Tariffs Loom, But OK FOMC Meeting and US Economic Data

The stock market may trade cautiously ahead of the February 1 deadline regarding 25% tariffs on Mexico and Canada.  Trump could go through with them (a market negative) or hold back and announce negotiations (a market positive).   The market should take this week's FOMC Meeting in stride.  Although the Fed will not cut rates, it will likely keep open the door for cuts later this year if needed.  Corporate earnings as well as this week's key US economic data will likely be market positives. 

Trump's threat to impose 25% tariffs on imports from Columbia is minor compared to such a tariff on Mexico and Canada.  US imports from Columbia were about $18 Bn last year, versus about $900 Bn from Mexico and Canada combined.

There are two reasons to expect the Fed to keep monetary policy steady at this meeting.  /1/ The macroeconomic background does not call for lower rates.   GDP Growth is strong and the labor market solid.  Underlying inflation is on the desired downward path, but the pace is still too high.  /2/ Trump's insistence that rates should be cut almost guarantees the Fed will not do so.  Fed officials need to show their independence, which they view as paramount.  Moreover, if they cut rates, inflationary implications of the implicit loss of independence would boost longer-term yields and weaken the dollar. 

In his post-Meeting news conference, Fed Chair Powell, nevertheless, will likely keep open the door for rate cuts later this year, since this possibility is part of the projections made at the December FOMC Meeting.  However, he may indicate that policy easing will happen only if warranted by economic conditions.  The trend in economic growth would have to weaken and inflation continue to slow.  (Note that the extremely cold weather in parts of the country could hurt economic activity temporarily.)  This policy stance should be positive for the stock market.  Continuing solid economic growth is good for profits, so  a steady Fed is not a problem.  Moreover, having a ready-to-ease-if-needed Fed in the background puts a floor on downside risks in the economic outlook.

Powell is likely to downplay any suggestion of policy tightening that may arise among the questions raised by reporters.  He could say this possibility was not discussed at the meeting and is not part of the officials' projections made in December.  Although economic growth appears to be continuing at a faster pace than expected by the Fed, officials will likely tolerate it for two reasons.  /1/ Strong productivity growth has been an important factor behind recent GDP growth.  To that extent, the growth should not be inflationary.  /2/ Labor cost inflation remains in check, particularly according to the broadest measure, Compensation/Hour.

Powell will not likely comment on Trump's policy proposals, such as clamping down on immigration and extending tax cuts, citing uncertainty surrounding them -- uncertainty regarding whether or to what extent they will happen and also what their effects might be.  

This week's key US economic data are expected to be market-friendly both for stocks and Treasuries.  The first release of Q424 Real GDP Growth is seen by consensus at a robust 2.7% (q/q, saar), close to the Atlanta Fed Model's forecast of 3.0%.  Consensus also sees a benign 0.2% m/m increase for the December Core PCE Deflator.  Although the modest December CPI suggests downside risk to the PCE Deflator, the large increase in PPI Airfares will feed into the PCE Deflator and stands as an offset.  The y/y for Core should be steady at 2.8%, but an uptick to 2.9% can't be ruled out.  Consensus expects the Q424 Employment Cost Index (ECI) to slow to 1.0% (q/q) from 1.1% in Q324.  Average Hourly Earnings (AHE)  supports the idea of a slowdown in the ECI, as speedups/slowdowns in the AHE were matched by the ECI a quarter ahead in 5 of the past 6 quarters (see table below).

                             (q/q percent change)

                          AHE                        ECI 

Q423                1.0                            na 

Q323        1.0     1.1

Q223        1.2     1.0   

Q123                0.8                            1.2                  

Q422                1.2                            1.1

Q322                1.1                            1.2

Q22                  1.1                            1.3   

Q122                1.3                            1.4

    

A Less Problematic Trump?

The stock market may be buoyed over the next couple of weeks by favorable corporate earnings reports and relief that Trump's tariff plan may not be as disruptive as feared.   In addition, Trump's intention to ease regulations and extend his earlier tax cuts should be supportive in the background.  It could add to a relief bounce on the peaceful transition of power on Inauguration Day.

News reports indicate that Trump's advisors are discussing a number of ways to implement tariffs to mitigate their inflationary impact.  These include a gradual pace of small increases over months, carve-outs for some industries, and temporary tariffs whose purpose is to persuade a country to change its approach to border control and drug trafficking.  Any moderation in tariff implementation would likely be viewed positively by the markets for having a smaller inflationary impact.

To be sure, a tariff would not only boost import prices (with the caveat that importers may not pass them through and that the stronger dollar will be a partial offset) but also prices in domestically-produced substitutes.  Demand would shift away from imports to the latter, allowing firms in that industry to raise prices.  The latter's increased revenue could boost profits or wages or both.

Corporate earnings should be helped by the strong economy.   The Atlanta Fed model's latest estimate is 3.0% for Q424 Real GDP Growth.  The Claims data indicate the labor market continued to strengthen in early January.  Initial and Continuing Claims so far are below their December averages.    

Meanwhile, inflation ended last year on a soft note.  The 0.2% m/m Core CPI in December showed a further increase in the share of components with 0.2% or lower prints.  Upcoming inflation reports for January and February will be important, as they will show whether there is any moderation in the typical start-of-year price hikes.  Last year, the Core CPI rose 0.4% in both months.  It is a potential window for a notable decline in the y/y pace for the Core CPI.  The latter was 3.2% in December.

                               Number of Major Core CPI Components 

                                   0.2% or Less                     0.3% or More

          Dec                   11              5

      

        Nov             9           7

Oct                                     7                                         9                                 

Sep                                    9                                         7

Aug                                  13                                         3

July                                    8                                         8

June                                 13                                        3

May                                  11                                        5

Next Market Focus -- Trump Tariffs, CPI and Q424 Corporate Earnings

Stocks may continue to trade cautiously this week as Trump's inauguration (January 20) approaches.  So far, his policy pronouncements have not been market-friendly and the risk is they will stay that way.  There is a scenario, however, in which Trump's policies may be market positive, as discussed below.  The market also will be facing December inflation data and the start of Q424 corporate earnings.  Both are expected to be decent.  So, there could be relief bounces while the overall tone is cautious.

The market focus will likely be on Trump's decision regarding how to proceed with imposing tariffs.  For example, a 10% tariff on all US imported goods would amount to about $200 Bn for the year.  A 25% on goods imports from Canada and Mexico would amount to about $230 Bn.  A full pass-through to prices in either example would boost the PCE Deflator by about 1.0%.  This impact would be mitigated if importers absorb some of the tariffs by lowering profit margins.  Also, the stronger dollar is an offset.   

In any case, there may be silver lining for the markets.  Trump could tie the revenue from tariffs to an overall goal of holding down, if not reducing, the federal deficit.  To be sure, he will probably aim to extend the expiring tax cuts of his first Administration, but he'll also talk about cutting federal spending. 

Emphasizing the goal of reducing the federal deficit could spark a rally in the long end of the Treasury market and stocks.  A precedent is the Clinton Administration in the 1990s.  The then Treasury Secretary, Bob Rubin, always would mention deficit cutting in his speeches and press conferences -- which would induce a positive response in the bond market and stocks.  The federal budget went into surplus during the Clinton years, helped in part by huge inflows of capital gains taxes stemming from the stock market.

Consensus looks for 0.3% m/m Total and 0.2% Core CPI for December.  Even though gasoline prices fell at the pump in December, they did not fall as much as seasonal factors expect.  So gasoline prices (seasonally adjusted) should be up fairly sharply, boosting the Total.  A 0.2% Core may require Owners' Equivalent Rent remaining at a low 0.2 as well as Lodging Away From Home and Used Car Prices flattening after they jumped in November.  There is some evidence suggesting this may be the case for Used Car Prices.  The extent of holiday discounting is important, as well.  However, the greater the discounting, the greater the potential snap-back in January or February as normal pricing reasserts itself.

A benign 0.2% Core CPI should be a market positive, as it would suggest the strong labor market, as seen in Friday's December Employment Report, can be tolerated by the Fed in its fight against inflation.  The latter was suggested already by the downtick in December Average Hourly Earnings to 0.3%  from 0.4%.  However, a cautionary note is that long-term inflation expectations have moved up.  This is seen in Friday's report of 3.3% for University of Michigan's 5-Year Inflation Expectations measure,   It broke above its recent 3.0-3.1% trend.

Consensus estimate for Q424 S&P 500 earnings is in the high single-digit to low double digit range, better than the mid-single digit increase in Q324.  The macroeconomic evidence suggests some downside risk.  /1/ Profit margins may have narrowed, as wages sped up by more than prices.  /2/ Real GDP Growth is slightly lower in Q424 than Q324 on a y/y basis.   /3/ And, earnings from abroad should be hurt a little more by the stronger dollar and softer foreign economic growth.  In contrast, oil prices stopped falling (y/y), which should help that sector. 

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

Q123            2.3                -19.5                +3.0                              4.5           5.5               47.9  

Q223            2.8                -32.0                 +0.5                              4.4           5.2               44.7

Q323            3.2                -12.0                 -2.5                               4.3           4.4               43.2

Q423            3.2                -12.0                 -2.5                               4.3           3.9               43.8

 

Q124            2.9                +14.0                  0.0                              4.3           3.8               46.4

 

Q224            3.0                  +2.5                +3.0                              3.9           3.4               46.3 

 

Q324            2.7                  -6.0                 +2.5                              3.8           3.2               45.3     

 

Q424            2.6                   0.0                 +3.5                              4.0           3.3               45.4                             

                                                                           

* Based on the Atlanta Fed Model's latest projection of 2.7% for Q424 (q/q, saar).

Upcoming Macroeconomic Data Market Friendly?

The stock market may very well move move up in the next week or two, as the macroeconomic data are expected to be market friendly.  The key data are seen showing moderate growth and inflation, a good combination now that the Fed is likely to be on hold for awhile.  Market caution may reassert itself as the Presidential inauguration on January 20 gets closer.

Consensus expects a near-trend December Employment Report.  Nonfarm Payrolls are seen rising 150k m/m and the Unemployment Rate steady at 4.2%.  A near-consensus increase would be between the 3-month average ( 173k) and the October-November average (132k).  (Note that October and November were impacted by strikes and bad weather, which should be cancelled out when the two months' jobs gains are averaged.)  An uptick in the Unemployment Rate can't be ruled out, as the Rate rounded down from 4.245% in November -- "noise" in the data could push the headline print up to 4.3%.  Consensus looks for a return to 0.3% m/m in Average Hourly Earnings.  This would be a favorable print for the markets and Fed, after AHE averaged 0.4% in the prior 4 months.

The November JOLTS data are expected by consensus to show a dip in Job Openings, with the Total being close to pre-pandemic levels.  A dip would indicate some softening in demand for labor.  It will be interesting to see if Hires soften, as well.  Continuing Unemployment Claims have hinted as such in recent weeks, adjusting roughly for holiday effects.

Last week's release of the December Mfg ISM offered evidence of moderate economic growth.  The 49.3 print is in line with a gradual (albeit uneven) improving trend since July.  It exceeded both the Q424 average (48.1) and the Q324 average (47.1).  This kind of gradual improvement should be market friendly (for both stocks and bonds), assuming the Fed is on hold.  Moderate growth is good for the profit outlook while still being non-inflationary.  The Mfg ISM Survey results do not call for tighter monetary policy. 

Indeed, the Atlanta Fed model's latest estimate of Q424 Real GDP Growth is 2.4% (q/q, saar), which, if correct, should keep Fed's policy intentions unchanged -- that is, keeping open the door for modest easing next year.  This pace is just above the longer-term trend estimated by the Fed.  It would put the 2024 (Q4/Q4) growth rate at 2.5%, matching the Fed's Central Tendency Forecast.  It should give the Fed more confidence in its forecast of 1.8-2.2% in 2025.