The economy’s weakness continues as the Fed remains committed to slowing monetary growth.
This week’s economic data reports should confirm a weakness in business activity continued at year-end and into the new year. Stocks are facing key resistance levels and could go either way in response to the news.
The Week That Was
The week’s economic reports showed a sharp decline in December retail sales and manufacturing output. These declines are consistent with reports from business surveys by S&P and ISM, which had previously indicated decreases in output of manufacturing and service companies.
The January Homebuilders’ survey registered an increase of four points to 35. Although 35 is an improvement, it still represents a rapidly deteriorating market for new homes.
In what can only be classified as a wacky labor market, initial unemployment claims declined to close to 200,000, one of the lowest levels since May. In contrast, insured unemployment payments rose to 1.6 million, the highest level since April. Go figure.
Things to Come
On Tuesday, S&P will present its first business survey on January business activity. S&P surveys consistently indicated a downturn in the economy in the closing months of the year.
An alternative, very optimistic survey of business activity identified a major weakening to a downturn in December. We suspect the early January S&P survey will show the downturn continues, with a reading close to the 45 registered in December. Scores below 50 are consistent with a decline in activity.
Two important reports are due Thursday and Friday. The first is for GDP growth between the third and fourth quarters. Our estimate for real growth is a 2.5 percent annualized rate. We expect the reports to show inflation was close to a 3.5 percent annual rate with current dollar GDP close to a 6 percent rate.
More important is Friday’s report on consumer spending and wages in December. We are expecting confirmation of a sharp slowdown in December, with current dollar GDP, inflation, and real growth consistent with other reports showing significant weakness at year-end.
Market Forces
The financial markets are off to a good start in the new year. Stock prices rose 4 percent in the first two weeks before leveling off with little gain this past week.
Financial market assume the Fed will raise its target rate February 1st by 0.25 percent, to 4.5 percent to 4.75 percent, and follow at the end of March markets with another 0.25 percent hike to a peak of 4.25 percent to 5 percent.
Financial market expectations will continue to change as economic data reveal the extent of any downturn in the economy and inflation. We expect a moderate downturn in the economy during the first nine months of this year. We also expect inflation to continue to decline, albeit slowly. If so, Fed policy will remain restrictive for at least the first nine months of this year.
Current market expectations are that the economy will weaken significantly and inflation will continue to move closer to the Fed’s longer-term target. We believe financial markets are overly optimistic about a smooth transition to lower inflation and an early peak in interest rates. If so, the Fed will have to remain restrictive for most of this year. This
would continue to provide a difficult environment for stocks.
Even so, we respect financial signals. Longer-term interest rates have performed far better than we had thought they would. If they continue to perform well, stocks will continue to advance and technical indicators will move from negative to positive.
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Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 21 percent
Monetary Policy: restrictive