Look Out, the Economy is in Good Shape!

Stocks dropped this morning following release of some pretty encouraging economic data. Currently, the Dow is down 264 points and the S&P 500 is off by 1%. This is also causing the dollar to appreciate vs. foreign currencies, resulting in lower commodity prices. WTI crude oil is flat this morning, but gold, silver, iron ore and natural gas are trading lower. Not surprisingly, then, the bond market is also selling off as interest rate expectations float higher. I’ll explain.

The Institute for Supply Management (ISM), a private research firm, says US service sector business activity accelerated more than expected last month. Not only did they see a spike in new business and hiring activity, but also in wholesale inflation. Here’s why this is important: ISM data is widely followed by investors, services make up the lion’s share of our economy, and this report implies that the economy is too strong to keep inflation from falling further.

Other recent data corroborate this view. At the beginning of the year, Fed projections called for some sort of recession, but clearly that’s not happening and they’ve had to revise economic growth estimates higher. Growth came in at a rather healthy 2% in both the first and second quarters, and the Atlanta Federal Reserve Bank says the third quarter is tracking better than that. According to Citigroup research, economic data is generally coming in much better than expected this year. Goldman Sachs economist Jan Hatzius just reduced his expected chance of recession to 15%, which is to say he doesn’t expect that outcome at all. (As an aside, the US economy is looking a whole lot more stable than say, China or Europe, leading to a stronger dollar.)

So what about inflation? The Fed’s goal is to slow the economy enough to get inflation to fall from 3% to 2%. So any sign of resurgent inflation may encourage them to either continue raising interest rates, or at least keep them at a very high level for the foreseeable future. And, of course, that would raise the chance of triggering a recession. So it all goes back to the Fed and guessing how they will react to data.

That said, is today’s report a game-changer? No, not unless you’re a trader. Focusing on one report or one trading session is often a trap. For those with a short-term investment horizon, good news for the economy is bad news for investing. But those with a longer-term outlook aren’t panicked. They see a resilient economy despite much tighter financial conditions. Economist Mark Zandi notes that inflation is coming in “gracefully” as Covid related shocks “fade into the rear-view mirror.” Meanwhile, wage growth is now higher than inflation, giving consumers more purchasing power. This should keep consumer spending resilient. And that’s why it’s tough to call for an imminent recession with any certainty.