Stock Rally Ahead?

Three macro themes should dominate the stock market in the next few weeks:  /1/ evidence of weaker economic growth,  /2/ moderating inflation, and /3/ uncertainty about the state of the banking sector.   Stocks should rally into the Spring if upcoming evidence points to economic slowdown rather than recession, lower inflation, and an easing of the banking crisis.  There is a good chance that it will.

The most important evidence regarding the economy will be the March Employment Report.  The Claims data, as well as other evidence, point to another slowdown in Payrolls.  And, an increase in the Unemployment Rate can't be ruled out.  But, the Report is unlikely to signal recession.  Layoffs have stayed at a low level so far this year, seen by the flat trend in Initial Claims.  Although re-hiring has pulled back -- Continuing Claims have moved up somewhat in the past two months --  a recession should entail a more severe move in hiring.  

Curiously, the Fed's Central Tendency Real GDP Forecast suggests flat to negative economic growth over the last 3 quarters of 2023, if the Atlanta Fed model's 3.2% Q123 estimate is correct.  The Central Tendency Forecast is for 0.0-0.8% for 2023 (Q4/Q4).  Together, the model's Q123 estimate and the Central Tendency imply -1.1% q/q to 0.0% in Real GDP Growth in each of the next 3 quarters -- that is, a recession.  To be sure, if payback for the warm winter begins to show up in March, as is likely, then the Atlanta Fed model's estimate of Q123 GDP could be revised down, implying somewhat stronger growth for the rest of the year if the Central Tendency Forecast is correct.

Slower economic growth, in any case, should help lower inflation.  Early evidence for the March CPI includes gasoline prices.  Although they are up at the pump so far in March, their increase is less than seasonal.  So, they should decline fairly sharply on a seasonally adjusted basis in the CPI.  Apparel prices, too, may slow significantly after two months of large increases.  The early Easter could help, as apparel discounting is typical ahead of the holiday.  And, the recent decline in oil prices could show up in lower airfares.  In contrast, Used Car Prices could move up, based on the recent uptrend at the wholesale level.  The big question remains whether Owners' Equivalent Rent will begin to soften noticeably.

Recent comments by Fed Chair Powell and Treasury Secretary Yellen seem to reveal a great deal of uncertainty about the extent of the banking problems.  Although Powell called the overall banking system sound in his post-FOMC news conference, the Fed's newly established lending facility (Bank Term Funding Program) suggests the risk is wider than a few isolated cases.  Note that many banks apparently have shifted their borrowing from the Fed's discount window to this new facility, as the latter may have lower borrowing costs than the window.  So, the increase in the new facility's loans should not be viewed as a measure of the banking system's fragility.  Yellen appears to be trying to prevent bank runs without making the bank business risk free.  All these somewhat contradictory statements and actions could continue to exacerbate market fears.  If the banking crisis winds down, however, the stock market should move up, particularly if an economic slowdown, not recession, becomes the dominating theme -- and especially if inflation falls.

The Fed's Dilemma

The Fed will either keep rates steady or hike by 25 BPs at this week's FOMC Meeting -- and either has problematical implications for the markets.  Keeping rates steady would suggest the banking issue is indeed serious.  Or, the policy could be viewed as inflationary.  Hiking by 25 BPs could be justified by saying the Fed addressed the banking problem with a different tool -- guaranteeing deposits.  But, a hike would raise concerns that it would exacerbate the banking situation, even if the latter was not viewed to be serious enough to force the Fed to pause in its anti-inflation fight, and raise the risk of recession.  It's not clear which policy choice would be the less costly decision for the economy or markets.  

The markets also will pay attention to the updated Fed's Central Tendency forecasts.  The forecasts, however, may have been made too early to take account of the banking problems.  Regardless, some considerations argue for little change in the new forecasts.  A slowdown in inflation and economic growth are still reasonable expectations. 

The inflation picture, indeed, may be better than most think.  Housing rent may be the main reason why the CPI is running above the Fed's 2% target.  The Core CPI Excluding Shelter has been down to a pace consistent with the target since October, rising 0.1-0.2% on a m/m basis in each of these five months. (see chart below).  Housing rent is a lagging indicator and so far has not captured the rent declines seen in private surveys.  It is expected to catch up in the second half of the year.   

Besides prospects of a rent-led slowdown in inflation ahead, economic growth risks slowing into the Spring.  The unusually warm winter likely was responsible for some of the strength seen in January and February -- as reflected in the Atlanta Fed model's above-trend 3.2% estimate of Q123 Real GDP Growth.  The warmth probably pulled ahead spending that would normally be seen as the weather improved in the Spring.  Payback should be a drag in March and into the Spring as temperatures revert to normal levels. 

Some Street Economists point out that the banking problems could result in more restrictive lending practices and damage consumer confidence, thereby hurting economic activity.  This is not the full story, however.  The fall-out also includes sharply lower long-term yields and oil prices.  Mortgage rates should come down, helping housing demand.  And, lower oil prices should boost consumer purchasing power.  So, a recession is not necessarily a consequence of the current financial crisis.

The decline in oil prices is probably a significant difference from the 2008 episode.  Then, oil prices surged to $145/bbl and "killed" the consumer.  My view is that the Fed made several major mistakes that year, one of which was viewing the banking crisis as a liquidity problem rather than a confidence problem among banks, which, in fact, it was.  By cutting rates sharply (to increase liquidity) the banking confidence problem was not solved but commodity prices, including oil, surged.  The drop in oil prices now is one of a number of reasons why 2008 is not a good analogy and why a recession ahead is not a foregone conclusion.

SVB, CPI and the Fed

The Silicon Valley Bank closure looks like it will be just a blip for the markets, as the Fed and FDIC appear ready to act to limit the fall-out.  Nevertheless, the bank's failure could make Fed officials more inclined to hike by 25 BPs than 50 BPs at the March 21-22 FOMC Meeting.  While the bank's failure may overstate the overall risks to the banking system or economy, it stands as a reminder that some feature of the economy tends to "break" when the Fed tightens monetary policy.  Besides this reminder, it is possible the economy's fundamentals will argue for a 25 BP hike.  Last week's key US economic data -- the February Employment Report and January Job Openings -- kept open the door for one.   Although the consensus estimate of this week's February CPI is on the high side from the Fed's perspective, a lower print cannot be ruled out.

Consensus looks for +0.4% m/m for both Total and Core CPI -- well above the annualized 2% Fed target.  Lower prints for both are conceivable, but this is far from certain.  A slowdown in Owners' Equivalent Rent (OER), declines in Used Car Prices and Airfares, and slowdowns in a number of other components (after start-of-year January hikes) could do it. 

1.  Although the Fed expects OER to slow sharply in the second half of the year, its slowdown in January raised the possibility that the CPI's rent survey may catch up to the actual declines in rents more quickly.  To be sure, OER may have to slow to +0.5% m/m from January's +0.7% to have a noticeable impact, which could be asking a lot of it. 

2.  While news stories have highlighted the bounce in the Manheim Used Car Price Index in February, there are several reasons to be cautious about mapping it into the CPI measure of Used Car Prices.  First, the Manbeim Index measures wholesale prices, and there is a lag before they show up at the retail level.  Second, seasonal factors subtract from Used Car Prices in the February CPI but add to the Manheim figure.  Third, the Manheim Index has tended to move in a wider range than the CPI measure.  

3.  Airfares in February are uncertain.  They have been on a downtrend for the past few months, even though the PPI measure of airfares has begun to rise.   The stabilization of fuel costs have helped keep them down.  Some airlines have boosted wage rates sharply, however.

4.  There is little historical evidence that the February Core CPI tends to slow from the January pace.  One reason may be that a number of CPI components are sampled on a bi-monthly basis, so start-of-year price hikes show up in the sample for 2-3 months.

Away from the current inflation rate, the Fed should feel encouraged by signs that US economic growth is slowing.  Thanks to a decline in the Nonfarm Workweek, Total Hours Worked dipped in February.  And, the Unemployment Claims data rose noticeably in the latest week.  Although Payroll growth remained strong in February, a lot of the increase appears to be catch-up from the pandemic.  This should not continue indefinitely, and the decline in Job Openings in January suggests this is the case.  Warm weather helped boost job growth in February, as well as in January.  Payback for the warm winter should be seen in a jobs and GDP slowdown in the next few months.  This week's reports on February Retail Sales and Manufacturing Output (part of Industrial Production) will likely underscore a weaker outlook.   This evidence will probably not be enough to stop the Fed from raising its projected endpoint of the Fed Funds Rate in this tightening cycle, but it suggests the markets should be cautious in taking an upward-revised projection at face value.

This Week's Critical Events

This week's critical events may prove positive for the stock market, but it is not a slam dunk.  Fed Chair Powell's Semi-Annual Monetary Policy Testimony should repeat the moderate message from the January FOMC Meeting, supporting the idea of a 25 BP hike at the March meeting -- a positive.  And, most February labor market data are expected to ease.  But, the data may not soften enough to calm market fears of Fed tightening.

The Fed's Semi-Annual Monetary Policy Report was released on Friday.  It reflects the consensus view of the FOMC as delineated in the latest FOMC Statement.   So, there is nothing new in it.  It repeats that inflation is too high and the labor market too tight.  Again, it points out that some inflation tied to supply disruptions is easing and that housing rent should slow later this year.  It argues that a slowdown in non-housing services prices, much of which is tied to wage inflation, needs to be seen ahead.  To this end, economic growth is expected to slow ahead.  The Report does not specify how much further monetary policy needs to tighten to achieve this, except to the extent shown in the Central Tendency forecasts.

There are two key labor market reports to be released this week -- the January JOLTS Data and February Employment Report.  Consensus looks for the JOLTS data to show a decline in Job Openings to 10.6 Mn  from  11.0 Mn in December.  While the downward direction is desirable, the level is still well above the pre-pandemic 7.5 Mn Openings.  Private surveys support the idea of a decline, according to news reports.  Although the Report could persuade the Fed that the labor market is moving in the right direction, its still-high level would leave open the door for further Fed tightening ahead.

Consensus looks for the February Employment Report to show a sharp slowdown in Payrolls to 200k m/m from 517k in January, but a steady 3.4% Unemployment Rate.  The Claims data and other evidence support the expectation of a Payroll slowdown.  But, the Claims data don't suggest a sharp softening in demand for labor.   Moreover, warm weather could boost jobs in February, as it probably did in January.  So, the consensus estimate risks being too low.  The market could excuse a higher-than-consensus Payroll print if the Nonfarm Average Workweek falls by more than the consensus estimate (34.6 Hours versus 34.7 Hours in January) or if the Unemployment Rate rises.  A Workweek decline could presage slower job growth ahead.  An increase in the Unemployment Rate would move in the Fed's desired direction.  Finally consensus looks for a moderate 0.3% m/m increase in Average Hourly Earnings (AHE), the same as in January and below the 0.4% recent trend. So, it would be a market positive.

Last week's release of Q422 Labor Compensation/Hour had some positive news for the Fed.  The data, which reflects benchmark revisions and is the broadest measure of labor costs, show that last year's labor cost inflation (Q4/Q4) was closer to the pre-pandemic pace (2019) than were the other major measures (AHE and Employment Cost Index) -- see table below.  It suggests the Fed may be able to achieve its 2% inflation goal without aggressive tightening.  Powell may be comfortable saying a modest increase in the Unemployment Rate could suffice when he gives his testimony this week.  While Compensation/Hour sped up in Q422 (q/q, saar), unlike the other two, it could have resulted from a jump in one-off bonuses.

(Q4/Q4 Percent Change)

Comp/Hour ECI AHE

2022 4.4 5.1 4.9

2021 4.6 3.9 5.3

2020 9.3 2.5 4.9

2019 3.8 2.7 3.2