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Written by: New York Life Investments
Economic overheating: Is it getting hot in here?
The strength of the U.S. economy continues to surprise investors and economists alike. Why? Because the sources of our economic resilience are fading or are even depleted today. But a reversal of this trend seems possible, driven by a number of factors including fiscal support, improving profit margins, manufacturing activity, and loosening bank lending standards. These developments could cause the U.S. economy to re-accelerate – or in terms our readers may be familiar with – the economic “dominoes” could stand back up. While this appears positive, we see a U.S. reacceleration as a key global market risk. Durable growth means still-sticky inflation, “higher for longer” rates, and potentially a more challenging credit cycle.
(For more on our economic dominoes check out slide 6 in Macro Pulse, or more on overheating…slide 15!)
The Fed seems to be stuck between a rock (strong labor market) and a hard place (sticky inflation)
The labor market surprised again, with nonfarm payrolls rising 303,000 on the month, well above expectations. The unemployment rate also dropped to 3.8% from 3.9% while year-on-year wage growth moderated. How can the labor market be expanding this quickly with wage growth not moving higher? We’ve had a favorable supply shock via immigration – check out last week’s note where we discussed the impacts.
It is difficult to be envious of the Fed’s position today. They still expect to cut rates three times this year but face a strong labor market and sticky inflation. However, a strong labor market, as Chair Powell pointed to in his last FOMC press conference, does not weigh heavily in their outlook for the path of the federal funds rate (though a weak labor market would).
The bond market is still playing ball, pricing in 3 cuts for the year, though the market pricing for a June cut is falling. Unless or until this changes, we expect credit spreads to remain tight.
We’re looking forward to next week’s inflation report as well. If the Fed wants to cut in June, it’s likely going to need to see at least two 0.1%-0.2% month-on-month core inflation prints between now and then (next week’s consensus forecast for March is 0.3%).
Data disagreements on the labor market
The ISM’s manufacturing PMI ticked above the neutral 50 level in March, marking the first month of expansion since 2022. Of course, this could be a bit of noise, but the signs of reacceleration, based on this survey, are clearer than they have been for a while. The ISM services index for March came in below expectations, but price pressures eased to the lowest levels seen in four years. Given that employment data from the ISM surveys continues to show signs of weakness, this report could strengthen arguments in favor of cutting interest rates. However, the mismatch between the ISM labor outlook and the employment report outlook suggests the Fed may approach any immediate action with caution.
Portfolio strategy
Stock market performance has diverged from economic fundamentals (below), but could this improve their outlook? Potentially, if equities hold up until the Fed cuts rates. This is because stock prices and yields have been negatively correlated (likely due to higher inflation) which suggests that equities could continue their rally when the Fed cuts interest rates.
Yet, this view overlooks the fact that the Fed typically cuts rates when something breaks in the economy – 2007/08 financial crisis, COVID pandemic – and a recession has started. In this scenario, when the economy is already in recession, rate cuts are typically not too supportive of equity performance. We’ll be watching to see how the market digests the labor data this week and whether good economic news will drive bad market news.
