See you in September?

Bottom Line 

The economy and the labor market are weakening, and inflation grinding lower. Will that combination be sufficient to draw the Federal Reserve off the higher-for-longer sidelines to begin to cut interest rates at its upcoming September 18 policy-setting meeting? That dilemma defines the Fed’s dual mandate trade-off of achieving full employment and moderate inflation.

Sticky inflation In his semi-annual Humphrey Hawkins testimony before Congress this week, Chair Jerome Powell reiterated the Fed’s message that we’ve made solid progress reducing inflation over the past two years. But getting core PCE inflation (the Fed’s preferred measure) back to its 2.0% year-over-year (y/y) target will be difficult. We’re at 2.6% in May 2024—down from 5.6% in February 2022—but the Fed believes that it will increase to 2.8% by the end of this year, as lower inflation base effects roll off, before turning back down to 2.0% by the end of 2026.

Softer labor market At the same time, the labor market has slowed, with the unemployment rate (U-3) rising from a 53-year low of 3.4% in April 2023 to a 32-month high of 4.1% in June 2024. That triggers renewed focus on the Sahm Rule, which states that if U-3 rises 0.5% or more on a rolling 3-month basis within a year, then the economy typically slows into a recession. In its June 2024 Summary of Economic Projections, the Fed forecast U-3 to hit 4.2% by the end of 2025. That estimate may prove to be too low. 

Beware July and August jobs data However, the Fed knows that in January and July, the Labor Department applies significantly positive seasonal adjustments, which could result in a stronger-than-expected July jobs report released August 2. Moreover, August is typically the quirkiest month of the year for employment data, due to temporary furloughs and plant closures for re-tooling, summer vacations and school re-openings (with teachers and students moving in and out of the system). These quirks eventually smooth out with revisions in September and October. 

No thumb on the scale Historically, the Fed also prefers to avoid making a monetary policy change between Labor Day and Election Day. That’s especially the case if the decision is a close call and it has the luxury of patience. That’s the case this year, and the Fed is lucky it is considering the contentiousness of the presidential election. 

When we piece together these trends in the labor market and inflation, and overlay the current toxic political environment, we believe the Fed will prudently exercise patience and ease rates after the election. We expect a quarter-point cut in each of the final FOMC meetings of the year (November 7 and December 18). Policymakers likely will follow that with another percentage point of cuts next year, at roughly an every-other-meeting pattern, which would take the upper band of the fed funds target rate from 5.5% now to 4.0% by the end of 2025.

Economy slower across the board Manufacturing, autos, retail sales and housing have all slowed over the past few months, and both the manufacturing and services ISM indices dropped below the contraction level of 50 in June. In addition, business and consumer confidence have been spotty. 

Second quarter reporting season should be solid The S&P 500 reporting season starts this week, and we’re expecting a relatively solid quarter. According to FactSet, revenue growth is expected to rise 4.6% y/y, marking the fifteenth consecutive quarter of year-over-year revenue growth. Earnings per share are expected to rise 8.8% y/y, marking the fourth consecutive positive quarter, after three consecutive quarters of declining earnings, representing the strongest y/y earnings gains since the 9.4% seen in the first quarter of 2022. So, while the upcoming second quarter revenue and earnings season should be fine, we’re also expecting results from the growth and technology companies to soften in the second half of 2024. We also expect revenue and earnings results from the value, small-cap and international sectors to strengthen into year end. 

AI FOMO Amid all of this, stocks rise to new record highs almost daily. The S&P is up 18% thus far this year, closing at a record 5,615 today. Over the past 18 months, the Magnificent Seven soared by 133%, which drove the S&P up by 42%. In contrast, the Forgotten 493 rose a paltry 21%. That performance difference of 112% is unsustainable, in our view, as are the stretched valuations of the growth and technology stocks. For that reason, we opted to lock in some profits and reduce our 5% equity overweight by 2 percentage points this week. We do expect this rally to broaden, benefiting the sectors that have underperformed. We also anticipate increased market volatility in coming months, due to heightened uncertainty regarding the timing of the Fed’s response and the fluid presidential election. 

Lowering our GDP and inflation estimates The equity, fixed-income, and liquidity investment professionals who comprise Federated Hermes’s macroeconomic policy committee met Wednesday to discuss the Fed’s next policy move, in light of slower economic growth and lower inflation: 

• The Commerce Dept. revised first quarter 2024 GDP up from 1.3% to a final gain of 1.4%, compared with GDP gains of 3.4% and 4.9% in last year’s fourth and third quarters, respectively. 
• We reduced our estimate for second quarter 2024 GDP, which will be flashed on July 25, from 2.1% to 2.0%. The Blue-Chip consensus lowered its estimate from 2.1% to 1.8% (within a range of 1.3% to 2.3%), while the Atlanta Fed’s GDPNow lowered its estimate from 4.2% in mid-May to 1.5% last week, before raising it to 2.0% on Wednesday. 
• We lowered our estimate for third quarter 2024 GDP from 1.9% to 1.8%. The Blue-Chip consensus increased its estimate from 1.6% to 1.7% (within a range of 0.9% to 2.5%).
• We expect the Fed to begin to cut interest rates after the election. So, we left our estimate unchanged for fourth quarter 2024 GDP at 1.7%. The Blue-Chip consensus raised its estimate from 1.5% to 1.6% (within a range of 0.9% to 2.3%).
• We left our full-year 2024 GDP estimate unchanged at 2.4%. The Blue-Chip consensus reduced its estimate from 2.4% to 2.3% (within a range of 2.1% to 2.6%).
• We tweaked our year-end 2024 forecast for core CPI inflation lower from 3.3% to 3.2% (compared with 3.3% in June 2024), while the Blue Chip left its estimate unchanged at 3.1% (within a range of 2.9% to 3.3%).
• We left unchanged our year-end 2024 estimate for core PCE inflation at 2.8% (compared with 2.6% in June 2024), while the Blue Chip reduced its estimate from 2.6% to 2.5% (within a range of 2.4% to 2.7%). Lower procedural base effects are rolling off at present, which should elevate inflation. 
• We cut our full-year 2025 estimate for GDP from 2.1% to 2.0%, while the Blue-Chip consensus left unchanged its estimate at 1.8% (within a range of 1.4% to 2.3%). 
• We lowered our year-end 2025 forecast for core CPI inflation from 2.8% to 2.7%, while the Blue Chip left unchanged its estimate at 2.4% (within a range of 2.0% to 2.7%). 
• We reduced our year-end 2025 estimate for core PCE inflation from 2.4% to 2.3%, while the Blue Chip consensus left its estimate unchanged at 2.2% (within a range of 2.0% to 2.4%).

Connect with Phil on LinkedIn