Could stagflation spark a correction?
The economy is slowing amid a host of headwinds.
The U.S. economy has slowed noticeably over the past two months, marked by sharply lower levels of business and consumer confidence and declines in the Federal Reserve’s regional indexes across the board. At the same time, sustainable inflation readings have spiked, even though the negative inflation readings from the Fed’s pandemic-related “procedural base effects” completed their roll-off in May. As a result, many investors are brushing up on their 1970s lexicon, as concerns about stagflation—the ugly combination of slowing growth and rising inflation—have many comparing the Biden and Carter administrations.
Peak earnings? The recently completed second-quarter earnings season likely represented the cyclical peak of this recovery, with much stronger-than-expected earnings per share (EPS) up by nearly 90% year-over-year (y/y) and with 85% of the S&P 500 companies beating estimates by almost 16%. This is the fifth consecutive quarter of powerful earnings surprises, likely due to a surge in corporate productivity in conjunction with resurgent global demand. We are not expecting a recession before 2024, but we do expect the pace of corporate earnings and GDP growth to slow from these peak levels in coming quarters.
Last month, Federated Hermes raised its EPS estimates for the S&P from $195 to $210 in 2021 (versus $137 in 2020), from $220 to $230 in 2022, and from $235 to $250 in 2023. Given our continued outlook for relatively benign interest rates, we raised our S&P target price for year-end 2022 from 5,000 to 5,300. As we discount back to present value, we also raised our 2021 year-end target price from 4,500 to 4,800.
Delta blues The delta variant of Covid-19 has sparked a fourth wave of infections, hospitalizations and mortalities over the summer, which has contributed to the economic slowdown, as vaccination rates have plunged 85% from their April peak at 3.5 daily million jabs. While delta may have already peaked and rolled over in half the country, it may be premature to definitively make that call. Moreover, we’re watching closely to see if the lambda and mu variants gather steam.
Sustainable inflation The core wholesale producer price index (PPI) hit a new record high this morning, rising by 6.3% y/y in August. The core retail consumer price index (CPI) rose to a 30-year high of 4.5% y/y in June, although it did ease to 4.3% in July. Finally, the core personal consumption expenditure (PCE) index, the Fed’s preferred measure of inflation, hit a 30-year high at 3.6% y/y in July, well above the Fed’s 2% target.
Fed shifting gears As a result, many investors are becoming increasingly more concerned about a potential monetary policy error. We believe the Fed will announce plans for tapering its $120 billion monthly bond-buying program at their Nov. 3 Federal Open Market Committee meeting, especially if they see a possible rebound in the September jobs report on Oct. 8. They could complete their taper by June 2022, which could set the table for an eventual lift-off in interest rates as early as December 2022.
Also, a possible leadership transition at the Fed looms, as Jerome Powell’s term as Fed chair expires in January, along with Vice Chair Richard Clarida and Vice Chair for Supervision Randy Quarles. Along with an open seat, this provides Biden the opportunity to remake the Fed with four nominations. Financial markets hate uncertainty, particularly at such a critical inflection point in the Fed’s policy journey, with important tapering and rate decisions coming soon.
Big doings in Congress On the fiscal policy side, Congress must soon address the expired debt ceiling and two spending bills that total an estimated $6.7 trillion in additional spending, paid for with higher debt and higher corporate and individual tax rates. We generally like Biden’s bipartisan 10-year, $1.2 trillion hard infrastructure bill (roads, bridges, upgrading the electric grid, wider broadband rollout, etc.), which is already paid for with unspent CARES Act funds and which should be a tailwind for the economy and the financial markets.
But we are not fans of his $5.5 trillion human infrastructure bill. The recession ended in April 2020 and the GDP output gap was fully closed in the second quarter of 2021. We don’t need to burden the economy with massively higher levels of federal debt and increased tax rates, which we fear will serve as an albatross around the neck of the U.S. economy.
Correction brewing? Yet, despite this growing mosaic of near-term concerns, the S&P has risen by 107% since its March 2020 pandemic trough, and by 20% thus far this year, to a new record last week at 4,546. Consequently, the odds are rising for a 5-10% air pocket over the next few months, which could take stocks back to their 200-day moving average, currently at 4082. We view such a potential correction as healthy, removing some of the froth from the market. Several of these aforementioned concerns will be at least partially resolved later this year, which could set the stage for a strong year-end rally up to our full-year target of 4,800.
Reducing our GDP estimates
- The Commerce Department revised second-quarter 2021 GDP up a tick to 6.6%.
- We’re still expecting a strong back-to-school season, but the delta variant and rising inflation have contributed to a noticeable slowing of economic activity in recent months. So we reduced our third-quarter 2021 GDP growth estimate from 7.8% to 5.2%. The Blue Chip lowered its forecast from 7.2% to 7.1% (within a range of 5.1% to 9.2%). The Atlanta Fed reduced its GDPNow forecast from 6.3% to 3.7%.
- We’re also still expecting a solid Christmas, but we are concerned about ongoing supply-chain shortages and the West Coast port backlogs from Asia. So, we cut our fourth-quarter 2021 estimate from 6.2% to 5.6%. The Blue Chip raised its from 5.5% to 5.6% (within a range of 3.5% to 7.6%).
- Those collective changes lowered our full-year 2021 estimate from 6.7% to 5.7%. The Blue Chip reduced its from 6.6% to 6.2% (within a range of 5.8% to 6.7%).
- We lowered our forecast for core CPI inflation from 5% to 4.8% for 2021. This metric is currently at 4.3% in July, just off a 30-year high of 4.5% in June. We also lowered our forecast for core PCE inflation from 4.5% to 4.3% in 2021 (it hit a 30-year high of 3.6% in July).
- We remain concerned about the prospect for fiscal drag from sharply higher tax rates and federal debt, if Biden’s proposed $5.5 trillion “human infrastructure” bill passes in a party-line reconciliation vote later this year. But we kept our full-year 2022 growth estimate unchanged at 4.2%. The Blue Chip, however, lowered its forecast from 4.5% to 4.4% (within a range of 3.4% to 5.5%).
- We increased our forecast for core CPI inflation from 3.3% to 3.4% for 2022, and we raised our forecast for core PCE inflation from 2.9% to 3.1%.