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US: The Markets vs. the Economy – Goldman Sachs

Discussion in 'Fundamental Analysis' started by FXStreet_Team, Feb 16, 2016.

  1. FXStreet_Team

    FXStreet_Team Well-Known Member Trader

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    Jan Hatzius, Research Analyst at Goldman Sachs, suggests that the US labor market recovery continues to make good progress.

    Key Quotes

    “How can we square this upbeat picture with the continued struggles in the equity and credit markets? One popular explanation is that the financial markets look forward while employment and wages lag. This view implies that a sharp economic slowdown may lie ahead, and maybe even a recession.

    The risk of a US recession, while higher than a year ago, is still below the historical average. This is largely because there are few signs of either economic overheating or excess leverage, the two most reliable economic harbingers of recession historically.

    An alternative explanation is that the equity and credit markets discount the nominal dollar earnings and cash flow of companies large enough to issue stocks and bonds, not future real GDP and employment, and that this distinction now matters. First, a tighter labor market has started to put upward pressure on labor’s share of GDP and corresponding downward pressure on profit margins, so profits are underperforming revenue and output. Second, commodities and China—the two biggest global economic worries—have a much bigger weight in the revenues of large publicly traded firms than in US GDP. And third, with headline inflation near zero, the picture looks much weaker in nominal than in real terms.

    While we see early signs of stabilization in the manufacturing ISM survey, the drop in the nonmanufacturing ISM and the drift higher in jobless claims hint at greater spillovers into other sectors. Partly because of these wobbles, our current activity indicator for January stands at 1.8%, down from an average of 2.3% in the second half of 2015, and we have cut our Q1 GDP estimate to 1¾% from 2¼% previously.

    The FOMC is unlikely to resume rate hikes until it has become clear whether the tightening in financial conditions is, indeed, followed by a more serious deterioration in the real economy. A hike in March is therefore now unlikely.

    But we still expect further hikes in June and beyond. This is partly because we see core PCE inflation moving higher as the year progresses. First, we have a bit more confidence in the Phillips curve than many others, especially now that our wage tracker—a weighted average of the four most important nominal wage series—has climbed to 2.7% and labor’s share of nominal GDP has clearly started to rise. Second, while the dollar has on net appreciated further in recent months and oil prices have fallen, the rate of change in both trends has likely peaked. And that is what matters for headline inflation and, ultimately, for the pass-through into core inflation. Third, we expect some convergence of the core PCE index (which is only up a touch to 1.4%) toward the core CPI (which has already accelerated to 2.1%), largely because of a pickup in healthcare cost inflation.

    Moreover, we think that risk management considerations will increasingly cut both ways for the FOMC, provided the economy makes further gains toward full employment. History shows that it is dangerous to let the labor market overheat to a point that requires a significant increase in the unemployment rate to get back into equilibrium. There is no instance, over any period, in which the unemployment rate has risen by more than 0.35pp on an unrounded 3-month average basis without a recession. Obviously, this time could be different, but we expect that the FOMC will not want to take that chance, and will thus become more eager to curb employment growth at the sub-100k pace that Chair Yellen recently identified as the long-term trend. That will probably require tighter money.”
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