Bad macro, good micro, accommodating Fed

• The U.S. Federal Reserve maintained rates but reduced quantitative tightening, a move well received by the markets.
• ISM Manufacturing Index saw a disappointing drop.
• With earnings season almost over, 80% of companies beat earnings expectations.

The U.S. Federal Reserve (the Fed) decided to keep interest rates steady at 5.25-5.5%, a move that was widely anticipated. Alongside this decision, the Fed also confirmed a reduction in the pace of its quantitative tightening (QT) efforts. Specifically, the Fed's statement reiterated that the economy continues to grow at a robust rate, emphasizing the ongoing strength in job creation and the sustained low levels of unemployment. This was pretty much the same message that we’ve heard on numerous occasions.

This approach by the Fed was perceived as somewhat accommodating, especially with its decision to reduce the monthly QT from US$60 billion to US$25 billion. This stance became more apparent during the press conference with Fed Chair Jerome Powell, where he indicated that an increase in interest rates was unlikely in the near term. Instead, the focus would be on maintaining the current policy stance for an extended period. Powell did express some reservations about recent inflation data, noting that it did not fully align with the Fed's goal of returning to a 2% inflation rate. However, he maintained his belief that current policies were restrictive enough to achieve this goal eventually.

Powell's commentary also highlighted a strategic shift in the Fed's approach, balancing concerns between unemployment rates and inflation more equally in future decisions. Should the need for tighter monetary policy arise, it would likely involve prolonging the duration of current interest rates rather than additional rate hikes. While the reduction in the balance sheet will continue, the process might be softer but extend over a longer period than previously anticipated.

In other economic news, the ISM Manufacturing Index indicated a reduction in manufacturing activity, dropping to 49.2 in April from 50.3, falling short of the forecast 50.0. This decline was coupled with a sharp increase in the inflation gauge, where prices paid soared to 60.9, surpassing expectations and previous months' figures. The report highlighted significant upward pressure on prices, largely driven by rising commodity costs.

The employment component of the ISM report showed a modest improvement, albeit still below the growth threshold. This mix of hot inflation readings and a contracting headline index contributed to growing concerns about stagflation, particularly following the recent U.S. gross domestic product (GDP) report. The ISM report further noted that while demand has slowed, overall output remains positive and input factors are supportive, suggesting some resilience in manufacturing activities.

Amid this economic backdrop, it’s important to note that the microeconomic side is doing well. Companies have showcased impressive earnings growth: of the 373 U.S. companies that have reported so far, 80% have beaten expectations. Companies like Google and Microsoft have not only beaten earnings expectations but have also contributed to a broader sense of market stability. Since the market lows of October 2022, the consistent growth in earnings among these firms suggests a solid indicator of potentially rising asset prices. Historically, such environments have reduced the likelihood of significant market corrections above 10%, with smaller corrections often viewed as buying opportunities rather than signs of a deeper market downturn. For more on this topic, be sure to listen to this week’s podcast.