While stocks staged a strong rebound last week, we continue to field concerns about the economy, inflation, and Federal Reserve (Fed) interest rate hikes. We have the following observations regarding these concerns.

Economic Readings Remain Consistent with Further Growth

Last week brought us several economic data points that continue to suggest minimal odds of a near-term recession.

The Chicago Fed National Activity Index (CFNAI) increased in April, signaling firmer growth at the start of the second quarter. Its three-month average edged down marginally but remains consistent with continued abovetrend growth. All four broad categories of indicators made positive contributions and three of the four categories improved from the previous month. The CFNAI Diffusion Index, which is based on 85 individual indicators, picked up to its highest level since October 2020. Excluding the current cycle, this was the highest index reading since December 1999. Such broad-based indicator strength reduces the risk of recession in the near term.

The Philly Fed State Coincident Indexes for April increased in all 50 states, indicating a broad-based expansion. The average percent change across all 50 indexes was 0.5% last month, more than double the historical mean of 0.2%. Similarly, the U.S. Coincident Index rose 0.3% in April, also more than its historical mean. It was up 5.7% y/y, off its peak growth rate last year, but faster than any other time since 1984. Such strong growth momentum is not consistent with recession in the near term.

While first-quarter GDP was revised down to negative 1.5%, this was caused by inventories and net exports which combined subtracted 4.3 percentage points from GDP growth. Both are relatively small but volatile GDP components that can swing the headline figure. Importantly, final sales to domestic purchasers, which exclude inventories and net exports, were revised up to a 2.7% annual rate. This is in line with the average growth rate since 1980, and slightly higher than the average rate in 2019, before the pandemic hit, a sign that underlying domestic demand has strengthened and, in aggregate, has moved toward normalization.

April personal consumption expenditures (PCE) increased 0.9%, above the consensus of 0.6%. Additionally, the previous month was revised up to 1.4% from 1.1%. The increase in April was driven by a 2.4% jump in durable goods spending, led by vehicles. Services spending also had a strong showing, up 0.9%—double the historical average since 1990.

Further Signs Inflation May Have Peaked

Friday’s PCE report gave further evidence that inflation may have peaked. The PCE Price Index increased 0.2%, the smallest gain since November 2020. On a y/y basis, PCE inflation eased to 6.3% from a peak of 6.6% in the previous month, while core PCE inflation dipped to 4.9% from 5.2% in the prior month. Like the Consumer Price Index (released several weeks ago), the moderation in PCE inflation was driven by durable goods prices, which posted an 8.4% y/y gain, down from a peak of 11.5% y/y back in January. Given elevated goods inventories relative to pre-pandemic trends and further shifting back to services from goods consumption as the pandemic fades, we think goods inflation can fall further.

The Federal Reserve closely watches consumer and market-based inflation expectations indicators. Importantly, longer-term expectations (5-10 year) remain contained, despite near-term elevated expectations. Given evidence of peak inflation, this should act to further restrain long-dated inflation expectations. This makes the Fed’s job of interest rate hikes easier and reduces the potential for a policy mistake that could lead to a recession.

We would also note that it is not the first Fed rate hike that can tip the economy into recession but the last. At about 0.75%, short-term interest rates are well below what the Fed considers neutral of about 2.4%. This suggests monetary policy remains conducive for further economic growth.

Easing inflation pressure that allows for a less hawkish Fed is a key catalyst for the economy and further stock market gains.

 


 

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