Some Favorable Evidence This Week?

The stock market is likely to sustain the rally this week, albeit cautiously, as expectations for key US economic data support the Fed's inclination to downshift rate hikes at the December 13-14 FOMC Meeting.  But, they leave open the door for an upward revision in the fund rate's endpoint.  Most evidence -- but not all -- supports the m/m direction of the consensus estimates, suggesting stocks will retain an upward bias but cautiously. 

This week's data, themselves, may not affect the Fed's Central Tendency forecasts or "dot" chart to be updated at this meeting.  This is because the District Bank Presidents probably will have submitted their forecasts before the data are released.  The data, nonetheless, will be important by influencing market expectations of future Fed policy.

Consensus looks for a softer November Employment Report.  Payrolls are seen slowing to +208k from +261k in October,  the Unemployment rising 0.1% pt to 3.8%, and Average Hourly Earnings (AHE) slowing to +0.3% m/m from +0.4%.  The AHE trend so far this year is +0.4%.   A near-consensus Employment Report would argue for a downshift in rate hikes, but also for further hikes in H123.  Payrolls would need to slow further and the Unemployment Rate higher to establish the labor market conditions that would sustain low inflation.

Most of the evidence supports a slowdown in Payrolls and an increase in the Unemployment Rate.  The Claims data support these ideas after the latest report showed another jump in Continuing Claims.  Also, less-than-normal holiday hiring could depress Retail Jobs.  But, Warehouse/Trucking/Courier jobs could bounce, as holiday shopping may have shifted to on-line from brick and mortar sources.  The composition of October Retail Sales suggests this could be the case, as does the latest news reports.  If holiday-related payroll effects show up in the data, however, they should be discounted.  This is because their reversals in January are likely as the post-holiday unwindings don't meet seasonal expectations.  Retail Jobs should bounce and Warehouse/Trucking/Courier jobs drop in January.  So, weak Retail Jobs or strong Warehouse/Trucking/Courier jobs in November should be discounted.  

The consensus estimate of a decline in Job Openings to 10.3 Mn in October from 10.7 Mn in September fits with the view of a softening labor market.   But, this estimate is still well above the pre-pandemic 7.0 Mn level.  So, the near-consensus print would show excess demand for labor continuing.

Consensus also expects a modest October PCE Deflator, with the Core up 0.3% m/m after +0.5% in September.  This is old news, however, as it largely reflects the slowdown already seen in the CPI.  The risks are mixed from the the technical differences between the two.  The PCE Deflator assigns a smaller weight to Owners' Equivalent Rent, which pushes down the Deflator relative to the CPI.  But, Health Services and Airfares are measured differently in the two measures, and they could add to the Deflator rather than subtract as they did in the CPI.

Consensus sees a decline in the Mfg ISM to 49.8 in November from from 50.2 in October, as most manufacturing surveys fell so far this month.  Note, however, that consensus also expects an increase in the November Chicago PM, and that survey has done the best job predicting the direction of the Mfg ISM in recent months.  A decline in Suppliers' Delivery could be a contributing factor to a fall in the Mfg ISM.  But, a lower Suppliers' Delivery would not indicate weak manufacturing.  Instead, it would suggest that supply constraints are easing -- good for economic growth and fighting inflation.  An easing in supply problems and lessened price pressures were cited in the Markit European PMIs.  An easing also was suggested by evidence from the Industrial Production Report, which shows motor vehicle production having continued to climb in October.

The November FOMC Minutes confirmed that the inclination of a number of Participants is to downshift rate hikes "soon."  But, they also showed that a number raised their expectation of the endpoint of the tightening cycle.   Revised Central Tendencies will be released at the December FOMC Meeting.  So, the stock market is not out of the woods yet with regard to near-term monetary policy developments.

 

Problem for Stocks: Macro Fundamentals Moving in Right Direction, But More Needed

The stock market should continue to trade cautiously this week, even though stocks tend to rise in the Thanksgiving week.  The focus is on Fed policy, and key US economic data are not due for another week.  

The macroeconomic fundamentals are moving in a favorable direction for the Fed, but officials' recent comments suggest they have not moved enough.  So, while a downshift to a 50 BP hike at the December 13-14 FOMC meeting appears to be the prevalent opinion, some officials have continued to highlight the possible need to raise the endpoint of the funds rate in this tightening episode.  This possibility will likely be mentioned in the November FOMC Minutes, released this week.  Endpoints of 5.0-7.0% have been mentioned. 

The Labor Market is one area that is moving in the right direction but has a long way to go.  Payrolls have slowed and the Unemployment has risen.  But, Fed officials would probably like to see the Rate move up a percentage point above its latest 3.7% level.  This would require a much more substantial slowdown in job growth, possibly to below 100k m/m.  Also, while Job Openings fell sharply in September, they were still well above pre-pandemic levels.  They need to fall another 3 Mn to get there.   Fed officials view the overage as a measure of excess labor demand.  

The Claims data so far don't suggest a significant further softening in the labor market, but one more week's data are needed for a complete picture.  The 4-week average of Initial Claims is only slightly higher than it was going into the October Payroll Survey Week-- 219k versus 212k.  It suggests a modest increase in layoffs this month, despite recent headlines.  Continuing Claims so far are higher than in the October Survey Week, suggesting hiring has slowed. But the increase still hasn't matched the increase between the September and October Survey Weeks.   Another week's data are needed to see if this changes.  The Insured Unemployment Rate so far remains at 1.0%, suggesting little change in the Civilian Unemployment Rate.  

The layoffs that have happened so far appear to have more to do with improving efficiency than adjusting to lower demand for products.  The Atlanta Fed model's latest estimate of Q422 Real GDP Growth is 4.2% (q/q, saar).  If correct, the strong output growth would likely translate into a bounce in Productivity.  This would be a good development for the fight against inflation.  But, such a high GDP growth rate would be a concern to the Fed, particularly if this pace is seen persisting into 2023.  An overheating economy, not recession, would become their chief worry.  It could lead to a return to 75 BP hikes.

Stock Rally To Continue For Now

The stock market should extend its post-midterms rally, possibly through the rest of the year, thanks to three developments suggested in part by last week's data: /1/ inflation may have peaked, /2/ labor market is softening, and /3/ a divided government remains a possibility.  The first two point to a downshift in Fed tightening to 50 BP hikes and possibly a not-so-large increase in the expected end-point.  The third point suggests the possibility of actions to reduce the Federal deficit.

The 0.3% m/m increase in the October CPI reflected slowdowns in a number of components that fundamentals suggest may persist.  New Vehicle Prices finally may be beginning to react to an easing in production disruptions.  Increased vehicle supply has been evident in Industrial Production data, and could be seen to have continued in October in this week's IP report.  The decline in Used Car Prices also reflects this improved demand/supply situation.  And, the CPI's measure of housing rent finally may have begun to pick up the declines seen in recent surveys.  But, declines in other components, like airfares and medical services, may be one-off.  So, while the October CPI is encouraging regarding a peaking in inflation, the problem may not be resolved satisfactorily as yet.   

The Claims data show a modest softening in labor market conditions.  Both Initial and Continuing Claims are moving up from their September lows.  In particular, the jump in Continuing in the latest week suggests that hiring has slowed.  A couple of more weeks of data are needed to determine whether they point to a slowdown in November Payrolls.  A sustained pickup in economic growth without re-triggering inflation requires substantially more slack in the labor market.

Republican control of the House has not been resolved yet, although control remains a possibility at this point.  Such a result could be positive for the stock and Treasury markets, particularly if it pushes the Administration to work with Republicans to pass legislation reducing the Federal deficit.  Even an announced intention to do so would likely lower the medium- and long-term Treasury yields -- a positive for stocks.  Note that anti-deficit talk from the Clinton administration had these market effects in the 1990s.

These developments are likely to persuade the Fed to downshift to 50 BP rate hikes at the December FOMC Meeting, as suggested by recent Fed officials' comments.  They also could hold down upward revisions to end-point estimates of the funds rate in the Fed's Central Tendency forecasts.  But, the market moves -- higher stocks, stable to lower Treasury yields, and lower dollar -- could lead to a renewed speedup in economic growth and inflation that could put more aggressive Fed tightening back on the table at some point.  So, what we may be going through is a cycle rather than a straight uptrend in the economy and markets.

What's Important -- Speed or Endpoint of Fed Tightening? A Different View of Wage Inflation

The stock market faces the midterm elections and October CPI this week.  Historically, stocks tend to rally after these elections.  But, this week's CPI release is expected to show that inflation remains a problem.  Along with fears of an upward-revised 2023 endpoint for Fed tightening at the December 13-14 FOMC Meeting, the stock market may have trouble following the historical pattern this year.  To be sure, a below-consensus CPI can't be ruled out, in which case the seasonal pattern could persist for awhile.

The stock market is now focused on the endpoint as well as the speed of Fed tightening, after Fed Chair Powell emphasized the former.  The speed, however, still could be more important from the stocks' perspective at this point.  A slower speed reduces the risk of a market or financial crisis (such as what happened in the UK).  It also reduces the risk the Fed will overshoot tightening and precipitate a recession. The endpoint is far down the road and could change.

A potential problem, however, is that a gradual pace of tightening may not be enough to achieve the Fed's goal of lower inflation.  This was the case in 1994, when Greenspan tried to slow the economy with a string of 25 BP hikes.  The economy slowed only after he shifted to larger hikes.  Ironically, a slower pace of hiking could result in a higher-than-otherwise endpoint.

The Fed's shift to emphasizing the endpoint as well as the speed of tightening feels like a compromise between FOMC members who are focused on eliminating inflation at any expense (eg, Powell) and those who are concerned about fall-out from continuing sharp rate hikes (eg, Brainard).  Powell suggested the year-end endpoint for 2023 will be raised from September's 4.4-4.9% in the revised Central Tendency forecasts at the December 13-14 FOMC Meeting.  Some economists, like Larry Summers, thinks it should be at least 6.0%.   

A silver lining of an endpoint forecast is that it is not written in stone -- as evidenced by the continuing revisions to the Fed's Central Tendencies.  December 2023 is a long way off, and many things could happen along the way to undermine the forecast.  So, while the markets will adjust to the new forecast, they will likely do so with some tentativeness.  Indeed, the funds rate may never reach the forecast if Powell's hawkish rhetoric directly impacts economic decision making and activity. 

Although the Fed is focused on wage inflation as a culprit behind the high price inflation, this may not be the main problem boosting labor costs (see table below).  Compensation/Hour -- the broadest measure of labor costs per worker -- is already settling back to the range seen before the pandemic (3.5% so far in 2022 versus 2.0-4.3%, avg 3.1%, over 2015-2019).  The real problem is the weak Productivity Growth (-3.2% so far in 2022).  It was responsible for the jump in 2022 Unit Labor Costs.

Labor hoarding by companies may be responsible for the decline in Productivity -- despite all the talk of labor shortages.  Companies have too many employees for current production levels.  If so, companies' efficiency drives, as seen in a recent pickup in hiring freezes and firings, could solve the productivity problem by eliminating excess labor per unit of output.  It also could help cut price inflation if companies had passed on the costs of holding excess labor.  This could be the main way prices are held down rather than by slowing wage rate increases.  The latter remains a problem, as seen in  the 0.4% m/m increase in October Average Hourly Earnings.  It  kept them on the trend, albeit too high, seen since the start of the year. 

This understanding of the labor cost/price inflation nexus suggests that a pass-through of higher aggregate labor costs has played an important role in explaining the surge in inflation, not just the speedup in hourly wage rates.  It implies that the trade-off between Unemployment Rate and Wage Inflation (the Phillips Curve) may be less significant in the battle against price inflation than most think.  Instead, a decline in headcount at companies could directly hold back price inflation.  Conceivably, this channel could result in a faster decline in inflation than many expect.

A speedup in productivity in Q422 is suggested by the October Employment Report.  Although Payrolls were strong, Total Hours Worked only edged up and are 1.1% (annualized) above the Q322 average.   Similar m/m gains in November and December would put the Q422 average about a percentage point below the Q322 pace.  Meanwhile, the Atlanta Fed model's early estimate is for a speedup in Q422 GDP Growth.

Labor costs are not the only factor boosting price inflation.  Housing rent is another.  It has begun to fall, but at most should slow a bit in the October CPI because of the way it is calculated.  Even so, it would take some softening in other components for a sub-consensus print.  Airfares are a big uncertainty, however.  Otherwise, the consensus estimates of +0.7% m/m for Total and +0.5% for Core seem reasonable.  The most important component could be Core less Shelter, as it would show whether the underlying inflation excluding rent is slowing.  So far it has not.  It was steady at +0.5% in September, staying at the 0.5% m/m average seen since January.

                                                 (Q4/Q4 Percent change)

            Compensation/Hour        Productivity     ULC                   Core CPI

2015            2.6                             0.8                      1.8                          2.0        

2016            2.0                             1.3                      0.6                          2.2   

2017            4.3                             1.4                      2.9                          1.8

2018            2.6                             0. 9                     1.6                          2.2            

2019            4.2                             2.6                      1.5                          2.3    

2020             9.9                            4.7                      4.5                          1.6   

2021             5.3                            1.9                      3.2                          5.0                        

2022 *            3.5                           -3.2                    7.0                          6.5

Q322 **        3.8                            0.3                      3.5                          6.4  

 ULC = Unit Labor Costs = Compensation/Output (essentially equal to the percent change in Compensation less percentage change in Productivity)

* annualized change over first 3 quarters of 2022

**  q/q saar

This Week's FOMC Meeting -- A Short-Lived Disappointment?

The stock market may be disappointed by the outcome of this week's FOMC Meeting.  But, the disappointment could be short-lived.  After rallying on the belief that the Fed will downshift rate hikes after this week's 75 BP hike, stocks could pull back somewhat if the Statement and Fed Chair Powell do not say so explicitly but emphasize data dependency in discussing future tightening.  Although this emphasis would keep open the door for a downshifting at the December FOMC Meeting, it is no guarantee.  It could depend on whether US economic data released up to the December meeting show lower inflation or weaker economic growth. 

The Fed could stick with its data dependency approach to tightening because so far there is little evidence that it is achieving its goals.  Economic growth picked up in Q322 and core inflation remained high.  Without evidence of success, the bond market could sell off if the Fed downshifts -- viewing it as premature.  

This week's October Employment Report (due Friday) and September JOLTS data (Tuesday), however, could fit the bill and keep alive the market's belief in a December downshift -- and thereby sustain the rally.  Consensus expects the October Employment Report to show a Payroll slowdown, an uptick in the Unemployment Rate and a modest increase in Average Hourly Earnings.

The Claims data support a forecast of a smaller Payroll in October than September's +263k m/m,  Consensus expects +220k.  Anecdotal evidence also suggests some jobs softness.  News reports indicate that retailers may hire fewer-than-normal holiday workers this year.  Retail job weakness may show up more in November and December than in October, however.  A Payroll slowdown would be in the right direction from the Fed's perspective, but a slowdown to +100k or less would be needed to clearly indicate a softening in labor market conditions.  

The consensus expectation of a 3.6% Unemployment Rate, up a bit from September's 3.5%, also does not suggest a significant easing in labor market conditions.  The uptick could be just noise.  The Rate needs to rise to 3.8-3.9% by year end to meet the Fed's expectation seen in its Central Tendency Forecasts.  

Possibly the most market-positive part of the Report would be a modest 0.3% m/m in Average Hourly Earnings, as consensus expects.  It would offer hope that labor costs are trending down.

The September JOLTS data also could provide encouraging evidence that the labor market is cooling.  A drop in Job Openings to sub-10 Mn from 10.05 Mn in August would indicate that excess demand for labor is winding down.  To be sure, Job Openings were in the 7 Mn range prior to the pandemic.  So, excess labor demand is likely to remain a problem for the Fed at this point.

In contrast to these softer Reports, the risk is for a counter-consensus increase in the October Mfg ISM (Tuesday), based on some regional manufacturing surveys.  Consensus looks for a dip to 50.0 from 50.9 in September.  The manufacturing sector is mixed.  The motor vehicle industry is escaping from the shortage problem.  Although some analysts raise concern about the impact of higher borrowing costs on vehicle sales, there is probably pent-up demand that needs to be satisfied.  Airlines, too, appear to be placing orders for additional planes now that air travel has bounced back.  Increased defense spending and a shift to "on-shore" production also are positives.   But, construction-/housing-related manufacturing likely is facing difficulties. An increase in the Mfg ISM could help persuade the Fed to stick to data dependency in talking about future tightening.

Will Bonds Let Stocks Break To The Upside?

The stock market may continue to be buoyed by the possibility of Fed downshifting after the November 1-2 FOMC Meeting -- a possibility highlighted by Friday's WSJ article.  But, a stock market bounce could be short-lived if longer-term Treasury yields jump as a result.  

Such reaction by yields is conceivable.  The Treasury market could be concerned that monetary policy downshifting is premature.  If the market is not persuaded that economic growth and inflation will slow, the yield curve could steepen.  This would be a problem for stocks.  With the Fed relying on tighter financial market conditions to bring inflation under control, bond yields have tended to jump when stocks bounce in response to a positive fundamental factor, like profits, or to holding technical support.  The higher yields have undermined the stock market's move, forcing it back to supporting the Fed's goal.  This "vigilante" role of the bond market could prevent stocks from reacting positively to a hint of future downshifting by the Fed at the November 1-2 FOMC Meeting.

To be sure, there are secondary effects of a policy downshifting that could help hold down longer-term Treasury yields.  A consequential reduction in the volatility of short-term rates as well as of dollar exchange rates should flatten the curve, according to some models.   

Evidence that the Fed is achieving its goals (lower wage/price inflation and softer labor market) may be what's needed to prevent a run-up in longer-term yields.  With the Fed succeeding, financial markets would not have to "work" as hard to support the Fed.   So the Treasury market could be comfortable with stocks breaking to the upside.

In this light, the Q322 Employment Cost Index (ECI) could be the most important US economic data to be released this week.  It is a broad measure of labor cost inflation and little affected by compositional shifts.  Consensus looks for the ECI to rise +1.3% q/q, the same as in Q222.   This estimate may be somewhat high.  /1/ While Average Hourly Earnings (AHE) sped up a bit in Q322, it remained below 1.3% (see table below).  But, AHE is a narrower measure of labor costs than the ECI, not covering many types of workers nor types of compensation, such as bonus payments.  As a result, the two can diverge considerably in a quarter, as was the case in Q421.  /2/ Away from AHE, a reduction in sales commissions, such as for realtors, could hold down the Q322ECI.

A below-consensus print for the ECI probably would be positive for the markets, but a print of 1.0% or higher still could be problematic for the Fed.  It would be well above the 0.6--0.7% trend prior to the pandemic.  A sub-1.0% print may be needed to satisfy the Fed and to truly lift stocks.

                         (q/q percent change)

            Avg Hourly Earnings        ECI

Q321              1.3                          1.2                                                

Q4                  1.5                          1.0                                               

Q1                  1.2                          1.4                                           

Q2                  1.1                          1.3

Q3                  1.2                          na

 

Stocks Not Out of Woods Re Fed

The stock market is not out of the woods with regard to the Fed after last week's key events.  The September FOMC Minutes and Fed Vice Chair Brainard's speech underscored officials' intent to bring down inflation, but they appear to plan sticking with the measured pace of tightening seen in the Fed's Central Tendency forecasts.  The high September CPI should not derail their adherence to this plan at the November 1-2 FOMC Meeting.  But, a slowdown in underlying inflation by early next year could be critical to their continued adherence.

The high 0.6% m/m September Core CPI underscored the stickiness of underlying inflation.  While the largest component, Shelter (includes Owner's Equivalent Rent) is largely backward looking and still moving up as a result of past increases, the Core Excluding Shelter rose +0.5% m/m in each of the past two months.  Although this pace is slightly less than the 0.6% m/m average over H122, it needs to slow to 0.2% or lower to get to the Fed's 2% target.

The real-side of the economy may not be slowing enough to knock down inflation. Ex Auto/Ex Gasoline Retail Sales slowed to +0.3% m/m in September from +0.6% in August.  The slowdown could be just the typical follow-through after a strong month, however.  The Atlanta Fed model's estimate of Q322 Real GDP only edged down to 2.8% (q/q, saar) from 2.9% as a result of the Retail Sales data.  Regarding the labor market, Initial Unemployment Insurance Claims have moved up a bit so far in October, but they remain below August levels.  Demand for labor remains strong.

One favorable feature of the current economic situation is that longer-term inflation expectations have been well contained -- which should mollify Fed officials to some extent and argue against the need to tighten more aggressively than what is embodied in the Central Tendencies.  The University of Michigan Consumer Sentiment Survey's 5-year inflation expectations rebounded to 2.9% in Mid-October from a low 2.7% in September.  The level is still low.  It has been in a 2.7-2.9% range since July, after a 3.0-3.1% range in H122. 

Fed Vice Chair Brainard, in her speech, acknowledged the contained longer-run inflation expectations.  And, she pointed out some evidence suggesting a re-balancing of the labor market.  Regarding monetary policy, she said it will take time for the cumulative effect of higher rates to bring inflation down.  This view suggests the Fed will not be derailed from its deliberate path of tightening because of currently high inflation prints. But, at some point, a continuation of high inflation data could prompt a more aggressive tightening path than now penciled in. 

She ended her speech with, "In light of elevated global economic and financial uncertainty, moving forward deliberately and in a data-dependent manner will enable us to learn how economic activity, employment, and inflation are adjusting to cumulative tightening in order to inform our assessments of the path of the policy rate."  The issue will probably become more critical early next year, when there will have been more time to see the effects of the recent tightening.   A further slowdown in underlying inflation would need to be seen by then.