Inside Markets — US Economic Surprise Index

A sharp decline in the US Economic Surprise Index challenges the benign macro environment that gave us low volatility and higher multiples. Something to be aware of as follow through from yesterday’s closing high in the SPX provides a path to 5415 (implied 1.9% upside from current levels). Caveat emptor.

Core PCE is still the Fed’s preferred inflation measure with this week’s PPI and CPI prints implying a ~0.23% increase in the April core PCE index. If realized, the YoY rate should tick down to +2.7% from +2.8%. April inflation data may be moving in the right direction, but still firmer than the Fed’s 2% target. Unfavorable base effects will likely keep YoY core PCE elevated through Q4, but the Fed could still cut rates maybe twice if the sequential pace of core inflation slows. It seems reasonable to expect a slower sequential pace of inflation given that start of year price adjustments have now passed and the well-understood lags in labor, wage and rent components. The timing (July or September) of the first rate cut will likely depend on labor market activity.

The ‘Goldilocks’ narrative where inflation falls faster than growth seems unreasonable given recent data. Inflation data has remained sticky, while the US Economic Surprise Index (ESI) has fallen to -22 from +41 in mid-April. The sharp decline in US ESI started on April 15 when March ISM manufacturing fell into contraction. ISM and PMI surveys are sometimes dismissed in favor of ‘hard data’ but these are still the most reliable forward-looking (3-4 month lead) indicators available. A ‘soft landing’ narrative where growth is falling, while inflation cools at a slower but consistent pace is possible, but unlikely given the lack of historical precedent. In our opinion, the benign macro conditions that delivered subdued equity volatility and multiple expansion are at risk of evaporating. The Fed’s dual mandate of controlling inflation and maximizing employment may soon be at odds. Disappointing labor data (weekly claims above ~260,000 or non-farm payrolls < 100,000) would likely result in higher volatility, multiple contraction and a correction in equity markets. But weaker labor market activity that brings policy easing often results in investors looking across a perceived short/shallow valley to the recovery ahead.