The time for cuts has arrived
Chances of a 50 bp rate cut being announced at next week’s September FOMC meeting dropped considerably following yesterday’s CPI report. Annualized core CPI showed inflation holding steady y/y at 3.2% while the three-month annualized pace rose to 2.1% from July’s 1.6% reading. Does it really matter whether we a get 50 or 25 bp cut? We don’t think so. The Fed has already indicated that it is ready to lower rates to a less restrictive and more neutral level in order to balance price stability and full-employment mandates. Now we are just debating the magnitude and timing of the FOMC’s actions.
The lingering question remains: Is the economy heading for recession or the desired “soft landing”? And, even if we do avoid recession, what kind of economy is likely to emerge once the Fed adjusts rates to that elusive “neutral rate”? Earlier this week, JP Morgan’s CEO Jamie Dimon stated that he is not discarding the possibility of stagflation. While maybe not the same variety of 1970’s stagflation, rising unemployment combined with slow economic growth, and high or rising inflation would certainly not be a desirable outcome for investors. So, let’s analyze the components of stagflation in today’s context.
Unemployment
The current U.S. unemployment rate is 4.2%, near its highest level (i.e., 4.3% last month was the recent high) since reaching a low of 3.4% in April of 2023. Though still historically low, the rising trend in unemployment is concerning. In fact, it has already triggered the Sahm Rule, an economic indicator that suggests a possible recession when the three-month moving average unemployment rate increases by 0.5% from its lowest point in the past year.
Other employment data also hints at a potential slowdown. Job openings have been decreasing, suggesting less active hiring, and the number of people newly applying for unemployment benefits has been higher than anticipated. Moreover, recent Fed surveys have reported that a rising number of respondents expect to soon become unemployed. Continuing claims for unemployment insurance, however, have stabilized near 1.8 million. While a cooling labor market can contribute to lowering inflation, excessive weakness could negatively impact economic growth.
Another concern, which we mentioned in prior comments, is that the U.S. Department of Labor surprised economists by acknowledging that it overstated job growth during the 12 months that ended in March by roughly 818,000 jobs. This figure slashed job creation figures by almost half of the prior released figures. Thus, the labor market may already be weaker than we previously thought. Unemployment trends will be a focus for markets as the Fed eases its policy rates.
Economic growth
The U.S. real gross domestic product (GDP) grew at an annual rate of 3.0% in the second quarter of 2024. This is an increase from the 1.4% growth rate in the first quarter. The growth was mainly due to increases in consumer spending, business investment, and inventory growth. Full-year 2024 GDP is expected to grow by 2.4% according to economists, which implies a modest slowdown from the first half of the year. Next year, GDP is expected to slow to 2.0%, but it is too early to know with any confidence.
Other indicators of economic growth include consumer spending as well as business activity. The ISM PMI reports, which offer insights into the supply side of the economy, show recent mixed signals. While the Manufacturing PMI briefly rose above 50 this year, indicating expansion, it dipped back below 50 in April and has declined to 47 in its most recent August reading. Meanwhile, the Services PMI, which stayed above 50 throughout 2023, also slipped below 50 in April, but has since recovered to 52. Although both measures being below 50 suggests a potential economic slowdown, it’s too soon to draw definitive conclusions as these figures can fluctuate. Nonetheless, it’s a trend worth monitoring.
Consumer spending seems to be holding up well, despite the mixed reports among retailers. According to the U.S. Census Bureau, estimates of U.S. retail and food services sales for July 2024 increased 1.0% from the previous month and 2.7% from July 2023. It appears that some consumers have maintained their spending levels by utilizing credit cards and other revolving credit products because cash balances have shrunk and savings rates have declined over the same period. There also seems to be a widening disparity in spending trends between the “haves” and “have-nots,” with upper-income cohorts offsetting some decline among those more challenged by high interest rates and inflation. Of course, a decline in interest rates, mortgage rates in particular, may help. Conventional 30-year mortgage rates have already declined to about 6.3%. Real estate experts expect that a move in the 5-6% range will accelerate transactions which can have a particularly strong effect on overall economic activity.
Inflation
The current inflation situation is complex and uncertain. Although inflation as measured by the CPI and the Fed’s favored PCE index has decreased significantly from its peak in 2022, it remains stubbornly above the 2% target, evidenced by yesterday’s CPI report. The Core Producer Price Index (PPI ex food and energy), which measures inflation for producers, was released this morning and showed a 0.3% m/m increase which was higher than the 0.2% expected. It may be too early to think that inflation has been tamed to a 2% sustainable level. Nonetheless, Fed officials are confident that inflation is trending lower.
Overall, inflation is declining to a slower rate of growth, but the pace of that decline has slowed recently. Any signs that inflation re-enters a period of sustainable increases will be problematic because investors’ expectations about future interest rates would change. Mr. Dimon’s concern about future inflationary problems is based on factors such as the large U.S. budget deficit, the long-term impacts from energy transition, and changes related to global trade (i.e., tariffs and re-shoring). If he is right, the current valuations for both stocks and bonds may be too high.
The 10-year U.S. Treasury yield is now under 3.7% which is near the lows of the year. A low 10-year yield is good for growth stocks assuming the economy avoids recession. The election is less than two months away and we are almost halfway through the rocky month of September. Next week’s Fed rate cut will come as no surprise to investors, but Powell’s comments related to the magnitude and speed of future cuts will matter. Keep your seat belt on.
Actress and singer Jennifer Hudson turns 43 today, actor Joe Pantoliano (Risky Business, The Fugitive) is 73, and Gerry Beckley, one of the founding members of the rock group America turns 72.
Christopher Gildea 610-260-2235