KEY DATA: LEI: +0.5%/ Phil. Fed (Manufacturing): -0.7 point; Orders: -2.1 points; Payrolls: +1.9 points/ Claims: -5,000
IN A NUTSHELL: “The economic momentum should be carried into next year.”
WHAT IT MEANS: The first reading on third quarter growth is released next week and it should be good. And if the Conference Board’s Leading Economic Index is any indicator of future growth (it is, even if it is a rough one), then the expansion should remain solid in the months ahead. The Index posted a strong gain in September after rising sharply in the previous two months. Taken together, they point to a solid gains in the next six months.
One sector that has been leading the way is manufacturing and it looks like it is continuing to do so. The Philadelphia Fed’s index of manufacturing activity eased modestly in early October, but the level remains quite solid. New orders are still strong, even if they are expanding a little less rapidly. To meet the high level of demand, firms are hiring a lot more workers and expanding hours worked, probably to make up for an inability to find even more employees. But there was one warning sign in the data for the Fed. Expectations on future price increases are rising and are at levels that indicate firms think they have significant pricing power. The last time we saw numbers in this range for any period of time was the 1980s. If Chair Powell thinks that inflation expectations are well anchored, he might want to think that over.
Jobless claims fell last week. The level is quite low. Enough said.
MARKETS AND FED POLICY IMPLICATIONS: Investors are trying to figure out the impact of rising rates on earnings and the confusion is great. The minutes for the last FOMC meeting make it clear the members are steadfast in their belief that rates will rise through next year and that the Fed might have to not only take its foot off the accelerator but could be forced to put it on the brakes. I think that is likely and the Philadelphia Fed’s future prices received index supports the view that inflation will accelerate. It is difficult to look past the strong earnings numbers that so many companies are putting up, but given the huge tax breaks, they should be robust. Hopefully, firms will invest those funds and the rising capital stock will allow for more and more efficient production. But as of now, little of that is happening, though it is still early. The Fed has a conundrum. Growth may moderate, but it is still likely to be above trend for the next year. That means firms pricing power is likely to grow and inflation is likely to accelerate. But unless housing and capital spending improve, the expansion is likely to fade. If inflation accelerates before growth slows, the Fed will have no choice but to start stepping on the brakes. That is why I believe we will have at least three if not four increases next year. As long as the Fed doesn’t jam on the brakes, and four increases only means at worst a mild tapping, then we should be fine. The Fed is sending the right signals and following the correct policy, regardless of what the equity market focused commentators may think.