Caution Ahead, But A Positive Macroeconomic Shift?

The stock market could trade cautiously this week as it faces the likelihood of a high January PCE Deflator and the start of a new set of monthly data.  However, last week's surge on Nvidia's earnings report underscores a potential macroeconomic shift that could be a big positive for stocks -- a ratcheting up in the productivity trend.  It would not only boost profits, but allow for higher real wages and lower inflation. 

Besides the potential for AI to lift productivity, the spate of corporate layoff announcements suggests that companies already have begun improving efficiency.  After being overly aggressive hiring after the pandemic, many corporations appear to be focusing on cutting costs.  This is another way of saying they are boosting productivity.  From a macroeconomic perspective, eliminating jobs boosts the pool of available workers, relieving pressure in the labor market.  In particular, it allows for a shift of workers toward areas favored by the Administration, such as alternative energy, EVs, re-shored businesses, etc., without putting large upward pressure on wages. 

Cost-cutting could be a factor behind the speedup in productivity growth last year.  Nonfarm Productivity rose 2.7% over the four quarters of 2023, much better than the -2.0% over 2022 and the +1.0% long-run trend assumed by the Fed.  The higher productivity growth explains how 2023 Real GDP Growth could substantially exceed the Fed's estimated long-run trend of economic growth without pushing down the Unemployment Rate significantly.  The question is whether the higher productivity pace will continue.

It is likely too soon for the Fed to raise its estimate of long-run Real GDP Growth from 1.7-2.0%, as it probably needs to see more evidence of persistently high productivity.  But whether the Fed raises it long-run GDP estimate is something to look for in the revised Central Tendency Forecasts released at the March 19-20 FOMC Meeting.   An upward revision would offset the inflationary implications of higher estimates for 2024 Real GDP Growth, which are likely given the strong start to the year.  The Fed can cite a productivity-led improvement in trend-growth as a reason to cut rates despite stronger economic growth than had been assumed earlier.

The consensus estimate of the January PCE Deflator (+0.3% m/m Total, +0.4% Core) reflects the same start-of-year price hikes seen in the CPI.  Indeed, the risk is that the Deflator may print higher than the consensus estimate.  While there may be knee-jerk selling on the print, it would be an overreaction, since these price hikes are not likely to persist.  Consensus also looks for an uptick in the Mfg ISM to 49.5 in February from 49.1 in January.  Stronger economic data should be less of a problem for the markets if higher productivity is helping to achieve this strength.

Marking Time and Consolidation

The stock market is likely to mark time if not consolidate recent gains this week, as there are few US economic data releases and the to-be-released FOMC Minutes are not likely to change consensus expectations for Fed policy.  Many of the important January economic data reported so far have been jostled  by start-of-year effects and weather.  These factors could unwind in the next set of data, but this won't be known for another couple of weeks or more.

Currently, the data point to moderately strong economic growth and sticky inflation.  The latest Atlanta Fed and NY Fed models project 2.8-2.9% (q/q, saar) for Q124 Real GDP Growth, based on data released so far.  This is down from the prior 3.5% projections, but they remain above the 1.7-1.9% Fed Central Tendency forecast for all of 2024.  The latter is still achievable if upcoming data are soft.  Indeed, the model projections are high relative to the weakness seen in Total Hours Worked in January.  A slowdown in Payroll growth looks likely at this point, as Continuing Unemployment Claims are above their level in the January Payroll Survey Week.  They have to stay high for another two weeks to get to the February Survey Week.  In contrast, some bounce-back in Retail Sales is likely in February, as the weather improved. 

The January CPI and PPI came in high, but much of the surge appeared to reflect start-of-year price hikes.  (Both the downside and upside risks mentioned in last week's blog showed up among the CPI components, but the upside risks dominated.)   The start-of-year price hikes most likely will prove to be one-off.  However, wage inflation and housing rent need to slow to bring inflation down permanently.  

The next Employment Report will show whether the jump in Average Hourly Earnings (AHE) in January was a fluke.  If AHE does not slow sufficiently, Fed rhetoric may become less dovish.  

Housing rent in the CPI, especially Owners' Equivalent Rent (OER), has not yet softened as much as rent measures seen in private surveys.  Indeed, OER sped up unexpectedly in January.   The speedup could have been just catch-up after a below-trend increase in December.  Even if it slows back to trend in February, the 0.4-0.5% m/m trend is still too high.  

There is less than meets the eye in OER, however, even though it is heavily weighted in the CPI.  OER is a phantom price, inasmuch homeowners don't pay it.  It is the imputed price of their use of homes and is calculated from a subset of the CPI rent sample.  In other words, it is the rent a homeowner would pay if renting the house.  Fed Chair Powell acknowledges its artificiality by emphasizing Core Inflation Less Shelter.   This inflation measure has been running in line with the Fed's 2% target.  It rose 0.2% m/m in each of the past three months and was up 2.2% y/y in January.  It should dampen market concerns that the Fed will turn hawkish. 

A "Powell Put" Supports Stocks

The stock market should continue to climb this week, helped by economic data expected to show benign inflation and slower growth.  They would likely be viewed as keeping rate cuts on the table in the Fed's outlook.  Moreover, although the market was disappointed initially by Fed Chair Powell's dismissal of a rate cut at the March FOMC Meeting, his and other Fed officials' comments that rate cuts at some point are still possible constitute a strong pro-growth stance that supports stocks.

The Fed's view of rate cuts ahead can be viewed as a "Powell put" -- the Fed will ease if there are signs of weaker economic growth or inflation.  It tells the stock market to downplay signs of economic weakness, since the Fed will respond.  It essentially eliminates a negative "tail risk" regarding the economic outlook.

To be sure, the Fed's Central Tendency Forecast of rate cuts in 2024 appeared to be tied to projections of sub-2.0% Real GDP Growth, higher Unemployment Rate and lower inflation.   The first two projections so far are not working out.  The Atlanta Fed and NY Fed nowcast models project 3.0-4.0% Real GDP Growth in Q124, based on data released so far.  And, the Unemployment Rate was steady in January.  There is tentative evidence, however, that the economy's strength may soften in February.  Both Initial and Continuing Unemployment Claims are above their January averages in the latest week.

The Fed's dovish stance in the face of strong data raise questions about its motivation.  The Fed's explanation is that real interest rates will rise if nominal rates are steady and inflation expectations fall.  Higher real rates will slow the economy.  The problem with this explanation is that inflation expectations are not reliably measured.  A more reliable way on which to base policy would be to see if economic growth, in fact, slows.  This result is probably what will truly prompt the Fed to cut rates.  Powell and other Fed officials indirectly suggest this is the case when they say they are not yet convinced that their 2% inflation target is being met. 

Keeping rate cuts on the table may have a political motivation.  It could deflect Congressional criticism of high interest rates by showing the Fed will ease at some point.  Ironically, one reason for the strong economic growth is the fiscal thrust from increased government purchases, incentives and subsidies.  So, when Senator Warren criticizes the Fed for keeping rates too high, she is pointing her finger to the wrong group.  Indeed, with Biden economics pushing the economy's resources into particular areas, a continuation of high interest rates may be needed to "crowd out" others.  Nevertheless, if economic growth slows into the Spring, it could give the Fed a window to cut rates.  The timing presumably would be advantageous, being well ahead of the Presidential election.

Slow-to-cut or steady Fed policy may become less of a problem for the stock market over time if economic growth remains strong.  The market could realize that corporate earnings will stay healthy despite continuing tight Fed policy.  

The long-end of the Treasury market will tell whether a patient Fed is what's called for.  Longer-term Treasuries stand ready to act as vigilantes against inflationary tendencies in the economy if they surface and the Fed fails to respond.  Longer-term yields will fall if economic growth and inflation slow.

To be sure, Powell's downplaying of a growth/inflation trade-off argues for policy patience.  Strong growth may not result in higher inflation according to this view.  This week's consensus estimate of the January CPI  (Total +0;.2% m/m and Core +0.3%) would lend support to this view, as it will likely translate into lower prints for the PCE Deflator.  The consensus estimate looks reasonable, with mixed risks.  On the upside, there is a possibility that start-of-year price hikes could boost the CPI.   On the downside, seasonals could overly depress some prices if there had less-than-normal seasonal holiday discounting in November-December.  There could be a smaller-than-normal rebound in prices in January.

Besides a benign January CPI, consensus expects softer real-side economic data this week.  Retail Sales are seen slowing to +0.2% m/m in January from +0.6% in December.  Although consensus sees a speedup in Industrial Production to +0.4% m/m from +0.2% in December, there is downside risk given the decline in Total Hours Worked in manufacturing last month.

Fed Patient WIth A Pro-Growth Message

The stock market may trade cautiously but with a positive tilt this week.  Caution would reflect concern about possible unfavorable data surprises like January's unexpected Payroll/Wage prints.  For example, the January CPI (due February 13) conceivably could be boosted by start-of-year price hikes.  However, the January Employment Report was not entirely strong.  And, the Fed's policy stance remains not only patient but essentially pro-growth, based on Chair Powell's comments at the post-FOMC news conference.  In an important comment, he downplayed a theoretical trade-off between growth and inflation  So, while the Fed and markets are likely to take a "wait and see" view -- waiting to see more data, including the February Employment Report (released well before the March FOMC meeting),  upside data surprises may damage stocks only temporarily.

The strong 353k surge in January Payrolls overstated the full import of the Employment Report, as it was not confirmed by other parts of the Employment Report.  The Household Survey showed a decline in Civilian Employment and a steady 3.7% Unemployment Rate.  The Nonfarm Workweek plunged to 34.1 Hours from 34.3 Hours in December.  As a result, the level of Total Hours Worked in January are 1.0% (annualized) below the Q423 average.  Possibly, there was a reporting problem impacting jobs and other data in the Establishment Survey.  There have been times in the past when company responses to the BLS survey were not accurately done during the holiday season.  If this is the case now, there could be large revisions in the February Report. 

The high 0.6% m/m jump in Average Hourly Earnings was most likely a one-off start-of-year spike, if not a measurement problem.  The February Employment Report should show a smaller increase.  This possibility, as well as the mixed composition of the January Employment Report should constrain market concerns that the Fed will shift back to a more hawkish stance.

The potential volatility of the data at this time of year nonetheless underscores why Powell ruled out a rate cut at the March FOMC Meeting.  Although the stock market did not take his comment well, in fact, the essential message of his remarks was highly positive for stocks.  He downplayed a trade-off between economic growth and inflation, highlighting that inflation has fallen despite strong growth over the past couple of years.  This a pro-growth/pro-stocks stance by the Fed.  It means the Fed will not act to restrain economic growth as long as inflation is seen moving toward its 2% target.  It could tolerate strong growth.  To be sure, data showing slower growth/easier labor market conditions are still a market positive, since they will increase the Fed's confidence in achieving sustained low inflation