Stock Recovery Continuing, But Risk of Aggressive Fed Looms

The stock market recovery was not derailed by a hawkish shift in Fed Chair Powell's message last week.  The possibility of a 50 BP rate hike is still too far ahead to dominate the market.  But the threat could weigh on stocks after the bulk of Q122 corporate earnings are reported and the May 3-4 FOMC  meeting approaches -- and especially since the March CPI, due April 12, will reflect the surge in oil prices.  However, this week's key US economic data, such as the March Mfg ISM and Employment Report (both due on Friday), risk pulling back from their strong February prints.  They still should be strong enough to argue for continuing Fed tightening.  But, they might dampen the risk of a 50 BP hike and, along with strong corporate earnings, sustain the stock market recovery for a while longer.

Consensus looks for a steady 58.6 March Mfg ISM.  This would keep the Index at a slightly lower level than the 60.7 2021 average -- still historically high but a bit more moderate than last year.  The evidence is mixed, with the Empire State Mfg ISM pointing to a decline while the Phil Fed Mfg Index to an increase.  But, the Phil Fed Index could have just been catching up to the increase registered by the Mfg ISM in February -- which it had missed.  The Empire State correctly predicted the direction of Mfg ISM in each of the past two months. 

The consensus estimates for March Nonfarm Payrolls (+475k m/m versus 676k in February) and Unemployment Rate (3.7% versus 3.8%) are consistent with the Unemployment Claims data.  While job growth is expected to slow somewhat, it still would be above trend -- as seen by the expected decline in the Unemployment Rate.  The most important part of the Report could be Average Hourly Earnings, after its flat print in February.  There is no evidence.  Consensus looks for a speedup to +0.4% m/m.  This would put it back to the pace that predominated between June and November 2021 and below the 0.5-0.6% increases seen in December and January.  Along with the flat February print, it could be viewed as confirming that the December-January speedups were aberrations and that wage inflation is contained so far.  This could spark a relief bounce in stocks and Treasuries.

Consensus-like prints of this week's key data would not guarantee a 50 BP hike by the Fed in May.  But, they would not rule it out either.  There are reasons why a more aggressive Fed tightening may be appropriate.   /1/ While the run-up in oil prices should be viewed as a relative price change, its impact on other prices is so pervasive that it gives the impression of higher overall inflation.  This could feed into increased wage demands -- and thus a wage-price spiral.  /2/ With the Unemployment Rate so low and job vacancies so high, demand for labor is too strong and has to be reduced to avoid wage/price inflation.  The sooner this happens, the less chance of inflation getting out of control.  /3/ A more aggressive Fed would likely undercut speculative demand in commodities.  Commodity prices could fall somewhat, although it seems that fundamental reasons are behind their recent run-up.

 

 

 

 

Stock Recovery to Continue, Evaluating Fed Policy

The stock market is likely to continue to recover, albeit not necessarily smoothly, through April for several reasons:  /1/ The Fed has signaled a gradual, measured approach to tightening, with the next FOMC meeting in early May.  /2/ A negotiated end of the Russia/Ukraine war and a new Iranian pact are reported to be possible soon.  They could push down oil and other commodity prices -- assuming OPEC doesn't offset with output cuts.  /3/ Q122 corporate earnings, to be rolled out in April, are expected to be decent, up about 5% despite tough year-ago comparisons.

Last week's FOMC results have received criticism by some economists for not being anti-inflationary enough.  Some, like Larry Summers, say the Fed's Central Tendency forecast of continuing above-trend growth and slowing inflation is not credible.  History, they say, suggests that below-trend growth with a concomitant rise in the Unemployment Rate is needed to bring down inflation.  They are right, but with several caveats.  /1/ If supply constraints end, prices could fall.  /2/ If oil prices fall, so would transportation costs helping to hold down the prices of many goods and services.  /3/ A flattening in the Unemployment Rate could temper the rate of increase in wages.  /4/ Some of the historical evidence of run-away inflation resulted from structural features that are different now.  For example, the run-ups in inflation in the late 1960s and late 1970s were aggravated by COLAs which resulted in a wage-price spiral.  They are not prevalent now.  

To be sure, with shortages restricting growth in a number of important industries, the short-term "trend growth" rate is lower than the Fed's 1.8-2.0% long-term trend estimate.  So, it would require a sharper growth slowdown than otherwise to bring down inflation.

Fed Chair Powell suggested another reason why the Fed's forecasts are not unreasonable.  He pointed out that demand for goods and services and for labor are well in excess of supply.  If tighter Fed policy eliminates this excess demand, then actual economic growth may not be hurt much while inflation pressures are reduced.  This is an interesting argument, but not necessarily correct or, at the minimum, difficult to realize.   Measures of excess demand worth following are Job Openings, Quit Rate, Inventory/Sales Ratio,  Unfilled Orders, and Supply Delivery Time.  If they show some relief from excess demand -- and inflation begins to moderate, then Fed officials could feel more confident about its gradual approach to tightening.  Powell and other Fed officials are scheduled to speak this week and may highlight these ideas.

 

 

Besides Russia/Ukraine, This Week's FOMC Meeting

The stock market will likely remain focused on the Russia/Ukraine war this week.  While the fighting appears to be intensifying, there have been some optimistic comments from Russian and Ukrainian officials regarding peace talks.  Another round of negotiations are expected early this week.

The markets are not likely to be moved much by a 25 BP hike at this week's FOMC Meeting, as it has been well signaled.  But, revised Central Tendency Projections could hurt stocks, as the revisions should show lower Real GDP Growth but much higher inflation for 2022 than the Projections done in December.  And, the "dots" chart should show more expected rate hikes this year than the three seen at the December meeting. 

Nevertheless, these are only forecasts, and the Fed's policy stance could ultimately be viewed positively from a stock market perspective if the Statement or Powell in his post-meeting news conference emphasizes the downside risks in the outlook (both for economic growth and inflation) and the likelihood of a gradual, measured path of tightening ahead.

The revised Central Tendency Projections are likely to take account of the surge in energy prices and drop in stock market, both of which hurt the consumer.  A similar drag on non-US economic growth could hurt US exports, as well.  The high end of the Central Tendency for Real GDP Growth probably will be reduced more than the low end.  The revised Central Tendency Projections for the PCE Deflator (Total and Core) will most likely be revised up sharply, reflecting the jump in oil prices, speedup in wage inflation and continuing impact of shortages.  But, these forecasts are highly tentative, as they could reverse dramatically if the Russia/Ukraine war ends.  So, the markets should view them with caution.

                        December Fed Central Tendency Projections for 2020*

Real GDP Growth             3.6-4.5       

Unemployment Rate         3.4-3.7      

Total PCE Deflator           2.2-3.0    

 Core PCE Deflator          2.5-3.0           

* Q4/Q4 percent change for all items except for the Unemployment Rate which is Q422 average. 

The stock market will likely take in stride a gradual path of monetary policy tightening as long as US economic growth is robust -- as was the case in the 2015-2017 tightening episode.  So, this week's US economic data should be positive for the market if they are strong.  The consensus estimates are mixed.  Consensus looks for +0.4% m/m for February Retail Sales, with Ex Auto up 1.0% -- very decent prints but strength has to be confirmed away from higher-priced gasoline sales.  Housing data are expected to remain volatile.  Consensus sees February Housing Starts up 2.7% m/m, but Permits down 2.6% -- both are partial offsets to January's m/m changes.  February Existing Home Sales are seen falling by 5.2% m/m, but this too just would partly offset January's jump.  Manufacturing data are mostly expected to be solid.  Consensus expects +0.5% m/m for February Industrial Production, with Manufacturing Output up a strong 0.8%.  The March Phil Fed Mfg Index is seen edging down, but the NY Empire State Mfg Index rising after it appeared to pull back too much in February.

 

 

  

 

 

 

 

 

Another Week of Russia/Ukraine and Impending Fed Rate Hike

The stock market should continue to be dominated by Russia/Ukraine developments this week, but also will likely have to contend with another high CPI report.  Despite the latter, as well as the strong February Employment Report, the Fed may very well opt for only a 25 BP hike at the March 15-16 FOMC Meeting.  Not only is there much uncertainty regarding Russia/Ukraine, but the resulting surge in oil prices could restrain US economic growth as it will act as a tax on the consumer.

The consensus estimate of the February CPI (+0.8% m/m Total, +0.5% Core) looks reasonable.  Besides the run-up in gasoline and heating oil prices, pass-through of the higher fuel prices to airfares and other goods and services could show up, as well.  Moreover, there could be residual start-of-year price hikes, particularly among components that are sampled bi-monthly.  These factors should more than offset a further softening in Used Car Prices.

The February Employment Report showed that the US economy retains a lot of momentum, so should be able to sustain a modest pace of Fed tightening.  Total Hours Worked in February are 4.4% (annualized) above the Q421 average, not much below the 6.0% Q421 pace (q/q, annualized).  This momentum risks slowing, however, as the surge in oil prices weighs on the consumer.  Oil prices are up about $50/bbl from their recent lows, amounting to the equivalent of a $300 Bn+ (annualized) tax hike.  While some of the drag should be offset by increased domestic oil production, this supply response is likely to be muted because of the anti-oil stance of the Biden administration.

The anomaly in the February Employment Report was the 0.0% m/m Average Hourly Earnings.  The surprising low print could have resulted from compositional shifts or some other technical factor, it also could have resulted from companies trying to hold down labor costs -- possibly by shifting to more part-time workers.  Whatever the cause, the flat AHE provides another reason for the Fed to take a cautious approach to tightening, giving more time to see if some of the recently high inflation unwinds as supply constraints ease.  

Aside from the specific reasons for the flat February AHE, some models offer a reason for wage inflation to slow somewhat.  These models say that wage inflation not only depends on the level of the unemployment rate but also on the latter's change.  So, with the unemployment rate having stopped falling as fast as it did through most of 2021, wage inflation could moderate.

 

 

Can Stocks Handle Fed Tightening?

The stock market may still have to contend with the Russia/Ukraine situation, but the impending Fed rate hike may not be an obstacle for a renewed rally.  While the start of a series of Fed rate hikes is expected to begin at the March 15-16 FOMC Meeting, the consensus has moved to a modest 25 BP hike for the first move.  Fed Chair Powell's testimony on Wednesday and Thursday will not likely endorse this expectation specifically, but indicate that the pace of hikes will likely be faster than in the 2015-17 period.  Even if the frequency of rate hikes is faster than in this earlier episode, the stock market should take it in stride as long as economic growth does not look to be impaired significantly.   

The US economic data so far suggest GDP growth looks to be decent in Q122.  The rebound in January Retail Sales keeps open the door for consumer spending to grow at about the same pace as the 3.2% in Q421.   But, there are some negatives in the consumer outlook: /1/ The surge in oil prices represents a tax that will drain spending away from other goods and services and /2/ the end of the advance Child Tax Credits could hurt.  Aside from consumption, it remains to be seen how much of the massive inventory build in Q421 unwinds this quarter.  At this point, Unemployment Claims data suggest the labor market continues to improve.  Both Initial and Continuing Claims in February are below their Q421 averages.

The near-term inflation outlook is not good -- and unless it proves temporary could eventually force the Fed to tighten by larger increments.  The run-up in oil prices will filter through to higher transportation costs for many goods and services.  The dollar continues to fall relative to the Chinese currency, raising the risk of higher prices of goods imported from there.  And, there is no sign that wage inflation is abating.  Technically, bi-monthly sampling could keep start-of-year price hikes showing up in the February CPI.

This week's US economic data are expected to remain strong.   Consensus looks for an uptick in the Mfg ISM to 58.0 in February from 57.6 in January.  But, the evidence is mixed, so a dip can't be ruled out.  Consensus expects Nonfarm Payrolls to slow only modestly, to 450k m/m from 467k in January.  The evidence is mixed regarding a speedup or slowdown.  Consensus sees a downtick in the Unemployment Rate to 3.9% from 4.0%.  Whether it falls could depend on the Labor Force Participation Rat not rising.  Consensus expects a high Average Hourly Earnings, up 0.5% m/m after 0.7% in January.  It would remain above the prior 0.4% trend for the 3rd month in a row.

Russia/Ukraine and Fed Tightening Remain Market Problems

The stock market will continue to be vulnerable to developments in the Russia/Ukraine situation and concerns about the extent of Fed tightening.  President Biden believes Putin has decided to invade, possibly within days.  The FOMC Minutes point to more than 4 rate hikes this year as well as a large reduction in the size of the Fed's balance sheet.  But, comments by some Fed officials, including NY Fed President Williams, suggest the March hike will be only 25 BPs.

The FOMC Minutes were clear on two aspect of the extent of Fed tightening.  Rate hikes would be faster than in 2015-2017 period and that balance sheet reduction would be faster than in the 2017-19 period.  

Specifically, the Minutes said:

1.  Most participants suggested that a faster pace of increases in the target range for the federal funds rate than in the post-2015 period would likely be warranted, should the economy evolve generally in line with the Committee’s expectation. 

 

2.  Participants generally noted that current economic and financial conditions would likely warrant a faster pace of balance sheet runoff than during the period of balance sheet reduction from 2017 to 2019. 

3.  Participants observed that, in light of the current high level of the Federal Reserve’s securities holdings, a significant reduction in the size of the balance sheet would likely be appropriate.

 

The post-2015 trajectory of rate hikes was in 3 steps:  /1/ +25 BPs in 2016, /2/ +75 BPs in 2017 and /3/ +100 BPs in 2018.  (The upper limit of the Fed Funds Rate peaked at 2.5% at the end  of 2018 and stayed there until August 2019 when a series of 3 25-BP cuts began.)  Combining 2016 and 2017, the trajectory points to more than four 25-BP hikes in 2022 and possibly additional hikes in 2023.  These expectations should push up the "dots" chart that will be released at the March 15-16 FOMC meeting.  The prior "dot" chart showed an expectation of 3 rate hikes in 2022.

The monthly pace of Fed balance sheet reduction in 2017-18 was as high as $50 Bn.  Some Street economists are calling for as much as $100 Bn monthly reduction this time.

The stock market rallied strongly over 2017, as the Fed tightening occurred during a speedup in Real GDP Growth (to 2.7% (Q4/Q4) from 2.0% in 2016).  Stocks were range bound for the most part from the beginning of 2018 through the Spring of 2019.   Real GDP Growth slowed a bit in 2018 (to 2.3% (Q4/Q4) from 2.7% in 2017), although there was a more pronounced slowdown from H118 to H218 -- which stopped the Fed tightening.   

 

 

Will the Fed Pursue Aggressive Tightening?

The stock market will be focusing on the pace of Fed tightening ahead, as well as the Russian/Ukrainian situation.  The high January CPI raised the risk of aggressive Fed tightening, including the possibility of a 50 BP hike at the March meeting according to some Street economists.  At this point, however, a CNBC news report suggests the high CPI did not prompt a majority of FOMC members to change their expectation of a measured approach to tightening, that is in 25 BP increments.  They would be more concerned if inflation continues to be high in H222.  This week's release of the January FOMC Minutes could highlight this view.

In any case, there is still more evidence to see before the March 15-16 FOMC Meeting, which could influence market expectations if not Fed officials.  It includes the February Employment Report (March 4) and February CPI (March 10).  Strong prints will raise the risk of a 50 BP hike, while softer ones could hold down expectations of a rate hike to 25 BPs. 

Another high print for the February CPI cannot be ruled out.  The January CPI showed a broad swath of components with large m/m increases.  Higher wages and oil prices were likely the main culprits -- and their pass-through is unlikely to disappear soon.  Nevertheless, a couple of temporary factors may have exacerbated the January CPI's move up:  /1/ start-of-year hikes (which could persist to some extent in February because of bi-monthly sampling, but probably should show up to a smaller extent than in January) and /2/ a larger boost from the new seasonal factors (which will be balanced by smaller boosts in other months).  So, there could be some easing in February inflation.  Historically, the February Core CPI slowed in the two years ahead of the pandemic.  In addition, the January report contained evidence that price hikes stemming from supply disruptions may be peaking.  New Motor Vehicle Prices were flat and Used Car Prices slowed.

The large +467k m/m increase in January Nonfarm Payrolls also appear to have resulted in part from revised seasonals.  Seasonals added about 230k more to the m/m change than they did in January 2020.  There will be "payback" in the remaining months of 2022.  And, a smaller jobs gain in February can't be ruled out.

Regardless of the technical issue regarding seasonal adjustment, the economy still has to slow enough to generate labor market slack.  The sooner and larger this slack is created, the shorter will be the period of high inflation.   Given its dual mandate of maximum employment and low inflation, however, the Fed may be reluctant to aim for such a strong attack against inflation.  If it doesn't and the labor market remains tight and inflation high, the Treasury and stock markets will likely take on the job of braking the economy. 

This week's US economic data are not expected to give the Fed solace.  Consensus looks for the January PPI to speed up to +0.6% m/m from +0.2% for Total and to remain high at 0.5% for Core.  Consensus also sees January Retail Sales rebounding 1.6% m/m after -1.9% for Total and +0.7% after -2.3% for Ex Auto.  A large upward revision to December would seem to be a good possibility, as well. The Unemployment Claims data also will provide clues whether labor market slack is developing.  After giving mixed evidence in January (Initial higher, Continuing lower m/m), they suggest a modest tightening in labor market conditions has resumed.  The latest week's Initial and Continuing Claims are below their January averages (255k and 1.634 Mn, respectively).