As often happens, the economy is giving mixed signals. Friday’s April S&P survey showed economic output and inflation moving higher. Other factors, however, show significant weakness in the economy after ten months of monetary restraint.
The Week That Was
Friday’s S&P April business survey showed business activity, new orders, and inflation all moving higher. That contradicts our expectation of an upcoming weakness in the economy. It also conflicts with our insights from shipping companies, which are experiencing a sharp decline in shipments.
Weekly unemployment data continue to drift upward. In the four weeks ending in mid-April, initial unemployment claims were close to 250,000, up from 200,000 in the first quarter. Insured unemployment numbers also are increasing, to 1.8 million, up from 1.4 million six months ago.
Things to Come
There are two economic reports due this week. Thursday, the government delivers its first estimate of growth in the overall economy (GDP) between the fourth and first quarters. On Friday it will announce March consumer spending and incomes.
The GDP numbers are old news. Most of the data already reported indicate the real growth rate was in the vicinity of 2 percent to 2½ percent. The inflation rate appears to have been close to 3 percent to 4 percent. Hence, current-dollar spending remained strong at 6 percent.
More important than what happened between these two quarters is the current state of the economy going into the second quarter. Next Friday’s report on March spending and incomes will provide the most comprehensive picture of the extent of any slowdown since the first quarter.
Business surveys for March show the economy holding up better than we expected. However, the surveys also show a significant slowing from February. Friday’s report will help determine the extent to which the economy is slowing going into the spring quarter.
Money, Money, Money
Friday’s report on March spending and incomes will provide the Fed with an alternative measure of consumer inflation. This measure showed inflation in February was at an annual rate of 3 percent to 4 percent, lower than most other measures.
Assuming March inflation measures are up 0.3 percent, the rate will remain in the 3 percent to 4 percent range, but the year-over-year inflation number will drop from 5 percent to 4 percent.
Inflation continues to decline. If I were at the Fed, I would vote to halt any additional monetary restraint. However, my decision would be based on expecting a sharp slowdown in the economy. Fed members are more likely to look at current inflation and recent growth and decide the central bank could risk losing credibility if it were to pause in its tightening of credit.
Market Forces
For the third consecutive week, the S&P500 ended where it was a week ago. This year the S&P500 has traded in the narrow range of 3,900 to 4,200.
The stability of stocks reflects ongoing uncertainty over how badly the economy will respond to the ten months of monetary restraint, and how quickly inflation will recede.
Inflation currently is in the 4 percent to 5 percent range. We expect business activity to slow through the remainder of this year. This should bring inflation down gradually to the 2½ percent to 3½ percent range by year-end.
The most important economic variable in the months ahead is the yield on 10-year Treasury Notes. Watch it closely. If it stays below 4 percent, it means financial markets are confident the Fed will achieve its inflation goal.
We expect one more 25 basis point increase in the fed funds rate at the Fed’s May 3 meeting. Short-term rates are likely to remain slightly above 5 percent through to year-end.
The next move in stocks will depend on how markets assess shifts in the economy and inflation. We believe the next moves on the economy and inflation will confirm a downturn in business activity amid a gradual unwinding of inflation.
We believe stocks are about 12 percent overvalued. Signs of a downturn could drive stock prices toward 3,900. This would likely place further downward pressure on interest rates. Expect the S&P500 to remain in the range of 3,900 to 4,200.
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Outlook
Economic Fundamentals: negative
Stock Valuation: S&P 500 overvalued by 12 percent
Monetary Policy: restrictive