Stock Market Stabilization This Week?

The stock market has a chance to stabilize this week, although this will likely require highly favorable prints for key US economic data.  With the Fed likely keeping rates steady and repeating its "wait and see" stance at this week's FOMC Meeting, the markets have become the vigilantes to make sure the Fed's goal of 2% inflation is achieved.  The strong September data underscored that the path to 2% inflation will not be a straight line and that more restraint from the markets may be needed.  Evidence of an easier labor market and benign wage inflation in this week's US economic data, thus, could provide some relief.  

Curiously, the election of a conservative Congressman as House Speaker could turn out to be a market positive.  While a government shutdown in mid November is a risk, the budget outcome could be a market positive if the Republicans succeed in blocking the Democrats' social spending proposals.  The long end of the Treasury curve could rally somewhat if fiscal restraint is seen.  This rally, in turn, would help stocks.

The Israel-Hamas war also seems to be moving to the background for the markets.  While the anti-Israel rhetoric has been loud, the war so far does not appear to be spreading significantly.

Consensus estimates of this week's key US economic data are market friendly, but may not be friendly enough.  Payrolls are seen slowing to a sub-200k gain, the Unemployment Rate steady at 3.8%, and Average Hourly Earnings rising  a moderate 0.3% m/m (although higher than the 0.2% September increase).   To be sure, the consensus Payrolls estimate excluding strikers (30k) is +218k.   Private Payrolls are seen at +145k and +175k ex strikers.  It's not clear whether this will be enough to placate the markets if Total Ex Strikers exceeds 200k.  The Claims data support the idea of a slowdown in Payrolls without the strikers and hint at an increase in the Unemployment Rate.  

The other Report that sheds light on the labor market will be the August JOLTS data.   Consensus sees Job Openings falling to 9.2 Mn from 9.61 Mn in July.  They would remain well above the 7.5 Mn pre-pandemic trend.  However, the market may be overstating its significance as a measure of excess labor demand.  Conceivably, companies may be keeping posted job openings but becoming cautious about filling them, concerned about an impending economic slowdown.  In this case, the level of Job Openings overstates labor demand.

This week's data will include all three major measures of labor costs -- October Average Hourly Earnings (AHE), Q322 Employment Cost Index (ECI), and Q322 Compensation/Hour.   All three may need to print low to appease the markets.  There is no evidence for AHE.  But, the evidence for the ECI suggests the consensus estimate of 1.0% q/q (the same pace as in Q223) is too high.  Average Hourly Earnings slowed to 0.8% in Q323 from 1.2% in Q223.  Consensus looks for Compensation/Hour to slow to 4.8% (q/q, saar) from 5.7% in Q223.  Partial evidence suggests the consensus estimate is too high, as well.  Even if not, a surge in Productivity is seen to continue to dampen the inflationary impact.  Unit Labor Costs are expected to slow to 0.8% from 2.2% in Q223.

 

Problems For Stocks, Despite Positive Fed

The stock market may continue to be weighed down by the Israel-Hamas war and the failure to elect a House Speaker.  These problems could persist for awhile.  Ironically, Fedspeak was market-positive last week, with many officials supporting a further pause in rate hikes.  

A ratcheting up of the Israel-Hamas war looks imminent, according to news reports.  This will probably result in contentious news headlines.  They, regardless of fact, could make the market nervous, as did last week's hospital explosion.  Moreover, the Israeli goal of toppling Hamas will likely take time to accomplish.  So, the risks of escalation could remain an issue for the market.  Alternatively, any movement toward a cease-fire would be a market positive.

The failure of the House to elect a Speaker also is a problem for the stock market.  The market does not like a dysfunctional government in Washington.  The market still may not like it if a Republican hardliner is eventually elected.  He could force a government shutdown in mid-November by insisting on spending cuts to pass a budget.  Instead, election of a moderate Republican could provide relief for the market.

In contrast to these developments, last week's speeches by Fed officials had a positive message for the stock market -- the Fed is willing to wait to see if inflation falls further before deciding whether additional rate hikes are necessary.  Powell's message was the most interesting.  He essentially said the Fed would tolerate strong economic growth if inflation continues to fall, although he acknowledged that history suggests below-trend growth and a looser labor market are needed for the latter.  He is counting on an "unwinding of pandemic-related distortions to supply and demand" and the tighter monetary policy to date to bring inflation down.

This week's release of the September PCE Deflator acquires even more importance after this speech.  Consensus expects +0.3% m/m for both Total and Core.  These estimates look reasonable.  They should result in a decline in the y/y inflation rates, although revisions to past months could affect the y/y, as well.  Powell mentioned that the y/y is expected to be 3.5% for Total, the same as in August (this assumes 0.4% m/m for September Total), and to fall to 3.7% from 3.9% for Core (this assumes 0.3% for September Core).  Looking ahead, Total needs to rise by less than 0.3% m/m and Core by less than 0.5% m/m on average over Q423 to fall further.  Early evidence suggests this may be the case in October.

An expectation of slower inflation could mitigate the market impact of the strong print expected for Q323 Real GDP Growth.   Consensus looks for +4.1% (q/q, saar), while the Atlanta Fed model projects 5.4%.  A high print could be viewed as "history," also mitigating its market impact.

Indeed, early evidence suggests the October Employment Report will show a slowdown in Nonfarm Payrolls (even excluding strikers, who should subtract from Payrolls this month) and possibly an uptick in the Unemployment Rate (unaffected directly by strikers).  The latest Unemployment Claims data suggest hiring has slowed more than layoffs.  Lower inflation and a looser labor market should reinforce expectations of steady Fed policy through year end.

 

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

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

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

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

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

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

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

A Relief Rally in Stocks, Despite Hurdles?

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

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

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

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

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

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

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

 

Stock Market Looking Better?

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

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

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

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

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

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

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

Q122            3.5                  63.4                +2.7                              5.4           6.4               57.8  

Q222            1.8                  60.9                +5.3                              5.3           6.0               53.9

Q322            1.9                  31.9                +9.0                              5.1           6.3               49.3

Q422            0.9                    6.7                +8.9                              4.9           6.0               47.1    

 

Q123            1.9                -19.5                 +3.0                              4.5           5.5               47.9 

Q223            2.4                -32.0                 +0.5                              4.4           5.2               44.7

Q323            2.9                -12.0                 -2.5                               4.3           4.4               43.2

                                                                           

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

 

Bideneconomics, The Fed and Markets

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

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

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

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

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

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

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

 

A Poor Reaction to This Week's FOMC Meeting?

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

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

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

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

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

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

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