong September data underscored that the path to 2% inflation will not be a straight line and that more restraint from the markets may be needed.  Evidence of an easier labor market and benign wage inflation in this week's US economic data, thus, could provide some relief.  

Curiously, the election of a conservative Congressman as House Speaker could turn out to be a market positive.  While a government shutdown in mid November is a risk, the budget outcome could be a market positive if the Republicans succeed in blocking the Democrats' social spending proposals.  The long end of the Treasury curve could rally somewhat if fiscal restraint is seen.  This rally, in turn, would help stocks.

The Israel-Hamas war also seems to be moving to the background for the markets.  While the anti-Israel rhetoric has been loud, the war so far does not appear to be spreading significantly.

Consensus estimates of this week's key US economic data are market friendly, but may not be friendly enough.  Payrolls are seen slowing to a sub-200k gain, the Unemployment Rate steady at 3.8%, and Average Hourly Earnings rising  a moderate 0.3% m/m (although higher than the 0.2% September increase).   To be sure, the consensus Payrolls estimate excluding strikers (30k) is +218k.   Private Payrolls are seen at +145k and +175k ex strikers.  It's not clear whether this will be enough to placate the markets if Total Ex Strikers exceeds 200k.  The Claims data support the idea of a slowdown in Payrolls without the strikers and hint at an increase in the Unemployment Rate.  

The other Report that sheds light on the labor market will be the August JOLTS data.   Consensus sees Job Openings falling to 9.2 Mn from 9.61 Mn in July.  They would remain well above the 7.5 Mn pre-pandemic trend.  However, the market may be overstating its significance as a measure of excess labor demand.  Conceivably, companies may be keeping posted job openings but becoming cautious about filling them, concerned about an impending economic slowdown.  In this case, the level of Job Openings overstates labor demand.

This week's data will include all three major measures of labor costs -- October Average Hourly Earnings (AHE), Q322 Employment Cost Index (ECI), and Q322 Compensation/Hour.   All three may need to print low to appease the markets.  There is no evidence for AHE.  But, the evidence for the ECI suggests the consensus estimate of 1.0% q/q (the same pace as in Q223) is too high.  Average Hourly Earnings slowed to 0.8% in Q323 from 1.2% in Q223.  Consensus looks for Compensation/Hour to slow to 4.8% (q/q, saar) from 5.7% in Q223.  Partial evidence suggests the consensus estimate is too high, as well.  Even if not, a surge in Productivity is seen to continue to dampen the inflationary impact.  Unit Labor Costs are expected to slow to 0.8% from 2.2% in Q223.

 

Problems For Stocks, Despite Positive Fed

The stock market may continue to be weighed down by the Israel-Hamas war and the failure to elect a House Speaker.  These problems could persist for awhile.  Ironically, Fedspeak was market-positive last week, with many officials supporting a further pause in rate hikes.  

A ratcheting up of the Israel-Hamas war looks imminent, according to news reports.  This will probably result in contentious news headlines.  They, regardless of fact, could make the market nervous, as did last week's hospital explosion.  Moreover, the Israeli goal of toppling Hamas will likely take time to accomplish.  So, the risks of escalation could remain an issue for the market.  Alternatively, any movement toward a cease-fire would be a market positive.

The failure of the House to elect a Speaker also is a problem for the stock market.  The market does not like a dysfunctional government in Washington.  The market still may not like it if a Republican hardliner is eventually elected.  He could force a government shutdown in mid-November by insisting on spending cuts to pass a budget.  Instead, election of a moderate Republican could provide relief for the market.

In contrast to these developments, last week's speeches by Fed officials had a positive message for the stock market -- the Fed is willing to wait to see if inflation falls further before deciding whether additional rate hikes are necessary.  Powell's message was the most interesting.  He essentially said the Fed would tolerate strong economic growth if inflation continues to fall, although he acknowledged that history suggests below-trend growth and a looser labor market are needed for the latter.  He is counting on an "unwinding of pandemic-related distortions to supply and demand" and the tighter monetary policy to date to bring inflation down.

This week's release of the September PCE Deflator acquires even more importance after this speech.  Consensus expects +0.3% m/m for both Total and Core.  These estimates look reasonable.  They should result in a decline in the y/y inflation rates, although revisions to past months could affect the y/y, as well.  Powell mentioned that the y/y is expected to be 3.5% for Total, the same as in August (this assumes 0.4% m/m for September Total), and to fall to 3.7% from 3.9% for Core (this assumes 0.3% for September Core).  Looking ahead, Total needs to rise by less than 0.3% m/m and Core by less than 0.5% m/m on average over Q423 to fall further.  Early evidence suggests this may be the case in October.

An expectation of slower inflation could mitigate the market impact of the strong print expected for Q323 Real GDP Growth.   Consensus looks for +4.1% (q/q, saar), while the Atlanta Fed model projects 5.4%.  A high print could be viewed as "history," also mitigating its market impact.

Indeed, early evidence suggests the October Employment Report will show a slowdown in Nonfarm Payrolls (even excluding strikers, who should subtract from Payrolls this month) and possibly an uptick in the Unemployment Rate (unaffected directly by strikers).  The latest Unemployment Claims data suggest hiring has slowed more than layoffs.  Lower inflation and a looser labor market should reinforce expectations of steady Fed policy through year end.

 

Corporate Earnings/Lower Yields Help, But Evidence of Slower Growth Needed

The stock market is likely to be buoyed by favorable corporate earnings reports and lower longer-term Treasury yields this week -- as long as the Israeli/Hamas war doesn't spread.  So far, most reported earnings have beaten expectations.  Flight-to-safety related to the Mideast crisis and softer US economic data should be behind the latter.  

The predominant macroeconomic question overhanging the markets is whether US economic growth will slow enough to bring inflation down to the Fed's 2% target.  Evidence of a slowdown is particularly important after the high September CPI.  The bulk of this week's US economic data are expected to point in this direction. 

September Retail Sales are seen slowing to 0.2-0.3% m/m from +0.6% in August.  What will be important is whether Ex Auto/Ex Gasoline Sales print at or below August's modest 0.2% increase.  They averaged 0.4% m/m so far this year.

September Industrial Production (IP) is expected to dip 0.1% m/m.  A weak print could reflect automotive plant shutdowns stemming from the strike.  This would be a temporary restraint on economic growth, followed by a bounce-back when the strike ends.  The September FOMC Minutes show that Fed staff lowered its forecast of Q423 Real GDP to reflect the strike, but raised its GDP forecast for Q124 to capture a strike-ending bounce-back in production.  The IP Report's data on manufacturing output excluding motor vehicles may be more indicative of the underlying pace of this sector.  The recent trend has been soft, with Mfg Output Ex Motor Vehicles averaging -0.1% m/m over the prior 6 months.  But, Mfg Output ex Motor Vehicles jumped 0.6% m/m in August. 

This week's Housing data are expected to be mixed.  Consensus looks for a flat 45 print for the October Housing Market Index.  It sees September Housing Starts up, but Permits down.  Starts have been volatile in recent months, so it will be difficult to discern a trend in them.  Permits have been trending up, so a decline would have to be sharp to be significant.  

Perhaps the most important data this week will be Unemployment Claims, which provide the broadest high-frequency measure of economic activity.  The latest data are consistent with a slowdown in job growth in October.  But, it is still too soon to be sure.  The consensus expectation of higher prints for Initial and Continuing this week would move in the right direction for this prediction. 

A Relief Rally in Stocks, Despite Hurdles?

The stock market may continue to improve this week, relieved that the September Employment Report raised the possibility of strong but non-inflationary growth.  It suggests neither the Fed nor financial markets need to restrain the economy sharply to avoid a speedup in inflation.  The sell-off in longer-term Treasuries can ease up. 

There are still some potential hurdles this week, but they may be manageable.  /1/ Any market impact from the Israeli-Hamas war should be short-lived if the scope of the situation does not expand.  /2/ Even if the September CPI shows another high Core print, as consensus expects, last month showed that it may not translate into a high Core PCE Deflator -- the Fed's targeted measure.  To be sure, a higher-than-consensus CPI can't be ruled out (nor can a below-consensus print).  /3/ This week's release of the July FOMC Minutes and speeches by some Fed officials will likely reiterate Powell's hawkish message, particularly as it relates to the undesirability of strong economic growth.  It is too soon to expect the Fed to alter the message coming out of the July FOMC Meeting.  So, the markets may discount this Fedspeak.

The +336k m/m jump in Nonfarm Payrolls was the only strong element of the September Employment Report.   The jobs surge boosted Total Hours Worked,  so that the latter is up 1.5% q/q (annualized) in Q323 versus 0.0% in Q223 -- consistent with a speedup in Real GDP Growth in Q323 from 2.1% in Q223.   THW's September level is 1.0% (annualized) above the Q323 average -- a good take-off point for Q423.  So, at this point, there is no sign of an impending end to economic growth.

Other key parts of the Report were subdued and represented good news for the inflation outlook.  The steady 3.8% Unemployment Rate stayed above its recent trend, the 0.2% m/m increase in Average Hourly Earnings (AHE) was below trend for the second month in a row, and the Nonfarm Workweek was flat.  A steady Labor Force Participation Rate, after it had risen in August, offers hope that the economy's capacity to grow has expanded.  

The sub-trend 0.2% m/m increase in AHE raises the possibility the economy doesn't have to weaken much to restrain inflation.  To be sure, this is the narrowest of the three major measures of labor costs.  And, it could be affected by compositional shifts.  A slowdown in the Q322 Employment Cost Index, which is less affected by the composition and due in late October, would be welcome confirmation.  The aggressive union actions in the automotive, health care and other industries, however, may become a factor in the inflation outlook, particularly if they have a broad influence on wage negotiations.

Nonetheless, the possibility that a sharp slowdown in economic growth is not needed to prevent a wage-price spiral could persuade the Fed to keep rates steady at the October 31-November 1 FOMC Meeting.  A pause, if not partial unwinding, of the recent increase in long-term Treasury yields could be important in turning the Fed in this direction.  Moreover, early evidence points to a slowdown in October Payrolls.  The low ADP Estimate and sharp slowdown in Civilian Employment in September hint at such.  Increases in Unemployment Claims over the next few weeks would, as well.  The November Employment Report will be released after the next FOMC Meeting.

The 0.3% m/m consensus estimate of September Total and Core CPI looks reasonable, but there are risks on both sides.  A 0.2% print can't be ruled out, but would require declines in some areas, such as Lodging Away From Home, only an uptick in Used Car Prices, and only a modest pass-through of higher oil prices to components like Airfare.  A 0.4% print also can't be ruled out -- it's possible if many components don't slow from their August pace.  The recent unwinding of some commodity prices is too late to show up in the September CPI, but is a welcome development for the inflation outlook.

 

Stock Market Looking Better?

The stock market has a chance to recover in October, as the macroeconomic background may be moving closer to the Fed's liking and Q323 corporate earnings beat expectations.  Another pause in tightening at the October31-November 1 FOMC Meeting can't be ruled out at this point. 

Friday's release of August Personal Income/Consumption/PCE Deflator had good news for the Fed.  It contained ingredients for a slowdown in Consumer Spending -- a slower trend in Disposable Income and low Saving Rate -- and evidence that core inflation is trending down to below the Fed's 2% target.  This week's key US economic data are expected to point to slower economic growth, as well, although the evidence is not entirely supportive of consensus estimates.

Consensus looks for the Mfg ISM to edge up to 47.9 in September from 47.6 in August.   But, the evidence is mixed.  Although the Markit Mfg PMI rose in early September, the Phil Fed Mfg Index and Chicago PM fell.  The latter two have tracked Mfg ISM better than Markit Mfg in the past couple of months.  A near-consensus or below-consensus print would be consistent with slow growth.  A decline should not hurt stocks much if the Index stays above the 46.0-46.9 range seen in May-July.  Hard data on manufacturing were not recessionary during this earlier period.

Consensus looks for mixed evidence regarding an easing in labor market conditions.  It sees a slowdown in Nonfarm Payrolls to +158k in September from +187k in August.  And it sees the JOLTS data showing a decline in Job Openings in August.  To be sure, the Claims data lean toward a speedup in Payrolls.  But, the m/m change in Claims is small, as it was in August when it missed Payroll's speedup.  So, it has to be viewed with caution.

In contrast to slower job growth, consensus expects the Unemployment Rate to slip to 3.7% from 3.8%.  An important question regarding the Unemployment Rate is whether the Labor Force Participation Rate stays high or moves up further.  The latter would be especially good news, as it would imply more room for non-inflationary growth in the economy.  Consensus sees +0.3% m/m for Average Hourly Earnings (AHE).  Even though this would be up from 0.2% in August, it would be below the recent 0.4% trend.  There is no evidence on either the Unemployment Rate or AHE.

Consensus expects S&P 500 corporate earnings to slip a bit on a y/y basis in Q323.  This would be an improvement  from the large declines seen in the prior 3 quarters.  Macroeconomic evidence is mixed, but on balance does not rule out an improvement in corporate earnings from Q222.  The biggest positive is the strength of US economic growth.  There is also help from a smaller y/y decline in oil prices, a weaker dollar (thanks to base effects) making earnings abroad more valuable in dollar terms, and a smaller y/y weakening in economic activity abroad compared to Q223.  But, profit margins may have been squeezed, as the Core CPI slowed by more than AHE.

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

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                              4.9           6.0               47.1    

 

Q123            1.9                -19.5                 +3.0                              4.5           5.5               47.9 

Q223            2.4                -32.0                 +0.5                              4.4           5.2               44.7

Q323            2.9                -12.0                 -2.5                               4.3           4.4               43.2

                                                                           

* Based on the Atlanta Fed Model's latest projection of 4.9% (q/q, saar).

 

Bideneconomics, The Fed and Markets

The stock market could try to stabilize this week in anticipation of a seasonally better October.  Also, a soft August Consumption/Core PCE Deflator report could help on Friday.  Although there will likely be a lot of wrenching headlines about the difficulty of passing legislation to extend the federal budget past month end, this should be accomplished at some point.  So, it's just a temporary issue.  More importantly, the macroeconomic/policy background remains problematic, as discussed below.  Clear evidence of slower economic growth is needed to open the door for a significant rally in stocks.

Market commentary on last week's FOMC outcome highlighted the implication that the funds rate will be higher for a longer period than had been projected at prior meetings.  It has not delved much into why this will be the case.  Two reasons are /1/ Bideneconomics and /2/ the inherent dynamism of the US economy.

Putting aside political considerations, Bideneconomics can be defined as using government subsidies to promote alternative energy and bringing manufacturing operations back to the US from abroad (called "reshoring").  Pushing alternative energy is based on the idea that the market doesn't reflect "externalities" in the price of oil.  The externalities include pollution and climate change.  There is also a defense rationale, as is the case for reshoring.  

From a macroeconomic perspective, all these initiatives have one important effect in common -- they create demand for labor and other resources.  This increased demand would not be a problem if the US economy had a lot of slack.  However, the economy is now essentially at full employment.  So, these initiatives lead to higher inflation if not offset by a decline in activity elsewhere in the economy.  And, that offset or "crowding out" is what the Fed tightening is trying to do.  And, when it eases up on tightening, the markets do the work.  Currently, the sharp rise in long-term Treasury yields and the strengthening of the dollar are doing most of the work. 

This situation is a double-edged sword for the stock market.  On the one hand, the Bideneconomic initiatives boost the economy, holding back a recession as the Fed tightens.  On the other hand, higher long-term yields lower the present value of future earnings.  And, a stronger dollar lowers the value of earnings from abroad. 

The second reason for expecting the funds rate to stay high for longer is the inherent dynamism of the US economy.  If the Fed and markets pause in their restraining actions, economic growth will be quick to speed up, particularly with the Bideneconomic thrust in the background.  And, inflationary pressures will reassert themselves.  This responsiveness may help explain why the US economy sped up this summer soon after the Fed downshifted its rate hikes.  It also raises doubts about the plausibility of the rate cuts envisioned by Fed officials for 2024.  The only scenario in which rate cuts would not create an inflationary problem is after a recession has pushed up the unemployment rate to a high level.  

The consensus estimate of the August PCE Deflator (+0.5% m/m Total and +0.2% Core) looks reasonable.  Airfares should not rise as much as in the CPI, since their smaller increase in the PPI is also used in the PCE Deflator.  And, Owners' Equivalent Rent has a smaller weight in the PCE Deflator than in the CPI.  The consensus estimate of August Consumer Spending (+0.5% m/m) translates into flat Real Consumption for the month.  It is premature to conclude that the consumer is weakening, however, since a flat August print could be just the typical pause after a strong month (July).  Unemployment Claims data still show strengthening demand for labor in September.

 

A Poor Reaction to This Week's FOMC Meeting?

The stock market may react poorly to this week's FOMC Meeting, despite the well-advertised Fed pause in rate hikes.  Fed Chair Powell's post-meeting news conference is not likely to contain new insights into future monetary policy.  He will probably repeat the Fed's intent to bring inflation down and leave open a possible resumption of hikes if warranted by the data.  However, the macroeconomic evidence so far does not fully support a decision to pause, and the market may fear that worse is yet to come.  Indeed, the latest bond sell-off suggests the Fed may be behind the curve, with the decision to pause a mistake.  The risk is for bonds to sell off further, hurting stocks.  It may depend on the reaction of commodity prices to a pause.

The market will likely focus on the number of rate hikes shown in the Fed's Central Tendency forecasts for the remainder of 2023.  The September forecast allowed for one more hike, followed by rate cuts in 2024.  Keeping this additional hike on the table would raise two questions.   First, what pace of economic growth and inflation will keep the Fed on hold?  Second, what is the likelihood that we'll see growth and inflation match the Fed's desired paces?  

The Central Tendency forecasts may offer guidance to answer the first question.  The Fed may continue to refrain from hiking if its growth and inflation forecasts look like they are being met.  So far, economic growth looks to be too strong but inflation in line with the Fed's outlook -- although the high August CPI raises a question regarding the latter.  If economic growth or inflation does not slow, longer-term Treasury yields may climb further, substituting for Fed inaction -- a negative for stocks.

US Real GDP Growth so far exceeds the 0.7-1.2% June Central Tendency Forecast for 2023.  It grew an annualized 2.0% in H123, and the Atlanta Fed model's latest estimate is 4.9% for Q323.  (These figures may change in the benchmark revisions to GDP, due September 28.)  This week's update of the Central Tendencies should show an upward revision to its 2023 Real GDP forecasts.  However, the markets may focus more on the 2024 Forecast as a guide to what will be an acceptable pace of growth going forward. The June Forecast was for 0.9-1.5% Real GDP Growth in 2024.  This forecast may be at risk, since the recent upsurge in commodity prices may be warning that US and global growth are picking up.  If the 2024 Real GDP forecast is raised, the Fed's expectation of the funds rate next year might be raised, as well.

To be sure, the June Forecast of 4.0-4.3% for the Unemployment Rate in Q423 looks achievable after the 3.8% printed for August.  And, it would be so much the better if it is attained by a speedup in the labor force rather than a decline in jobs, as was the case last month.  Doing so would mean the economy can accommodate faster growth without exacerbating inflation.  However, a renewed downturn in the Unemployment Rate will likely be problematic for the Fed.  And, the latest Unemployment Claims data don't indicate a weakening in the demand for labor.

June's 2023 Central Tendency Forecasts for the PCE Deflator, Total and Core, were being met through July.  In July, the y/y was 3.3% for Total and 4.2% for Core, versus forecasts of 3.0-3.5% for Total and 3.7-4.2% for Core for the year.  The risk, however, is that Total and possibly Core exceed these ranges in August, given the high CPI.  

What may not be fully appreciated by the market is that the June inflation forecast for 2024 is higher than the Fed's 2.0% target.  Total was seen at 2.3-2.8% and Core at 2.5-3.1%.  These forecasts can be viewed as "intermediate" targets, so that a somewhat higher than 2.0% inflation pace may not trigger a hike through next year.  It is somewhat comforting that the latest 3-month annualized increase in the Core CPI is 2.4%.  Also, the decline in the University of Michigan's 5-Year Inflation Expectations to a below-trend 2.7% in Mid-September is good news.

All Depends On The CPI

The stock market's path this week may depend on the August CPI Report, due September 13.  A high CPI, particularly Core, would depress the market, as it would exacerbate concern the Fed will continue to tighten to restrain the economy.  Even if the Fed pauses at the September 19-20 FOMC Meeting, Powell's rhetoric would presumably be hawkish -- raising the possibility of a resumption in rate hikes at subsequent FOMC meetings.  In contrast, a benign print for the Core CPI, which is the consensus estimate, could trigger a relief rally in stocks and Treasuries, as it would add to the evidence in the August Employment Report that suggests a longer pause in Fed tightening can be justified.

Consensus looks for a benign print for Core -- +0.5% m/m August Total and +0.2% Core.  The consensus estimates can't be ruled out, but there is upside risk for both Total and Core.  A jump in gasoline prices is primarily responsible for a high Total, and it may push up Total by more than consensus expects.  It can't be dismissed as temporary, since the continued run-up in crude oil prices points to a further increase in gasoline prices in September as well as the potential for higher fuel costs to be passed through to Core components.

There is mixed evidence regarding the Core CPI.   Higher fuel prices and a boost from seasonal factors raise the risk of a jump in Airfares in August.  This could lift the Core CPI to 0.3%.   However, a slowdown in Owners' Equivalent Rent (OER) to 0.4% from 0.5% could prevent a 0.3% print.  This is conceivable, since this deceleration was already seen in Primary Rent in July.  But, there is no guarantee it will happen for OER in August.

There are other favorable developments in the background.  The stronger dollar holds down import prices.  Indeed, Import Prices for Non-Auto Consumer Goods fell in June and July. while prices of imports from China have been in a downtrend.  Also, some large companies are reported to be cutting wage rates, eliminating the premium paid post-pandemic amidst labor shortages.   

Aside from inflation, the latest Unemployment Claims data argue against a slowdown in economic growth in early September.  Initial Claims show that layoffs are down to their lowest level since February.  And, Continuing Claims suggest re-hiring has resumed, as they are down to their mid-July level.  Near-consensus prints for August Retail Sales (+0.2% m/m Total and +0.4% Ex Auto) would add to this bullish-growth evidence.  Even taking out higher-priced gasoline sales would likely show little, if any, payback for the sales jump in July -- if the consensus estimate is right.  The Atlanta Fed model's latest estimate of Q323 Real GDP Growth is 5.6% (q/q, saar).

. 

A Good Employment Report for Stocks and Fed -- Not Treasuries

The stock market could tread water in this data-light week as it consolidates last week's bounce.  The August Employment Report justified the bounce, as it showed an easing in labor market conditions and slower wage gains while economic growth continues -- all stock-market positives.  It arguably supports a pause in Fed tightening at the September 19-20 FOMC Meeting.  The last hurdle will be the August CPI on September 13.  Stocks and Treasuries may trade cautiously into it, since the risks are to the upside -- in part reflecting higher commodity prices.

The important message from the Employment Report is that labor market capacity may have increased.  Even though Civilian Employment climbed 222k, in line with the solid 187k gain in Nonfarm Payrolls, Labor Force jumped 736k as the Participation Rate rose.  Increased participation of the population in working or looking for a job expands the labor market's capacity to accommodate stronger demand for labor.  The expanded capacity is seen in the jump in the Unemployment Rate to 3.8%, its highest level since February 2022.  Increasing labor supply rather than reducing demand is the best way to achieve the Fed's goal to loosen labor market conditions.  To be sure, it remains to be seen whether the higher Participation Rate is sustained in coming months  For now, the August jump gives the Fed a window to pause.

The slowdown in Average Hourly Earnings (AHE) to +0.2% m/m from +0.4% in each of the prior four months is an encouraging sign that the labor market is easing.  To be sure, the slowdown may be partly noise, as the AHE slowed from July in only 6 o the 13 major sectors.  However, more importantly, the 3-month average is 0.3% or lower for 8 of these sectors.  A 0.3% m/m or lower increase in AHE is consistent with the Fed's 2% price inflation target, taking account of productivity growth.  

The Report's evidence of solid economic growth may be problematic for the longer-end of the Treasury market.  Treasuries still need to be concerned that some restraint will be needed to ensure non-inflationary growth.  There was nothing in the Report to suggest a slowdown in economic activity over Q323.  Besides the speedup in Nonfarm Payrolls (+187k in August from +150k in July), the Nonfarm Workweek rebounded.  Both lifted Total Hours Worked, so that the July-August average is 1.0% (annualized) above the Q223 average, compared to 0.0% (q/q) in Q223.  The renewed upturn in commodity prices also hints at faster economic growth internationally as well as in the US.  The Atlanta Fed model's estimate of Q323 Real GDP is now 5.6% (q/q, saar), after Real GDP rose 2.1% in Q223.

 

Optimism Ahead of Key US Economic Data?

The stock market may trade optimistically this week as key US economic data could persuade the Fed to skip hiking rates at the September 19-20 FOMC Meeting.  The August Employment Report should be softer than July's, and it may be soft enough to assuage the Fed.  Even modest softening in Payroll growth and an uptick in the Unemployment Rate -- which is the risk -- may be enough, given Powell's comment that the Fed could "proceed carefully."  The Mfg ISM may tick up, but remain at a low level -- not a surprise for the Fed. 

Powell's speech at Jackson Hole on Friday highlighted the importance of slower economic growth and an easing in the labor market conditions in determining Fed monetary policy.  Two potential triggers of a rate hike are evidence that Real GDP Growth will continue to exceed its long-run trend (1.7-2.0%) and that the labor market is not softening enough.  

The Atlanta Fed model's latest estimate of 5.9% (q/q, saar) for Q323 Real GDP Growth is troublesome from this perspective.  However, it is still an early estimate and could come down as more data become available.  Indeed, softer data over August and September could point to slower GDP growth in Q423, which could comfort the Fed.

Consensus estimates for the August Employment Report may cement expectations for a pause at the September FOMC Meeting.  Consensus looks for Nonfarm Payrolls to slow to +170k m/m from +187k in July.  The Unemployment Claims data support the idea of a slowdown in Payrolls.   However, the consensus estimate still is high enough to keep the labor market under pressure.  The Fed would probably like to see Payrolls rise by about 100k or less to indicate sufficient easing in demand for labor, but it may be willing to wait to see if this degree of jobs slowdown evolves -- as long as the trend is down.  Reflecting a continuation of tight market conditions, consensus sees a steady 3.5% Unemployment Rate.  The Claims data don't rule out a slight uptick in the Rate, however.  Consensus also expects Average Hourly Earnings (AHE) to slow to 0.3% m/m from 0.4% in July.  AHE printed 0.4% in each month since April.  

A 0.3% m/m print in AHE would be a welcome slowdown from the Fed's perspective.  Arguably, it would be consistent with the Fed's 2% Inflation Target once productivity is taken into account.  Moreover, Powell mentioned that wage sensitivity to unemployment may have changed.  This suggests that a moderation in wage inflation in the face of low unemployment could diminish the importance of the latter regarding the inflation outlook.

The other key data this week is the August Mfg ISM.  Consensus looks for an uptick to 47.0 from 46.4 in July.  Evidence regarding the m/m direction is mixed.  The consensus estimate is still below the 48.7 historical demarcation between expansion and recession.  A low, consensus-like print would not surprise the Fed.  Powell mentioned that the trend in Manufacturing Output has been flat this year.

Controlling Fear of the Fed

The stock and Treasury markets may need to see signs of a US economic slowdown to better control their fear of the Fed.  In particular, they may need to see evidence that the labor market is easing.  There are reasons to think this evidence will show up in coming weeks, including softer August Employment and Retail Sales Reports.  So, despite the somewhat hawkish July FOMC Minutes, the question of whether the Fed will hike 25 BPs at the September 19-20 Meeting remains open.

Although FOMC participants acknowledged an improving inflation picture in the July FOMC Minutes, they emphasized potential upside risks stemming from developments such as renewed supply chain problems, an upturn in commodity prices, and an insufficient slowdown in aggregate demand.  The strong start to Q323, as captured by the huge 5.8% (q/q, saar) early Real GDP Growth estimate of the Atlanta Fed model, may have focused the markets on this last risk.  

The strong start to Q323. however, does not mean strength will continue through the quarter.  For example, a large increase in Retail Sales, as in July, typically is followed by 2-3 months of softer sales.  Moreover, while the evidence from the Claims data is not yet complete, at this point it suggests a slowdown in August Payrolls (due September 1) and possibly an uptick in the Unemployment Rate.  Layoffs are up and hiring may have slowed.  Fed officials probably want to see more labor market slack to be less concerned about the inflationary consequences of strong aggregate demand.  

Besides softer real-side economic data, lower commodity prices also may be needed to assuage Fed officials and the markets.  As of now, these prices appear to be off their highs for the most part, but are still well above recent lows.  A decline in oil prices could be particularly important after they jumped in August.  It looks like the associated jump in gasoline prices will add significantly to the August Total CPI.  A sharp downturn in oil prices ahead of the CPI's September 13 release would allow the Fed and markets to dismiss the August jump as temporary.

Ironically, if the latest market turmoil helps slow the economy sharply, the markets may refocus on the other set of risks mentioned in the July FOMC Minutes -- a sharper-than-desired economic slowdown.  This turn of events, however, remains to be seen.

Stock Market Weakness More Than Seasonal?

The stock market has had a hard time rallying on favorable economic data during this seasonally weak period.  Profit-taking after the steep rally in July is reasonable.  The question, however, is whether  something more fundamental is pulling down stocks.  The run-up in longer-term Treasury yields is a potential culprit.   And, it could be tied to the rising Federal deficit and hints that Fed tightening will end soon.  Higher yields serve to crowd out private spending to make room for the fiscal stimulus.  And, the burden to do so falls more on longer-term yields if it looks like short-term rates will not rise much further.  One way private spending is held down is through wealth destruction in the stock market, as the higher long-term yields cut the present value of future earnings.

Many years ago, another economist and I published a New York Fed Research Paper showing that the Treasury yield curve would steepen if the expected Federal Deficit widened.  We augmented the Fed model's term structure equation with the projected Deficit and showed the latter to be statistically significant.  With this in mind, the increased subsidies stemming from the so-called Inflation Reduction Act, which apparently are larger than had been expected, could be a factor behind the run-up in longer-term yields.  On top of this, the sharp increase in Treasury issuance following the debt ceiling fight in June could be exerting a significant temporary boost in yields, as well.  

Some of the run-up in longer-term yields could unwind ahead if congestion from heavy Treasury issuance abates in the next few months.  However, the need to crowd out private spending to make room for subsidized spending suggests longer-term yields will not fall by much, unless the Fed tightens more aggressively.  In the latter case, the short-end of the curve will take on more of the burden to restrain demand.

The more volatile Foreign Exchange market could be a factor lifting longer-term yields, as well.  Our Research Paper showed that the volatility of the dollar in the FX market also impacts the term structure of Treasury yields.  

The actual inflation data are not the issue regarding high long-term yields.  The underlying CPI (Core less Shelter and Used Car Prices) was flat in July for the second month in a row.  And, while the PPI was slightly above consensus, the culprits appear to be narrowly situated in the financial sector.  The longer-run 5-Year Inflation Expectations in the University of Michigan Consumer Sentiment Index slipped back to 2.9% in mid-August.  The Treasury market could be extra sensitive to the recent run-up in commodity prices, however.

At this point, an ending of the downward pressure on the stock market may require an abatement in Treasury issuance and a flattening out in commodity prices.  A sharp decline in commodity prices would not likely help stocks, as it would suggest economic weakness.  This week's US economic data are expected to show this is not the case.  Consensus looks for increases in July Retail Sales, Housing Starts and Industrial Production.  The Atlanta Fed model's latest estimate of Q323 Real GDP Growth is a strong 4.1% (q/q, saar).

 

 

Is A Growth/InflationTrade-Off Right?

The stock market should get relief from this week's July CPI Report, which could print below the already low consensus estimate.  But, it may not be enough to preclude another 25 BP Fed rate hike at the September 19-20 FOMC Meeting.  Friday's July Employment Report kept open this risk, although it argued against a more aggressive policy tightening.   Nonetheless, there is a way to interpret the jobs data in a favorable way regarding the inflation outlook that could hold back the Fed at some point.

Consensus looks for +0.2% m/m in both Total and Core CPI.   This would be close to the Fed's annualized 2.0% target for the second month in a row.  Moreover, a 0.1% print for both can't be ruled out.  Owner's Equivalent Rent needs to rise no more than 0.5% (as in June), used car prices and airfares fall, and hotel rates flatten out.  For a below-consensus Total, food at home prices need to fall, as well, which is suggested by recent softness in PPI food prices.  

Whether a low CPI is enough to persuade the Fed to hike once and pause or to pause in September could depend on its view of the labor market.  Friday's Report showed the latter to be still tight, with the Unemployment Rate slipping to 3.5% and wage inflation remaining high at 0.4% m/m.  It keeps open the door for a September hike.  However, the latter is still not a foregone conclusion, since the Fed will see the August Employment Report before the September meeting.  And, the BLS will release its estimate of the Benchmark Revision to Payrolls on August 23 -- possibly revising down the trend in job growth.

In any case, there may be a way to interpret the latest data to draw a more positive view of the inflation outlook.  More than half of the Payroll gain was in Health, Education and Government.  While their demand for workers helps to keep wage inflation high, other sectors look like they are trying to economize on high-cost labor by cutting jobs and the workweek.  These efforts should help offset higher wage rates and hold down prices.  And, they may not reduce output if offset by higher productivity of the retained workers.  

Last week's Q223 Productivity Report was encouraging in this regard.  The 4-quarter trend in Productivity is now 1.3%, up from -0.2% over 2021-202 and close to the pre-pandemic pace (1.6% over 2017-19).  With the latest Atlanta Fed model's estimate of Q323 Real GDP Growth at 3.9% (q/q, saar) and July Total Hours Worked only 0.3% (annualized) above the Q223 average, another strong increase in productivity seems possible in Q323. 

Strong Productivity offsets the impact of fast wage growth on price inflation.  Unit Labor Costs  (Compensation Growth Less Productivity Growth) averaged only 0.9% (q/q, saar) over the past 3 quarters.  It may be one reason why core inflation could be slowing.  The large wage increases could be viewed as labor capturing part of the productivity gain and not requiring a pass-through to prices.  In this view, the Fed could tolerate the high pace of wage increases and pause in its tightening. 

Stock Rally Continuing in August?

The stock market's rally may be slowed by August's seasonal weakness, but it should not be derailed.  The supportive macroeconomic themes of moderate growth and inflation should persist.  Further ahead, stocks could face a problem if growth and inflation do not abate and the Fed becomes more aggressive in tightening.  With this in mind, there are some upside risks to the key data released in August.  Their implications for Fed policy, however, will be mitigated by the fact that another set of key data will be released before the next FOMC Meeting in September.

At this point, it seems likely that the funds rate will be hiked another 25 BPs at the September 19-20 FOMC Meeting.  Economic growth doesn't appear to be slowing.   And, a hike would be consistent with the Fed's Central Tendency forecast.  For both reasons, the market could take the hike in stride.  What could be a more significant negative for the market would be if the Fed raises its endpoint of tightening.  And, unless July-August inflation data slow further, this is a good possibility.  At his post-FOMC news conference last week, Powell opened the door for a string of rate hikes ahead.

Powell essentially said the Fed will keep tightening until it becomes clear that inflation will settle down at 2% for an extended period.  When this will happen is not known.  He said that while monetary policy tightening may stop before 2% inflation is achieved, Fed officials will need to have a good sense that this goal will be realized soon thereafter.  He was not specific about which data points would be persuasive, but presumably a softening in labor market conditions is one of them.  The latest Unemployment Claims data don't suggest this is happening now.

Powell mentioned one factor that presumably makes officials comfortable with their gradual pace of tightening -- the real funds rate is above its historical average.  He didn't say this, but there are reasons why a high real funds rate is now appropriate and should not be reversed soon.  Defense restocking, shifting production back to the US from abroad, and rebuilding the US energy system are providing thrusts to economic activity.  A high real funds rate is needed to crowd out other economic activities, given how tight the labor market is, if these developments are not to further ignite inflation.    

Failure to accomplish a significant enough amount of crowding out may be the most important downside risk to the stock market.  Fed officials could become frustrated with their gradual 25 BP tightening approach and opt for a larger hike at some meeting -- similar to what happened in 1994.  

Consensus estimates of this week's key US data do not suggest these macroeconomic issues will be resolved soon.   Labor market data are expected to show continued above-trend job growth with little, if any, easing in labor market tightness.  Payrolls are seen up 200k m/m, about the same as in June (+209k), with the Unemployment Rate steady at 3.6%.  Job Openings are estimated to fall to 9.62 Mn in June from 9.82 Mn in July --  in the desired direction, but still well above the 7.5 Mn pre-pandemic trend.  Average Hourly Earnings are seen at 0.3% m/m, welcome after printing 0.4% in the prior two months but one month does not make a trend.  

Note that the Claims and other evidence don't rule out a speedup in Payrolls.  Consensus expects Private Payrolls to speed up, but to be offset by a decline in Government Jobs after the latter jumped in June.  Timing or seasonal adjustment issues may have caused the jump and could reverse in July.  Strikers will subtract only a minor amount this month.

Consensus estimates of the Mfg and Non-Mfg ISMs are mixed.  The Mfg ISM is seen edging up to 46.8 in July from 46.0 in June -- a somewhat better level but still in recession territory.  The Non-Mfg ISM is seen slipping to 53.0 from 53.9. 

Stock Market Caution In Face of FOMC and ECI

The stock market may trade cautiously this week, as it faces the possibility of a hawkish FOMC Meeting and key inflation/labor cost data.  Moreover, the market soon will be facing the risk of seasonal weakness in August.  To be sure, the market may take the FOMC Meeting in stride, as a 25 BP rate hike and threats of at least another hike ahead are well expected.  The US economic data, as well as corporate earnings, may be more important.  As for the data, consensus expectations are friendly regarding the PCE Deflator but somewhat disappointing regarding the Employment Cost Index.  The latter would underscore the likelihood of another Fed rate hike ahead.

Consensus expects the Core PCE Deflator to slow to +0.2% m/m in June from 0.3% in May, the same as what was seen in the Core CPI.  The y/y is seen falling to 4.2% from 4.6%.  This seems like a reasonable expectation.  While it should be welcomed by the Fed, there likely needs to be more months of 0.2% or lower core inflation to convince officials that their fight against inflation has been won.   With oil prices up, Ukraine wheat exports on hold, and the dollar softer, the Fed has to remain cautious about the inflation outlook.

The consensus estimate of a 1.2% q/q increase in the Q222 Employment Cost Index (ECI) implies no softening in labor cost inflation.  It keeps the pace in its recent range, as did the speedup in Average Hourly Earnings (AHE) in Q22 (see table below).   Although the ECI is a broader measure of labor costs than AHE, both have risen by similar amounts in recent quarters -- up about 5.0% (annualized).  However, the broadest measure of labor costs -- Compensation/Hour -- has been softer, rising only 3.0% over the year ended in March 2023.   This broadest measure does not keep the composition of jobs constant, unlike the ECI.  This is often viewed as a drawback.  Allowing for compositional shifts, however, may be a better way to understand the impact of labor costs on price inflation if companies are shifting their labor force composition to hold down costs.

The other important data this week will be Unemployment Claims.  While Initial Claims fell in the latest week, Continuing Claims rose.  As they stand now, Initial show fewer layoffs in July than in June.  But, Continuing Claims have risen and suggest a slowdown in July Payrolls.  One more week's data are needed to finalize the implication of Continuing for July Payrolls.

               (percent change over the quarter)

                          AHE                        ECI      

Q223                1.1                            na                       

Q123                0.9                            1.2                 

Q422                1.2                            1.1

Q322                1.1                            1.2

Q22                  1.1                            1.3  

Q122                1.3                            1.4 

Corporate Earnings and FOMC Meeting Won't Likely Derail Rally

 The stock market will be focusing on Q223 corporate earnings and the message coming out of the July 25-26 FOMC Meeting over the next few weeks.  Both will not likely derail the rally.  Earnings may not pose a problem, as the macroeconomic data don't fully support the weak consensus expectations.  The FOMC Meeting, to be sure, should not be market friendly.  A 25 BP rate hike seems to be in the cards.  And, the Fed will probably leave open the door for at least another rate hike ahead.  However, both are widely expected.  And, further tightening is far enough away that it could be put on the back burner. 

Consensus estimates a large 7% or more y/y drop in Q223 S&P 500 corporate earnings.  The macroeconomic evidence is not altogether weak, however, suggesting consensus may be too downbeat (see table below).  Negatives among the evidence include a drop in oil prices (reflecting a spike in Q222) and softer economic growth outside of the US.  But, the dollar is not as strong on a y/y basis as it has been, so it is less of drag on earnings from abroad.  Another negative appears to be a decline in profit margins, as the CPI slowed by more than Average Hourly Earnings.   In contrast, a speedup in Real GDP Growth could save the day for corporate earnings.

The Fed can point to the latest CPI report to justify its recent downshift in tightening.  Although it will likely emphasize that one report does not make a trend, and therefore leaves open the door for further tightening ahead, the inflation trend does appear to be down.  Excluding Used Car Prices and Shelter, the Core CPI was flat in June and registered its fifth month of deceleration.  Moreover, Used Car Prices should fall over the next few months and Owners' Equivalent Rent (the largest component of Shelter) may be in the process of slowing, as it did in June.  Nevertheless, the Fed cannot take its foot off the brake while the Unemployment Rate is so low.  A speedup in economic growth, as well as in commodity prices, could reignite inflation.  Ironically, the Fed may have to overshoot in its tightening to create enough slack in the economy to allow for faster, non-inflationary growth.

The next round of key US economic data may illustrate the problem.  Early evidence points to a speedup in July Payrolls (particularly adding back strikers).  And, the recent upturn in oil prices could feed through to core prices.  

This week's US economic data are expected to be mixed, but consensus risks being too low for some.  Consensus looks for a speedup in June Retail Sales, which seems reasonable.  But, its estimate of flat Manufacturing Output in the June Industrial Production Report risks being low.  While consensus expects a drop in June Housing Starts, this could be due to volatility or the weather.  Permits are expected to rise.  Consensus sees some improvement in the July Phil Fed Mfg and Empire State Mfg Indexes.

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

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                              4.9           6.0               47.1    

 

Q123            1.9                -15.0                 +3.0                              4.5           5.5               47.9 

Q223            2.5                -30.0                 +0.5                              4.4           5.2               44.7

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.3% (q/q, saar).