Let’s See How It Plays Out
Chairmen Powell was in an enviable position at last week’s FOMC press conference where he had a ‘free option’ to nudge the narrative in whatever direction he wanted. Economic data has been favorable on the growth front of late and inflation data on a 3-month and 6-month basis is trending towards the Fed’s objective. The icing on the cake is this ‘goldilocks’ backdrop aligning with a labor market remaining firm and at the Fed’s objective of ‘full employment’. That being said, Powell was pragmatic when referring to growth and inflation – acknowledging that both are in a good place. He parlayed this assessment into a noncommittal stance as it pertains to future policy moves, while (relative to market expectations) leaning slightly hawkish.
In a rare appearance on “60 Minutes” (taped on Thursday before Fridays labor report), Powell reiterated that things are in a good place, that the Fed would likely wait for additional incoming data before further adjusting monetary policy, and that the FOMC is unlikely to cut interest rates in March. Moreover, Powell hinted that any move to recalibrate rates lower will come later in the year and be contingent on the Fed having more “confidence” that inflation is heading “sustainably” towards its 2% target:” the danger of moving too soon is that the job’s not quite done…we have a strong economy…the labor market is strong”. Powell was clear that while inflation is trending towards their target, they want to see further evidence before acting on it, “doesn’t need to be better than what we’ve seen, or even as good. It just needs to be good”.
Between the press conference, Friday’s surprisingly strong (on the headline) payroll print, the 60 minutes interview, and this morning’s better than expected ISM non-manufacturing print the markets got the message and is repricing a ‘higher for longer’ interest rate backdrop. Market-based odds of a March rate cut have plunged to just 20% and May odds are down to 70% from 95% prior to Friday’s jobs report. As of this morning the probability of at least six rate cuts (150 basis points) in 2024 has cratered to 20% from north of 60% last week. The bond market is pricing an end-of-year Fed Funds rate of 4.2% compared to a 3.9% expectation just a couple of weeks ago. This is why we’ve seen the yield on the 10-year T-note rip from 3.83% on Thursday morning to 4.16% today – almost 35 basis points in less than three days is a lot for the world’s major reserve asset. The yield on the 2-year T-bill has jumped by 40 basis points from 4.16% to 4.46% as it has to reset back to a ‘higher for longer’ environment.
This repricing is not isolated to the bond market with the DXY dollar index breaking out on the back of higher U.S. rates – pushing above the 104 level and now rapidly approaching the 100-day moving average. Keep in mind it was the expectation of a more accommodative Fed, lower interest rates, and a weaker dollar that created the perfect recipe to kickstart the rally in everything in the last two months of 2023. All of these variables are now reversing and eventually (should they persist) will act as a headwind for asset prices to move higher. This is a toxic cocktail for small cap stocks (everyone’s darling at the end of 2023), emerging market equities, and the commodity complex (which are priced in dollars).
While I understand and agree with the stance Chairmen Powell is taking – ‘if it’s not broke, don’t fix it’ – and generally view the Fed as just playing for time. I find myself more in Greg Ip’s camp when thinking about things on a longer-term time horizon. The below snippet from Mr. Ip’s article “Fed Shouldn’t Take Too Long to Declare Victory on Inflation”, in last week’s WSJ hits the nail on the head:
“Where should rates be? Go back to March 2022, when the Fed first started tightening. At the time, officials thought core inflation would end 2023 at 2.6% and unemployment at 3.5% - close to what actually happened. And they thought this would require a federal-funds rate of 2.8% - fully 2.5 percentage points lower than it is today. This doesn’t mean the rate should be 2.8% now, but it does mean the rate could be lower than 5.25% while remaining restrictive. Economists use the Taylor Rule to calculate where the Fed should set rates given actual and target inflation, economic slack, and the neutral interest rate, which over time keeps both inflation and unemployment stable. Three versions of the rule calculated by the Atlanta Fed suggest the Fed’s target rate should be 3.47% to 4.37%.”
Let’s be fair in that all of us have the luxury of chirping from the cheap seats and passing judgement on policymakers without the responsibility. I do think Powell and the Fed deserve credit for the position we are in with monetary policy. They have a lot of optionality at this point to adjust to whatever the future holds. Not to mention, they’ve navigated monetary policy through some unprecedented events over the last several years, and here we are today where the ‘Fed Put’ is back – if and when it’s needed. This should bring comfort to investors. Furthermore, the Fed has a lot of ammunition to combat a downturn in the economy and this is something investors need to recognize before getting too confident in the bear camp. However, I don’t want to see the Fed snatch defeat from the jaws of victory by waiting too long to recalibrate policy to an inflation backdrop that in my estimation no longer requires rates staying at current levels.
Real-time inflation metrics like Truflation, which uses more than 10 million data points to calculate inflation, show inflation to be +1.4% year-over-year, not the +3.4% reported in the CPI data.
Our work suggests that the risk of a return to deflation is greater than the risk to any sustainable reacceleration in inflation. Sure, many are trying to draw attention to the surge in container costs from the disruptions to shipping routes in the Middle East, but the simple reality is that these play a de minimis role in total shipping costs. Yes, a prolonged disruption to shipping channels will have an impact on goods inflation, but this upward pressure will pale in comparison to the decline we are seeing in the housing and rental components that will soon be filtering through the inflation calculations.
As for markets, the S&P 500 logged its 13th weekly gain in the last 14 weeks with both it and the Dow reaching new record highs. It’s worth noting the lopsided nature of Friday’s trading session where the Nasdaq popped +1.7% and the S&P 500 gained +1.1% while only half the sectors were up on the day and the advance/decline line was actually negative. Friday was just the second day in the last 62 years that the S&P 500 gained +1% on a day when there were 2 losers for every winner on the NYSE.
The domination of the Magnificent Seven was on full display last week, all be it with mixed results. Meta registered the largest one-day market cap gain (+200 billion) in history following blockbuster results which sent the shares up more than +20%. Amazon also bested analysts’ expectations as it turns up its operating efficient lever on its quest to world supremacy. As for Alphabet, Microsoft, and Apple, all reported higher profits and sales that topped analyst views, but the numbers across key parts of their business segments were not good enough with each selling off after they released results (Alphabet -7.5%, Microsoft -2.7% and Apple -3%, before each staged a comeback). All in all, with roughly 50% of S&P 500 companies having reported Q4 results, earnings are coming in better than expectations. But in all sincerity the stock market has become a showcase of the supremacy of these Mega Cap Tech behemoths. The consensus for Q4 earnings growth among the Mag7 (excluding Tesla) was a whopping +63%, whereas it is -8.6% for the other 494 companies that make up the S&P 500 (+4% for the overall index).
I was sent the following comment on the Mag7 from JP Morgan’s trading desk which I think pretty accurately sums up how one should think about them:
“Cash flow, cash levels, growth opportunities, and buyback potential make the Mag7 a different animal relative to the Tech Bubble. Mag7 are a disproportionately higher percentage of the SPX’s revenue growth and EPS growth, relative to their absolute percentage of revenue and earnings. Ultimately, a call to short the U.S. is a call to short these names and this past week showed the risk in taking that action.
Where from here? Up. These companies just proved their earnings prowess in an elevated bond yield environment… if this rally fails to broaden these companies will have an outsized benefit…the Mag7 end the fiscal year with a combined cash level that exceeds $478bn, with 3 of the Mag7 in the top 5 most profitable companies in the world (Apple, Microsoft, and Alphabet). This is a long-winded way of saying if you do not own these stocks, you should; and, if you do, you should own more.” JPM market intelligence
As for last week’s economic data, it was constructive. Auto sales was the only data point that disappointed. The ISM manufacturing index, while still in contraction territory at sub-50 for the 15th consecutive month showed rate of change improvements in many metrics. It went from 5.6% of the industries in expansion mode in December to 22.2% in January – not great, but going in the right direction. The ISM non-manufacturing survey released this morning was rock solid with the exception of prices paid coming in a little too hot. As for the jobs report, where we got a blockbuster +353k headline print (above every Wall St economist forecast) – I’ll reserve judgement. Yes, I think it was too good to be true and not an accurate representation that the labor market is on fire. If that were the case, we wouldn’t have seen the workweek shrink -0.6%. The effect of the combination of the decline in hours worked and jobs added is equivalent to payrolls actually declining by -550k last month. So, to describe last week’s jobs report in a word – confusing. That being said, investors should take it with a grain of salt – the labor market remains firm – and leave it at that.
As for some closing thoughts on the capital markets – put me in the Powell camp of awaiting more data to confirm or deny my view. A view that is emphatically neutral. The economy, inflation, and liquidity data look fine to me. Corporate earnings and the economy are tracking pretty closely together as depicted in the below S&P EPS growth chart – we had a soft patch in economic growth with negative GDP prints in Q1 and Q2 of 2022 which flowed through with a lag to corporate earnings in Q4 2022 and early 2023, but both steadily improving since.
I’m not suggesting that economic growth won’t moderate from its above trend growth pace over the last two quarters – it should, as restrictive monetary policy works its way through the system. But there is a lot of space between where we are today and recession risks.
Equities trading at a P/E of 20x are already reflective of things being pretty good. Furthermore, positioning and sentiment are in a similar place. With this setup you’re not going to catch a lot of investors off guard if things continue to hum along as they have been. The risk is things take a turn from good to less good. Recall what I pointed out above – interest rates, the U.S. dollar, and Fed policy have shifted in a less constructive fashion than was the case when this leg higher in asset prices started last November. Should these variables continue in this direction then there will come a point where they are a more material headwind to a further rise in asset prices.
The fixed income market has experienced a material repricing over the past week and while I can see yields pushing a little higher – perhaps as high as 4.50% on the 10-year – I think the bulk of the rates move is behind us. I still think the path of Fed funds and interest rates is lower rather than higher, but it won’t occur in a straight line.
In a nutshell, what I’m saying is own assets and retain optionality with the portfolio mix you feel comfortable holding. Leave the guessing up to the speculators at this juncture. This economy and markets have proven that they are very difficult to predict and front-run – let it reveal itself in time. At this moment the aggregate sum of the signals and indicators I follow send a mixed message which tells me, now is not the time to take a stand or be bold in one direction or the other.
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