The Macro Backdrop

Remaining on the 'Good' Growth Path

One of the hallmarks for the U.S. economy over the last few years has been its resiliency. This calendar year has been no exception as the war in the Middle East led many a market prognosticator to pencil in the potential for a recession stemming from the effects of the Middle East war. Needless to say, not only has a downturn failed to materialize, but overall growth has continued on a good, moderate path, with no caution or danger signs evident on the horizon.

Oftentimes, investors look towards the labor markets for signs of not just where current economic activity stands, but also where things could be going in the months ahead. Interestingly, the monthly employment report’s nonfarm payrolls and unemployment rate are certainly not leading economic indicators; rather, they are coincidental, at best. Nevertheless, the markets did receive a potential scare a couple of months ago. Indeed, new hiring came in on the negative side of the ledger in July, accompanied by downward revisions to the prior two months. This development re-ignited concerns of the previous two summers when cooler than expected jobs numbers pushed the Fed into rate cuts.

Interestingly, this labor market backdrop was completely reversed in August, and even though the September report was somewhat softer than expected, it was not soft enough to alter the markets’ economic and rate outlooks. There is little doubt that this changed the labor market outlook considerably. In addition, weekly jobless claims, which are a leading indicator, remain about 100,000 below the levels seen before prior recessions over the last forty years, or so.

That brings us to the two primary cylinders of the growth engine: personal consumption and investment. Household spending has continued to provide underlying support for the economy, even in the wake of higher energy prices. Given the recent robust reading for retail sales, it looks as if the consumer is going to remain in a supporting role.

The other cylinder of the economic engine, fixed investment, is also providing a positive contribution to the overall economy. The massive build-out within the AI space is showing up in the categories one would expect as part of the Bureau of Economic Analysis’ GDP reports, and we anticipate this trend continuing.

All in all, the underpinnings of the U.S. economy still seem to be on a relatively solid note and should help keep overall growth moderately positive during the final three months of the year.

Inflation: Can the 2% Target Ever be Attained?

In last quarter’s Outlook publication, we posed the same question we are asking now: Can the Fed’s 2% inflation target ever be attained? Following the news of the Memorandum of Understanding (MOU) a few months ago, energy prices fell back to almost pre-war levels and inflation readings, such as core CPI, were revealing a modest disinflation trend.

Well, we all know what has recently occurred on the energy front with crude oil back above the $100 per barrel threshold while the recent readings for both CPI and PPI revealed that the moderation in price pressures stopped.

That brings us to the Fed’s preferred inflation gauge, the core PCE deflator. Unlike core CPI, this measure had actually not revealed any disinflationary tendencies during the summer. Indeed, the year-over-year reading has consistently stood at +3.0%, or above, as of this writing. This figure is a full percentage point above the Fed’s target.

From a core inflation perspective, renewed concerns of pass-through effects from higher energy prices to the broader macro landscape could linger and take more time to potentially reverse course. Demand pressures from the AI buildout perspective will remain a dominant force as well.

Either way, the Fed’s 2% target will more than likely continue to be elusive.

Fed Policy: Finally, 'Walkin'' the Walk

The Federal Open Market Committee (FOMC) decided to raise rates by a quarter-point, bringing the new fed funds trading range to 3.75%-4.00%. The money and bond markets had been pricing in a potential rate hike at this gathering, and Warsh & Co. ultimately realized that such a move was warranted. That being said, the ‘rate hike’ story does not end here. In fact, you can make the case that this is not over by any means whatsoever and the bond market will continue to challenge the Fed to stay the course, of course data permitting.

Interestingly, Chairman Warsh had been ‘talkin’ the talk’ and giving off the impression that he’s an inflation hawk, but it wasn’t until this Fed gathering that he finally was ‘walkin’ the walk’. It must be noted, however, that getting to this point was not a smooth ordeal. In fact, the Chairman put himself into this position due to his prior rhetoric, and perhaps most importantly, his refusal to provide any forward guidance at all, and based upon Warsh’s Jackson Hole comments, the hawkish tenor he set forth provided him with no wiggle room.

The perception now is that the September FOMC meeting resulted in a ‘hawkish’ rate hike. Warsh’s acknowledgment of a strengthening in economic activity and non-restrictive financial conditions was noteworthy. There is no question that inflation is now job #1 of the Fed’s dual mandate.

There’s an age-old motto: When you see a chance, take it. Well, the Fed took it and now the question becomes: What next? If upcoming data continues to show good growth and above-target, sticky inflation, we don’t necessarily see this rate hike as the beginning of a new tightening cycle, but rather just removing some of the rate cuts that occurred during the September-December period of last year.

Searching for GeoAlpha

Over the course of the third quarter, the issues facing the market remained broadly the same as the second quarter. The U.S.-Iran conflict dragged on following the collapse of the Memorandum of Understanding. Though it evolved from kinetic to a predominately stalemate “wait-and-see” phase, the Strait of Hormuz issues and the involvement of the Houthis in Yemen continued to elevate energy prices globally. This was compounded by the continuation of the Ukraine War, and the destruction of refining capacity in Russia. Between the two, dislocations have happened across numerous important products. Everything from diesel to aviation fuel has seen price spikes, not to mention plastics and fertilizer.

With risks come opportunities. And that means there is plenty of opportunity. While the energy-related risks garner most of the headlines, there is also the U.S.-Canada trade relationship, the U.S.-China trade relationship, and the looming midterm election. Putting these together with the current situation around energy might feel daunting. But taking each in turn shows a bit of a different picture.

The U.S.-Iran conflict’s evolution from kinetic to stalemate is a marginal net positive, and—following the UN General Assembly—there are renewed efforts around mediation. While nothing happens quickly (whether it is diplomacy or rebuilding refining capacity), the directionality is positive. This is compounded by the push from the Trump Administration to have Ukraine and Russia cease hitting energy infrastructure. The slow and steady mitigation of these issues is the most likely outcome, creating a needed tailwind to the consumer-focused names into the holiday season. And a much-needed headwind to inflation into 2027.

The other risks are far more “headline and fade” risks and opportunities. The U.S.-Canada trade relationship can be solved rapidly if and when the two sides agree to a resolution. The U.S.-China trade relationship remains in a détente. Following the state visit by Xi to the U.S., the agreement to continue to talk was the primary takeaway. The midterms are the most “known of the known” risks with the outcome polled to oblivion with a substantial lead time. Investors should be prepared for these opportunities but know they will be short-lived.

U.S. companies have mitigated many of the geopolitical risks over the course of the year, and the earnings growth is evidence of this phenomenon. Will these shocks change that trajectory? Probably not. In the end, these are mostly opportunities to incrementally reallocate to areas of the market that have been out of favor due to the headlines. That is a continuation of the turn from “headline risk to bottom line risk”, something investors should embrace.