Fed Credibility On Watch
Equity markets were flat to down last week with the Nasdaq Composite (-1.0%) and Russell 2000 (-2.1%) fairing the worst of the major indices. This was the second straight week of losses for the Tech-centric index as it is showing some signs of losing momentum. Although the news this morning of Apple using Alphabet’s Gemini AI tool for the iPhone is providing a bump to the Mag7 trade. While the S&P 500 has been chopping sideways over the last several weeks what appears to be happening under the surface is a rotation among sectors with energy, materials, and cyclicals performing better as the TMT (Tech, Media, and Telecom) space takes a bit of a breather. This is a healthy development in my eyes and aligns with the pickup we’re seeing in the global economic activity data at the start of the year.
China is a major driver of this pick up in global growth optimism where the data we got overnight continues to show improvement. Don’t get me wrong this isn’t the China of fifteen years ago that was growing double digits, but a rate of change from bad to better is meaningful in markets. Industrial production for the January-February period rose to +7.0% YoY - the best level in two years. Retail sales rose +5.5% YoY, and growth in fixed investment came in at +4.2% - the fastest pace in almost a year. Commodity markets have been acting better on the back of improving global growth momentum as the price of WTI pushes north of $81 a barrel and copper prices have been surging.
Meanwhile, back to markets where bonds continue to go through a bout of indigestion following last week’s sticky CPI and PPI prints and increasing odds that the Fed’s rate cutting cycle gets kicked further out the calendar. The 10-year Treasury yield rose +21 basis points to 4.30% last week and now is itching up to 2024 highs. Equity markets don’t seem too fussed about it at the moment, but higher rates are a headwind for multiples and highly indebted entities. The yield on the 2-year T-note has ripped more than +40bps this year and is back to where it was last December (4.70%) when the S&P 500 was trading closer to 4,700 – nearly 10% below today’s price. As for credit spreads, they’ve only been tighter 10% of the time in the past (see chart below from BofA). These very thin spreads are coinciding with company defaults in 2024 at their highest level (29) to start a year since the GFC (36) – according to S&P Global Ratings.
We have a hefty calendar of central bank meetings this week: the Bank of Japan (BOJ) on Tuesday where they are expected to shift out of NIRP for the first time in nearly a decade, the Fed concludes its two-day meeting on Wednesday, and the Swiss National Bank (SNB) and Bank of England (BOE) meet on Thursday. Expectations are high that we see a shift in the dot-plots from 3 cuts to 2 following the release of the SEP (Summary of Economic Projections) on Wednesday. It will only take two FOMC voters to shift their views for this to happen. Not sure it will be too big of a market moving event for the bond market as it has already repriced to not expect much from the Fed year, but equities always seem to throw a temper tantrum when the Fed puts the lid on the cookie jar.
The futures market is just a little over 50/50 odds the Fed will cut at least once by July which is a major adjustment from the start of the year where there was a 75% chance of at least one cut by March. In total the swaps market is pricing in a little less than 3 cuts (71 basis points) for all of 2024, down from 6 cuts (-150 basis points) at the start of the year).
As for my thoughts on markets, I think we’re at the ‘prove it’ part of the cycle on many fronts.
Inflation needs to prove whether the pickup we’ve seen in the first two months of the year was an over exaggeration on the upside – aided and abetted by seasonal distortions – or if we will start to see the downtrend reassert itself into the back half of the year?
Equity valuations need to prove whether they are deserving of trading at peak cycle P/E multiples of 21x with nominal GDP growth and the labor market remaining firm. Solid economic growth is supportive of earnings which should underpin equities and allow multiples to remain high. Multiples could also compress in a good way with earnings catching up to price, but a deceleration in growth and/or a weaker labor market likely takes a couple points out of peak multiples.
Interest rates need to prove whether they are peaking out or set to push even higher. The yield on the 10-year Treasury is nearing a critical level at 4.35% - 4.50%, a move above 4.50% poses a problem for asset prices. For now, we’re at the top end of the range with Fed expectations already having reset to a ‘higher for longer’ strategy. Should the Fed have to lean even harder into the hawkish camp because inflation remains stubborn, or asset prices get to out in front of rate cuts then we could experience a 2022 redux where both stocks and bonds come under pressure.
In a nutshell, much of what supported the equity rally since last fall is reversing. Policy is getting tighter than expected (so far it hasn’t mattered, but that doesn’t mean that it won’t) and economic conditions are becoming more challenging. Yes, it’s an election year and political motivation out of this administration is high to keep everything in check or even give it a boost – so markets have that going for them, but investor sentiment, positioning, and valuations are much higher than they were last fall. This is the type of setup that is ripe for disappointment and/or a reversal.
Speaking of sentiment, bullish sentiment is hitting extremes. The most recently published readings from the Investors Intelligence survey has bullish sentiment at 60.9% among investment advisors. This is above the 60% level generally considered as being “excessive” and the highest point since mid-2021. The bearish contingent is down to a lowly 14.5% - also the lowest since 2021. Not to mention the National Association of Active Investment Managers exposure just moved up to 104.75 – its highest level in over two years. Anytime this reading gets north of 100 it’s an indication that all the kids are back in the pool.
This isn’t me jumping aboard the bear train by any means, but rather highlighting a setup that in the near term is littered with indicators suggesting the risk of disappointment is high. Let me walk you through a plausible what/if scenario. What if inflation sticks in the 3.5-4.0% area code into June when the Fed is widely expected to cut rates? Either they don’t cut, or expectations get pushed out further, and not for the reasons the market would like (stronger fundamentals) but rather because inflation is not under control. Markets wouldn’t like this outcome.
However, what if the Fed cut regardless of inflation remaining stubbornly above their target? This would imply the Fed is willing to tolerate higher inflation and undermine their inflation fighting credibility. Perhaps the Fed has to go down this path with the fiscal year 2024 government spending up 9% YoY in the first five months of the year and a budget deficit that is up 15% (annualizing at $2.0 trillion). U.S. government debt is now rising $1 trillion every 100 days, which is putting intense stress on funding markets. Perhaps it’s this backdrop, where the Fed ultimately has to backstop the Treasury market, sprinkled with a dose of stagflation that has crypto and gold at all-time highs.
All I’m getting at is that the margin of error with today’s setup is razor thin. And I’m saying this as a humble analyst that is not that worried about economic growth or inflation at the moment. Understand that it’s my job to worry and be concerned about risks that many view as inconsequential or low probabilities. Fair enough, and most of the time I come to similar conclusions, but to dismiss them with haste or a lack of diligence is both irresponsible and imprudent when you are tasked with stewarding other people’s capital. Not to mention the complexities with analyzing and trusting data in this post-covid world. I’m not one that buys into the conspiracy theory that government officials’ smooth data to serve their political interests. Sure, we all spin narratives to fit our biases, but the raw effort of gathering, tabulating, and reporting government data is done so with great integrity (in my opinion).
However, we are seeing revisions to previously reported data that call into question how much confidence one can have in their initial analysis. Consider the following four tweets where the number of jobs created in California from September 2022 through September 2023 have been revised from +325k to +50k.
Oh, don’t worry it’s only 85% less job growth than originally reported! Are you kidding me? Please don’t extrapolate this into every data point that gets reported by the Federal, state, or local government, but keep this in mind when listening to all the talking heads offering instant analysis of the monthly jobs report 30 seconds after its reported. And then never mention it again because its ancient history when the next report gets published a month later. Let this serve as a lesson in humility and an appreciation for how difficult a task it is to measure something as large and complex as the U.S. economy. Analyzing and drawing inferences on capital markets is just as humbling and the lack of certainty requires that successful investors have discipline, remain prudent, and exercise patience.
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