Equities around the world put up a robust week of gains last week with the Nasdaq Composite ripping +4.22% (recouping most of the -5.36% loss the week prior), the S&P 500 rallied +2.67%, the Russell 2000 gained +2.79%, and the Dow Jones Industrial Average registered a modest increase of +0.67%.  Whether the correction that started at the end of March is over or this ends up being a ‘dead cat bounce’ is still unknown, but the preponderance of evidence over a 6-12 month time horizon still favors the bulls even if this correction isn’t over.  Helping to undermine the bearish equity case is Q1 earnings where 230 S&P 500 companies have reported thus far with 77% beating EPS estimates (above the 10-year average of 74%).  Analysts were estimating +3.0% year-over-year growth when Q1 earnings season kicked off and that number has now been taken up to +5.6%.  This is another jam-packed week of earnings reports headlined by Amazon on Tuesday and Apple on Thursday.

Those investors solely focused on U.S. equities are missing the fact that the global equity market is performing every bit as well as the U.S.: Europe is up more than +5.0% ytd, the UK is up nearly 6%, Japan +5%, and India is up more than +7%.  Perhaps most surprisingly, Chinese stocks are coming off their best weekly returns since December 2022, with the MSCI China index rallying +8% (led by Tech – HSTECH +13%).  From the trough in late January when Chinese equities wear being hopelessly abandoned by everyone and their sister, China offshore equities have rebounded +19%, outperforming both Developed and Emerging Market benchmarks.  The KWEB (China Internet) ETF was down as much as -15% in the first three weeks of 2024, but has since rallied aggressively and caught back up to the Nasdaq year-to-date performance (both up roughly +6% for 2024). 

Hedge funds have been buying H shares all year and the trend is accelerating.  Sure, geopolitical risks are high, long-term demographic headwinds are horrible, and the unpredictable nature of the PBOC policy are all meaningful risks, but valuations in this part of the world (China and Hong Kong) are some of the most compelling on the planet.  Hedge funds’ net allocations to China are still close to 5-year lows, while their allocations in other EM markets are near historical highs.  Furthermore, sentiment on China looks to have turned a corner with the onshore stock market on track for three consecutive months of positive net inflows (not too big of a surprise with the herd trampling each other to get out late last year and early this year).  As depicted in the chart below the CSI 300 is breaking out of a consolidation range that has kept it in check for the last four weeks, not to mention breaking above the 200-day moving average.        

Here is what some of the brain trust at GS have to say on the matter:

“Valuations for Chinese stocks are still suppressed from a historical context notwithstanding the recent surge, with MSCI China and CSI300 trading at 9.6x and 11.4x respectively, still around 1sd below long-term averages.  China’s significant valuation discounts to global equities have started to manifest in its recent resilience/outperformance when its global peers are digesting a less friendly growth and Fed combination, underscoring the diversification benefits from international investors to stay engaged in China.” Goldman Sachs

Two policy events this week that are a must watch for investors and sure to impact the short and intermediate-term tone of capital markets: the FOMC interest rate announcement at 2:00pm on Wednesday and the Treasuries QRA issuance schedule.  It’s going to be a tall order for Powell and Co. to be more hawkish than they’ve been over the past month unless he comes right out and says actual rate hikes are back on the table.  Unlike where we wear at the start of the year, we are not going into this meeting with an expectation for six, three, or even two rate cuts for this year.  Market pricing is recalibrated for just one cut in 2024 and that one cut continues to get pushed further and further out the calendar.  The swaps curve is pricing in a nearly 1 in 5 chance that the Fed will leave rates steady through the rest of 2024 (up from just 1% a month ago).  Compare that to the consensus expectation coming into the year of 150 basis points of cuts coming in 2024.  That is a meaningful shift in Fed policy expectations that has played out in the first four months of the year. 

At this point it is going to take something unexpected for the Fed to shift its stance in either direction, but I continue to think the bar is higher for them to get incrementally tighter than for them to get incrementally looser.  What could such a shock be: a substantially weaker turn in the labor market, a deep equity market correction, widening credit spreads, and/or a destabilizing geopolitical event are a couple things that come to mind.  We are seeing verifiable signs that this higher interest rate regime is having a meaningful impact on areas of the economy most sensitive to rates.  Last week we got the March Architecture Billings Index, which plummeted sharply to 43.6 from 49.5.  This marked the 14th consecutive month of declining billings at firms as inflation, supply chain issues, and other economic challenges continue to affect business.  The report indicated that while inquiries into new projects have continued to grow, it has been at a slower pace than in 2021 and 2022.  We also got mortgage application data for the week of April 19th which suffered their steepest decline (-2.7%) since late-February.  This is an indication that housing is now responding negatively to this latest bout of upward pressure on mortgage rates.   

I continue to remain concerned that the Fed is going to end up making a policy misstep by waiting too long to walk back tight policy.  But I also recognize that this view carries with it a bias towards how cycles have played out over the past four decades and that we very well might have shifted into a new regime post-Covid.  A regime dominated by fiscal policy makers where larger deficits, bigger government, and populism dictate policy and these drivers overwhelm the potency of monetary policy.  Furthermore, I find myself more perplexed than ever in measuring and interpreting incoming data.  So much so, that I wonder if the way the government collects and calculates economic data is out of step with the dynamism and evolution in an economy as large and complex as the U.S.?  That’s just me thinking out loud and the answer to such an abstract question is way above my paygrade.

In addition to earnings, the Fed, and the ISM manufacturing index we get the latest read on the health of the labor market with the April jobs report set to be released on Friday.  I have to say based upon last week’s data from the QCEW (Quarterly Census of Employment and Wages) and the companion BED (Business Employment Dynamics) from the BLS, I consider the monthly jobs report to be much less relevant than the talking heads make it out to be.  The QCEW data covers 11.9 million establishments compared to around 700k entities for the monthly nonfarm payroll report.  Both data sets are lagged, but the monthly jobs report has become less reliable in its accuracy because of historically low response rates and a flawed Birth-Death model (measuring the net change in jobs from newly formed and shuttered businesses).      

I make this claim because the QCEW data as of September 2023 show that year-over-year employment growth was +1.5% and marks a dramatic slowing from the +4.4% pace a year ago.  Beyond the dramatic slowing in job growth is the difference in employment growth between the QCEW (+1.5%) and the monthly nonfarm payroll report that everyone trades off of showing job growth at +2.0%.  That may not seem like a big difference to the casual observer, but it amounts to the monthly jobs data being overstated by roughly 800k jobs, or nearly 70k jobs per month.

The BED database is seasonally adjusted and revealed a -192k decline in private employment in Q3 of last year, but the monthly reported payroll data on private jobs showed a whopping +521k surge.  This level of job loss is typically seen in the early quarters of an economic recession.  The BED data provide details on gross hirings and firings with the latter continuing to decline which is being ratified by the low initial jobless claims’ week-in and week-out.  This database also revealed a meaningful discrepancy with the monthly payroll data where in the year up to Q3 only +205k net new jobs were created by net new business formation, but the payroll data via the Birth-Death model showed around +1 million jobs created.  Additionally, the BED data showed private employment rose +1.6 million over the four quarters to Q3 which is roughly 1 million less than the +2.6 million in the monthly nonfarm payroll survey.  As an aside the QCEW data show a gap of near -800k with the nonfarm payroll survey.  So, no matter how you slice it the monthly payroll data looks to be substantially overstated and substantial negative revisions are likely in our future when we get annual revisions in six months’ time. 

What’s your point Corey?  It doesn’t seem like the markets care about this data, so why bring it up?  Because it’s a data point, it’s a more thorough and longer-term look at where the labor market is, and more than anything it reinforces the importance of taking every reported data point with a grain of salt.  Also, it is a reminder that what we think we know in real-time with a lot of the government provided data is at best an approximation of incomplete data.  This is by no means and indictment against those hard-working civil servants tasked with putting out these reports – they are some of the finest people the world has to offer – but rather the challenges with issuing timely and accurate data on an economy as large, dynamic, and complex as the U.S. 

Looking beyond the labor market the global economy is showing broadening signs that the manufacturing recession is over.  European data led by Germany has inflected positively over the last several months.  China is showing signs of climbing out of its eight-quarter abyss, albeit in a two steps forward one step back manner.  And in the U.S. the March ISM manufacturing sector moved above 50 for the first time in 16 months.  Leading indicators suggest a sustained upcycle is forthcoming, but higher for longer interest rates could limit the robustness of the expansion. This global manufacturing upturn is substantiated by the pickup in global trade coming through the data over the last few months.  Export data from the top 10 exporters is up +10% from year ago levels and being led by goods producing nations like Japan, South Korea, and Taiwan  

The improvement in global manufacturing and goods demand has aligned with a rebound in a broad set of commodity prices.  The CRB is making highs not seen in more than a decade.

The pickup in global goods demand and manufacturing production represents an important shift in the global economic landscape in 2024 relative to 2023.  Many central banks were guiding toward interest rate cuts on the expectation that inflation pressures would be abating more aggressively in part because of soft commodity demand.  The activity data and commodity prices confirm that this improvement in global goods demand is real and likely to continue for at least the first part of '24.  Do not underestimate the extent to which past stimulus policies like the IRA (Inflation Reduction Act and Chips Act) are fueling this pickup.  The below graphic from Apollo’s Torsten Slok compares the Marshal Plan that was implemented back in the 1940’s to contextualize just how big the Covid -era policy response is.  

I’m going to sign off this missive with a thought on return expectations and the fixed income markets.  One method investors use to back into return expectations for equities is take the projected earnings over the next twelve months and divide that by the price the security is trading at.  Keeping all other things constant (a big assumption for sure) this provides you with a reasonable estimate of what said investment should return over a 1-year timeframe.  Let’s walk through this exercise with the S&P 500 where the consensus estimates forward 1-year earnings to be $252/share.  With the S&P 500 trading at 5,100 this gives you an earnings yield of 4.94%.  Now compare this with the 5.2% yield on a 1-year T-bill or the 5.3% yield from a AA rated corporate bond maturing in 1 year’s time.  In a nutshell, the risk/reward to endure the uncertainty and volatility of owning equities with a 4.94% earnings yield compared to a riskless Treasury or virtually risk-less AA rated corporate bond is not very compelling. 

I am by no means a bond bull over the intermediate or long-term given my view that we are in the midst of a regime shift that will persist for years to come.  But interspersed within this regime shift will be moments of opportunities where I expect fixed income to outperform equities or it will be the more optimal asset to hold for a period.  I think we are at one of those junctures.  Right now, you get a return profile that is similar to what you would expect from stocks without having to incur the risk or volatility.  Furthermore, you get the certainty of a mid-single digit return on your capital with the option to change your mind at any point in the future without having to worry about a negative drawdown if you are wrong. When I see prominent and brilliant (I might add) strategists like Michael Hartnett at BofA Merrill Lynch putting out new acronyms like ABB (Anything But Bonds) or Rick Reider at Blackrock culling duration in his fixed income funds I take that as a pretty loud contrarian signal that sentiment has become overly skewed to the negative side.

Consider this for context, unbeknown to investors at the time, the S&P 500 peaked in the first week of January 2022 at roughly 4,800.  It then went on to fall -27% into October 2022.  Since the October 2022 low the S&P has rallied +46% (3,491 to 5,100) but that equates to a modest +6.25% gain from the 4,800 level it first reached in January 2022.  Not that much better than what a 2-year T-bill offers you today.  The biggest difference between today and January 2022 is that the 2-year T-bill yielded 0.75% compared to 4.98% today.  The S&P 500 earnings yield in January 2022 was 4.50% ($215 EPS estimate at the start of the year divided by 4,800 price) compared to 4.94% today.  Earnings ended up falling in 2022 ($171) and have since increased 47% – in line with the gain in price from the October 2022 trough.  The TINA (There Is No Alternative) era is over, yet I’m seeing investors behave as if it isn’t.     

Keep in mind that we are talking about fixed income opportunities where you don’t have to go out more than a couple years or stay within 12 months and you can get a mid-single digit return with very little risk of principle.  I get it, risk takers get the big paydays, but when you’ve already accrued enough wealth to secure financial independence for you and your family, the math changes where preserving the capital is just as important as compounding it. The investment backdrop today does not necessitate the need for investors to reach for returns, all one needs to do today is accept that 5% with no thrills and no worries is good enough for peace of mind and stability in a prudently allocated portfolio.   

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