There is a lot of new data on the economy, but unfortunately the numbers provide little clarity on key issues.
The Week That Was
Friday’s report on March spending and incomes showed a slowdown in spending, wages, and inflation. March consumer spending rose 1 percent, real disposable income rose 3.5 percent, and wages and salaries at 4 percent (all annual rates). March consumer inflation was down to a 1 percent annual rate, while core inflation was at a 3.4 percent rate.
On the surface, all these March numbers appear to point to a significant slowing in the economy and inflation. However, revisions to prior months were all in an upward direction. As a result, the first three months of the year show spending, wages, real disposable income, and inflation up at annual rates of 4.5 percent, 6 percent, 8 percent, and 5 percent, respectively.
Although the economy may have slowed in March, the first three months of this year appear to have been every bit as strong as the fourth quarter of last year.
We doubt the Fed can use a one-month inflation rate of 3.4 percent to justify pausing in its battle against inflation.
Things to Come
The busy week ahead begins today with the April ISM and S&P manufacturing surveys. The advance S&P April survey showed an acceleration in business activity. Let us hope this is wrong. If business activity remained strong in April, it would mean inflation and interest rates will be heading still higher.
On Wednesday ISM and S&P report surveys for service companies. We expect continued signs of slower growth. If not, the Fed has more of a challenge than we expected.
On Thursday, the government reports first quarter productivity. With real growth at 1 percent and aggregate hours worked up 3 percent, it appears the year-over-year decline in productivity continues to plague the economy.
Friday’s job report is widely projected to be another strong one. The labor market remains tight, and there are relatively few signs of layoffs in the weekly data on initial unemployment claims. Even if the economy slows, employment is often a late indicator of serious problems.
Money, Money, Money
The Fed almost certainly will raise short-term interest rates by 25 basis points this month. Although this could be the final upward move, the Fed will probably continue removing money from the economy in its effort to contain inflation if there are no further signs of a slowdown.
Current inflation remains in the 4 percent to 5 percent range—the same as it has been for the past 12 months. Without a clear indication of more progress on containing inflation, the Fed will be compelled to continue tightening.
The yield on 10-year Treasury Notes remains a key indicator of the financial markets’ confidence the Fed will reach its inflation objective. With the yield remaining around 3.5 percent, the markets remain confident the Fed is on the right path.
We expect one more 25 basis point increase in the fed funds rate at the Fed’s May 3rd meeting.
Market Forces
For the fourth consecutive week, the S&P500 ended in the vicinity of where it was a week ago.
This year the S&P500 has traded in the narrow range of 3,900 to 4,200. There still is nothing in the current data to resolve two key issues: how badly the economy will respond to ten months of monetary restraint, and how fast inflation will recede.
Friday’s news of slower growth in March provides some reason for hope the economy is responding to monetary restraint. However, the consensus expects the April business surveys to show the economy remains strong.
Under current conditions, we expect stocks to remain about 12 percent overvalued. Signs of a downturn could drive the S&P500 toward 3,900. However, a drop in stock prices would also suggest the upward cycle in short-term rates will end sooner than later. 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