The Bad And The Good In The July FOMC Minutes

The July FOMC Minutes had good as well as bad news for the markets.  Bad News -- The Fed is intent on reducing inflation by tightening further.  Good News -- Although officials acknowledge the possibility of overshooting, their data-dependent approach to policy decisions would enable them to respond quickly by adjusting the pace and magnitude of tightening.   It suggests there could be a "Fed put" at some point.  

These ideas could be repeated by Fed Chair Powell and other Fed officials at this week's Jackson Hole meeting.  So, the "bad" implications of the Minutes may continue to weigh on stocks, particularly in this seasonally weak period.  But, the market could shake off its fear of tightening if upcoming US economic data, such as this week's July PCE Deflator, argue for a downshift in rate hikes to 50 BPs from 75 BPs. 

The July FOMC Minutes had three main messages for the markets -- /1/ rates will continue to be hiked until sustainable 2% inflation is achieved,  /2/ the pace of tightening would likely slow at some point once the cumulative effect of past rate hikes starts to bite the economy, and /3/ rates would likely be held steady at that point in order to ensure that 2% inflation is sustainable.  

The Fed's hope is to achieve its inflation target without a recession.  The Minutes, however, contain a fairly detailed analysis of the inflation problem that raises doubts on whether a sustainable 2% inflation rate can be obtained without a hard landing, that is recession.  Fed staff, as well as officials, acknowledge that the economy is operating at a level above its long-run potential.  Growth has to fall below its long-run 1.8-2.0% trend to bring the economy to a level that does not precipitate inflation.  Although the Minutes don't say this explicitly, the Unemployment Rate has to rise significantly -- which could entail a recession.  

To be sure, there could be mitigating factors helping to push down inflation without the need to boost unemployment.  The Minutes list /1/ competitive pressures that restrain price increases, /2/ "the apparent absence  of a wage-price spiral, " /3/ the tightening of monetary policy outside of the US, /4/ an easing of supply constraints, and /5/ the dollar's appreciation holding down import prices.  While lower commodity prices should continue to help lower inflation in the next few months, Fed officials view commodity prices as a "potential source of upward pressure on inflation."  Moreover, even with the mitigating factors, they think that "a slowing in aggregate demand would play an important role in reducing inflation pressures."

Although monetary policy aimed at slowing the economy is not good for the stock market, the Minutes indicated that officials would try to avoid going too far in trying to restrain the economy.  Many participants agreed that the tightening could be "more than necessary to restore price stability."  They believe, however, that the Fed's "data-dependent approach" to tightening will be an important element helping them mitigate that risk.  Presumably, this means the Fed will stop tightening or possibly ease if the economy's weakening appears to be excessive.  This possibility should cushion the impact of upcoming  monetary policy tightening on the stock market.

This week's US economic data are likely to leave open the possibility of a downshift in Fed tightening.   Consensus looks for a 0.3% m/m July PCE Deflator, the same pace as the Core CPI.  And, there is downside risk to the consensus estimate, based on the different compositional weights in the two inflation measures.  Housing data are expected to weaken further, with July Pending Home Sales and New Home Sales falling.  Manufacturing data, however, are expected to increase, with July Durable Goods Orders up modestly.

FOMC Minutes and Data Should Not Derail Stock Rally

The stock market should rally further this week, now that the low July CPI undercut fears of very aggressive Fed tightening ahead.  This week's US economic data will likely sustain expectations of a 50-75 BP hike at the September FOMC Meeting rather than the possibility of 75-100 BPs that was raised by the strong July Employment Report.  Moreover, the data should be more consistent with a slowdown than recession.

The release of the July FOMC Minutes on Wednesday should reaffirm the Fed's commitment to bringing down inflation to its 2% target.  The Minutes will probably be vague on the magnitude of the next rate hike, as was Powell at his news conference.  He had indicated that future Fed policy would be data-dependent and not constrained by forward guidance.  What may be important would be if the Minutes reiterated the Fed view that a recession is not its most likely expectation.  It would suggest the Fed will be measured in its tightening path, trying to avoid a sharp move that could lead to an abrupt downturn in the economy.

Whether the Fed will succeed in achieving  a "soft landing," and thus avoid recession, remains to be seen.  The July CPI was held down by a number of "special" factors, such as the drop in gasoline prices and airfares, that might last for only a few months.  High wage inflation is still a problem that could keep price inflation above the Fed's target after these special factors flatten out.  The possible need for a recession to bring down wage inflation has not gone away, but it is not imminent.

This week's US economic data are expected to point to slow growth in Q322.  Consensus looks for a slight 0.1% m/m increase in July Retail Sales, with Ex Auto 0.0%.  The low prints largely reflect the drop in gasoline prices.  So,  it will be important to look at Ex Auto/Ex Gasoline Retail Sales.  It could very well slow from the strong 0.7% June gain --  but this could be explained as the typical pattern after a strong month.  To be sure, higher prices will boost food sales, which are in Ex Auto/Ex Gasoline.

Consensus risks being too low in its forecast of +0.3% m/m July Industrial Production, with Manufacturing Output 0.0%.  Total Hours Worked in Manufacturing point to an increase in the latter.  This would be important, since the output declines in the prior two months were hinting at recession -- their being one of the pieces of evidence used to date business cycle turns.   Other positive manufacturing evidence would be seen if consensus is right that the Phil Fed Mfg Index will move up to -5 in August from -12.3 in July.  A rebound in the Phil Fed Index is the risk, as it appeared to be too low relative to the Mfg ISM in July.

Some of this week's Housing data are expected to stabilize.  The rate of decline is expected to ease for July Housing Starts.  Consensus looks for -1.2% m/m versus -2.0% in June -- and a stronger print can't be ruled out given the revised uptick in June Housing Permits.  The August Homebuilder Index is seen at a steady 55.  But, July Housing Permits are expected to decline.

Strong Payrolls Versus Slower Growth

The stock market could have trouble rallying further this month, as the possibility of a 75-100 BP hike at the September 20-21 FOMC Meeting is back on the table after the strong July Employment Report.  Nevertheless, this week's July CPI Report could be important in determining the market's near-term path.  A higher-than-expected print could prompt talk of a 100 BP hike if not an inter-meeting hike, a big negative for stocks.  A lower-than-expected CPI could give the rally some breathing room.

The +528k surge in Payrolls and 0.1% pt dip in the Unemployment Rate to 3.5% seemed to defy recent data, such as Unemployment Claims and Q222 Real GDP, that suggested a softening in economic growth.   But, a combination of slower economic growth and strong job gains can be explained as a difference between levels and rates of change:

What may be happening is that companies need to expand employment because /1/ the current level of economic activity is still too high relative to the level of jobs or /2/ the level of demand is greater than what is being produced.   Put another way, the earlier stimulative fiscal and monetary policies pushed demand and output to higher levels than they did Payrolls.  Now, Payrolls are catching up -- that is, closing the gap.  That gap could be about 3.5 Mn jobs, based on Job Openings data.  In this case, Payrolls could continue to post large gains for a number of months.

The strong job growth then reflects companies' efforts to catch up to an already strong level of demand.  So, most companies are not at a point of having to eliminate workers in response to a slowdown.  They need the additional workers just to meet current demand.  As a result, from the Fed's perspective, a slowdown in growth may not be enough to reduce labor market pressures sufficiently.  A recession that lowers the level of economic activity may be needed to bring equilibrium back to the labor market. 

A reconciliation of a slowdown in GDP Growth and an almost independent speedup in Payrolls results in a decline in Productivity.  It is an offset to the increases in Productivity in 2020-21.  This outcome is not good for the inflation outlook.  A decline in Productivity would boost Unit Labor Costs just as Average Hourly Earnings shows no sign of slowing wage inflation.

This week's calendar of US economic data will highlight inflation.  Consensus looks for +0.2% m/m Total and +0.5% Core for the July CPI.  The drop in gasoline prices will hold down Total.  The risks are probably balanced with regard to Core.  A pass-through of lower gasoline prices would hold down some prices.  And, there is anecdotal evidence that inventories are being reduced through price discounting.  But, higher labor costs could lift prices.  And, housing rents could speed up further, as they lag reports of slowing rents.

The other important inflation report this week will be the University of Michigan's 5-Year Inflation Expectations for Mid-August.  They were 2.9% in July, staying within their recent range.  But, the final monthly number was above the 2.8% mid-month read.  This means that Expectations were likely closer to 3.0% in the 2nd half of July.  So, the risk could be for an uptick from the July level.

 

 

Stocks Too Optimistic?

The stock market probably has room to climb further this week, but the rally risks stopping soon for a couple of reasons.  Last week's positive reaction to Powell's comments may have been overly optimistic.  While the Fed might prefer an economic slowdown than recession to bring down inflation, a downturn may be necessary to generate enough slack to cut it.  The market will be facing possibility of recession for some time (if it already hasn't begun).  If US economic data don't weaken sufficiently to point to increased slack, the market will face the prospect of further aggressive tightening by the Fed.  If the data weaken too much, stocks would have to deal with recession.  Technically, stocks tend to be weak in August-September.   

The key to the degree of Fed tightening is twofold.  The labor market has to weaken significantly, with the Unemployment Rate rising to at least 4.5-5.0% by sometime next year.  And/or, Total and Core Inflation needs to fall toward the Fed's target of 2%.  This week's US economic data (for the most part) are expected to move in these directions, but the consensus estimates are not weak enough to conclude that further aggressive Fed tightening is out of the picture.   

The July Employment Report is expected to show a slowdown in Nonfarm Payrolls and a steady Unemployment Rate.  Consensus looks for +250k m/m in Payrolls and a 3.6% Unemployment Rate.  A slowdown in Payrolls makes sense, considering the decline in Q222 Real GDP.  The weakness in Final Demand and Inventories would seem to suggest companies overly expanded employment during H122.  But, the consensus estimate is likely the maximum jobs pace that would make the Fed comfortable.  A Payroll gain of less than 100k would be more comforting, as it would match the anemic growth rate of the US population and thus not tighten the labor market further.  To be sure, an increase in the Labor Force Participation Rate would raise the comfort level for job gains.

The consensus estimate of a steady 3.6% Unemployment Rate is consistent with the Insured Unemployment Rate from the Unemployment Claims data.  But, it is far from signaling an easing in labor market conditions.   

Consensus stuck near the 0.3% m/m trend for its estimate of Average Hourly Earnings (AHE), as there is no evidence on which to base an estimate.  However, last week's release of the Q222 Employment Cost Index -- a broader measure of labor costs that is less affected by compositional shifts -- showed a slightly larger q/q increase than AHE.   So, the latter loses some significance for the Fed.

From a stock market perspective, near-consensus Employment Report prints could raise warning signs for corporate earnings.  A combination of weakening demand and increasing labor costs is not a good recipe for profits.

This week's other important report is the July Mfg ISM.  Consensus looks for a dip to 52.0 from 53.0 in June.  But, there is some evidence suggesting a sub-50 print.  Although the markets are trained to view sub-50 as signaling recession, statistical evidence says that the recession cutoff for this Index is 48.7.  In other words, the Mfg ISM has to fall below 48.7 to signal recession in the overall economy.  

Fed Tightening in the Face of A Weakening Economy

The stock market will likely trade cautiously this week as it moves through Tuesday/Wednesday's FOMC Meeting and key US economic data on Thursday/Friday.  A large 75 BP hike when evidence is mounting of a broad-based softening in economic activity is a recipe for recession and not positive for stocks.  Nevertheless, a relief rally is possible if the Fed signals the possibility of a downshift in tightening ahead and the key data are in line with consensus.  But, the drag on earnings from slow growth or recession is becoming more of a downside risk.  So, a rally would likely be short-lived.

With the Fed generally expected to hike by 75 BPs at the July 26-27 FOMC Meeting, the question will be whether officials signal the possibility of a smaller rate increase at the September meeting.  My guess is that Fed Chair Powell may acknowledge that a 50 BP hike is a possibility, but emphasize that it is still a significant move and that the Fed will not diverge from tightening until inflation -- both Total and Core -- falls back to the Fed's 2% target.  Such a mixed message could spark volatility in the stock market.  But, the volatility could end on the upside, as the idea grows that the Fed will be responsive to the real economy and that the worst of the tightening could be over.  The 75 BP hike also should lead to a further inversion of the Treasury yield curve, with mixed implications for stocks -- while the inversion would be viewed as pointing to recession, the lower longer-term yields would be seen as already moving in a way to cushion the economy's weakening.

Cycles of overshooting weakness and strength will likely mark the outlook for the economy and stock market over the next few years.  A standard econometric model of the US economy -- like the one used by the Fed -- can generate successive business cycles after a shock.  So, after the pandemic slammed the economy, the bounce-back overshot to the upside.  To squeeze out the consequential inflation, the economy has to weaken sharply -- and overshoot to the downside to prevent a wage-price spiral.  This weakness has to be accompanied by a sizable increase in the Unemployment Rate -- perhaps to a level above its long-run, full-employment level.  This overshoot should then be followed by an easing Fed that risks boosting economic growth and the stock market too much.  And, so on.  

At this point, the US economic data are only beginning to show weakening signs, although these signs are building.  This week, the most important releases should be the first print of Q222 Real GDP and Employment Cost Index.  

Consensus looks for a slight increase of +0.4% (q/q, saar) in Q222 Real GDP -- essentially a flat print but stronger than the Atlanta Fed model's estimate of -1.6%.  These estimates can change, possibly significantly, after advance prints of June Trade Balance and Inventories are released ahead of the GDP print.  An increase in Q222 Real GDP would show that recession has not yet begun, in contrast to the message from a decline like the Atlanta Fed model's estimate.  This would be a positive for the stock market.  But, flattish or lower GDP would argue that the recent strength in job growth was overdone (and should show up in a decline in Productivity).   It would point to a sharp slowdown in Payrolls ahead.

The ECI is broader than Average Hourly Earnings, so it will be important to see if the latter's slowdown is confirmed.  Consensus looks for the ECI to slow to 1.2% (q/q) in Q222 from 1.4% in Q122.  This estimate is consistent with the slowdown seen in AHE  (see table below) and would be a market positive -- even though it still would be historically high, almost double the pre-pandemic pace (2019 avg).

                                                (Q/Q Percent Change)         

                                                AHE            ECI

              2019  Avg                    0.7                 0.7

              2021 Avg                     1.2                1.0

              Q122                            1.2                1.4

             Q222                             1.0                1.2 (e) 

Consensus expects other US economic data this week to show declines in June New Home Sales and Total Durable Goods Orders.   But, the more important question is whether the expected uptick in Ex Transportation Durable Goods Orders is too high.  All manufacturing surveys indicate a pullback in new orders, and confirmation from Ex Transportation Durables would spark more talk of a softening in the manufacturing sector.   Consensus also looks for the Core PCE Deflator to speed up to +0.5% m/m from +0.3% in May.  This old news, as it mostly reflects the already-released CPI.  But, it would underscore the difficulty in bringing down inflation.  A smaller-than-consensus increase would be a market positive.

Has A Recession Already Begun?

Over the next few weeks, the stock market still has to contend with the risks of soft Q222 corporate earnings and a large rate hike at the July 26-27 FOMC Meeting.  Nevertheless, stocks could be helped by a growing expectation that the Fed will downshift tightening after the July FOMC Meeting. 

Although the market and some Fed officials flirted with the idea of a 100 BP Fed rate hike at the end of the month, a 75 BP hike appears to be the likely outcome -- according to the WSJ.  Macroeconomic evidence supports this smaller extent of policy tightening.  There are mixed signals coming from inflation and real-side data.  And, the possibility that a recession already has begun cannot be ruled out.

The June CPI was high, and the Core could continue to be so for awhile -- as inflation is a lagging indicator and tends to be sticky.  In particular, the CPI calculates housing rent  as a moving average, so it takes time for the latter to settle down from a steep run-up.  But, the June PPI and Import Prices have elements pointing to more subdued inflation pressures ahead.  The underlying Core PPI Ex Trade Services  and Core Intermediate Prices moderated.  The soft June Import Prices show the effects of the strong dollar and weak economies abroad.  Moreover, the decline in the 5-Year Inflation Expectations component of the University of Michigan Consumer Sentiment Survey to 2.8% in mid July put them back to their prior range. It suggests the Fed's anti-inflation intentions are being viewed as credible -- which could prevent inflation from spiraling higher.  

Real-side data are sending divergent signals, as well.  Strength was seen in parts of the Employment Report, Durable Goods Orders and Retail Sales.  But, if the Atlanta Fed model's projection of a decline in Q222 Real GDP is correct, the start of a recession conceivably could be dated in April or May.  Declines in Civilian Employment and Manufacturing Output began then.  They are inputs in the cyclical dating process.  While Payrolls were strong during the quarter, their import was deflated somewhat by a decline in the workweek.  Moreover, benchmark revisions to Payrolls (an estimate of which is due in August) could reduce the recent pace of job gains.   The Conference Board Leading Indicators are expected to fall in this week's report for June.  This would be their third decline in a row -- an old, but not right all the time, rule of thumb pointing to recession.  

Even if Q222 Real GDP did not decline, signs of a developing slowdown are building.  Initial Unemployment Claims are trending up.  Job openings are falling.  And, most commodity prices have unwound their Spring bounce.  A significant slowdown in economic activity, even without a recession, would argue for a downshift in Fed tightening.

This week's US economic data will feature some housing-related data and manufacturing surveys.  Consensus looks for declines in June Existing Home Sales and Housing Permits, but an increase in Housing Starts.  The risk is for a counter-consensus decline in Starts, as well.  Consensus also expects an uptick in the Phil Fed Mfg Index, similar to what was seen in the NY Fed Empire State Mfg Index.  But, consensus sees a dip in the Markit US Mfg PMI.  All the manufacturing surveys so far are not in recession territory.

Two More Hurdles for Stocks -- June CPI and Q222 Corporate Earnings

The stock market is not out of the woods yet, but a summer rally is possible.  The market has two hurdles to get past over the next few weeks -- the June CPI and Q222 corporate earnings.  Another high CPI is expected, but the market could dismiss it now that oil and gasoline prices have moved down.  Corporate earnings are seen slowing.  Whether the Fed hikes by 50 or 75 BPs at the July 26-27 FOMC Meeting remains an open question.

Consensus looks for another high CPI in June.  Total is seen at +1.0% m/m and Core at +0.6%.  The jump in gasoline prices accounts for most of the difference between Total and Core.  But, gasoline prices have fallen in early July, which should hold down the next CPI print.  Owners' Equivalent Rent and Airfares should be the main culprits behind the jump in Core, as they were in recent months.  The drop in oil prices could help to hold down airfares and other prices ahead, however.  So a high Core print could be dismissed, as well.

Macroeconomic evidence supports the consensus expectation of a slowdown in Q222 Corporate Earnings for the S&P 500 (see table below).  Consensus looks for about +5.0% (y/y), versus about 11.5% in Q122.  In Q22, economic growth slowed on a y/y basis, as did the ascent in oil prices.  Also, earnings from abroad should be hurt by weakening growth in Europe and China as well as the stronger dollar.  And, it looks like profit margins may have contracted, with the Core CPI expected to slow by more than Average Hourly Earnings.  

The June Employment Report did not resolve the question regarding the Fed's next move.  It points to a moderation in economic growth and constrained wage inflation, but it also shows a strong, broad-based  labor market.  Despite the Payroll strength, Total Hours Worked (THW) slowed to 2.7% (q/q, saar) in Q222 from 3.5% in Q122, because the Average Nonfarm Workweek slipped.  As for wage inflation, the moderate 0.3% m/m increase in Average Hourly Earnings (AHE) remained within the range seen since March.  So, both THW and AHE argue for a downshift in Fed tightening to 50 BPs.

But, the Report contained broad-based evidence that the labor market is solid and has fully recovered from the pandemic.  The most striking result from the Household Survey is the drop in the broadest measure of labor market slack -- U-6.  It fell 0.4% pt to 6.7%, possibly an all-time low for this measure.   The Survey's decline in Civilian Employment and Labor Force could reflect the particulars of the relatively small sample, although they can be leading indicators of a slowdown in Payrolls.  The small-sample effects drop out in the calculation of the Unemployment Rate.  The Rate slipped on an un-rounded basis, rounding to 3.6% in both May and June.  The labor market's strength gives hawks an argument for hiking by 75 BPs. 

Perhaps the most important US economic data for the Fed this week will be the Mid-July University of Michigan's 5-Year Inflation Expectations measure on Friday.  Remember that this measure unwound a mid-month jump in June to end the month at a near-trend 3.1%.  It will be an important positive for the Fed and markets if these expectations stay at this level or move lower.

Three cyclically-related data will be released Friday, as well.   They risk being mixed.  /1/ Consensus looks for a speedup in June Retail Sales.  But, much of the increase could be price-related.  /2/ Consensus also sees the Mid-July Consumer Sentiment Index falling further.  But the risk is for an increase as consumers react positively to the decline in gasoline prices.  /3/ Consensus expects a 0.1% m/m uptick in June Industrial Production, with Manufacturing Output flat.  But, the risk is for weaker prints, based on Total Hours Worked in the Manufacturing Sector.    . 

                                Macroeconomic Evidence Regarding Corporate Earnings

                                                                                                                                           Markit
                                                                                                                                          Eurozone                        Real GDP     Oil Prices        Trade-Weighted Dollar    AHE     Core CPI    PMI  
                [                                y/y percent change                                                   ]    (level)
Q119            3.2                -12.8                 +7.9                             3.2           2.1               51.9 
Q219            2.7                -12.2                 +5.9                             3.1           2.1               47.8    
Q319            2.1                -19.2                 +3.6                             3.2           2.3               46.4
Q419            2.4                  -3.6                 +1.7                             3.2           2.3               46.2

Q120           -5.0                -16.5                 +2.9                             3.1           2.3               47.2

Q220         -10.6                -53.5                 +5.9                             6.5           1.4               40.1

Q320           -2.8                -27.8                 +1.0                             4.8           1.7               52.4

Q420           -2.4                -25.5                  -1.9                             4.8           1.6               54.6

 

Q121            0.4                  26.3                 -4.4                              4.9           1.4               58.3   

Q221          12.2                  32.1                 -8.3                              1.2           3.4               63.1 

Q321            4.9                  72.7                 -3.4                              4.2           4.1               60.9

Q421            5.5                  82.4                +1.3                              4.6           5.0               58.2  

 

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.5                  60.9                +5.3                              5.3           6.0               54.0

                                                                           

* Based on the Atlanta Fed Model's latest projection of -1.2 (q/q, saar).