The long and winding road
Employment, inflation and bonds combine for twists and turns for the journey of Fed policy.
The Federal Reserve’s tightening campaign over the past 18 months to slay inflation is clearly winding down. But the robust September labor report and steady wholesale (PPI) and retail (CPI) inflation readings for September—both unexpectedly strong—present a choice of avenues ahead of it.
In one of their last FOMC meetings of the year, will policymakers sneak in a quarter-point insurance hike, before pausing into the second half of 2024? Or will they let the bond market do its work for them, declare victory over inflation and skip another hike? Certainly the lifting has been heavy, as benchmark 10-year Treasury yields have risen from an overbought 3.25% in April 2023 to an oversold 4.90% Oct. 6.
But yields have consolidated to 4.60% this week, in a flight-to-safety rally in the wake of the tragic terrorist invasion of Israel. The reintroduction of geopolitical risk in the lexicon of investors has roiled markets across the board—stocks, bonds, currencies and commodities.
Labor market still hot Nonfarm payrolls surged by a stronger-than-expected 336,000 jobs in September, the largest monthly gain since January. In addition, previously reported July and August gains combined were revised higher by 119,000 jobs, which means that payroll employment soared by a sizzling 455,000 jobs last month. That’s consistent with the ongoing strength in initial weekly jobless claims, whose September survey week was at an eight-month low, and the lagging JOLTS report, which surprisingly leapt in August to more than 9.6 million job openings.
Persistent inflation Nominal CPI inflation peaked at 9.1% y/y in June 2022 and fell sharply to 3.2% in July 2023. But it’s leapt back to 3.7% in each of August and September, perhaps due to resurgent energy prices. Core PCE (the Fed’s preferred measure of inflation that strips out energy and food prices) peaked at 5.4% in February 2022 and has slowly declined to 3.9% in August 2023. The Fed’s target remains at 2%, a level the central bank hopes to achieve by year-end 2026.
Rising energy prices Energy has been exceptionally volatile as of late, with crude oil (WTI) surging by nearly 50% over the past six months to a recent peak of $95 per barrel, and lagging gas prices up 25% this year to $3.90 per gallon. Increased geopolitical risk likely complicates the price action, with involvement from important oil producers such as Iran, Russia and Saudi Arabia.
Fed watching wage inflation The growth in average hourly earnings has slowed from a 2-year high of 5.9% y/y in March 2022—as employers were trying to entice their employees to return to work post-Covid—to a 4.2% increase in September 2023. But the Fed is watching the ongoing United Auto Workers strike and other labor activity for clues on the direction of wage inflation. Manufacturing activity perked up in late summer, but that could have been a temporary inventory build among auto-related companies bracing for a long strike. Employers could pass the higher labor costs onto end customers in the form of higher prices, which is inflationary. Or they could absorb them to reduce profit margins and corporate earnings, which likely would slow economic growth and lower stock prices.
Consumer spending slows Although spending on services remains relatively firm, Back-to-School spending on goods from June through August has risen only 2.1% y/y, compared with a robust 9.8% y/y gain in 2022. Easter and Passover “Marpril” spending for March and April rose a tepid 1.7% y/y for 2023, versus 8.6% for 2022. The important Christmas shopping season from October through January also might be weak, given their 73% positive correlation over the past 30 years.
Policy crossroads Over the past year, the Fed has shrunk its balance sheet from $9 trillion to $8 trillion, while hiking the fed funds rate from near zero to 5.5%. That restrictive policy was appropriate, given elevated food, energy and shelter prices, as well as rising wages. We expect another quarter-point rate hike by the FOMC on November 1 or December 13, and we do not expect policymakers to cut interest rates before the second half of 2024. But with the significant rise in 10-year Treasury yields over the past six months, they may decide to press the pause button earlier than we are expecting.
Third quarter earnings season starting According to FactSet, revenues are expected to increase by 1.6% y/y, versus a 0.5% y/y increase in the second quarter of 2023 and a more robust 11.1% y/y increase in the third quarter of 2022. Earnings per share are expected to decline -0.3% y/y. That would be the fourth consecutive—but the smallest—quarter of declining earnings. That compares with a -4.2% y/y earning pe share decline in the second quarter of 2023 and a 3.3% y/y increase in the third quarter of 2022. Without buybacks, earnings in the second quarter of 2023 declined about -6%. Given normal “beat” percentages, this year’s third quarter could post marginally positive results, but it also could mark the seventh consecutive quarterly decline in profit margins.
Pulling in our horns on stocks While we’re still expecting a soft landing, the runway increasingly looks rocky, strewn with rising Treasury yields, key yield-curve inversions and growing geopolitical risks. Consequently, we’ve opted to conservatively reduce our year-end target by a full P/E multiple point, reducing our target price for this year to 4,600, and pushing our 5,000 target out to year-end 2024.
We were expecting a healthy 8-12% correction in the S&P 500 during the historically choppy August-October period, and that’s largely happened, with stocks touching 4,220 last week. This year’s rally should broaden out, with domestic value, small caps and international stocks playing catch-up, while the growth and technology stocks trim some of their recent froth.
Raising our GDP estimates The equity, fixed-income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met yesterday to discuss the economic outlook, growing geopolitical risk and the Fed’s likely policy response:
- The Commerce Dept. will flash third quarter 2023 GDP on October 26. While the consumer is softening, the labor market remains strong, with initial weekly jobless claims at an eight-month low, and manufacturing has been solid. In light of the data, we increased our estimate from 2.3% to 2.7%. That compares with GDP growth rate of 2.1% in this year’s second quarter, 2.2% in the first quarter, and 2.6% and 2.7% in last year’s fourth and third quarters, respectively. The Blue-Chip consensus increased its estimate from 2.4% to 3.5% (within a range of 2.4% to 4.5%). The Atlanta Fed reduced its GDPNow estimate from 5.6% to 5.1%, and the Bloomberg consensus estimate is at 4.0%.
- Spending on services remains strong (think “revenge travel”), offsetting slower Christmas spending on goods. We raised our fourth quarter 2023 GDP growth estimate from 1.0% to 1.3%. The Blue-Chip consensus inched up its estimate from 0.6% to 0.7% (within a range of -0.7% to 1.7%).
- We left our full-year 2023 growth projection unchanged at 2.1%. The Blue-Chip consensus ticked its up from 2.1% to 2.2% (within a range of 2.0% to 2.4%).
- We lowered our year-end 2023 forecast for core CPI inflation from 3.9% to 3.8%, while the Blue Chip raised its estimate from 3.7% to 4.1% (within a range of 3.8% to 4.2%). That compares with actual inflation of 4.1% in September 2023, down from a 40-year high of 6.6% in September 2022. We also reduced our year-end 2023 forecast for core PCE inflation from 3.6% to 3.5%, while the Blue Chip raised its estimate from 3.5% to 3.8% (within a range of 3.5% to 3.9%). That compares with actual inflation of 3.9% in August 2023, down from a 39-year high of 5.4% in February 2022.
- We raised our estimate for first quarter 2024 GDP growth from 0.8% to 1.0%. The Blue-Chip consensus doubled its estimate from 0.1% to 0.2% (within a range of -1.4% to 1.4%).
- We ticked up our forecast for second quarter 2024 growth from 0.8% to 0.9%. The Blue-Chip consensus left its estimate unchanged at 0.5% (within a range of -1.1% to 1.7%).
- We increased our estimate for third quarter 2024 growth from 1.1% to 1.2%. The Blue-Chip consensus reduced its estimate from 1.3% to 1.2% (within a range of -0.2% to 2.3%).
- We raised our estimate for fourth quarter 2024 GDP from 1.3% to 1.5%. The Blue-Chip consensus lowered its estimate down from 1.8% to 1.6% (within a range of 0.7% to 2.6%).
- As a result, we increased our full-year 2024 GDP estimate from 1.1% to 1.3%. The Blue-Chip consensus also raised its estimate from 1.0% to 1.1% (within a range of 0.4% to 1.7%).
- We left unchanged our year-end 2024 forecast for core CPI inflation at 3.0%, while the Blue Chip lowered its estimate from 3.2% to 2.7% (within a range of 2.2% to 3.2%). We also left unchanged our estimate for core PCE inflation at 2.7%, while the Blue Chip lowered its estimate from 3.0% to 2.4% (within a range of 2.0% to 2.9%).