Like the weather, it’s best to remain sanguine on the current economic heat, because the cooling is coming. (UBS)

Late summer heat seems to be the story for the US economy too, and it has some investors—and therefore the markets—just a bit uncomfortable. But like the weather, it’s best to remain sanguine on the current economic heat, because the cooling is coming.

Said heat refers to above-trend growth, reflected by the Atlanta Fed 3Q GDP tracking estimate still at 5.6%, and the risk that the economy re-accelerates. This week should provide a reminder that inflation is still running too hot for comfort, and the Fed. The Bloomberg consensus has August headline CPI rising to 3.6% y/y, and 0.6% m/m. For June, these numbers were down to 3% and 0.2%, respectively, data that helped investors embrace a soft landing. The August CPI data won’t suddenly reverse that view. Core inflation is expected to keep falling, and the likely increase in headline CPI has been well-telegraphed and attributable to specific factors, such as higher oil prices, that aren’t indicative of inflation re-accelerating. But the steady disinflation path is hitting some turbulence.

So is the economy running too hot, leading to a “good news is bad news” dynamic for the markets, and vice-versa for bad news being good? Recent price action suggests as such. Last Thursday, the ISM services index surprised to the upside and initial jobless claims fell to their lowest level since February, adding to re-acceleration concerns. The S&P 500 (lower) and Treasury yields (higher) responded accordingly that day. The prior Friday, the S&P was higher after the August payrolls report capped a week of data indicating a cooling labor market—i.e., “bad” data was good for equities. Granted, Treasury yields also rose that day, implying that the data wasn’t so bad.

Of course, this price action is not about the strength of the economy per se, but about Fed policy expectations. Good data should be positive for risk assets, but only up to a point. Beyond this level, the economy running too hot should lead to more restrictive monetary policy that increases future downside risk to growth. Recent data is flirting with this territory.

The flip-side of this dynamic is more intriguing for the market outlook, especially if you think, as we do, that growth is much more likely to slow from its current level than re-accelerate. It’s easy to understand why equities would rally on softish data if it all but ensures that the Fed is done hiking rates. Better yet for risk assets is the prospect of rate cuts. Those may not happen until well into 2024, but once the Fed is done hiking, the market will likely pull forward the timing of cuts on any weak growth data. In other words, the market could start to act as if the Fed put is back, warranted or not.

The time to watch for this development is the 2 November FOMC meeting. A hike at the 20 September FOMC meeting is very unlikely—the market odds are less than 10%, and Fed officials gave no indication that a hike was coming before the blackout period. Market pricing for one last hike in November is about 50%. If economic conditions don’t justify another hike then, it will be hard to believe that the Fed isn’t done hiking, or at least, the markets will see it that way. If you want to make the case for a year-end rally, this scenario is a pretty good starting point.

The bottom line: We expect the economy to cool into year-end after this final blast of summer heat. Until there’s sufficient clarity for that happening, investors are likely to continue to toggle between “good is bad” and “bad is good” interpretations of the data, resulting in choppy, range-bound prices across asset classes. The prospect of the economy cooling enough for the Fed to end its hiking cycle by November creates the possibility that the markets could heat up as the weather starts to turn colder.

Main contributor: Jason Draho, Head of Asset Allocation, CIO Americas

Original blog – Heat wave , 11 September, 2023.