Sitting, Waiting and Watching
There is plenty going on in the world and undoubtedly developments are unfolding that matter to capital markets, but not enough to jostle us away from the state of stasis we are in. The Fed is in a holding pattern. Economic data is meh (not strong or weak enough to matter). U.S. politics are, well, U.S. politics. Geopolitics are concerning but contained enough. Positioning and sentiment are skewed bullishly, but lacking the spark that would force an unwind.
Sure, you have idiosyncratic events that are impactful for single stocks or narrow market themes, but for the most part the noise to signal ratio at the moment is high which relegates stewards of capital like me to ‘sitting and waiting’. The broad markets rallied last week with the S&P 500 gaining 1.84%, the Nasdaq gained 3.22% while the Dow and Rusell 2000 limped along with gains of 0.34% and 0.01%, respectively. For all the major averages except the Russell 2000, last weeks gains recaptured the tax selling losses incurred to kick off the year.
For the most part the S&P 500 remains stuck inside a trading range that has been in place since mid-December – resistance at 4,850, support at 4,700 (see chart below). A lot of choppy back and forth, but little progress being made in either direction. A breakout or breakdown in either direction will likely create some momentum in that direction, but the negative RSI divergence (purple line in below chart) should keep investors on the lookout for a breakdown.
I’m not suggesting investors should get overly complacent or let their guard down – risk happens slowly, then all at once – but the kickoff to earnings season from the banks last week is a good example of where we are. Some numbers were better than expected some numbers worse, but the underlying message was ‘things are okay’: credit is healthy, so is the consumer, and higher rates are benefitting some while hurting others. Ho-hum, nothing groundbreaking here. The same story holds for broad equity valuations where whether you’re looking at the S&P 500 on a market cap basis (dark blue line in below chart) or on an equal weighted basis (light blue line) – valuations are above their historical averages going back to 1990, but not at extremes.
We’ll see what the rest of the earnings season tells us, but I don’t expect it to move the needle either. Afterall, the bar has been lowered dramatically coming into the quarter, so I expect we’ll see modest upside beats in the aggregate. The events that I expect will be market moving come at the end of the month with the Fed meeting (January 31st) and the Quarterly Refunding Announcement (QRA) issuance schedule.
What caught my eye last week was the behavior of the bond market, where comments by Fed members (Bostic in this case) pushing back against the aggressive rate cutting cycle priced into markets are starting to be listened to. Yields along the curve fell sharply coming into 2024 with six rate cuts getting priced into the swaps market. The 2-year Treasury yield peaked on October 8th at 5.21% and then went on to collapse over the last two months of the year – ending 2023 at 4.24%. Same goes for the 10-year yield which traded at 5% at its peak in October of last year and subsequently plunged to 3.86% at the start of 2024 (trading today at 4.06%). What investors need to understand about capital markets today is that it’s ‘all one trade’. Every major asset class is taking its cue from interest rates: interest rates fall – everything rallies except the U.S. dollar, interest rates rise – everything sells off except the U.S. dollar.
One of the major contributors to the loss of momentum in the everything rally at the end of last year is the fact that interest rates have stopped falling. I’m not saying this is a permanent correlation, but it is and has been a very consistent relationship since this Fed tightening cycle got underway in 2022. The slide in interest rates in the last six weeks of 2023 relieved a lot of pressure on the economy and financial system, but concerns are resurfacing at the Fed that financial conditions have loosened too much, too soon and they are coming out in force to pushback against this development. It was comments by St. Louis Fed President Waller in November, “I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2%” that cemented the markets belief that the Fed’s tightening cycle was over. As investors are prone to do, they took this message and extrapolated it into an aggressive rate cutting cycle commencing as early as March.
Well, Governor Christopher Waller delivered remarks at a Brookings Institution event today in a speech titled, "Almost as Good as It Gets…But Will It Last?". Great title! I couldn’t have written it better myself. In his speech he expressed confidence in the economy and that his confidence in the Fed being able to get inflation to 2% while avoiding a recession has increased. However, he did pour some cold water over the aggressive rate cutting path the markets have priced in, to wit:
“When the time is right to begin lowering rates, I believe it can and should be lowered methodically and carefully. In many previous cycles, which began after shocks to the economy either threatened or caused a recession, the FOMC cut rates reactively and did so quickly and often by large amounts. This cycle, however, with economic activity and labor markets in good shape and inflation coming down gradually to 2 percent, I see no reason to move as quickly or cut as rapidly as in the past. The healthy state of the economy provides the flexibility to lower the (nominal) policy rate to keep the real policy rate at an appropriate level of tightness. But I will end by repeating that the timing and number of rate cuts will be driven by the incoming data.”
In case there was any ambiguity, later in his speech Waller made sure to be clear that while the Fed is attempting to walk a fine line between employment and inflation, he deems policy to be appropriately restrictive at the current time:
“This brings me to the implications for monetary policy. The progress I have noted on inflation, combined with the data in hand on economic and financial conditions and my outlook has made me more confident than I have been since 2021 that inflation is on a path to 2 percent. While the emphasis of policy since that time has been on pushing down inflation, given the strength of the current labor market the FOMC’s focus now is likely to be more balanced: keeping inflation on a 2 percent path while also keeping employment near its maximum level. Today, I view the risks to our employment and inflation mandates as being more closely balanced. I will be watching for sustained progress on inflation and model cooling in the labor market that does not harm the economy. “
…“I believe policy is set properly. It is restrictive and should continue to put downward pressure on demand to allow us to continue to see moderate inflation readings. So, as I said, I believe we are on the right track to achieve 2 percent inflation.”
While I hold the view that the high for interest rates this cycle were put in back in October and I think bonds should serve as a solid total return investment for investors going forward, I also think the odds of March rate cut at 65% are way too high. Furthermore, I have my doubts that we get six rate cuts out of the Fed in 2024 – barring a financial catastrophe or economic recession. Eventually, I think we’ll get there with the Fed attempting to calibrate interest rates to slower economic growth and falling inflation, but the swaps market has gotten well ahead of itself as it has left no meat on the rate cutting bone. The last time the swaps market was priced for no cut at the March meeting was back in mid-November with the yield on the 10-year Treasury at 4.5%, the 2-year yielded 4.9%, the U.S. dollar was at 105, and the S&P 500 was sitting at 4,500. Food for thought as markets recalibrate to the Fed trying to navigate its way towards a soft landing while not ceding ground on the inflation front.
As for the markets and what an investor should do? Not a whole lot at the moment. The way I see it we’re in a state of limbo, call it the “Bermuda Triangle” where things that mattered yesterday are gone tomorrow.
Incoming economic data is inconclusive as to whether we’ll get a soft landing or if this is just the natural progression in an economic cycle on its way towards a hard landing.
Inflation is tracking towards the Fed’s target, but not there yet to provide cover for the Fed to back off dramatically. The labor market, while softening, is at what many would consider fully employed. Corporate earnings are solid, the banking sector looks to be well capitalized, and the housing market, while lethargic and in a state of stasis, seems to be rebalancing itself through time.
The challenge for investors is finding investment opportunities with a constructive risk/reward setup looking out over the next 6 – 12 months. As I stated earlier, the aggregate stock market is meh – otherwise known as far from enticing. One area that checks a lot of boxes is energy stocks having declined roughly 5% since late-October compared to an S&P 500 that has appreciated more than 15%. The energy sector trades at a P/E multiple of 11x which is a bit below its historic average and cheap relative to the S&P 500 at 20x. Earnings estimates are modest for this year at +1.8%, which provides the opportunity for upside surprises if global growth picks up and the price of oil moves off the lower end of its trading range. Furthermore, investor positioning is dramatically underweight the energy sector based upon the recent BofA Fund Manager Survey.
Outside the oil market but still in the energy space is a long-time favorite of mine – uranium and the budding resurgence of nuclear energy as a carbon free source of energy production around the globe. The price of uranium just shot through the $100 level, a tripling in price over the last three years and five-fold increase from when we started kicking the tires when it was trading under $20/lbs. back in 2016. It appears investors are becoming much more pragmatic about the need for reliable, affordable, and sensible power generation. Wind and solar, while great compliments to an energy grid, are proving themselves to be inadequate in delivering the necessary reliable energy output demanded by global energy grids. Storage has proven to be the cog in the wheel of this intermittent source of energy supply. I’m sure this obstacle will be overcome in time, but in the meantime it’s nice to see policy makers and investors wise up to the raw economics. On an all-in basis, including storage and transmission, the average cost per megawatt-hour for natural gas is $38, nuclear $114, wind $291-$504, and for solar $413-$1,548.
In 2023 the NERC added “energy policy” as a key grid stability risk: in its view, the push for wind and solar has made the grid more fragile to extreme events. Think about the dominos of this growing recognition in energy policy circles. Now add to it the rising demand from electrification efforts, grid capacity, and A.I. – the 1.5mn A.I. Nvidia unit is estimated to consume 85 terawatt-hours of power per year, almost a third of the annual consumption of the U.K.
Investors should think about the next ten years and consider gradually increasing exposure to real assets in their portfolio, which include natural resources, commodities, energy, base metals, precious metals, and real estate. Many of these areas have fallen off the radar and why not with the Technology sector making up nearly 30% of the S&P 500 (energy sector is at 4%) and the Magnificent Seven – yes, seven companies making up 32% of what is marketed to the public as a diversified index. Without question these companies exhibit the attributes of monopolistic empires which will be very difficult to unseat, and all investors should have some exposure to them, but this likely will not always be the case.
Another area in the capital markets that is showing subtle signs of relative strength is emerging markets. The EEM ETF just underwent a golden cross where the 50dma moved above the 200dma (see chart below compliments of RenMac) – an important signal of strength among technical analysts. Don’t get too excited as this has been the case of ‘false dawn’ after ‘false dawn’ for more than a decade where emerging markets are set to reassert leadership only to get left in the dust by U.S. equities. Time will tell, but if/when we do get into a real U.S. dollar bear market (I don’t think its too far off) then EM equities should outperform.
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