In times long gone by, a popular event at town fairs and school sports days was the sack race. The competitors would assemble at the starting line, each encased up to the waist in a burlap bag and gripping firmly onto its sides. At the gun, they would hop furiously in the direction of the finish line, 100 yards ahead. As a sporting contest, it lacked dramatic tension, with most of the competitors biting the dust in the first 50 yards. But it was entertaining to speculate on which brave athlete would roll over first.

U.S. financial markets are currently witnessing the equivalent of a sack race between growth and inflation. Both are going to roll over. But the sequence of which rolls over first is important. If inflation falls first, the Federal Reserve could cool its hawkish rhetoric, markets might price in fewer rate hikes, and long-term interest rates and the dollar could fall, providing relief to both the housing market and U.S. exports.

If, however, growth stumbles first, the tabloid headlines will shriek “stagflation” and Jay Powell, gritting his teeth, could don the long-discarded mantle of Paul Volker, pushing rates higher still, even at the cost of toppling the economy into recession.

So how is the race looking in the last week of June?

On the growth side, there is plenty of evidence of a slowdown, with the U.S. flash composite purchasing manager index falling from 53.6 in May to 51.2 in early June, its lowest level in 5 months and very close to its lowest level since the start of the pandemic. Consumers appear to be even gloomier than purchasing managers, with the University of Michigan’s Consumer Sentiment Index falling to its lowest reading ever.

This week’s numbers should confirm this weakness with declines expected in May durable goods orders (particularly in real terms) and in May pending home sales. Unemployment claims could also edge up from an admittedly very low current level and real consumer spending for May could come in unchanged. 

Investors will also be interested in flash readings on May U.S. goods exports and wholesale and retail inventories, due out tomorrow, and June light-vehicle sales, due on Friday. These numbers should be better, suggesting that the economy will still log solid real GDP growth in the second quarter.

Third quarter growth looks less secure. The surge in consumer spending on travel, leisure, entertainment and restaurants as pandemic effect faded has now faltered and could even reverse in the face of low consumer confidence, high prices and staff shortages. Retail sales could also post further weak numbers following a -0.3% reading for May, as low and middle-income consumers are squeezed by high gasoline prices and the lagged impact of a cutoff of federal government stimulus programs last year. A recent downward trend in housing starts and home sales could continue in the face of an almost doubling of mortgage rates since the start of the year. Trade could also worsen in the third quarter due to the twin impacts of a very high dollar and a slowing international growth, particularly in Europe.

However, growth could still remain positive in the third quarter due to three important trends.

First, auto production is gradually recovering with May U.S. light vehicle assemblies reaching their highest level since January of 2021. If the chip shortage can ease sufficiently to allow this trend to continue, light-vehicle sales could rise throughout the rest of the year, due to pent-up demand among consumers who are hesitant to buy with inventories were at super low levels.

Second, at least some parts of investment spending should continue to grow strongly as companies with healthy balance sheets try to upgrade productivity in the face of labor shortages and high energy prices encourage more domestic production.

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