Economy slows noticeably, while inflation remains elevated.
The S&P 500 has rallied by more than 6% over the past three weeks to a new record intraday high this morning, propelled by a good start to the nascent third quarter corporate reporting season. This rally erases the 6% correction stocks suffered from Sept. 2 through Oct. 4. But benchmark 10-year Treasury yields have spiked from 1.30% to 1.70% over the past month as inflation has risen sustainably and as the Federal Reserve is on the cusp of beginning to withdraw its accommodation.
It’s now clear, however, that the second quarter represented peak growth, with the pace of both corporate earnings and GDP growth slowing noticeably in the third quarter. At the same time, shelter, food and energy prices and wages have risen sustainably, contributing to growing stagflation concerns. In addition, the labor market, the manufacturing sector and the regional Fed indices and confidence metrics we monitor have all softened in recent months. So, we may not be completely out of the woods just yet, as increased equity market volatility could result in another 5-8% air pocket in stocks in coming weeks.
Peak delta Although the Covid-19 delta variant crested around Labor Day and has since rolled over in most of the country, it is unclear if other variants will emerge in coming months. Delta sparked a fourth wave of infections, hospitalizations and mortalities during July and August, certainly contributed to the economic slowdown. While vaccination rates have plunged from their April peak of 3.5 daily million jabs to about 500,000 now, we are approaching adult herd immunity and children aged 5-12 will begin to be vaccinated in coming weeks. Collectively, these should help to mitigate the risk of a dreaded fifth wave of infections in November and December.
Peak labor Nonfarm payrolls grew at an anemic pace in August and September, despite delta variant fears fading, schools and childcare facilities re-opening, and government unemployment benefits ending. The unemployment rate has plunged to a post-pandemic cycle low of 4.8% in September, and the JOLTS report posted a record 11 million open jobs in August. In addition, initial weekly jobless claims have fallen to a cycle low of 290,000 yesterday (down 95% from their April 2020 peak), so we expect more labor-market improvement in coming months.
Peak consumer Retail sales were much stronger than expected across the board in June, August and September, sparking a powerful Back-to-School (BTS) retail sales gain of 15.9% year-over-year (y/y). We’re expecting a solid Christmas from a year ago (perhaps up 10% or so), but that will represent a slower sequential gain from BTS. The personal savings rate is normalizing, slowing to 9.4% in August versus an elevated 26.6% in March, although consumers still have plenty of dry powder in their bank accounts. But the ongoing supply-chain problems across the country are exacerbated by the West Coast port logjam, which will keep many retailers from properly stocking their shelves ahead of the critically important holiday shopping season.
Peak earnings We’re roughly a quarter of the way through the third-quarter corporate reporting season, and we now know that second-quarter earnings marked the cyclical apex of this economic recovery from the pandemic recession. We expected third-quarter profits to rise by 25-30% y/y, and they’ve risen by more than 45% so far (versus an 88% y/y gain in the second quarter), with 83% of the S&P 500 companies beating estimates by almost 14%. This is the sixth consecutive quarter of powerful earnings surprises, with cyclical companies (energy, materials, financials, industrials and consumer discretionary) posting the largest outsized gains due to their pricing power in a rising inflationary environment.
Peak inflation The core wholesale Producer Price Index (PPI) hit a new record high in August, rising 6.3% y/y, although September’s increase did slow to 5.9%. Nominal retail inflation soared to a 13-year high in September at 5.4% y/y. But the core Consumer Price Index (CPI), which rose to a 30-year high of 4.5% y/y in June, eased to 4.3% in July and to 4% in August and September. 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 June, July and August, well above the its 2% target.
With sustainable inflation rising at a pace well above what the Fed had expected, it may announce plans for tapering its $120 billion monthly bond purchases as early as the Nov. 3 Federal Open Market Committee meeting. The taper program could conclude in June 2022, which could set the table for an liftoff in interest rates as early as December 2022.
The Fed’s leadership transition issue also looms. Jerome Powell’s term as Fed chair expires next January, along with that of Vice Chair Richard Clarida. Randy Quarles’ term as Vice Chair for Supervision expired last week and an open seat remains. This presents President Biden with 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.
Peak fiscal policy Congress has a temporary respite into early December on the expired debt ceiling and the continuing resolution to fund the government. But two bills that could total more than $4.7 trillion in additional spending (paid for with higher debt and corporate and individual tax rates) are winding their way through Congress, though with stiff resistance.
Reducing our GDP estimates again The equity, fixed-income and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to dissect the slowing economy:
- The Commerce Department revised second-quarter 2021 GDP up a tick to a final gain of 6.7%.
- Back-to-School (BTS) spending rose by a strong 15.9% y/y, but the surging delta variant in July and August and sustainably rising inflation contributed to a significant slowing of economic activity. So, we lowered our third-quarter 2021 GDP growth estimate from 5.2% to 3.2%. The Blue Chip halved its forecast from 7.1% to 3.6% (within a range of 2.2% to 5.2%). The Bloomberg consensus is now at 3% and the Atlanta Fed reduced its GDPNow forecast from 3.7% to 0.5%. The Commerce Department will flash third-quarter GDP on Oct. 28.
- We’re also still expecting a relatively solid Christmas y/y, but holiday spending will probably not be as sequentially robust as BTS spending. We are concerned about ongoing supply-chain shortages and the West Coast port backlogs, which could prevent retailers from fully stocking their shelves. So, we cut our fourth-quarter 2021 estimate from 5.6% to 4.5%. The Blue Chip trimmed its estimate from 5.6% to 5.3% (within a range of 3.5% to 7.1%).
- Those collective changes slimmed our full-year 2021 growth estimate from 5.7% to 5.6%. The Blue Chip forecast was reduced from 6.2% to 5.7% (within a range of 5.4% to 6%).
- We lowered our full-year forecast for core CPI inflation from 4.8% to 4.7% for 2021 (consensus forecast is 4.4%). This metric sat at 4% in August and September, just off a 30-year high of 4.5% in June. We also lowered our full-year forecast for core PCE inflation from 4.3% to 4.2% in 2021 (consensus is 3.2%). It reached a 30-year high of 3.6% in June, July and August.
- We remain deeply concerned about the prospect for Washington-related policy drag in 2022. We expect the Fed to complete its bond-buying taper by June 2022, with at least one quarter-point rate hike before year end. If Biden’s proposed $5.5 trillion “human infrastructure” bill passes in a party-line reconciliation vote later this year, the “pay-fors” will likely include sharply higher tax rates on corporations and individuals and higher federal debt. So we reduced our full-year 2022 GDP growth estimate from 4.2% to 4%. Blue Chip lowered its forecast from 4.4% to 4.1% (within a range of 3.4% to 5.5%).
- We increased our full-year forecast for core CPI inflation from 3.4% to 3.7% for 2022, compared with the consensus estimate of 3.3%. We also raised our full-year forecast for core PCE inflation from 3.1% to 3.2%, versus the consensus forecast of 2.8%.