Too hot to handle

Bottom Line

This week’s updates on retail and wholesale inflation for March were stronger than expected, and last Friday’s sizzling employment data for March extended the trend of surprisingly robust economic data. Two notable examples are March’s Leading Economic Indicator (LEI), which posted a positive reading for the first time in 22 months, and the ISM manufacturing index, which rose above the important contraction level of 50 for the first time in 16 months. Historically, when the LEI is consistently negative and the ISM index sits below 50, the market braces for a slowing economy or an outright recession. It’s hard to imagine the Federal Reserve easing interest rates anytime soon. We expect it to remain in a hawkish, data-dependent, wait-and-see mode that might push the first cut until later this year or in 2025.

Financial market reversal The bond market has been sniffing these developments, as benchmark 10-year Treasury yields soared from an overbought 3.8% on February 1 to an oversold 4.6% yesterday, perhaps on their way to a re-test of 5.0%.

Equity investors, however, have been generally oblivious to economic fundamentals over the past five months. The S&P 500 soared 10% in the first quarter–the market’s best opening quarter since 2019–amid a powerful 28% rally since October 27. But investors received a jarring wake-up call recently. The S&P is now down about 3% over the past fortnight. This may be the start of a healthy, long-overdue and much-needed 5-10% correction.

We continue to anticipate a barbell-shaped year for stocks, with a choppy second quarter due to Fed-related uncertainty and a volatile third as investors price in election-related concerns. That should lead to a powerful post-election, sigh-of-relief rally to finish the year in record territory. This cleansing rotation should continue to broaden, with the underperforming domestic large cap value, small cap growth and international stocks playing catch-up, while the growth and technology stocks trim some of their froth.

Stubborn inflation Nominal CPI retail inflation plunged from a 41-year cycle high of 9.1% year-over-year (y/y) in June 2022 to 3.1% in January 2024. But this metric surprisingly rose to 3.2% in February and to 3.5% in March. Core CPI (which strips out volatile food and energy inflation) peaked at 6.6% in September 2022 and has slowly fallen to 4.0% y/y in each of October and November 2023, to 3.9% in both December 2023 and January 2024, and to 3.8% in February and March. Moreover, core CPI has stalled at a higher-than-expected 0.4% month-over-month (m/m) in January, February, and March, which annualizes to 4.8%.

Nominal PPI wholesale inflation plunged from a record high of 11.7% y/y in March 2022 to 0.8% in November 2023. But this metric has surprisingly risen to 2.1% in March 2023. Core PPI hit a record high of 9.7% in March 2022, plummeted to 1.8% y/y in December 2023 and soared to 2.4% y/y in March 2024.

What’s a Fed to do? As the base effects of these inflation metrics roll off in coming months, and inflation continues to rise, it’s unclear how the Fed can justify easing. To maintain its credibility, it would be wise to postpone action until after the election to avoid the appearance of impropriety and any conflict of interest. That would suggest as few as one or two rate cuts this year, targeting November 7 and December 18. That will push a half dozen additional cuts out into 2025 and 2026, the timing of which will be determined by the economic data.

Amid the fog of “immaculate disinflation” and “immaculate pivot,” the prevailing consensus view at the beginning of this year was that the economy was headed into recession, inflation was declining to the Fed’s 2% core PCE target, and the central bank would cut interest rates upward of seven times in 2024, with the first coming at the just-passed March FOMC meeting. That was clearly too optimistic, and financial markets are in the process of repricing this new reality.

Raising our GDP and inflation estimates The liquidity, equity and fixed-income investment professionals who comprise Federated Hermes’s macroeconomic policy committee met Wednesday to discuss the re-acceleration of inflation, the strong labor market and the positive inflection in several key economic metrics in recent weeks:

• The Commerce Department revised fourth quarter GDP growth up from 3.2% to a inal 3.4%, largely due to improvement in personal consumption. That’s down from 4.9% growth in the third quarter, and it did not change full-year GDP growth at 2.5%.
• Commerce will flash first quarter 2024 growth on April 25. The Blue Chip consensus raised its estimate from 1.7% to 2.1% (within a range of 1.3% to 2.6%), the Bloomberg consensus is at 2.0% (quarter-over-quarter, annualized), while the Atlanta Fed’s GDPNow raised its estimate from 2.0% to 2.5%. We’re still expecting a post-Christmas hangover on goods spending, so we left our estimate for first quarter 2024 growth unchanged at 2.2%.
• We raised our estimate for second quarter 2024 GDP growth from 1.8% to 2.0%. The Blue Chip consensus raised its from 1.1% to 1.6% (within a range of 0.8% to 2.4%).
• We left our estimate for third quarter 2024 GDP unchanged at 1.7%. The Blue Chip consensus increased its estimate from 1.2% to 1.4% (within a range of 0.7% to 2.2%).
• We expect the Fed to begin to cut rates after the election, as the re-acceleration in inflation slows the economy. So, we trimmed our estimate for fourth quarter 2024 growth from 1.7% to 1.6%. The Blue Chip consensus reduced its estimate from 1.5% to 1.4% (within a range of 0.6% to 2.2%).
• We increased our full-year 2024 growth forecast from 2.5% to 2.6%. The Blue Chip consensus lifted its from 2.1% to 2.4% (within a range of 2.0% to 2.7%).
• We increased our full-year 2025 GDP growth estimate from 2.0% to 2.1%, while the Blue Chip consensus left its at 1.7% (within a range of 1.3% to 2.3%).
• Due to the sharp re-acceleration in inflation in recent months, we raised our year-end 2024 forecast for core CPI inflation from 2.9% to 3.3% (compared with 3.8% in February and March 2024), while the Blue Chip raised itsfrom 2.6% to 2.9% (within a range of 2.5% to 3.2%).
• We also bumped up our year-end 2024 estimate for Core PCE inflation from 2.5% to 2.8% (compared with 2.8% in February 2024), while the Blue Chip raised its estimate from 2.1% to 2.4% (within a range of 2.1% to 2.6%). We expect base effects to roll off in the second half of 2024, driving inflation higher.
• We raised our year-end 2025 forecast for Core CPI from 2.6% to 2.9%, while the Blue Chip tweaked its higher, from 2.2% to 2.3% (within a range of 2.0% to 2.6%).
• Lastly, we raised our year-end 2025 estimate for Core PCE from 2.1% to 2.4%, while the Blue Chip consensus left its at 2.1% (within a range of 1.9% to 2.4%).

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