The equity market continued on a roll this week with both the DJIA and the S&P 500 closing at new historic highs on Friday (October 11th). For the week, all four major indexes were up around the +1% level.
The so-called “Magnificent 7” had mixed results for the week with Nvidia the only real winner. Of the remaining six, Microsoft, Apple and Amazon were marginally higher, Meta and Google marginally lower, with Tesla the biggest loser (-12.9%).
The equity market seems to be momentum driven, as earnings forecasts have not risen, moving the market’s price/earnings ratios ever higher, now standing at nearly 28X; the historical normal is 16X-18X.
Bonds, on the other hand, have seen rising yields in October, as market participants have priced out the “Recession” scenario. The 10-year Treasury yield has risen from its 3.62% low on September 16th to 4.09% on Friday (October 11th). Historically, the rise in bond yields is, contrary to popular belief, not unusual after the Fed’s first rate cut, as markets believe that the Fed has acted in time to prevent Recession. Nevertheless, history also shows that a few months later, rates are significantly lower as the Fed moves the Fed Funds Rate to or through “neutral” (2.8% currently).
Employment and the Labor Market
Financial markets were shocked by the September Non-Farm Payroll (NFP) report (issued on October 4th). That report indicated that America’s economy created +245K jobs in September, making a mockery of the consensus estimate of +150K. In addition, job growth for the prior two months (July & August) was marked up by +72K. Almost universally, the report was hailed as “super strong,” and the odds of an economic slowdown were reduced to near zero, all based on this single report. Even subtracting out the Birth/Death model automatic add-in of 105K, the number actually counted, at 149K, was spot on to the 150K consensus view.
The Birth-Death model is an uncounted “add-in” to the job numbers; it is a trendline estimate of jobs created by small businesses which are not surveyed by the Bureau of Labor Statistics (BLS). This biases the data, especially at economic turning points. To this point, we note the reduction of more than -800K jobs in a recent BLS revision to the job numbers for the year ending in March.
ADP, which produces its own job estimates each month and releases them just prior to the “official” BLS release, reported a +143K number, not much different than the +149K number cited above (ex-Birth/Death). The issue with ADP’s number is that its raw (not seasonally adjusted) number was -260K (the negative sign is not a typo). According to Rosenberg Research, the seasonal adjustment for ADP’s September payroll calculation was the most generous for any September back to 1939. As a result, it is our view that those payroll numbers will be revised down, and while the consensus is that the payroll numbers show a “strong” economy, we have reservations, as other closely watched indicators are not corroborating that story.
- The ISM Manufacturing Index, at 47.2 contracted in September for the sixth month in a row (50 is the demarcation line between expansion and contraction). This index has shown contraction in 22 of the past 23 months. From that, we conclude that manufacturing has been in a Recession for nearly two years.
- Challenger, Gray and Christmas, the outplacement employment firm, says that layoff announcements are up +53.5% over the past year. Outside of the Pandemic, such announcements are the highest since 2011. At the same time, the firm says that hiring announcement are down nearly -32% from a year ago with autos, construction, leisure/entertainment, industrial goods, tech, and retail announcing the sharpest pullbacks.
- The Conference Board’s September survey indicated that the “jobs are plentiful” question has been negative (under 50) for seven months in a row, while the “jobs hard to get” response was the highest since February 2021.
- In the latest (September) JOLTS (Job Openings and Labor Turnover Survey), hiring fell -9.7%, job openings were down -14.1%, and voluntary quits (dark line, left axis) always a marker of the strength of the labor market, were down -14.2% (and by more than -50% since their 2022 peak).
- The chart also shows that on a year/year basis, the growth in compensation has been falling and has now approached 4%. Given the growth in productivity, compensation growth does not appear to be inflationary.
- The workweek shrank from 34.3 hours to 34.2, overtime hours were cut -3.3%, and those out of work for more than 27 weeks rose to 23.7% in September from 21.3% in August indicating that jobs are becoming harder to find.
- While Non-Farm Payrolls grew by +254K, the government sector (non-cyclical) grew a whopping +785K. According to Rosenberg Research, except for June 2020 (post-Pandemic), this is a record growth for government back to 1948. No doubt, hiring teachers for back-to-school played a significant role, but that should be taken into account in the seasonal adjustment process. So, given the +254K official Establishment Survey number (the Household Survey was +430K), private sector jobs decreased significantly; by -531K via the Establishment Survey and by -355K in the Household Survey.
- On a year/year basis, jobs in the private sector are down -463K. That a loss rate of -0.4% over the past year. Meanwhile, public sector employment is up +2.8% over that time period (+598K).
A continuing contraction in manufacturing (a fall in production) and a decline in labor input (a fall in the hours worked in the workweek) are part of the employment data release that are important from an overall macroeconomic standpoint. Unfortunately, these have been moved to the shadows because the NFP number (+254K) has been billed by the media as “super-strong.”
Inflation
On Wednesday (October 10th), the September Consumer Price Index (CPI) showed up a little hotter than expected causing some consternation in the Bond market, with yields rising significantly off their September lows.
The headline number was up +0.2% for September, and the core (ex-food and energy) rose +0.3%. The consensus estimate was +0.1% and +0.2% respectively. That took the year/year headline reading down to 2.4% (Fed’s target is 2.0%) from 2.5% in August and the core to 3.3%. The year/year headline number was the lowest since February 2021. Further analysis shows that 75% of the move higher in the CPI came from a rise in food costs (+0.4%) and the cost of shelter (+0.2%) which offset the -1.9% fall in energy costs. In past blogs, we have noted that the BLS uses lagged data in its calculation of shelter costs. A truer picture of shelter costs can be seen in the charts below.
The charts shows that shelter costs have been falling (-0.7% year/year), and that, because BLS uses shelter numbers that a lagged nearly a year, falling rents will soon begin showing up in the CPI.
Then on Friday, the Producer Price Index (PPI) came in flat (0.0%) for September. Wall Street’s expectation was for a +0.1% reading, so the flat reading was a “beat” in Wall Street terms. The index now stands +1.8% higher than it was in September 2023, a year ago. The PPI is important because it measures prices early in the production process, and is a leading indicator of future movements in the prices of final goods and services.
The Fed
Given the gentle downward path of the annual inflation rate in both consumer and producer prices, and the fact that the payroll numbers were not as super strong as the media has portrayed, the question on the minds of Wall Street analysts is “What impact will these inflation numbers have on the Fed’s interest rate decisions at its upcoming November and December meetings?”
The November Fed meeting dates are November 6-7 and December 17-18. For the November meeting, the Fed won’t have another CPI or PPI update since they aren’t due out until mid-month. By December’s meeting, since it occurs mid-month (December 17-18), they will have access to both the October and November CPI and PPI reports.
While CPI and PPI are important inputs into Fed rate decisions, the Fed’s preferred measure for inflation is the Personal Consumption Expenditure (PCE) Index, and particularly core PCE (ex-food and energy). Those come out at month’s end. So, at the November meeting, the Federal Open Market Committee (FOMC) will have seen the September PCE numbers and they will have access to October’s PCE results at their December meeting.
Because we expect softer inflation numbers for the remainder of the year, we think those softer inflation numbers will counter the “super strong” Non-Farm Payroll numbers and expect -25 basis point reductions in the Fed Funds rate at both of the remaining 2024 meetings.
Here is our logic: The Fed’s estimate of the “neutral” Fed Funds rate is now estimated to be about 2.8%. Any Fed Funds rate above that 2.8% neutral rate is considered “restrictive”; conversely, a Fed Funds rate below 2.8% is “accommodative.” Currently, the Fed Funds rate target is 4.75%-5.00%.
- In a “soft-landing” or “no-landing” economic scenario, the Fed will logically move rates toward that “neutral” 2.8% level.
- In a hard-landing (i.e., Recession), the Fed should logically be moving rates below “neutral.”
- Only in the case of a reacceleration of economic activity will the Fed not get to “neutral.” But even in this case, rates are likely to go lower from current levels.
Evidence of an acceleration of economic activity is scarce. So, it is our view that the Fed will move rates down by at least 200 basis points (2 percentage points) to “neutral” in a soft-landing environment, and by more if a Recession develops.
Final Thoughts
Equity markets continue to move higher with the DJIA and S&P 500 closing at new historic highs on Friday (October 11th). A cautionary note here: the market’s P/E ratio is two standard deviations above its historic mean.
Bond yields, on the other hand, have risen (prices falling) on the belief that the Fed has engineered a “soft” or “no” landing scenario. Historically, bond prices have generally had a momentary spike after the Fed’s first rate cut. But, after that momentary “tantrum,” history shows that those rates fall significantly, especially when the economy shows signs of slowing.
The most recent payroll report has been labelled “extremely strong.” But, an in depth analysis reveals many cracks. The increase in employment was all from government employment; private sector jobs have shrunk.
Inflation, as measured by the CPI, came in slightly hotter than Wall Street expected. The sister PPI was slightly cooler. As a result, unless there is dramatic evidence to the contrary, we expect the Fed to lower rates by 25 basis points at both its November and December meetings, and that by the end of next year, the Fed Funds rate will be at the “neutral” rate (near 3%) if there is a “soft-landing” or lower if a Recession appears.
(Joshua Barone and Eugene Hoover contributed to this blog.)