Corporate Earnings/Lower Yields Help, But Evidence of Slower Growth Needed

The stock market is likely to be buoyed by favorable corporate earnings reports and lower longer-term Treasury yields this week -- as long as the Israeli/Hamas war doesn't spread.  So far, most reported earnings have beaten expectations.  Flight-to-safety related to the Mideast crisis and softer US economic data should be behind the latter.  

The predominant macroeconomic question overhanging the markets is whether US economic growth will slow enough to bring inflation down to the Fed's 2% target.  Evidence of a slowdown is particularly important after the high September CPI.  The bulk of this week's US economic data are expected to point in this direction. 

September Retail Sales are seen slowing to 0.2-0.3% m/m from +0.6% in August.  What will be important is whether Ex Auto/Ex Gasoline Sales print at or below August's modest 0.2% increase.  They averaged 0.4% m/m so far this year.

September Industrial Production (IP) is expected to dip 0.1% m/m.  A weak print could reflect automotive plant shutdowns stemming from the strike.  This would be a temporary restraint on economic growth, followed by a bounce-back when the strike ends.  The September FOMC Minutes show that Fed staff lowered its forecast of Q423 Real GDP to reflect the strike, but raised its GDP forecast for Q124 to capture a strike-ending bounce-back in production.  The IP Report's data on manufacturing output excluding motor vehicles may be more indicative of the underlying pace of this sector.  The recent trend has been soft, with Mfg Output Ex Motor Vehicles averaging -0.1% m/m over the prior 6 months.  But, Mfg Output ex Motor Vehicles jumped 0.6% m/m in August. 

This week's Housing data are expected to be mixed.  Consensus looks for a flat 45 print for the October Housing Market Index.  It sees September Housing Starts up, but Permits down.  Starts have been volatile in recent months, so it will be difficult to discern a trend in them.  Permits have been trending up, so a decline would have to be sharp to be significant.  

Perhaps the most important data this week will be Unemployment Claims, which provide the broadest high-frequency measure of economic activity.  The latest data are consistent with a slowdown in job growth in October.  But, it is still too soon to be sure.  The consensus expectation of higher prints for Initial and Continuing this week would move in the right direction for this prediction. 

A Relief Rally in Stocks, Despite Hurdles?

The stock market may continue to improve this week, relieved that the September Employment Report raised the possibility of strong but non-inflationary growth.  It suggests neither the Fed nor financial markets need to restrain the economy sharply to avoid a speedup in inflation.  The sell-off in longer-term Treasuries can ease up. 

There are still some potential hurdles this week, but they may be manageable.  /1/ Any market impact from the Israeli-Hamas war should be short-lived if the scope of the situation does not expand.  /2/ Even if the September CPI shows another high Core print, as consensus expects, last month showed that it may not translate into a high Core PCE Deflator -- the Fed's targeted measure.  To be sure, a higher-than-consensus CPI can't be ruled out (nor can a below-consensus print).  /3/ This week's release of the July FOMC Minutes and speeches by some Fed officials will likely reiterate Powell's hawkish message, particularly as it relates to the undesirability of strong economic growth.  It is too soon to expect the Fed to alter the message coming out of the July FOMC Meeting.  So, the markets may discount this Fedspeak.

The +336k m/m jump in Nonfarm Payrolls was the only strong element of the September Employment Report.   The jobs surge boosted Total Hours Worked,  so that the latter is up 1.5% q/q (annualized) in Q323 versus 0.0% in Q223 -- consistent with a speedup in Real GDP Growth in Q323 from 2.1% in Q223.   THW's September level is 1.0% (annualized) above the Q323 average -- a good take-off point for Q423.  So, at this point, there is no sign of an impending end to economic growth.

Other key parts of the Report were subdued and represented good news for the inflation outlook.  The steady 3.8% Unemployment Rate stayed above its recent trend, the 0.2% m/m increase in Average Hourly Earnings (AHE) was below trend for the second month in a row, and the Nonfarm Workweek was flat.  A steady Labor Force Participation Rate, after it had risen in August, offers hope that the economy's capacity to grow has expanded.  

The sub-trend 0.2% m/m increase in AHE raises the possibility the economy doesn't have to weaken much to restrain inflation.  To be sure, this is the narrowest of the three major measures of labor costs.  And, it could be affected by compositional shifts.  A slowdown in the Q322 Employment Cost Index, which is less affected by the composition and due in late October, would be welcome confirmation.  The aggressive union actions in the automotive, health care and other industries, however, may become a factor in the inflation outlook, particularly if they have a broad influence on wage negotiations.

Nonetheless, the possibility that a sharp slowdown in economic growth is not needed to prevent a wage-price spiral could persuade the Fed to keep rates steady at the October 31-November 1 FOMC Meeting.  A pause, if not partial unwinding, of the recent increase in long-term Treasury yields could be important in turning the Fed in this direction.  Moreover, early evidence points to a slowdown in October Payrolls.  The low ADP Estimate and sharp slowdown in Civilian Employment in September hint at such.  Increases in Unemployment Claims over the next few weeks would, as well.  The November Employment Report will be released after the next FOMC Meeting.

The 0.3% m/m consensus estimate of September Total and Core CPI looks reasonable, but there are risks on both sides.  A 0.2% print can't be ruled out, but would require declines in some areas, such as Lodging Away From Home, only an uptick in Used Car Prices, and only a modest pass-through of higher oil prices to components like Airfare.  A 0.4% print also can't be ruled out -- it's possible if many components don't slow from their August pace.  The recent unwinding of some commodity prices is too late to show up in the September CPI, but is a welcome development for the inflation outlook.

 

Stock Market Looking Better?

The stock market has a chance to recover in October, as the macroeconomic background may be moving closer to the Fed's liking and Q323 corporate earnings beat expectations.  Another pause in tightening at the October31-November 1 FOMC Meeting can't be ruled out at this point. 

Friday's release of August Personal Income/Consumption/PCE Deflator had good news for the Fed.  It contained ingredients for a slowdown in Consumer Spending -- a slower trend in Disposable Income and low Saving Rate -- and evidence that core inflation is trending down to below the Fed's 2% target.  This week's key US economic data are expected to point to slower economic growth, as well, although the evidence is not entirely supportive of consensus estimates.

Consensus looks for the Mfg ISM to edge up to 47.9 in September from 47.6 in August.   But, the evidence is mixed.  Although the Markit Mfg PMI rose in early September, the Phil Fed Mfg Index and Chicago PM fell.  The latter two have tracked Mfg ISM better than Markit Mfg in the past couple of months.  A near-consensus or below-consensus print would be consistent with slow growth.  A decline should not hurt stocks much if the Index stays above the 46.0-46.9 range seen in May-July.  Hard data on manufacturing were not recessionary during this earlier period.

Consensus looks for mixed evidence regarding an easing in labor market conditions.  It sees a slowdown in Nonfarm Payrolls to +158k in September from +187k in August.  And it sees the JOLTS data showing a decline in Job Openings in August.  To be sure, the Claims data lean toward a speedup in Payrolls.  But, the m/m change in Claims is small, as it was in August when it missed Payroll's speedup.  So, it has to be viewed with caution.

In contrast to slower job growth, consensus expects the Unemployment Rate to slip to 3.7% from 3.8%.  An important question regarding the Unemployment Rate is whether the Labor Force Participation Rate stays high or moves up further.  The latter would be especially good news, as it would imply more room for non-inflationary growth in the economy.  Consensus sees +0.3% m/m for Average Hourly Earnings (AHE).  Even though this would be up from 0.2% in August, it would be below the recent 0.4% trend.  There is no evidence on either the Unemployment Rate or AHE.

Consensus expects S&P 500 corporate earnings to slip a bit on a y/y basis in Q323.  This would be an improvement  from the large declines seen in the prior 3 quarters.  Macroeconomic evidence is mixed, but on balance does not rule out an improvement in corporate earnings from Q222.  The biggest positive is the strength of US economic growth.  There is also help from a smaller y/y decline in oil prices, a weaker dollar (thanks to base effects) making earnings abroad more valuable in dollar terms, and a smaller y/y weakening in economic activity abroad compared to Q223.  But, profit margins may have been squeezed, as the Core CPI slowed by more than AHE.

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

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                -19.5                 +3.0                              4.5           5.5               47.9 

Q223            2.4                -32.0                 +0.5                              4.4           5.2               44.7

Q323            2.9                -12.0                 -2.5                               4.3           4.4               43.2

                                                                           

* Based on the Atlanta Fed Model's latest projection of 4.9% (q/q, saar).

 

Bideneconomics, The Fed and Markets

The stock market could try to stabilize this week in anticipation of a seasonally better October.  Also, a soft August Consumption/Core PCE Deflator report could help on Friday.  Although there will likely be a lot of wrenching headlines about the difficulty of passing legislation to extend the federal budget past month end, this should be accomplished at some point.  So, it's just a temporary issue.  More importantly, the macroeconomic/policy background remains problematic, as discussed below.  Clear evidence of slower economic growth is needed to open the door for a significant rally in stocks.

Market commentary on last week's FOMC outcome highlighted the implication that the funds rate will be higher for a longer period than had been projected at prior meetings.  It has not delved much into why this will be the case.  Two reasons are /1/ Bideneconomics and /2/ the inherent dynamism of the US economy.

Putting aside political considerations, Bideneconomics can be defined as using government subsidies to promote alternative energy and bringing manufacturing operations back to the US from abroad (called "reshoring").  Pushing alternative energy is based on the idea that the market doesn't reflect "externalities" in the price of oil.  The externalities include pollution and climate change.  There is also a defense rationale, as is the case for reshoring.  

From a macroeconomic perspective, all these initiatives have one important effect in common -- they create demand for labor and other resources.  This increased demand would not be a problem if the US economy had a lot of slack.  However, the economy is now essentially at full employment.  So, these initiatives lead to higher inflation if not offset by a decline in activity elsewhere in the economy.  And, that offset or "crowding out" is what the Fed tightening is trying to do.  And, when it eases up on tightening, the markets do the work.  Currently, the sharp rise in long-term Treasury yields and the strengthening of the dollar are doing most of the work. 

This situation is a double-edged sword for the stock market.  On the one hand, the Bideneconomic initiatives boost the economy, holding back a recession as the Fed tightens.  On the other hand, higher long-term yields lower the present value of future earnings.  And, a stronger dollar lowers the value of earnings from abroad. 

The second reason for expecting the funds rate to stay high for longer is the inherent dynamism of the US economy.  If the Fed and markets pause in their restraining actions, economic growth will be quick to speed up, particularly with the Bideneconomic thrust in the background.  And, inflationary pressures will reassert themselves.  This responsiveness may help explain why the US economy sped up this summer soon after the Fed downshifted its rate hikes.  It also raises doubts about the plausibility of the rate cuts envisioned by Fed officials for 2024.  The only scenario in which rate cuts would not create an inflationary problem is after a recession has pushed up the unemployment rate to a high level.  

The consensus estimate of the August PCE Deflator (+0.5% m/m Total and +0.2% Core) looks reasonable.  Airfares should not rise as much as in the CPI, since their smaller increase in the PPI is also used in the PCE Deflator.  And, Owners' Equivalent Rent has a smaller weight in the PCE Deflator than in the CPI.  The consensus estimate of August Consumer Spending (+0.5% m/m) translates into flat Real Consumption for the month.  It is premature to conclude that the consumer is weakening, however, since a flat August print could be just the typical pause after a strong month (July).  Unemployment Claims data still show strengthening demand for labor in September.

 

A Poor Reaction to This Week's FOMC Meeting?

The stock market may react poorly to this week's FOMC Meeting, despite the well-advertised Fed pause in rate hikes.  Fed Chair Powell's post-meeting news conference is not likely to contain new insights into future monetary policy.  He will probably repeat the Fed's intent to bring inflation down and leave open a possible resumption of hikes if warranted by the data.  However, the macroeconomic evidence so far does not fully support a decision to pause, and the market may fear that worse is yet to come.  Indeed, the latest bond sell-off suggests the Fed may be behind the curve, with the decision to pause a mistake.  The risk is for bonds to sell off further, hurting stocks.  It may depend on the reaction of commodity prices to a pause.

The market will likely focus on the number of rate hikes shown in the Fed's Central Tendency forecasts for the remainder of 2023.  The September forecast allowed for one more hike, followed by rate cuts in 2024.  Keeping this additional hike on the table would raise two questions.   First, what pace of economic growth and inflation will keep the Fed on hold?  Second, what is the likelihood that we'll see growth and inflation match the Fed's desired paces?  

The Central Tendency forecasts may offer guidance to answer the first question.  The Fed may continue to refrain from hiking if its growth and inflation forecasts look like they are being met.  So far, economic growth looks to be too strong but inflation in line with the Fed's outlook -- although the high August CPI raises a question regarding the latter.  If economic growth or inflation does not slow, longer-term Treasury yields may climb further, substituting for Fed inaction -- a negative for stocks.

US Real GDP Growth so far exceeds the 0.7-1.2% June Central Tendency Forecast for 2023.  It grew an annualized 2.0% in H123, and the Atlanta Fed model's latest estimate is 4.9% for Q323.  (These figures may change in the benchmark revisions to GDP, due September 28.)  This week's update of the Central Tendencies should show an upward revision to its 2023 Real GDP forecasts.  However, the markets may focus more on the 2024 Forecast as a guide to what will be an acceptable pace of growth going forward. The June Forecast was for 0.9-1.5% Real GDP Growth in 2024.  This forecast may be at risk, since the recent upsurge in commodity prices may be warning that US and global growth are picking up.  If the 2024 Real GDP forecast is raised, the Fed's expectation of the funds rate next year might be raised, as well.

To be sure, the June Forecast of 4.0-4.3% for the Unemployment Rate in Q423 looks achievable after the 3.8% printed for August.  And, it would be so much the better if it is attained by a speedup in the labor force rather than a decline in jobs, as was the case last month.  Doing so would mean the economy can accommodate faster growth without exacerbating inflation.  However, a renewed downturn in the Unemployment Rate will likely be problematic for the Fed.  And, the latest Unemployment Claims data don't indicate a weakening in the demand for labor.

June's 2023 Central Tendency Forecasts for the PCE Deflator, Total and Core, were being met through July.  In July, the y/y was 3.3% for Total and 4.2% for Core, versus forecasts of 3.0-3.5% for Total and 3.7-4.2% for Core for the year.  The risk, however, is that Total and possibly Core exceed these ranges in August, given the high CPI.  

What may not be fully appreciated by the market is that the June inflation forecast for 2024 is higher than the Fed's 2.0% target.  Total was seen at 2.3-2.8% and Core at 2.5-3.1%.  These forecasts can be viewed as "intermediate" targets, so that a somewhat higher than 2.0% inflation pace may not trigger a hike through next year.  It is somewhat comforting that the latest 3-month annualized increase in the Core CPI is 2.4%.  Also, the decline in the University of Michigan's 5-Year Inflation Expectations to a below-trend 2.7% in Mid-September is good news.

All Depends On The CPI

The stock market's path this week may depend on the August CPI Report, due September 13.  A high CPI, particularly Core, would depress the market, as it would exacerbate concern the Fed will continue to tighten to restrain the economy.  Even if the Fed pauses at the September 19-20 FOMC Meeting, Powell's rhetoric would presumably be hawkish -- raising the possibility of a resumption in rate hikes at subsequent FOMC meetings.  In contrast, a benign print for the Core CPI, which is the consensus estimate, could trigger a relief rally in stocks and Treasuries, as it would add to the evidence in the August Employment Report that suggests a longer pause in Fed tightening can be justified.

Consensus looks for a benign print for Core -- +0.5% m/m August Total and +0.2% Core.  The consensus estimates can't be ruled out, but there is upside risk for both Total and Core.  A jump in gasoline prices is primarily responsible for a high Total, and it may push up Total by more than consensus expects.  It can't be dismissed as temporary, since the continued run-up in crude oil prices points to a further increase in gasoline prices in September as well as the potential for higher fuel costs to be passed through to Core components.

There is mixed evidence regarding the Core CPI.   Higher fuel prices and a boost from seasonal factors raise the risk of a jump in Airfares in August.  This could lift the Core CPI to 0.3%.   However, a slowdown in Owners' Equivalent Rent (OER) to 0.4% from 0.5% could prevent a 0.3% print.  This is conceivable, since this deceleration was already seen in Primary Rent in July.  But, there is no guarantee it will happen for OER in August.

There are other favorable developments in the background.  The stronger dollar holds down import prices.  Indeed, Import Prices for Non-Auto Consumer Goods fell in June and July. while prices of imports from China have been in a downtrend.  Also, some large companies are reported to be cutting wage rates, eliminating the premium paid post-pandemic amidst labor shortages.   

Aside from inflation, the latest Unemployment Claims data argue against a slowdown in economic growth in early September.  Initial Claims show that layoffs are down to their lowest level since February.  And, Continuing Claims suggest re-hiring has resumed, as they are down to their mid-July level.  Near-consensus prints for August Retail Sales (+0.2% m/m Total and +0.4% Ex Auto) would add to this bullish-growth evidence.  Even taking out higher-priced gasoline sales would likely show little, if any, payback for the sales jump in July -- if the consensus estimate is right.  The Atlanta Fed model's latest estimate of Q323 Real GDP Growth is 5.6% (q/q, saar).

. 

A Good Employment Report for Stocks and Fed -- Not Treasuries

The stock market could tread water in this data-light week as it consolidates last week's bounce.  The August Employment Report justified the bounce, as it showed an easing in labor market conditions and slower wage gains while economic growth continues -- all stock-market positives.  It arguably supports a pause in Fed tightening at the September 19-20 FOMC Meeting.  The last hurdle will be the August CPI on September 13.  Stocks and Treasuries may trade cautiously into it, since the risks are to the upside -- in part reflecting higher commodity prices.

The important message from the Employment Report is that labor market capacity may have increased.  Even though Civilian Employment climbed 222k, in line with the solid 187k gain in Nonfarm Payrolls, Labor Force jumped 736k as the Participation Rate rose.  Increased participation of the population in working or looking for a job expands the labor market's capacity to accommodate stronger demand for labor.  The expanded capacity is seen in the jump in the Unemployment Rate to 3.8%, its highest level since February 2022.  Increasing labor supply rather than reducing demand is the best way to achieve the Fed's goal to loosen labor market conditions.  To be sure, it remains to be seen whether the higher Participation Rate is sustained in coming months  For now, the August jump gives the Fed a window to pause.

The slowdown in Average Hourly Earnings (AHE) to +0.2% m/m from +0.4% in each of the prior four months is an encouraging sign that the labor market is easing.  To be sure, the slowdown may be partly noise, as the AHE slowed from July in only 6 o the 13 major sectors.  However, more importantly, the 3-month average is 0.3% or lower for 8 of these sectors.  A 0.3% m/m or lower increase in AHE is consistent with the Fed's 2% price inflation target, taking account of productivity growth.  

The Report's evidence of solid economic growth may be problematic for the longer-end of the Treasury market.  Treasuries still need to be concerned that some restraint will be needed to ensure non-inflationary growth.  There was nothing in the Report to suggest a slowdown in economic activity over Q323.  Besides the speedup in Nonfarm Payrolls (+187k in August from +150k in July), the Nonfarm Workweek rebounded.  Both lifted Total Hours Worked, so that the July-August average is 1.0% (annualized) above the Q223 average, compared to 0.0% (q/q) in Q223.  The renewed upturn in commodity prices also hints at faster economic growth internationally as well as in the US.  The Atlanta Fed model's estimate of Q323 Real GDP is now 5.6% (q/q, saar), after Real GDP rose 2.1% in Q223.