What Will Calm The Stock Market?

The stock market may stay under pressure from fears of more aggressive Fed tightening until evidence suggests otherwise. A more aggressive stance could consist of a return to 50 BP hikes or a longer stretch of 25 BP hikes.

The next set of key data begins this week, with the February Chicago PM and Mfg ISM.  Neither is expected to be weak enough to undercut these fears.   They are expected to rebound a bit, but stay below the 50 level.

More important reports will be released in the weeks after, including the February Employment Report (March 10), CPI (March 14) and Retail Sales (March 15).   While the risks are for Payrolls and Retail Sales to slow, it's not clear they will slow enough.  They may have to weaken to a below-trend pace if not an outright decline to calm the market's fear.  Similarly, there are reasons to expect the February Total CPI to slow, but the same factors that boosted the Core in January could persist to some extent in February.   So, stocks may not be out of the woods until there is some word from the Fed about its intentions, possibly as late as the March 21-22 FOMC Meeting, itself.

Maintaining a 25 BP pace of tightening can't be ruled out, nonetheless.  Indeed, on Friday, Cleveland Fed President Mester backed away from being adamant about the need for hiking by 50 BPs.  The Fed may decide that the recent economic strength is temporary, possibly reflecting exaggerated seasonal adjustment or warm winter weather.  Payback in the Spring is possible.   The path to lower inflation could be viewed as uneven.  Fed officials could be counting on a sharp slowdown, if not reversal, in Owners' Equivalent Rent in the second half of the year.  This, by itself, could pull the Core CPI down to a 0.2% m/m (about 2% annualized) pace.  

A period of sustained low inflation, however, most likely requires more labor market slack.  With sufficient slack, possibly meaning a 4.5+% Unemployment Rate, the economy can grow moderately without lifting inflation.  The quickest way to push up the Unemployment Rate is through a recession.  Fed comments suggest this would be the last resort in its fight against inflation.  Instead, they appear to be aiming for an extended period of below-trend economic growth to lift the Rate.  Currently, GDP Growth is above trend, according to the 2.7% (q/q, saar) Atlanta Fed model estimate for Q123.  The Fed estimates trend growth at 1.7-2.0%.   To achieve below-trend growth, a long drawn-out path of 25 BP hikes may be needed.  A pause in tightening could result in a bounce in economic growth, given the resiliency of the US economy -- which in turn could prompt renewed Fed tightening.  Under this uneven scenario, the stock market would likely stay in a wide range until enough labor market slack is achieved.

 

 

To Hike By 25 or 50 BPs?

The stock market and other financial markets were "spooked" by last week's US economic data, building in a greater degree of Fed tightening ahead.  Speculation of a 50 BP rate hike at the March FOMC Meeting, however, is premature.  Temporary factors exacerbated the strength seen in Employment, Retail Sales, Manufacturing Output and Inflation in January.  The markets' fears could abate if these data moderate, if not pull back, in February or March -- as will likely be the case at least for some of them.  

The markets will be looking for clues regarding Fed policy in this week's release of the January 31-February 1 FOMC Meeting's Minutes.  The Minutes, as well as the upcoming Semi-Annual Monetary Policy Report and Testimony, should reflect the the more moderate message of Fed Chair Powell's post-Meeting news conference -- which could prompt a relief bounce in stocks.  Although some Fed officials raised the possibility of a 50 BP hike in March last week, they were probably voicing their own, well-known hawkish, positions rather than the official view.  Nonetheless, having some officials make hawkish comments could be part of Fed strategy for the purpose of restraining financial markets.

A Moderation in Growth Likely, But...

The Claims data so far suggest a moderation in growth immediately ahead.  Both Initial and Continuing are above their January average in early February.  This is a mirror image of what happened last year, when low Unemployment Claims contradicted some weak spending data.  The Claims data were right then.

The real-side strength in January likely resulted in part from temporary factors, such as the warm winter and post-holiday-induced exaggeration by seasonal adjustment.  The effects of unusually warm, or cold/snowy, January's have tended to unwind in February and March.  So the weather's impact on Q1 GDP Growth is small.  With the warm weather continuing in February, though, the unwinding could be delayed to March-April.  If so, GDP Growth would likely slow in Q223.

Temporary factors are not the only reason why the economy so far has defied forecasts of recession.  Fiscal policy remains growth-supportive, with Social Security COLAs being the latest surge in transfer payments.  Also, military restocking and the return of manufacturing to the US from abroad are lifting economic activity. 

If evidence of a moderation accumulates over the next few weeks, a 25 BP hike at the March meeting may very well become the markets' consensus.  Nevertheless, expectations of an increase in the Fed funds rate's endpoint in the Fed's Central Tendency Forecasts (to be released at the meeting) will likely remain.    

A Lower February CPI?

A pullback in the February CPI is uncertain.  It will require start-of-year price hikes to be behind us.  But, bi-monthly sampling of some components will sustain these hikes to some extent in February.  There is some favorable news.  Weekly data so far point to a slowdown in Gasoline Prices.  And, a drop in piped gas prices remains a possibility, as they have not yet reflected the plunge in natural gas prices. But, wholesale data suggest a near-term end to the decline in Used Car Prices.  Whatever prints, the Fed appears to have a longer-term view of the slowing path for inflation.  So, hawkish rhetoric and a higher funds endpoint may be the response to another high CPI.

 

 

 

    

Excessive Fear of the Fed?

The stock market's concerns about the path of Fed policy could be exacerbated by this week's US economic data, as consensus looks for a high January CPI, Retail Sales and Manufacturing Output component of Industrial Production.  But, these concerns are excessive, since the Fed's new gradual approach to tightening should not be derailed by one month's data -- particularly for January, a month when start-of-year effects could dominate.  This consideration applies to the January Employment Report, as well.

Consensus looks for +0.4% m/m for both Total and Core CPI, higher than the Q422 averages (+0.3% m/m for both Total and Core).   The Total risks printing above consensus, while the Core's risks may be balanced.  A big uncertainty for Total is the extent to which the collapse of natural gas prices is captured in the CPI this month.  There is an irony in the drop of natural gas prices.  It will add to the Core CPI in coming months, since natural gas prices are subtracted from Primary Rent in calculating Owners' Equivalent Rent (OER).  So, a smaller subtraction will raise OER relative to Primary Rent.

Consensus also looks for strong January Retail Sales, with Total up 1.5% m/m and Ex Auto up 0.7%.  But, these gains would follow soft prints for November and December, suggesting that the latter two were just the typical pause after a strong month (October).  Despite the m/m volatility, Real Consumer Spending Growth has been steady, in the 2.0-2.3% (q/q, saar) range in the past 3 quarters.  So, while softer prints in February and March are likely if January is strong, the trend should be moderate.

Early evidence suggests that both Payrolls and the CPI will slow in February, as well.  Initial and Continuing Claims are above their January average in the latest week.  And Retail Gasoline Prices have flattened out in early February.  They are still above the January average, but the m/m increase so far is smaller than in January.  Longer-term inflation expectations appear to remain in check.  The 5-year inflation expectations reported in the University of Michigan Consumer Sentiment stayed at 2.9% in mid-February.  

The stock market should view the gradual approach of Fed policy positively, even if the rate hikes persist into the Spring.   A modest pace of tightening increases the odds that the economy will slow without falling into recession.  It shows that the Fed is not ignoring growth while focusing on fighting inflation.  This, in turn, means that the financial markets should not tighten so much as to precipitate a downturn in economic activity, based on the idea that the markets move in ways to achieve the Fed's targets.

Even without a slowdown, the increases in labor and commodity costs should force companies to make cost-saving adjustments.   This may be behind the recent large layoff announcements.  An interesting possibility relates to restaurants.   Higher wages and food prices have boosted meal prices at restaurants.  A broad-based shift to home cooking in response could prompt restaurants to reduce labor costs by becoming more efficient.  The alternative could be to go out of business.  In either case, the recent surge in restaurant jobs may soon come to an end.  Shifts like this are occurring already.  Consumers are reported to have shifted from buying higher-priced brand-named foods to lower-priced store-branded foods at supermarkets.  Generally, labor-/commodity-intensive industries are at a competitive disadvantage.  Market forces precipitated by the run-up in wages and commodity prices, even without slower growth, will push them in ways to cut costs and thereby hold down prices.

 

  

 

Digesting the January Employment Report

The stock market should stay in a range this week, as it digests the implications of the strong January Employment Report.  Rather than underscoring concern about impending recession, above-trend economic growth now appears to be in play -- a positive for the profits outlook.  Offsetting this positive, the Report dashed hopes for a a near-end of the Fed tightening cycle.  At this point, any conclusion about Q123 economic growth or the next Fed rate move has to be tentative.  The Fed will see another set of monthly data, for February, before the FOMC meets again.

The January Employment Report offered several indications of strong growth.  /1/ The 0.1% pt decline in the Unemployment Rate to 3.4% put it well below the 3.6% Q422 average.  A q/q decline in the Unemployment Rate is a significant sign of above-trend growth.  /2/ Total Hours Worked (THW) in January are up 4.6% (q/q, saar) from the Q422 average.  This is a strong start to the quarter, well above the 1.9% Q422 pace.  /3/ Personal Income looks like it should be strong in January, based on the jump in THW -- which could allay fears of a weakening consumer.  /4/ Manufacturing Output (in the Industrial Production Report, due February 15) should rebound about 1.0% m/m, based on THW. 

Also, the +517k Payroll jump clearly was huge.  To be sure, it probably can be explained in part by technical factors.  There appears to be an upward shift of about 25k in underlying m/m job growth from the benchmark revision.  Also, an unwinding of special factors that may have held down jobs and the Workweek in November/December -- /1/ holiday-related seasonal exaggerations and weather --  may have resulted in catch-up in January.  In addition, companies may have been overly cautious amidst talk of recession in late 2022.  In these cases, jobs should slow sharply and Workweek decline in February.  At this point, the Claims data (so far) and other evidence hint at a slowdown in February Payrolls, but the issue will be by how much.  The Fed can wait and see, since the February Employment Report (due March 10) will be released before the next FOMC Meeting (March 21-22).

The Report contained friendly data regarding wage inflation.  The 0.3% m/m increase in Average Hourly Earnings (AHE) was below the 0.4% prior trend.  About half of the 13 main sectors posted below-trend increases.  Nevertheless, with AHE revised up to 0.4% from 0.3% in December, the first-print for January has to be taken with some caution, as it too may be revised up in the next Report. 

The next key US economic report will be the January CPI (due February 14).  It can surprise to the upside, as well.  Gasoline prices are up, Used Car Prices have begun to rise at the wholesale level, and start-of-year price hikes could show up.  To be sure, natural gas prices have dropped, but it is not clear how much of the plunge will be captured in the data.  The stock market will probably trade cautiously ahead of this Report.  And, its implication for Fed policy also will be somewhat tentative, since the February CPI will be released before the next FOMC Meeting.

 

 

 

 

This Week's Key US Economic Data and FOMC Meeting: Market Positives?

The stock market is likely to enter the week with positive expectations of a downshift in Fed rate hikes at the FOMC Meeting and softer key US economic data.  But, the FOMC Meeting and key US economic data may not resolve the issue regarding the endpoint of Fed tightening, a continuation of which could temper the market rally.  Although the Fed is likely to downshift to a 25 BP rate hike at the Meeting, it should keep open the door for additional hikes ahead.  This possibility risks being underscored by above-consensus prints for the January Mfg ISM and Payrolls. 

The market will probably view Tuesday's Q422 Employment Cost Index (ECI) as an important input into the Fed deliberations, since Fed Vice Chair Brainard highlighted it in her speech.  But, its importance may be exaggerated for reasons discussed below.  Consensus expects the ECI  to slow to 1.1% from 1.2%.  A slowdown in the ECI, though, is not a slam-dunk, as the evidence is mixed.  Lower sales commissions, resulting from fewer autos and homes sold, may hold down the ECI.   But, Average Hourly Earnings (AHE) did not slow in Q422, when measured over the 3 months of the quarter (which is how the ECI is measured).  Both moved in the same direction in each of the prior 3 quarters (see table below).  And, even if the consensus estimate prints, the y/y would rise. 

AHE and ECI do not measure labor costs the same way.  ECI looks at wage and benefits for specific occupations and is not affected by compositional shifts among them, unlike AHE.  But, as I have argued, a compositional shift toward lower-paid workers, -- either by substituting new, younger workers for retiring older workers or by reducing overtime through hiring additional workers  -- can play a role in reducing price inflation.  So, the ECI may not tell the whole story regarding labor costs and price inflation.  It's unlikely that an above-consensus print for the Q2ECI will prevent the Fed from downshifting.

Although not typically getting much market attention, the Productivity/Unit Labor Cost Report for Q422 is expected to have good news regarding the inflation outlook.  Nonfarm Productivity is seen rising an above-trend 2.4% (q/q, saar) and Unit Labor Costs (ULC) rising 1.5%.  ULC incorporates the broadest measure of labor costs, Compensation/Hour.  The consensus estimates imply 3.9% for it.  This would be a speedup from 3.2% in Q222, but would put the Q4/Q4 increase at 2.9%, versus 5.2% in 2021.

Consensus could be underestimating other data due this week, as well.  Consensus looks for another dip in the January Mfg ISM.  But, a number of other manufacturing surveys suggest an uptick.  Consensus expects a slowdown in January Payrolls to +185k m/m from +223k in December.  But, the Claims and other evidence suggest a speedup.   For one, seasonal factors could overly boost jobs in Retail, Couriers and Temporary Help, to the extent the seasonals overly depressed them in November or December.  In this case, the market could discount a strong Payroll print as being one-off. 

Other parts of the January Employment Report could move in a Fed-friendly way.  Consensus sees the January Unemployment Rate moving back to 3.6% after it unexpectedly dipped to 3.5% in December.  The Claims data suggest upside risk to consensus.  Consensus also sees a modest 0.3% m/m increase in Average Hourly Earnings, an increase that would be consistent with 2% (annualized) price inflation after taking account of trend productivity growth.   Away from the Employment Report, consensus sees a 300k decline in December Job Openings to 10.2 Mn.   This would be in the "right" direction, but still well above the pre-pandemic 7.0 Mn level.  So, it would not close the door on more rate hikes ahead.

                                                         Table

                   Average Hourly Earnings and Employment Cost Index

 (Qtr-End to Qtr-End 3-Month Percent Change)            y/y percent change

                               AHE                       ECI                  AHE         ECI          

Q122                      1.2                          1.4                     5.6           4.5

Q2                          1.1                          1.3                     5.2           5.1     

Q3                          1.0                          1.2                     5.1           5.0    

Q4                          1.0                          1.1 (e)               4.6            5.2 (e)

Fed Downshifting Versus Risk of Recession

The stock market will likely continue to contend with the risk of recession, but the possibility of a further downshifting in Fed rate hikes to 25 BPs from 50 BPs may very well win out. 

Fed Vice Chair Brainard's speech last week spells out how inflation can be beaten without necessarily a recession.   It also reiterated that interest rates would remain at restrictive levels for an extended time, although did not mention how much further or how fast they will climb from here.  But, her analysis, described below, suggests that not much more tightening will be needed.  So, the door remains open for another downshift in Fed rate hikes at the January 31-February 1 FOMC Meeting, particularly since other Fed officials appear to be favoring a 25 BP hike. 

Brainard expects the US economy to slow further this year, as the lagged impact of last year's tighter monetary policy takes hold.  The labor market already is beginning to cool, as she cites the declines in the Nonfarm Workweek, Temporary Help Services and Payroll Growth.  Also, the labor force has been constrained by the extraordinary increase in retirements and the impact of long-COVID symptoms.  And, immigration has been low.  

She also saw reasons for a slowdown in inflation without a recession.  Softening import prices,  easing supply constraints, inventory rebuilding and weaker demand has lowered Core Goods Inflation.  Slowdowns in wage rates and other factors could continue to help slow Non-Housing Services Inflation.  And, Housing Services Prices should begin to reflect the declines in new leases by the summer.  Finally, longer-run inflation expectations appear to be well-anchored.  

Last week's US economic data did not resolve the question of recession or slowdown in 2023.  Weakness in December Retail Sales and Industrial Production keep open the possibility of recession.  But, other data were not as weak.  The January Phil Fed Mfg Survey's components suggest a stabilization in the manufacturing sector, although the overall Index remained negative.  December Housing Starts fell, but the decline was in the volatile Multi-Family Units.  1-Family Starts rose.  And, the Claims data remained low, not rebounding from the low prints in the prior two holiday weeks.  These data suggest a speedup in January Payrolls.

Next week's US economic data also may not resolve the recession/slowdown debate.  Consensus looks for another decline in the Leading Indicators, raising the possibility of a recession in early 2023 according to the Conference Board.  But, December Durable Goods Orders are seen rebounding and Consumer Spending slipping only 0.1% m/m -- less of a decline than seen in Retail Sales.  Consensus expects the first-print of Q422 Real GDP to be up 2.6%.  This is below the Atlanta Fed model's 3.5% estimate.  While both are above trend, an in-line print could be viewed as "history" by the markets.  The December Core PCE Deflator is seen at +0.3% m/m, the same as the Core CPI.

Are US Data Pointing to a Downshift in Fed Rate Hikes?

The stock market should continue to move up ahead of the January 31-February 1 FOMC Meeting, as the latest (as well as expectations of upcoming) data keep open the door for a further downshifting in Fed rate hikes to 25 BPs from 50 BPs. 

The December CPI had a number of favorable elements from the Fed's perspective, even though the 0.3% m/m Core was above the Fed's inflation target.   A decline in motor vehicle prices and car rental prices provided more evidence that easing supply constraints will unwind earlier shortage-induced price hikes.  Most other prices posted subdued increases.  Food prices, both in the grocery store and restaurants,  slowed -- a positive factor for lowering inflation expectations and suggestive of a moderation in labor costs.  And, while Housing Rent remained high, it should catch up to the declines seen in recent surveys as the year progresses.  The Core CPI Less Housing, which Fed Chair Powell likes to cite, fell 0.1% m/m for the 3rd consecutive month.  Note, however, that some of the weakness in this measure reflects the pass-through of lower fuel costs to airline fares and a technical issue with how health insurance costs are measured -- not, as Powell suggests, because of slower wage increases.

Besides the favorable elements of the December CPI, inflation expectations appear to be contained, according to the University of Michigan Consumer Sentiment Survey.  The Fed's favorite measure, 5-Year Inflation Expectations, was  3.0% in mid-January, remaining within its recent range.

The increase in the overall Michigan Sentiment Index should help allay fears of recession, as it suggests the consumer is in decent shape.  Similarly, the Unemployment Claims data suggest some improvement in labor market conditions, although these data have to be viewed with caution because of holidays in the reported weeks.  If seasonal factors did not adequately offset holiday-related declines in Claims (both Initial and Continuing), they could overly boost them in next week's report.  As they stand, the Claims data raise the risk of a speedup in December Payrolls.

In contrast to the Claims data, data due this week are expected to show a soft ending in 2022.  December Retail Sales are seen falling, both Total and Ex Auto.  Price declines likely play a role in these estimates.  An unwinding of some of October's strength could play a role, as well, since a pause after a strong month could last for a couple of months.  December Industrial Production is expected to fall.  A decline in Manufacturing Output would be consistent with Total Hour Worked in the sector.  December Housing data also are expected to weaken in this week's reports.  All these weaker reports would be consistent with the Fed's desire for an economic slowdown, but they could help persuade the Fed to downshift.