Connect Four

Incoming

With the change in political leadership in January, the markets are faced with juggling four potential forces that could influence the economy next year. Between net fiscal spending, tariffs, immigration, and the efficiency egg hunt, there are various paths the economy and the markets could travel. Determining the impact of any one of those programs is difficult enough, but predicting how all four may coalesce is extremely complex. As of today, the market remains skeptical of maximal Trump, pricing in about one-third of his proposals.  

Looking through the lens of the foreign exchange market is a good guide. Many currency strategists believe the full inflationary impact of the personal and business tax cut, workforce reduction from the immigration crackdown, and the complete implementation of tariffs could result in an interest rate differential between the US and Europe that exceeds 400 basis points. George Saravelos at Deutsche Bank calculates that the FX market is currently only pricing in a 30% probability of the maximum possible hit.  

Placing a one-third probability on programs that are not even rolled out yet is reasonable. Because the cumulative impact is indeterminable if they all manifest next year, the markets could be in for significant volatility. Our economy is incredibly intricate; adding in the global interrelationships makes for a forecasting nightmare. As we look toward 2025, we are using wide guardrails. To survive and hopefully thrive, remaining flexible in one’s outlook and nimble in positioning will be crucial. 

Hope the Cleveland Fed Is Not Your Landlord

The Cleveland Fed may be the spoiler of the year. If their October paper on the future of rent inflation is correct, the voters on the Federal Open Market Committee (FOMC) are far too optimistic about a fall in housing inflation. The study forecasts that the shelter component in the Consumer Price Index (CPI) will not drop next year, and that throws a house-sized wrench into the Fed’s expectation for 2% inflation. An essential belief behind the FOMC’s rate-cutting campaign is that the recent slowing in rent increases for new leases will feed through to CPI housing inflation.

Housing inflation must fall; otherwise, CPI will not hit the 2% target. Annual core CPI (ex-food and energy) is still elevated at 3.3%, while “super core” CPI (ex-food, energy, and shelter) is below the Fed’s 2% target. The problem is that shelter inflation in the total CPI calculation carries an enormous weighting of 1/3 and has risen 4.9% over the past year.

Rents have been falling relatively fast. The Zillow Rent Index tracks annual rent as increasing just above 3%, but CPI rental inflation is 4.6% (rent is one of three components comprising shelter inflation). CPI has some statistical quirks that have created the gap:

·       CPI data for rent is collected every six months, not each month as is the case with most of the other components, which creates lagging, sticky prices.

·       The CPI rent subindex also includes existing renters renewing leases, which change less than new leases.

Previously, we discussed how fragility in the job market is making it difficult for job seekers to find jobs. Job seekers are not moving locations to start new jobs, and existing workers are staying put. This logjam has added to the long-term decline in U.S. mobility for renters and homeowners. In 2001, 31% of apartments would turn over each year, and that rate has fallen to 22%. Instead of dropping to 2% over time, the Cleveland Fed economists forecast rent inflation to stay above 3.5% through Q2 2026. Under that scenario, the FOMC will only be cutting rates if goods and other services fall dramatically, which is unlikely if the planned immigration or tariff policies are established next year. Therefore, the base case for continued rate cutting by the Fed only occurs in the case of a recession. ‍

State of Employment

The states have made their voice clear, and the job market is weak. The Bureau of Labor Statistics (BLS) releases the individual state employment data about three weeks after the monthly nonfarm payrolls report. The latest state report covered the October national report that showed a minuscule headline increase of 12,000 and a 28,000 contraction in private employees. Most investors immediately waved it off when payrolls were released, assuming there were enormous errors due to October’s big strikes and hurricanes. However, the individual state statistics portray a job market in decline. Netting out Florida, the state most affected by the October hurricanes, yields a net payroll increase across the other 49 states of only 50,000.

Adjusting for striking workers during October (which are omitted from the payroll calculation), national employment only rose to half this year’s monthly average of 175,000. Not surprisingly, the state data has seen the same downward revisions as the headline payroll data over the last 12 months. That means that this initial October estimate will likely be revised down, making it even weaker. California saw a contraction, which is concerning, especially when employment in New York also fell last month.

Investors who want to look at the glass as half full can rejoice that the Fed will probably be cutting 25 basis points in December, not pausing at the next meeting. However, those cuts may be due to concern over a diminished employment outlook.

What to Look for This Week

1. Tuesday, November 26 at 2:00 p.m. E.S.T. FOMC Minutes of the November 6-7 meeting are released. Since Powell switched his tune regarding a December pause after his press conference, it would not be surprising to hear many FOMC participants discussing that possibility in the minutes. The balance between those who want to cut versus pause may become apparent. We will also be looking for any comments mentioning potential policy changes coming from the next administration.

2. Wednesday, November 27 at 8:30 a.m. E.S.T. October Personal Consumption Expenditures Price Index. The series has been in a tight 2.60-2.70% range between May and September. The Cleveland Fed’s Inflation Nowcasting model is forecasting 2.76% for November and 2.90% for December, which could sway the FOMC toward a December rate pause. 

3. Wednesday, November 27 at 10:00 a.m. E.S.T. November Conference Board Consumer Confidence. This will be the first report since the election. Consumers’ optimism over the next six months about their Family’s Current Financial reached a series high with many Republicans anticipating a Trump win. We expect a big bump in many areas of the survey, and what will be important is how big an impact the election had to possibly gauge excess optimism.

NOTE: There will be no Three Pointer published next Monday. Enjoy the holidays!