Another Fed Choice

The stock market's continuing concern about the health of the banking system suggests the Fed will have to make another choice besides whether to announce an upcoming pause in tightening -- whether or not to hike by 25 BP at the May 2-3 FOMC Meeting.  A hike would work toward achieving the Fed's 2% inflation target.  But, it also would exacerbate the banking system's problems, as discussed below.  The chances are the Fed will hike, hoping that regulatory actions will support the banking system.  But, it is also likely the Fed will announce a potential pause after this meeting.  The latter should be an important positive for the stock market.

Here are four negative effects of higher short-term rates on the banking system: /1/ Outflows of deposits to higher-yielding Treasury bills, /2/ Paper losses on longer-term mortgages and other debt held by banks, /3/ A loss in profits from "playing the yield curve" -- paying low short-term rates for funds and lending at higher long-term yields, /4/ lower demand for loans and other financial activities as the economy slows.  These are typical outcomes when the Fed tightens, and banks in the aggregate adjust by themselves to address this fallout.  So, the Fed could believe that the problematic banks are outliers that can be handled independently of monetary policy.

The primary focus of monetary policy, in this case, should be economic growth and inflation.  Here the evidence has not been overwhelmingly dovish with regard to Fed policy.  Although growth has slowed, the labor market is still tight and inflation too high.  Evidence on wage inflation has been mixed.  Friday's higher-than-expected Employment Cost Index (ECI) for Q123 showed no significant slowdown from the 2022 pace.  Nevertheless, this week's US economic data are expected to be soft, keeping open the possibility that the Fed will pause in tightening.

Consensus looks for an uptick in the April Mfg ISM to 46.7 from 46.3.  Such an uptick still would signal a sluggish manufacturing sector.  The Index has to exceed 48.7 to indicate growth.  The evidence is mixed, with Markit US Mfg PMI up for the fourth month in a row, while Phil Fed Mfg Index down in April.  More weight probably should be placed on the Markit Mfg PMI.  Recent history hints that it leads the Mfg ISM, while the decline in the Phil Fed Mfg may be catch up after it missed the direction of the Mfg ISM in March.  The Phil Fed Index often plays catch-up with Mfg ISM. 

Consensus also looks for Nonfarm Payrolls to slow to +180k m/m in April from +236k in March.  The evidence, however, is mixed regarding a slowdown or speedup in job growth.  The trend in Initial Claims is somewhat higher in April than in March, showing a modest increase in layoffs.  But, Continuing Claims did not rise as much as they did in March, suggesting hiring picked up, too. 

The Claims data support the consensus expectation of an increase in the Unemployment Rate.  Indeed, the data suggest it could rise by more than the 0.1% pt increase to 3.6% seen by consensus.   Besides the Unemployment Rate, a confirmation or not of March's jump in Civilian Employment could be important.  The jump could have resulted from the relatively small sample of this survey.  The April Report will tell whether the jump was an aberration or not.  

Consensus looks for a benign 0.3% m/m increase in Average Hourly Earnings (AHE), the same pace as in two of the past three months and not inconsistent with the Fed's 2% inflation target (taking account of the productivity trend).   There is no evidence.  A modest AHE probably shouldn't be dismissed because of the still high ECI.  There could be a shift toward lower-paid workers in the composition of employees, which the AHE would capture but the ECI not.  A compositional shift could hold down overall labor costs and help slow inflation.

Consensus expects Job Openings to fall to 9.6 Mn from 9.8 Mn.  This is in the right direction for the Fed, but the level is still well above the 7.5 Mn pre-pandemic trend. 

The Fed's Choice

The stock market should hone in even more on the upcoming May 2-3 FOMC meeting.  A 25 BP rate hike that brings the funds rate target up to the bottom of the Fed's Central Tendency forecast for 2023 is a strong possibility.  But, whether the Fed hints that it could be the last, or at least could be followed by a pause, may be more important for the market.   This week's US economic data could bear on the Fed's choice of message to convey.

Consensus has moved up to an expected slightly above-trend 2.0% (q/q, saar) increase in Q123 Real GDP.   The Atlanta Fed model's latest forecast is somewhat higher at 2.5%.  Any strength in Q123 GDP likely will be dismissed as history.   Nonetheless,  a high GDP print could suggest the potential for growth momentum carrying into Q223.  So, if anything, it would argue for another 25 BP hike.

Fed tightening and payback for the warm winter point to a weaker GDP print for Q223.  The question will be the extent of softening.  Unemployment Claims provide the broadest and most up-to-date measure of the economy.  So far,  Initial Claims have stayed in a relatively high range since mid-March (228-247k), indicating a flattening in the pace of layoffs.  Staying in this range would suggest only a modest slowdown in economic activity.  Continuing Claims, however, jumped in the latest week, suggesting hiring has stalled.  This jump needs to be confirmed in this week's report.  A confirmation -- particularly if they climb steeply again -- would spark more talk of a sharp slowdown, if not near-term recession.  High prints for the Claims data could help persuade Fed officials to choose to hint of a pause in tightening ahead.

This week's inflation data -- Q123 Employment Cost Index (ECI) and March PCE Deflator -- could influence the Fed's choice, as well.   Consensus-like prints would argue against a pause.  Consensus looks for the Core PCE Deflator to rise 0.3% m/m, the same pace as in February.  This pace is too high from the Fed's perspective -- annualized it is 3.7% versus the Fed's 2.0% target.  Consensus also looks for a speedup in the ECI to 1.1% (q/q) from 1.0% in Q422 -- showing that labor costs are speeding up.  But, the ECI looks like it could slow, based on Average Hourly Earnings (AHE) --  see table below.  Also, since ECI is a broader measure of labor costs than AHE, it may pick up cuts in year-end bonus payments.  A slowdown would be a significant difference from the consensus estimate.  It could raise hopes of slower inflation ahead and support the possibility of a pause in Fed tightening after the May FOMC meeting. 

                             (q/q percent change)

                          AHE                        ECI      

Q123                0.8                             na                 

Q422                1.2                            1.0

Q322                1.1                            1.2

Q22                  1.1                            1.3  

Q122                1.3                            1.4

Corporate Earnings and Fed

The stock market should trade with an upward bias in the second half of April, as Q123 corporate earnings are likely to surprise to the upside -- the macro background may have been better than thought (see my April 2 blog).  There could be some market caution as the May 2-3 FOMC Meeting approaches, nonetheless, since the Fed could choose to do another 25 BP rate hike.  

The stronger-than-expected bank earnings, reported last week, may impact the Fed's decision.  They could assuage the Fed's concerns about the fall-out from the SVB failure in March.  Some comments attached to the earnings reports also appear to be more upbeat about the economy than what their leaders had been saying.

Recent US economic data can be read two different ways from the Fed's perspective.  Both economic growth and inflation are moving in the right direction -- both slowing.  But, their slowdowns are gradual and their paces remain too high.  Fed officials could conclude that another 25 BP hike is warranted and won't push the economy into recession.  Some recent speeches by Fed officials have made this point.

Airfares reflect the problem.  They jumped another 4.0% m/m in April -- without it the Core CPI would have printed 0.3% instead of 0.4%.  Along, with the 6.0% March jump, they more than made up for the 6.9% decline over the prior 4 months.  While movements in the cost of fuel were important contributors to these swings, the more recent rebound also  may be a response to an expected surge in air travel over the summer -- particularly since labor shortages forced airlines to reduce the number of scheduled flights.  In other words, the jump in airfares reflects strong consumer demand relative to supply.  So, the Fed will probably not dismiss the jump as a development beyond their control (i.e., just blaming it on OPEC's output decisions).

Recent data may not be as weak as appears at first glance.  The drop in March Retail Sales probably was largely the typical payback seen for several months after a surge (January).  The pullbacks in February and March most likely shouldn't be extrapolated to Q223.  A q/q consumer slowdown is a good bet, however, after Real Consumption looks to have risen a strong 4+% (q/q, saar) in Q123 -- and the Atlanta Fed model's latest estimate of Q123 Real GDP is back up to 2.5%.  Although Initial Claims rebounded in the latest week, the uptrend in layoffs may have eased.  They remain within a range seen since mid-March.   There is mixed evidence so far whether Nonfarm Payrolls will slow or speed up in April.

 

 

Good Economic News for Stock Market

The stock market should resume rallying, as Friday's March Employment Report argues for an economic slowdown but not recession and this week's March CPI Report may very well be benign.  The combination of slowing growth and moderating inflation raises the possibility the Fed will refrain from tightening at the May 2-3 FOMC Meeting.

The March Employment Report contained a number of components that were more indicative of slower economic growth than recession.  Besides slowing overall, March Payrolls showed only a slight decline in cyclical sectors -- Manufacturing (-1k m/m), Construction (-9k) and Retail (-15k).  The next Industrial Report (due Friday) should show flattish manufacturing output, similar to February's +0.1% m/m print.  Indeed, the essentially steady jobs and workweek in this sector suggests the Mfg ISM Report overstates weakness.  The Household Survey showed jumps in Civilian Employment and Labor Force.  Although they could reflect the small sample size of this survey, this "bias" is essentially eliminated in the calculation of the Unemployment Rate.  So, the 0.1% pt decline in the Rate to 3.5% is solid evidence against recession.  To be sure, the dip in the Nonfarm Workweek pushed down Total Hours Worked to below the Q123 average -- a soft take-off point for Q223.  Slower growth in Q323 is likely, in part  payback for the warm winter.

The Employment Report also showed that wage inflation may be shifting down to a pace consistent with the Fed's 2% price inflation target.  The 0.3% m/m increase in Average Hourly Earnings annualizes to 3.3%, which would be close to the target once trend productivity is taken into account.   A majority of the major sectors had wage increases at 0.3% or lower.  Wage inflation may stay modest, as news reports and anecdotal evidence indicate some companies are cutting or freezing wage rates in response to weaker demand -- a very quick response suggesting the post-pandemic surge in wage rates may not be as permanent as thought.  If the latter turns out to be prevalent, then the Unemployment Rate may not have to rise as much as thought to tame inflation.

The moderation in wage inflation may help to hold down the March CPI.  Consensus looks for +0.3% m/m Total and +0.4% Core CPI, both 0.1% pt lower than February's prints.  Even lower-than-consensus prints can't be ruled out.  Some of the 0.4-0.5% increases seen in the January and February Core CPI likely stemmed from start-of-year hikes and the pass-through of higher oil prices, both of which should dissipate in March -- and possibly by more than consensus builds in.  In contrast, arguing for the consensus Core estimate is the risk that Used Car Prices will begin to move up, as has been the case at the wholesale level for the past several months according to the Manheim Survey.  Also, airfares may still climb to reflect the past increase in oil prices.  

The other important US data this week will be March Retail Sales.  Consensus looks for -0.4% m/m Total and -0.3% Ex Auto.  Although near-consensus prints could prompt recession talk, the latter may be an overstatement.  A soft Report could be just further payback for the sales strength seen in January -- in other words, the typical pause after a strong month.  The overall pace so far appears to be strong -- Real Consumption for Q123 is on course for 4+% (q/q, saar) through February -- assuming flat March and no significant downward revisions to January and February.  Note that the latest Atlanta Fed model's estimate is 1.5%, but risks being too low as it embodies an estimate of only 3.4% for Q123 Real Consumption.

Stock Market Rally Should Continue For Now

The stock market's rally should not be derailed by US economic data or Q123 corporate earnings over the next few weeks -- although there could be some pullback at the start of this week if some of Friday's bounce was just quarter-end window dressing.  This week's key US economic data should be market friendly, based on the consensus estimates and risks surrounding them.  Macro evidence suggests upside risk to the consensus estimate of Q123 corporate earnings.

Consensus expects the March Employment Report to be consistent with a slowdown rather than recession.  Payrolls are seen slowing to +238k m/m from +311k in February.  And, the Unemployment Rate is seen steady at 3.6%.   The Claims data and other evidence support the expectation of a slowdown in Payrolls.  Claims don't rule out a slight increase in the Unemployment Rate, as well.  Consensus also looks for a modest 0.3% m/m increase in Average Hourly Earnings.  Although this would be up from February's +0.2%, it would remain below the 0.4% average in Q422 and be consistent with the Fed's 2% inflation target (taking account of productivity).  A near-consensus Employment Report should be viewed favorably by the Fed and keep open the possibility that it may not tighten further.

Consensus also expects to see evidence of slower growth in February Job Openings and the March Mfg ISM.  Job Openings are expected to fall to 10.4 Mn from 10.82 Mn in January.  The level would still be a above the 7.5 Mn pre-pandemic trend, but a decline would be in the right direction.  Moreover, news reports suggest companies are keeping job openings listed even though they don't intend to fill them.  So, the significance of the high level of Job Openings is somewhat suspect.  

Consensus looks for a dip in the March Mfg ISM to 47.5 from 47.7 in February.  Other manufacturing surveys, however, suggest an uptick.  But, none is a reliable predictor.  The historical cut-off point in the Mfg ISM between expansion and decline in the manufacturing sector is 48.7.

Consensus expects for S&P 500 corporate earnings to fall 7.4% y/y in Q123.  This risks being too pessimistic.  Economic growth improved both in the US and Europe on a y/y basis, which should have at least cushioned the drag from the Covid-related shutdowns in China during the quarter.  Also, the stronger dollar became less of a drag on earnings abroad in Q123.  And, profit margins may have been sustained, based on a comparison between Core CPI and Average Hourly Earnings (AHE).  But, oil companies' profits were probably hurt by the drop in oil prices.

                                Macroeconomic Evidence Regarding Corporate Earnings

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

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.9           6.0               47.1    

 

Q123            1.9                -15.0                 +3.0                              4.5           5.5               47.9                  

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.5% (q/q, saar).