What Will Calm The Stock Market?

The stock market may stay under pressure from fears of more aggressive Fed tightening until evidence suggests otherwise. A more aggressive stance could consist of a return to 50 BP hikes or a longer stretch of 25 BP hikes.

The next set of key data begins this week, with the February Chicago PM and Mfg ISM.  Neither is expected to be weak enough to undercut these fears.   They are expected to rebound a bit, but stay below the 50 level.

More important reports will be released in the weeks after, including the February Employment Report (March 10), CPI (March 14) and Retail Sales (March 15).   While the risks are for Payrolls and Retail Sales to slow, it's not clear they will slow enough.  They may have to weaken to a below-trend pace if not an outright decline to calm the market's fear.  Similarly, there are reasons to expect the February Total CPI to slow, but the same factors that boosted the Core in January could persist to some extent in February.   So, stocks may not be out of the woods until there is some word from the Fed about its intentions, possibly as late as the March 21-22 FOMC Meeting, itself.

Maintaining a 25 BP pace of tightening can't be ruled out, nonetheless.  Indeed, on Friday, Cleveland Fed President Mester backed away from being adamant about the need for hiking by 50 BPs.  The Fed may decide that the recent economic strength is temporary, possibly reflecting exaggerated seasonal adjustment or warm winter weather.  Payback in the Spring is possible.   The path to lower inflation could be viewed as uneven.  Fed officials could be counting on a sharp slowdown, if not reversal, in Owners' Equivalent Rent in the second half of the year.  This, by itself, could pull the Core CPI down to a 0.2% m/m (about 2% annualized) pace.  

A period of sustained low inflation, however, most likely requires more labor market slack.  With sufficient slack, possibly meaning a 4.5+% Unemployment Rate, the economy can grow moderately without lifting inflation.  The quickest way to push up the Unemployment Rate is through a recession.  Fed comments suggest this would be the last resort in its fight against inflation.  Instead, they appear to be aiming for an extended period of below-trend economic growth to lift the Rate.  Currently, GDP Growth is above trend, according to the 2.7% (q/q, saar) Atlanta Fed model estimate for Q123.  The Fed estimates trend growth at 1.7-2.0%.   To achieve below-trend growth, a long drawn-out path of 25 BP hikes may be needed.  A pause in tightening could result in a bounce in economic growth, given the resiliency of the US economy -- which in turn could prompt renewed Fed tightening.  Under this uneven scenario, the stock market would likely stay in a wide range until enough labor market slack is achieved.

 

 

To Hike By 25 or 50 BPs?

The stock market and other financial markets were "spooked" by last week's US economic data, building in a greater degree of Fed tightening ahead.  Speculation of a 50 BP rate hike at the March FOMC Meeting, however, is premature.  Temporary factors exacerbated the strength seen in Employment, Retail Sales, Manufacturing Output and Inflation in January.  The markets' fears could abate if these data moderate, if not pull back, in February or March -- as will likely be the case at least for some of them.  

The markets will be looking for clues regarding Fed policy in this week's release of the January 31-February 1 FOMC Meeting's Minutes.  The Minutes, as well as the upcoming Semi-Annual Monetary Policy Report and Testimony, should reflect the the more moderate message of Fed Chair Powell's post-Meeting news conference -- which could prompt a relief bounce in stocks.  Although some Fed officials raised the possibility of a 50 BP hike in March last week, they were probably voicing their own, well-known hawkish, positions rather than the official view.  Nonetheless, having some officials make hawkish comments could be part of Fed strategy for the purpose of restraining financial markets.

A Moderation in Growth Likely, But...

The Claims data so far suggest a moderation in growth immediately ahead.  Both Initial and Continuing are above their January average in early February.  This is a mirror image of what happened last year, when low Unemployment Claims contradicted some weak spending data.  The Claims data were right then.

The real-side strength in January likely resulted in part from temporary factors, such as the warm winter and post-holiday-induced exaggeration by seasonal adjustment.  The effects of unusually warm, or cold/snowy, January's have tended to unwind in February and March.  So the weather's impact on Q1 GDP Growth is small.  With the warm weather continuing in February, though, the unwinding could be delayed to March-April.  If so, GDP Growth would likely slow in Q223.

Temporary factors are not the only reason why the economy so far has defied forecasts of recession.  Fiscal policy remains growth-supportive, with Social Security COLAs being the latest surge in transfer payments.  Also, military restocking and the return of manufacturing to the US from abroad are lifting economic activity. 

If evidence of a moderation accumulates over the next few weeks, a 25 BP hike at the March meeting may very well become the markets' consensus.  Nevertheless, expectations of an increase in the Fed funds rate's endpoint in the Fed's Central Tendency Forecasts (to be released at the meeting) will likely remain.    

A Lower February CPI?

A pullback in the February CPI is uncertain.  It will require start-of-year price hikes to be behind us.  But, bi-monthly sampling of some components will sustain these hikes to some extent in February.  There is some favorable news.  Weekly data so far point to a slowdown in Gasoline Prices.  And, a drop in piped gas prices remains a possibility, as they have not yet reflected the plunge in natural gas prices. But, wholesale data suggest a near-term end to the decline in Used Car Prices.  Whatever prints, the Fed appears to have a longer-term view of the slowing path for inflation.  So, hawkish rhetoric and a higher funds endpoint may be the response to another high CPI.

 

 

 

    

Excessive Fear of the Fed?

The stock market's concerns about the path of Fed policy could be exacerbated by this week's US economic data, as consensus looks for a high January CPI, Retail Sales and Manufacturing Output component of Industrial Production.  But, these concerns are excessive, since the Fed's new gradual approach to tightening should not be derailed by one month's data -- particularly for January, a month when start-of-year effects could dominate.  This consideration applies to the January Employment Report, as well.

Consensus looks for +0.4% m/m for both Total and Core CPI, higher than the Q422 averages (+0.3% m/m for both Total and Core).   The Total risks printing above consensus, while the Core's risks may be balanced.  A big uncertainty for Total is the extent to which the collapse of natural gas prices is captured in the CPI this month.  There is an irony in the drop of natural gas prices.  It will add to the Core CPI in coming months, since natural gas prices are subtracted from Primary Rent in calculating Owners' Equivalent Rent (OER).  So, a smaller subtraction will raise OER relative to Primary Rent.

Consensus also looks for strong January Retail Sales, with Total up 1.5% m/m and Ex Auto up 0.7%.  But, these gains would follow soft prints for November and December, suggesting that the latter two were just the typical pause after a strong month (October).  Despite the m/m volatility, Real Consumer Spending Growth has been steady, in the 2.0-2.3% (q/q, saar) range in the past 3 quarters.  So, while softer prints in February and March are likely if January is strong, the trend should be moderate.

Early evidence suggests that both Payrolls and the CPI will slow in February, as well.  Initial and Continuing Claims are above their January average in the latest week.  And Retail Gasoline Prices have flattened out in early February.  They are still above the January average, but the m/m increase so far is smaller than in January.  Longer-term inflation expectations appear to remain in check.  The 5-year inflation expectations reported in the University of Michigan Consumer Sentiment stayed at 2.9% in mid-February.  

The stock market should view the gradual approach of Fed policy positively, even if the rate hikes persist into the Spring.   A modest pace of tightening increases the odds that the economy will slow without falling into recession.  It shows that the Fed is not ignoring growth while focusing on fighting inflation.  This, in turn, means that the financial markets should not tighten so much as to precipitate a downturn in economic activity, based on the idea that the markets move in ways to achieve the Fed's targets.

Even without a slowdown, the increases in labor and commodity costs should force companies to make cost-saving adjustments.   This may be behind the recent large layoff announcements.  An interesting possibility relates to restaurants.   Higher wages and food prices have boosted meal prices at restaurants.  A broad-based shift to home cooking in response could prompt restaurants to reduce labor costs by becoming more efficient.  The alternative could be to go out of business.  In either case, the recent surge in restaurant jobs may soon come to an end.  Shifts like this are occurring already.  Consumers are reported to have shifted from buying higher-priced brand-named foods to lower-priced store-branded foods at supermarkets.  Generally, labor-/commodity-intensive industries are at a competitive disadvantage.  Market forces precipitated by the run-up in wages and commodity prices, even without slower growth, will push them in ways to cut costs and thereby hold down prices.

 

  

 

Digesting the January Employment Report

The stock market should stay in a range this week, as it digests the implications of the strong January Employment Report.  Rather than underscoring concern about impending recession, above-trend economic growth now appears to be in play -- a positive for the profits outlook.  Offsetting this positive, the Report dashed hopes for a a near-end of the Fed tightening cycle.  At this point, any conclusion about Q123 economic growth or the next Fed rate move has to be tentative.  The Fed will see another set of monthly data, for February, before the FOMC meets again.

The January Employment Report offered several indications of strong growth.  /1/ The 0.1% pt decline in the Unemployment Rate to 3.4% put it well below the 3.6% Q422 average.  A q/q decline in the Unemployment Rate is a significant sign of above-trend growth.  /2/ Total Hours Worked (THW) in January are up 4.6% (q/q, saar) from the Q422 average.  This is a strong start to the quarter, well above the 1.9% Q422 pace.  /3/ Personal Income looks like it should be strong in January, based on the jump in THW -- which could allay fears of a weakening consumer.  /4/ Manufacturing Output (in the Industrial Production Report, due February 15) should rebound about 1.0% m/m, based on THW. 

Also, the +517k Payroll jump clearly was huge.  To be sure, it probably can be explained in part by technical factors.  There appears to be an upward shift of about 25k in underlying m/m job growth from the benchmark revision.  Also, an unwinding of special factors that may have held down jobs and the Workweek in November/December -- /1/ holiday-related seasonal exaggerations and weather --  may have resulted in catch-up in January.  In addition, companies may have been overly cautious amidst talk of recession in late 2022.  In these cases, jobs should slow sharply and Workweek decline in February.  At this point, the Claims data (so far) and other evidence hint at a slowdown in February Payrolls, but the issue will be by how much.  The Fed can wait and see, since the February Employment Report (due March 10) will be released before the next FOMC Meeting (March 21-22).

The Report contained friendly data regarding wage inflation.  The 0.3% m/m increase in Average Hourly Earnings (AHE) was below the 0.4% prior trend.  About half of the 13 main sectors posted below-trend increases.  Nevertheless, with AHE revised up to 0.4% from 0.3% in December, the first-print for January has to be taken with some caution, as it too may be revised up in the next Report. 

The next key US economic report will be the January CPI (due February 14).  It can surprise to the upside, as well.  Gasoline prices are up, Used Car Prices have begun to rise at the wholesale level, and start-of-year price hikes could show up.  To be sure, natural gas prices have dropped, but it is not clear how much of the plunge will be captured in the data.  The stock market will probably trade cautiously ahead of this Report.  And, its implication for Fed policy also will be somewhat tentative, since the February CPI will be released before the next FOMC Meeting.