Strong Corporate Earnings and Productivity Growth

The stock market should be supported this week by expectations of another strong quarter of corporate earnings to be reported in January.  Although the next FOMC Meeting is not until the end of January, market "talk" also may center on the implications of strong productivity growth for monetary policy after last week's release of Q325 Real GDP.  If strong productivity is sustained, it would point to strong growth with low inflation.   It means that the Fed could still cut rates while GDP Growth is strong.

Productivity has been growing well above the trend seen in earlier years.   The typical estimate of trend productivity in the 1990s and early 2000s was 1.0-1.5%.  In 2024, the official measure of productivity rose 2.1% (Q4/Q4).  In H125, productivity averaged 0.8%, but this weakening may be temporary.  Using the difference between Real GDP Growth and Total Hours Worked (THW) as a proxy for productivity suggests strong productivity growth in H225.   The proxy suggests the Q4/Q4 growth will be close to 2.0% -- similar to that of 2024 (see first table below).   Note that this proxy has underestimated official productivity figures more often than not in recent quarters. 

Higher trend in productivity growth means that faster GDP Growth need not put pressure on the labor market.  The non-inflationary trend in GDP Growth would have moved up.  With trend labor force growing about 1.0% per year (based on population growth), trend GDP Growth (sum of labor force and productivity growth rates) is likely around 3.0% rather than the 1.8-2.0% Fed estimate of longer-term growth.  This pace should be consistent with both steady unemployment and inflation, if labor force participation rate is steady.  The participation rate, however, has risen since July.  If this is the start of an uptrend, labor force growth should continue to grow faster than the trend based on population growth alone and lift the Unemployment Rate further.  It would allow economic growth to exceed 3.0% without stirring up inflation.

This combination would argue for the Fed to refrain from tightening while GDP Growth looks to be excessive from an historical perspective.  Indeed, if AI is behind the ratcheting up of productivity growth and is resulting in fewer people being hired, the Fed should aim for even faster GDP than the higher trend growth rate.  

To be sure, it is difficult to predict the trend in productivity or labor force participation ahead.  The Fed has to judge whether sustained 3-4% Real GDP Growth will lead to higher inflation.  How the Fed responds could depend on whether the economy is operating at full employment.  At full employment, the risk is that the faster growth would result in higher inflation .  Higher interest rates would be required to match the productivity-driven higher rate of returns on business investments.  Otherwise,  investments would accelerate and consumption be boosted by a stronger stock market, both possibly leading the economy into inflationary territory.  At less than full employment, the Fed could allow more time to assess the possibility of sustained higher productivity (and labor force growth), keeping interest rates low and allowing the economy to grow faster than its earlier trend.  Currently, the high 4.6% Unemployment Rate means that the fast GDP pace in Q325 and expected for Q425 should not stop the Fed from maintaining an accommodative monetary policy.

Besides an accommodating Fed, the productivity-driven faster GDP Growth is a positive for corporate profits.  Consensus looks for about 8% y/y for S&P 500 earnings in Q425.  Although this is below the near-15% gain seen in  Q325, the risk is that the consensus estimate is too low.

The macroeconomic evidence supports strong corporate earnings in Q425.  Real GDP Growth looks to be up sharply on a y/y basis in Q425 (see second table below).  And the weaker dollar combined with better economic activity outside the US means that earnings from abroad should boost US company profits, as well.  These pieces of evidence are stronger in Q425 than in Q325.  Although profit margins may have been held down in Q425, as core inflation rose by less than wages, they could have been offset by the depressed pace of Payrolls -- holding down the "wage bill."  

                                                       Annualized Growth Rate                  

                            Real GDP Growth Less THW                Official Productivity Growth

Q124                                0.5                                                            1.7

Q224                                2.8                                                            2.9

Q324                                3.0                                                            2.1

Q424                                0.4                                                            1.6  

Q4/Q4                             1.7                                                             2.1    

Q125                                -1.3                                                         -1.8 

Q225                                2.3                                                            3.3

Q325                                4.3                                                            na

Q425    *                          1.7                                                            na   

Q4/Q4                              1.8                                                            na 

* Using Atlanta Fed Model's early estimate of 3.0% (q/q, saar), for Q425 Real GDP Growth and November' THW to represent Q425 average.  

                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    Mfg PMI  

          [                                y/y percent change                                                   ]          (level)

 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            2.5                   0.0                 +3.5                              4.1           3.4               45.4       

 

Q125            2.1                  -6.5                +6.0                               3.9           3.1               47.6                                       

Q225            2.0                -16.0                +3.5                               3.9           2.8               49.3     

 

Q325            2.3                -11.0                -1.5                                3.8           3.1               50.0  

 

Q425            2.6  *            -14.0                -4.0                                3.5           2.6               53.3                                                                                        

                                                                           

* Based on the Atlanta Fed Model's latest projection of 3.0% for Q425 (q/q, saar).

 

 

Year-End Rally?

The stock market may try to eke out a year-end Christmas rally in the next couple of weeks, as the macroeconomic background is not standing in the way.  Although some Fed officials and market analysts voiced concern about the accuracy of last week's key US economic data,  the latter do not shut the door on a January Fed rate cut even if somewhat distorted.  

The November Employment Report painted a picture of a sluggish labor market.  Private Payrolls sped up to only 69k m/m from +52k in October.  The latest 3-month average is 75k m/m, which may in fact be only +15k if the Fed is right that the m/m changes in Payrolls are now overstated by 60k.  With job growth so slow, it's not surprising that the Unemployment Rate has moved up noticeably.  These two parts of the Report confirm the Fed's concern of a weak labor market.  

That said, other parts of the Report argue against a weakening economy.  Although companies held back in expanding payrolls, they lengthened the hours worked by existing employees.  The Nonfarm Workweek edged up to 34.3 Hours from a low 34.2 Hour in the prior two months.  As a result, Total Hours Worked (THW)  in November are about 1.0% (annualized) above the Q325 average (taking account of the overstatement in Payrolls), compared to 0.0% (q/q, annualized) in Q225.  The improvement in THW so far in Q425 suggests a speedup in economic growth.  However, all that may be happening is a catch-up in this measure of labor to the strong GDP Growth in Q325 -- if the Atlanta  Fed Model's 3.5% estimate or the consensus estimate of 3.2% of the latter is correct (the actual will be released on Tuesday).  

A more interesting possibility is that AI and other capital investments are substituting for labor without hurting GDP Growth.  While some growth in THW through a longer workweek is needed to meet demand, Productivity Growth has ratcheted up.  If this is correct and sustaining, then the longer-run, non-inflationary trend in economic growth is significantly higher than the 1.8-2.0% Fed estimate.  In this case, the Fed should aim for stronger Real GDP Growth than what it has been doing.   It would call for easier monetary policy next year.  From a stock market perspective, it would be a positive for corporate earnings even if the Fed does not cut rates.

The low November CPI, at least on the surface, offered hope that inflation is moving down.  The y/y fell to 2.7% for Total and 2.6% for Core.  Some Fed officials and market economists raised questions about the ways some major components, such as Owners' Equivalent Rent (OER), were calculated, given the timing and sampling issues stemming from the government shutdown.   OER was estimated to rise by the same percentage change in October and November as the low print for September.  This may not be a bad estimate, however, despite the doubt expressed by some.  A sustained low rate of increase in OER would be consistent with the softening in rents seen by private surveys.  The accuracy issue with the CPI could be resolved with the back-to-normal December CPI Report, which should be released before the January FOMC Meeting.

 

 

 

When Is The Next Fed Rate Cut?

The stock market is now focused on whether and when the Fed will ease next year.  Although this week's key US economic data -- November Employment Report and CPI -- may shed light on the answers to these questions, they will probably not be conclusive since the Fed believes they could be subject to measurement problems related to the government shutdown.  A better sense for the answers may be inferred from Fed Chair Powell's comments at his post-FOMC news conference last week.  They suggest the most likely window for another rate cut is from the Spring on.  

Powell provided guidelines on how the Fed thinks the economic background will unfold in 2026.  The Central Tendency Forecast for Real GDP Growth was raised to 2.1-2.5% (Q4/Q4), putting it above the longer-run estimate of 1.8-2.0%.   He said that 0.2% pt of the 2026 growth results from a bounce-back from the government shutdown, which had subtracted a like amount from 2025 GDP growth.  Most of this bounce-back should be seen in Q126 -- adding 0.8% pt to the annualized q/q growth rate then.   A resilient consumer and strong business investment, in part due to AI, are also behind the GDP speedup.   The $2,000 tariff-offset tax refund should help the consumer in H126, as well.

Regarding inflation, Powell says the Fed's best guess is that the impact of tariffs will be a one-time boost to the price level, so that the impact on inflation will be short-lived.  He expects most of the boost will occur by Q126, then flatten out in the Spring and disappear in H226.  A goal of the Fed is to prevent this one-time boost from precipitating a sustained speedup in inflation, in other words a wage-price spiral.  He mentioned that the slowdown in the Q325 Employment Cost Index was a good sign that wage inflation remains in check.  And, he reiterated that the tariff-impacted goods prices are the main reason for this year's pickup in inflation, as services inflation has been soft.

If the Fed is right that economic growth and inflation may be highest in Q126, then the window for a Fed rate cut will become more of a possibility in the Spring and in the second half of the year.  Nonetheless, Powell did say that the upcoming slew of US economic data will be important considerations at the January FOMC Meeting.  However, he pointed out they could be distorted by technical problems.  So, the Fed may be reluctant to rely on them to make a policy decision.

In particular, the CPI and Unemployment Rate could be mi-measured because of deviations from the standard timing of their surveys in October and November.  Besides a question of full survey information, the timing could be out of sync with seasonal adjustment.  And, the m/m change in Nonfarm Payrolls will be overstated by about 60k (as they have been in recent months) because of a persistent problem in the way jobs are estimated for the net change in new and closed businesses.  

Powell also mentioned the importance of the Unemployment Claims data, highlighting that the recent decline in Initial Claims had suggested fewer layoffs while the still high Continuing hinted at more cautious hiring.  December-January Claims data, however, are tricky to seasonally adjust because of the varied timing of holidays from year to  year.  The sharp swings in Initial and Continuing in last week's report are illustrative.  So, the Claims data may not be reliable measures of the labor market at this time, making it more difficult for the Fed to figure out what's happening.  

This week should see the Employment Report and CPI for both October and November.  Given the Fed's estimate of a 60k overstatement of the m/m change in Payrolls,  the chances are that both month's figures will be viewed as weak by the market.  Payrolls averaged 62k m/m (2k after subtracting 60k per month) during Q325.  The m/m change in the Unemployment Rate could confirm or raise doubt about the weak jobs figures.  Continuing Unemployment Insurance Claims suggest the Unemployment Rate has risen since September.  The sampling issue Powell alluded to, however, suggests it should be viewed with caution.

The October-November CPI also may be impacted by sampling problems, according to Powell.  Market-friendly prints would be 0.2% m/m or less, with the Core more important than Total.  Such a low print would be below the 0.3% m/m increase implicit in the Fed's Central Tendency Forecast for the Q4/Q4 inflation rate.  A low print can't be ruled out.  Owners' Equivalent Rent would need to be soft, as in September, and Airfares and Lodging Away From Home need to rise at most modestly.  Seasonals help to hold down Airfares in these two months, but they boost Lodging Away From Home.  

 

Market Caution Into Fed Rate Cut?

The stock market may trade cautiously this week as it shifts to focusing on prospects for Fed monetary policy after a 25 BP cut on Wednesday.  While the evidence suggests the Fed should keep the door open for more rate cuts in 2026, officials may want to present that possibility as not a certainty.  This could result in some market volatility after the meeting, but would not rule out a year-end rally -- particularly if the November Employment Report (due December 16) or November CPI (due December 18) is benign.

A 25 BP cut at this week's FOMC Meeting will not be a surprise.  What may be more important for the market is the extent of dissent among members.  A positive surprise -- and one that should not be ruled out -- would be if there were only a few no votes, as in October (2 dissents, one of which was for a half point cut).   Another positive surprise would be if Powell does not downplay the likelihood of further rate cuts in 2026, in contrast to the cautious tone he took at the October post-meeting news conference.  If he sticks to the standard Fed line that policy will depend on the evolving economic evidence, the market may find his comments a relief.

The updated Central Tendency Forecasts will be important, as well.  In September, they showed another two 25 BP rate cuts in 2026 (see table).  The market will be looking to see if this forecast remains.  Currently, the Fed funds rate is 3.75-4.0%.

As for the Central Tendency's Economic Forecasts (see table), the most important may be for inflation.  In September, the y/y's for the PCE Deflator and Core PCE Deflator were both 2.8%.  This is still above the Fed's 2% inflation target, but below the 2025 Fed forecasts.  Total and Core need to rise by less than 0.2% m/m over Q425 for their y/y's to end the year below 2.8%.  Nevertheless, the risk is for the Central Tendency Inflation Forecasts to be revised down for 2025 and possibly 2026.  The latter would be a market positive.

Note that the latest University of Michigan Consumer Sentiment Survey shows a decline in longer-term inflation expectations to 3.2% in early December from 3.4% in November.  These 5-year expectations are now back down to their range before the advent of tariffs (2.8-3.2%).  This is good news for the Fed.

Regarding the other Central Tendency components, the risk is for the Real GDP Growth forecast to be revised up.  Using the Atlanta Fed Model's 3.5% for Q325, Q425 Real GDP Growth would have to stall at +0.2% in Q425 to get to the 1.7% Q4/Q4 forecast.  Such a sharp slowdown would likely be accompanied by higher Unemployment, which in September was 4.4%.  So, the Q425 Forecast for the Unemployment Rate would likely be unchanged (if the Real GDP Forecast is upped) or be raised (if the Real GDP Forecast stays near 1.7%).  

                                               September Central Tendency Forecasts

                            (Q4/Q4 percent change, except for Unemployment Rate and Fed Funds Rate) 

                                                2025        2026              

Real GDP Growth                1.4-1.7        1.7-2.1

PCE Deflator                        2.9-3.0        2.4-2.7      

Core PCE Deflator                3.0-3.2        2.5-2.7    

Unemployment Rate  *         4.4-4.5         4.4-4.5   

Fed Funds Rate    *               3.6-4.1         2.9-3.6    

*  Q4 level, percent    

The latest evidence on the labor market continues to be mixed.  The ADP Estimate has Private Payrolls falling in November after speeding up in October.  In contrast, the Unemployment Claims data suggest the opposite, with October Payrolls weakening and then rebounding somewhat in November.  Continuing Claims have done a better job than the ADP Estimate in tracking speedups/slowdowns in Private Payrolls (see first table below).  A caveat is that Continuing Claims data have experienced unusually large revisions in the past two weeks, so their reliability in the latest week is a question.  Challenger Layoff Announcements,  presumably a precursor of layoffs and Unemployment Claims, were up on a y/y basis in November but substantially lower than in October (71k versus 153k).  The latter suggests that weakness in job growth is not snowballing.  The bottom line may be that the November Employment Report, due December 16, will show a sluggish trend in job growth -- which would justify the 25 BP rate cut and keep the door open for more cuts next year.

The delayed Q325 Employment Cost Index (ECI) will not likely influence this week's FOMC decision,  as it will be released on the morning of the Meeting's second day.  Evidence from Average Hourly Earnings (AHE) suggests the ECI will print at or near its 0.9% q/q trend (see second table below).  If so, the ECI would not change the risks in the inflation outlook.  A market-positive surprise would be if it prints 0.8% or less. 

With wage inflation in check, a benign November CPI cannot be ruled out, particularly if Owners' Equivalent Rent stays low, as it did in September (latest report).  The question will be whether more of the tariffs have been passed through to the consumer. 

                                        Private Payrolls (m/m change, 000s)   

                        ADP Estimate        First-Print BLS        Latest-Print BLS    Continuing Claims *        

    March               155                          209                            120

    April                   62                          167                            133                               14                            

    May                    37                          140                              69                              -74           

    Jun                    -33                            74                             -27                              -57                              

    Jul                    104                            83                               77                               18   

   Aug                     54                            38                               -4                                 2                            

   Sep                    -32                           119                                na                             28 

   Oct                     42                             na                                na                              -41 

   Nov                   -32                            na                                                                   14

 * the inverted change in Continuing Claims between Payroll Survey Weeks, 000s

                             Wage Inflation Measures

                                (q/q percent change)

                            AHE                            ECI 

Q325                1.0                            na

Q225                0.8                            0.9                 

Q125                1.0                            0.9

Q424                1.0                           0.9                                                

Q324                0.9                           0.8    

Q224                1.0                           0.9                     

Q124                1.0                           1.0