Transports, Insurance & More AI

January 30 (Thursday)

Industrials: Transports Chug Along. After a tough 2024, the S&P 500 Transportation Composite is having a strong start to the year, with traffic gains in multiple modes of transportation leading to strong earnings and rising stock prices. The Transports’ stock price index has risen 7.2% ytd through Tuesday’s close, bolstered by several of its component industries: S&P 500 Passenger Ground (12.8%), Passenger Airlines (7.2), Rail Transportation (6.9), Cargo Ground Transportation (5.8), and Air Freight & Logistics (4.1) (Fig. 1). The index still hasn’t topped its March 29, 2022 peak, but it has been moving steadily higher after hitting bottom on September 30, 2022.

Let’s take a look at two of the strongest industries in the Transportation sector: Airlines and Railroads:

(1) Flying high. Anyone who’s been in an airport recently knows the airline business is booming. Demand remains robust from consumers traveling far and wide and business travelers back in the skies, returning air traffic to levels last seen before the pandemic (Fig. 2). The S&P 500 Passenger Airlines stock price index has risen 65.4% over the past year, on the wings of United Airlines Holdings (149.9%), Alaska Air Group (94.2), Delta Air Lines (70.7), and Southwest Airlines (5.9) (Fig. 3).

Alaska Air’s shares have risen on strong earnings and growing expectations that its pending merger with Hawaiian Airlines will be completed now that the Justice Department has decided against challenging the deal. It still needs approval from the US Department of Transportation, which is more likely with President Trump in office.

United Airlines shares keep flying higher as the airline’s earnings have bested analysts’ estimates. The airline reported Q4 adjusted earnings per share of $3.26, topping the $3.00 analysts expected and far above the $2.00 earned a year earlier, a January 21 CNBC article reported. UAL told analysts to expect adjusted earnings per share of $11.50-$13.50 in 2025, in line with analysts’ target of $12.82 and above 2024’s adjusted EPS of $10.61. For the full year 2024, United reported that it operated the most flights and carried the most customers in its history, and so far this year, demand has continued to accelerate.

(2) Smaller carriers hit turbulence. Unlike some of the large carriers, budget airlines have been having a tougher time of it. JetBlue Airways shares are up only 9.3% over the past year through Tuesday’s close, after they sold off sharply on Tuesday. The company, which has been restructuring its operations, reported Q1 revenue guidance that disappointed analysts and investors.

“The company’s costs are rising faster than its revenue, and its turnaround efforts are being stymied by changing consumer preferences and issues with aircraft,” a January 28 WSJ article reported. Labor and maintenance costs have been rising faster than revenues. The company also blamed the late timing of Easter this year.

With Southwest still on tap to report Q4 results, the y/y earnings growth rate so far for S&P 500 Passenger Airline industry is 42.8%, and analysts see clear skies ahead. The industry’s revenues are forecast to grow 6.8% this year and 5.8% in 2026, leading to prospective earnings growth of 35.9% this year and 15.1% next year (Fig. 4 and Fig. 5). Meanwhile, at 9.6, the industry’s forward P/E is on par with its historical average (Fig. 6).

(3) Chugging along nicely. Union Pacific shares are leading the way in the railroad industry. Its shares have climbed 9.3% ytd, followed by Norfolk Southern (7.5%) and CSX (1.3). Railcar loadings are up 6.9% since the recent bottom in July to 498,000 units in January, using a 26-weekly average (Fig. 7). Rail activity has been boosted by an uptick in trade, with the number of containers entering and leaving the West Coast ports increasing to 10.7 million TEUs as of December on a 12-month-sum basis (Fig. 8). Companies may have been importing goods proactively late last year in order to avoid the tariffs President Trump is expected to announce. That could be a headwind this year.

At Union Pacific, a drop in fuel surcharge revenue depressed the railroad company’s Q4 revenues, down slightly y/y at $6.12 billion. Excluding the fuel surcharge, revenue grew 4%. UNP net income rose 6.7% y/y to $1.76 billion as fuel expense dropped sharply and operating expenses declined by 4%. Freight volume rose 5% y/y in the quarter, including a 16% gain in intermodal shipments.

International volumes were up 26% in the quarter due to imports from the West Coast, which means this year’s comparisons will be difficult. Also dragging on the business is reduced demand for coal and curtailed production by car makers to better manage high inventories.

Conversely, the railroad expects a pickup in its industrial chemicals and plastics business due to plant expansions in its territory. “[W]e currently have over 200 track construction projects in progress with a potential revenue of $1.5 billion, and our business development pipeline is just as strong as it was this time last year,” said Kenny Rocker, UNP’s head of marketing and sales, in the railroad’s earnings conference call.

While the railroad’s business could be hurt if President Trump follows through with tariffs, it could benefit if the President lowers regulations and taxes. UNP continues to boost efficiency with 75 productivity initiatives. It’s automating its terminals, inspections, maintenance tasks, and distribution of materials, said CEO Jim Vena. In addition, it is thinking about automating some of its vans. Add it all up, and this year UNP executives anticipate high-single-digit to low-double-digit earnings growth.

The S&P 500 Rail Transportation stock price index has been in the same sideways channel since roughly 2021 (Fig. 9). Likewise, its forward revenues per share and forward operating earnings per share have plateaued over the same time period (Fig. 10 and Fig. 11). But analysts are optimistic that results will improve this year, with revenue expected to increase 3.4% this year and 4.8% in 2026 and earnings forecast to rise 8.6% this year and 12.6% next year (Fig. 12 and Fig. 13). Some of that optimism is priced into the stocks, trading at a forward P/E of 19.1 (Fig. 14).

Financials: California Insurance Update. Travelers and Chubb, two insurers with modest exposure to California’s wildfires, reported earnings in recent days. Both companies posted strong results, with pricing and earnings rising. Chubb gave some color on the impact the wildfires would have on its Q1 results. Travelers took a pass. Here’s a look at what they had to say:

(1) Wildfires to hit Q1. Chubb reported that its current estimate of the California wildfires cost is $1.5 billion net pre-tax, and it will impact the company’s Q1 results. The estimate is based on what their adjusters on the ground have determined after evaluating each property, said CEO Evan Greenberg in the company’s Q4 earnings conference call. The estimate includes Chubb’s projection of what the assessment will be from the California’s state-run Fair Access to Insurance Requirements (FAIR) plan.

Prior to the fires, Chubb had more than halved its exposure to the ravaged area. “We’re not going to write insurance where we cannot achieve a reasonable risk-adjusted return for taking the risk,” said Greenberg.

He took the state to task for not allowing insurers to charge a fair price or to tailor coverage in California to improve availability and affordability. By offering more affordable insurance through the FAIR plan, California is distorting the insurance market, leading consumers and businesses to take on more risk in deciding where to live or work, he said. The underpriced insurance also encourages less risk management and loss mitigation activity by federal, state, and local governments. One way or another, Greenberg contends, the citizens of the state pay the price for insurance coverage.

Travelers did not produce an estimate of the California wildfire claims’ cost. But CFO Dan Frey said in the earnings conference call that the fires were a “material event for the industry” that would “have a material impact on our first quarter earnings.” The company had been shrinking its exposure to California prior to the event, he noted, but didn’t provide any additional specifics.

(2) A look at their numbers. Chubb reported Q4 adjusted earnings of $6.02 a share, meeting analysts' consensus estimate and rising above last year’s adjusted earnings of $5.54. Results benefited from a 6.7% increase in property and casualty net premiums written, excluding agriculture. The company also reported a 13.7% increase in net investment income to $1.69 billion.

“We are confident in our ability to continue growing operating earnings and EPS at a double-digit rate, driven by our three major sources: P&C underwriting, investment income, and life income,” said Greenberg in the company’s earnings press release. Chubb shares rose 3.4% this week through Wednesday.

Travelers reported Q4 earnings per share of $9.15, up from $7.01 a year earlier, beating the analysts’ consensus forecast of $6.63 a share. Net written premiums increased 7% to $10.7 billion; net investment income increased 23% pretax y/y, and total revenues increased 10% to $12.0 billion. Travelers’ shares likewise added 3.2% this week through Wednesday.

Disruptive Technology: Digging into DeepSeek. The global competition for the best AI model is heating up. Focus on China’s DeepSeek and its AI model managed—momentarily—to grab the spotlight away from President Donald Trump. Developers behind the model claim that DeepSeek is able to crunch data and process information far faster than OpenAI using far less infrastructure, like Nvidia’s chips. Not to be outdone, Alibaba Group Holding stated on Wednesday that its new Owen2.5-Max AI model outperformed DeepSeek-V3, OpenAI GPT-4, and Meta Platforms’ Llama3.1-405B in certain benchmark tests, a January 29 SCMP article reported.

In last Thursday’s Morning Briefing, we highlighted DeepSeek as one of several technology companies in China that aim to dominate the artificial intelligence (AI) business. Below are more aspects of the DeepSeek story that have caught our attention:

(1) DeepSeek tows the party line. If the US government opposed TikTok due to the potential influence the Chinese government could exert through the app to users, the US government should most definitely oppose the use of DeepSeek. So far, only the US Navy has prohibited DeepSeek’s use by Navy members due “security and ethical concerns associated with the model’s origin and usage,” a January 28 CNBC article reported.

The app reportedly gives answers that parrot the Chinese Communist Party. In a January 27 article, The Epoch Times reported that when DeepSeek was asked whether the Chinese regime has backed intellectual property thefts from the United States, DeepSeek replied that such allegations “are unfounded and not in line with the facts” and that the Chinese regime “has always been a staunch defender of intellectual property rights and has made significant progress in establishing a comprehensive legal framework for IP protection.”

When asked “Who is the president of Taiwan?,” the app replies that the question is beyond its “current scope.” DeepSeek also wouldn’t answer “What do Chinese people think of Xi Jinping?,” “What’s the Falun Gong Protection Act?,” and “What’s the White Paper movement?” And when asked what occurred on June 4, 1989, the app wouldn’t say that the massacre of protestors on Tiananmen Square occurred on that date. Given that DeepSeek was more popular on the Apple store than OpenAI this week, we might have expected the US government to have acted. It might at least have made Apple put a warning on the app’s listing noting its biases.

(2) DeepSeek’s a hometown hero. Judging by some headlines in the South China Morning Post, DeepSeek has become a national hero in China. “DeepSeek’s tech breakthrough hailed in China as answer to win AI war,” read one article on Tuesday. Chinese tech leaders claim that the company changed China’s “national fate” in its tech war with the US and has “upended the world.”

(3) A bit surprised. Given China’s desire to win the tech war with the US, it’s a bit surprising that DeepSeek was allowed to open source its product. As a result, tech gurus across the world can follow DeepSeek’s mechanics and replicate them to make their AI programs faster and more efficient.

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On Eurozone Stocks, BOJ Policy & More On AI Stocks

January 29 (Wednesday)

Global Stocks: New Dawn for the Eurozone? Eurozone stocks have been off to the races this year. The best ytd performers among the MSCI country indexes all have been European (Fig. 1). While Eurozone stocks are still broadly trailing US stocks since the bear market bottomed in October 2022, MSCI Germany and MSCI Spain have nearly caught up with their US counterpart (Fig. 2). In fact, MSCI EMU (European Economic and Monetary Union) recently hit a record high—and not because of a quickly expanding valuation multiple (Fig. 3).

Most Eurozone country indexes trade between 10 times to 15 times forward earnings (Fig. 4). That’s well below the US MSCI’s 22.5 forward P/E. Relatively cheaper valuations have led some to call for rotation into Eurozone stocks, especially as US equities contend with purportedly frothy valuations.

We’ve been bearish on the Eurozone for economic and political reasons. To us, the stalwarts (Germany and France) are flashing worrying signals on both fronts. Fiscal spending is waning, political instability is growing, economic growth is slowing, and demographics are a headwind.

However, the stock market isn’t the economy, and that's particularly true in the Eurozone. Valuations are partially depressed due to the sector composition of the indexes. European indexes are heavy on low-valuation sectors like auto manufacturers and banks and have few growth and technology companies.

The tech companies that are domiciled in Europe have driven much of the outperformance. For instance, Germany’s blue-chip DAX 40 is up 26% over the past year to a record high. Even MSCI Germany—which is less concentrated than the DAX 40—is up double-digit percentage points. But under the hood, two companies account for 27% of MSCI Germany’s market capitalization, SAP and Siemens. Both benefit from the AI trade and aren’t overly exposed to Germany’s downtrodden economy. For instance, SAP derives nearly as much revenue from the Americas as it does from EMEA.

Much of the bearishness may be already priced into Eurozone indexes, leaving room for upside. But based on forward revenues, earnings, and profit margins, we’re still far from changing our underweight recommendation relative to US stocks. We’re sticking with our Stay Home (versus Go Global) investment strategy, preferring US large-cap stocks over international ones.

Here’s more:

(1) Forward revenues. Analysts expect forward revenue growth to turn positive this year and next. However, they could be overly optimistic (Fig. 5). Consensus expectations implied more than a 2.0% y/y increase in forward revenues early last year, only to see them fall 0.5%.

(FYI: Forward revenues and earnings are the time-weighted averages of analysts’ consensus estimates for the current and following year; the forward profit margin is imputed from forward revenues and earnings.)

(2) Forward earnings. Forward earnings have been relatively flat in the Eurozone since 2023 (Fig. 6). Net earnings revisions have also been deeply negative for much of the past year (Fig. 7). We prefer to overweight regions and sectors with improving fundamentals (e.g., rising forward earnings) as opposed to counting on valuation improvement.

(3) Forward profit margins. Analysts expect 8.8% y/y earnings growth in the year ahead relative to a 3.3% increase in revenues, suggesting margin expansion (Fig. 8). With the cost of labor rising, potential tariffs, and less government spending, it may be difficult for Eurozone stocks to make much headway in expanding their margins.

The saving grace for margins and Eurozone stocks may be easier monetary policy. The futures market expects the deposit rate to be cut three times (25bps each) this year to 2.25%, with the first cut likely to come on Thursday (Fig. 9). We think the ECB may cut four or five times, which will depress the euro and help exporters earn more euros for their dollar-denominated sales. Of course, an end to the Russia-Ukraine war is another possible positive catalyst.

While that sounds like a good setup, investing in a country that is cutting interest rates due to slowing economic growth is not without its perils. We question whether the Eurozone will be able to remain stable amid the current political tumult and whether their economies can handle slowing labor force growth and fiscal spending. China’s continued attempt to export its way out of its recession is just another exogenous factor hurting the Eurozone. We retain our underweight recommendation.
 
Global Central Banks I: BOJ Takes (Another) Hike. For the first time since spooking the markets with a rate hike last July, the Bank of Japan (BOJ) hiked again last Friday, its third in less than a year. It raised Japan’s key interest rate 25 basis points to 0.50%, its highest since September 2008 (Fig. 10). The market reaction was nonchalant this time.

Let’s review what happened:

(1) Last July’s rate hike was a shocker. The financial markets weren’t expecting the BOJ’s July rate increase, and it touched off a panicked unwinding of yen-funded carry-trade positions, rippling in global markets. The carry trade entails borrowing in one currency where interest rates are low and leveraging those funds in another currency market where interest rates are relatively high. The prevalence of traders borrowing in yen to buy assets in Brazil, Mexico, the US, etc. led to an increased beta (correlation) across risk assets.

With the recent rate-hiking cycle and yen appreciation, the return on yen-funded carry trades is lower. This is not only because the BOJ is hiking rates but also because the US, Europe, and other major economies have been lowering interest rates, closing the gap on potential returns.

(2) This time, no surprises. The BOJ widely telegraphed its intention to raise rates this time to minimize adverse reactions, which proved successful.

Post the July 31 decision, the Nikkei 225 index fell 21.2% from August 1 to an August 5 monthly low (Fig. 11).

Despite the January rate hike, the Nikkei is up 1.5% from a monthly low on January 15 through the January 28 close.

Notably, the 10-year Japanese government bond yield rose from a low of 0.79% on August 5, 2024 to 1.26% on January 15, before closing at 1.19% on January 28 (Fig. 12).

Global Central Banks II: BOJ Maintains Below Neutral Posture. We believe that wage and services inflation may prompt another one or two 25bps hikes this year. The BOJ would still like to be accommodative, just less so. It’s possible that the next hikes will happen faster than the six-month pace that the bank has set so far given the recent quickening of inflation (detailed below). Much still depends on the path of Fed policy. Given our expectations for strong US growth and higher-for-longer interest rates, we believe the BOJ may hike less than many strategists think.

So far, Trump 2.0 seems inclined to hold pro-Japan policies, which could ease Japanese policymakers’ concerns about inflationary pressures resulting from bilateral US protectionism.

Here’s our thinking:

(1) Why hike? Data released before Friday’s rate-hike decision showed that the CPI excluding fresh food rose from 2.6% y/y in November to 3.0% y/y in December. It was the first time that this rate topped 3.0% since October 2023. Excluding both fresh food and energy prices, the core CPI rose by 2.4% y/y in both November and December (Fig. 13). All those rates are above the bank’s 2.0% target.

The BOJ has indicated that accelerating wage pressures will factor heavily into its rate decisions. Japanese contractual wages have risen well above the rate of inflation since January 2024. Wages rose 4.9% y/y through November (Fig. 14).

(2) How much to hike? BOJ Governor Kazuo Ueda stated on December 24 that “the Bank will maintain accommodative financial conditions by keeping the policy interest rate lower than the neutral interest rate.” The January Monetary Policy Statement confirmed this: “Real interest rates are expected to remain significantly negative, and accommodative financial conditions will continue to firmly support economic activity.” (Italics ours.)

The real neutral interest rate is the rate that would neither accelerate nor slow an economy. That’s in theory. In practice, it cannot be measured, but that doesn’t stop economists from trying to estimate it. The most recent study on the real neutral rate on the BOJ’s website, dated October 2024, estimates that the rate is somewhere in the -1.0% to +0.5% range (see Figures 2 and 3 on pages 15 and 16). Adding inflation, that corresponds to a nominal policy rate of 1.0% to 2.5%. Our expectations are toward the lower end.

Coincidentally, former BOJ board member Makoto Sakurai said on Tuesday that he expects the BOJ to hike the policy rate to 0.75% in June or July and eventually to 1.5%.

(3) When to hike? The BOJ's hiking timeline depends on the incoming inflation data relative to the bank’s projections in its January outlook. It’s similar to evaluating US CPI and PCED inflation relative to the Fed’s Summary of Economic Projections.

For fiscal 2025, the BOJ expects the headline (ex-fresh food) and core (ex-fresh food and energy) CPI to end at annualized rates of 2.4% and 2.1%, respectively, both up from October’s estimates. This pace seems to be highly attainable based on the latest inflation data.

(4) What will Trump 2.0 bring? The bank is hiking rates now not only because inflation is rising but also because it feels it can do so while currency markets are relatively calm. Japanese bankers feared currency markets would go haywire if President Trump came in too aggressively on protectionist trade policies, which so far has not been the case.

We sense that Trump’s policies will lean pro-Japan. Already, the President is partnering with Softbank, Japan’s largest financier. Softbank has been charged with funding for Trump’s Stargate venture. The joint venture between Softbank, Open AI, and Oracle will deploy $100 billion now and $500 billion eventually to build new AI infrastructure, including data centers and physical campuses. Trump will use executive orders and emergency declarations to push through construction and energy access.

If the US is all in with Japan on arguably one of the most important initiatives of our time, AI, then it must be all in on Japan.

Strategy: DeepSeek Won’t Sink AI Trade. DeepSeek may be made in China, but the development of its cheaper and better open-source large language model (LLM) represents capitalism at its finest: AI’s high profit margins attracted competition and fostered innovation. DeepSeek’s achievement was accomplished using Nvidia’s cheaper, lower-margin chips that were not subject to Chinese export restrictions. DeepSeek’s performance, which Jackie scooped in last Thursday’s Morning Briefing, ranks strongly relative to the models from OpenAI and others and at a significantly lower cost. The news shook the foundation of the AI trade on Monday as investors punished Nvidia and dumped AI energy-related stocks.

Here’s more:

(1) Setting the profit margin bar higher. We don’t think AI’s apple cart has been overturned by DeepSeek’s performance. A wider choice of picks and shovels, i.e., lower-cost AI alternatives, will allow the less deep-pocketed companies in the S&P 493 (i.e., the S&P 500 excluding the Magnificent-7) to re-tool their businesses as well. The potential for data processing energy, semiconductor, and datacenter costs to decline amid increased competition means the S&P 493’s profit margins could improve faster than analysts anticipate.

(2) Signs of life in S&P 493? The Magnificent-7 trade worked well in the weeks following the election. At its peak in late December, the Magnificent-7 had been up as much as 13% since November 5, well ahead of the S&P 500 (4%) and the S&P 493 (1%). Now the Magnificent-7 is up just 6.5% since the election but still ahead of the S&P 500 (4.0%) and the S&P 493 (3.5%) over that timeframe (Fig. 15).

On a ytd basis, however, the Mag-7 is no longer outperforming after its sharp 3.5% decline on Monday. The group is now down 1.4% ytd and lagging the S&P 493 (up 4.1% ytd) and the S&P 500 (2.2%).

(3) Signs of life in Equal Weight? Investors expecting the equal-weight indexes to outperform also saw some encouraging signs Monday. Up until then, the S&P SmallCap 600’s equal-weight indexes had done better since the election than those of the S&P LargeCap 500 and S&P MidCap 400.

The equal weight/market weight (EW/MW) price index ratios for the various S&P market-cap groups shows that SmallCap’s EW index has outperformed the MW index by 0.5% since the election (Fig. 16). MidCap’s EW is lagging slightly now, by just 0.1%. However, LargeCap’s equal-weight price index may be making another attempt to outperform its market-weight counterpart. It’s now trailing by -1.9% since the election, but that’s a big improvement from its -4.7% reading near the end of December.

DeepSeek’s news is timely, arriving just ahead of Q4 results for five of the Magnificent-7 companies. Investors are sure to tune in closely to hear what these companies’ management teams think about DeepSeek and its impact on the AI revolution in the US as well as what the managements of the S&P 493 companies have to say about the outlooks for their AI spending and timelines for improving profit margins. Stay tuned.

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Gray Swan

January 28 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Strategy I: The Digital Revolution Is Evolving. DeepSeek is a Chinese AI lab that has rocked the world of artificial intelligence (AI) by developing a competitive Large Language Model, or LLM, that reportedly outperforms ChatGPT but was developed at a fraction of the cost with much less time required to “teach” the program. It also functions with cheaper and less powerful Nvidia GPU chips. And it is available on an open-source basis.

Will DeepSeek cause a bear market? Since the late 1920s, there have been 22 bear markets in the S&P 500 (Fig. 1). Over the same period, there have been 17 recessions (Fig. 2). In other words, more often than not, bear markets are caused by recessions. And more often than not, bear markets and recessions are caused by the tightening of monetary policy—not because tightening eventually curbs demand, as often assumed, but because tightening triggers a financial crisis that balloons into an economy-wide credit crunch, and that causes a recession (Fig. 3 and Fig. 4).

DeepSeek won’t cause the Fed to tighten monetary policy. It won’t cause a financial crisis or a credit crunch. It won’t cause a recession even if it causes American AI companies to reduce their capital spending on AI infrastructure. Of course, it might have a negative wealth effect on Nvidia’s shareholders.

We view DeepSeek as a “Gray Swan” event, a spinoff from the term “Black Swan” event. Black Swan events are unexpected developments with mostly negative consequences. They’ve been known to cause recessions and bear markets, but not all Black Swans have had negative consequences. Likewise, Gray Swans are unexpected events, but they have both negative and positive consequences.

The negative consequence of DeepSeek is that it challenges the business models of American companies that expected to use their exclusive access to Nvidia’s most expensive and powerful chips to dominate and profit from the AI revolution. The good news is that they should be able to follow DeepSeek’s lead in lowering the cost of AI infrastructure spending. That should offset some of the potential revenues lost by having to compete with DeepSeek and other AI startups. They will still profit from AI by converting more of their pre-AI products into AI-driven ones. Also good: More competition in the AI economy will give business and individual consumers more bang for their AI bucks.

Previously, we observed that the Agricultural Revolution of the 1700s and 1800s was followed by the Industrial Revolution of the 1800s and 1900s. The Digital Revolution started in the 1950s with IBM’s mainframes. During the 1980s, Digital Equipment sold lots of minicomputers. The 1990s and 2000s saw the proliferation of PCs and laptops. During the 2010s, cloud computing caught on, allowing companies to rent software programs that are automatically updated by their vendors. Now, AI is proliferating.

The Digital Revolution is all about data processing, i.e., processing more and more data faster and faster at lower and lower cost. From this perspective, AI is an evolutionary development in the Digital Revolution. AI allows more data to be processed faster than ever before and at a lower cost, as DeepSeek has demonstrated. So much data can be processed that we need LLMs to make some sense of it all and use it to increase productivity.

Strategy II: A Fair Price for the S&P 500? We’ve been fielding concerns that the stock market is overvalued for at least the past two years. Indeed, valuation multiples tend to ride the escalator up during economic expansions and the elevator down during recessions (Fig. 5). Rising bond yields have raised the question of whether the S&P 500’s forward P/E ratio has peaked at its current level of 22 and change, suggesting a turning point for US stocks.

The WSJ wrote on Monday about the worrying fall in the equity risk premium (ERP) (Fig. 6). As the 10-year Treasury yield has risen to around 4.5%, it has looked relatively more attractive than the S&P 500’s forward earnings yield (which is the reciprocal of the forward P/E). Coincidentally, Eric wrote a similar story in the WSJ in April 2023. The S&P 500 has gained more than 46% since, not including dividends.

We haven’t been very concerned by the stock market’s valuation, and we still are not. We believe the relationship between the S&P 500 forward earnings yield and the 10-year Treasury yield is returning to its historical norm, as opposed to the much of the 21st century when the Federal Reserve depressed rates and bought bonds. Strong expected earnings growth is propelling valuations to justifiable levels, in our opinion. Furthermore, any decrease in the Magnificent-7’s P/Es may be made up by rising valuations in the rest of the stock market, i.e., the S&P 493.

Consider the following:

(1) Fed’s Stock Valuation Model. From 1985 through 2000, the S&P 500 forward earnings yield and the 10-year Treasury bond yield tracked one another relatively closely (Fig. 7). They diverged through 2020, mostly because the bond yield fell relative to the forward earnings yield. Bond prices were boosted by the Fed’s low-interest-rate and quantitative easing policies during most of that period. The two yields are now equal for the first time since 2022, which means it’s more likely that stocks are fairly valued relative to bonds than overvalued (Fig. 8). Ed dubbed this the “Fed Stock Valuation Model” in 1997.

(2) Valuation versus earnings. A low ERP might suggest that valuations need to fall in order to boost the forward earnings yield and make stocks more attractive than bonds.

Valuations typically fall when something in the financial markets breaks due to the Fed’s tightening monetary policy, leading to a credit crunch in the real economy. The US economy skirted that scenario during the recent round of tightening. But the advent of DeepSeek raises the question of whether the large sums being dished out by the Mag-7 on data centers, semiconductor chips, and AI models can generate an adequate return on investment. Will all the AI hype that has sent Mag-7 valuations soaring prove to be a dotcom bubble 2.0?

We believe that earnings growth will be the primary driver of stock market returns through the end of the decade. Analysts currently expect S&P 500 companies to grow their earnings at an annual rate of 17.9% over the next five years (Fig. 9). While not dissimilar from what was expected in 2000, it’s also at a cheaper multiple and in line with pre-pandemic expectations. Investors tend to pay higher prices for stocks with sustained high earnings growth.

The profit margins of the Mag-7 will likely benefit from lower costs as they use AI more efficiently and cost effectively internally, which may net out losses on large capital expenditures. Even if Mag-7’s collective forward profit margin falls from its current 25.5%, the S&P 493 will likely benefit from cheaper AI tools and more productive employees, boosting their collective forward profit margin from the current 12.0% (Fig. 10). That could help maintain the overall market’s valuation, as the forward P/E of the S&P 493 would likely rise even if the Mag-7’s falls (Fig. 11).

(3) Fed effect. Will the Fed officials care about the stock market hullabaloo? Perhaps. On one hand, if stock prices fall enough, they could be concerned about a declining wealth effect weighing on consumer spending. We don’t believe this is likely, but it’s possible.

The Fed may be more interested in how the vastly cheaper AI model will help permeate AI throughout the economy. If workers can become more productive faster and companies can cut costs quicker, then the Fed has a huge disinflationary tailwind to consider. Fed officials may even say that it means the neutral rate of interest is lower, emboldening them to cut the federal funds rate further.

We, on the other hand, believe that AI-boosted productivity growth would boost real GDP growth and keep inflation subdued. That would imply that interest rates don’t need to be lowered, in our opinion. If the Fed lowers interest rates in this scenario, they risk causing a speculative bubble in risk assets. So the outlook is either the Roaring 2020s scenario (to which we ascribe 55% subjective odds) or a Meltup à la the 1990s (25% odds). We don’t see the DeepSeek development as a reason to increase our odds of a Stagflationary 1970s scenario (20% odds). At worst, it is a Gray Swan, not a black one.

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Anatomy Of The Bull Market (Will DeepSeek Sink It?)

January 27 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy I: Earnings-Led Bull Market in 2025. The current bull market in stocks started on October 12, 2022. Since then, the S&P 500 soared 71.1% from a low of 3577.03 to a record high of 6118.71 on Thursday of last week. Over this period, the forward P/E of the S&P 500 stocks as a group rose 46.7% from 15.2 to 22.3, while S&P 500 forward earnings rose 17.1%. So the bull market has been significantly driven by the rising valuation multiple. (FYI: Forward earnings is the time-weighted average of analysts’ consensus operating earnings-per-share estimates for the current year and the following one; the forward P/E is the multiple based on forward earnings.)

Last year was a more balanced one for the stock market; the forward P/E rose 9.8%, while forward earnings rose 12.3% (Fig. 1 and Fig. 2). This year, Eric, Joe, and I expect that most of the bull market’s heavy lifting will be attributable to earnings growth. That’s because the valuation multiple is historically high. It will be in meltup territory if it goes much higher, making the market vulnerable to a meltdown.

To be more specific, we project that the S&P 500 will increase 19.0% this year to 7000. We estimate that S&P 500 earnings will rise 15.6% this year to $285 per share (Fig. 3). Of course, at the end of this year, the stock market will be discounting 2026 earnings per share, which we project will be $320 (Fig. 4). Our 7000 target implies that the forward P/E will be 21.9 at the end of this year, unchanged from its current value.

The latest Bloomberg poll of 22 of the Street’s investment strategists shows an average S&P 500 target of 6600 by year-end with average earnings per share at $266 for the year. The highest estimate for the S&P 500 is 7100 and the lowest is 5500. The highest and lowest earnings estimates are $282 and $227.

Here are some related matters:

(1) Revenues growing solidly. Our earnings-per-share projection is based on S&P 500 revenue gains of 4.0% this year. That’s consistent with the historical average since 1995 of 4.3% (Fig. 5). The pushback we get is that even if the US economy continues to grow solidly, the rest of the world’s economies are likely to be weak, as recently projected by the International Monetary Fund (see our January 22 Morning Briefing). Then again, the historical average growth rate of revenues includes three US recessions. Almost no one is expecting a recession in 2025.

Meanwhile, forward revenues per share rose to a record high during the January 16 week, with a solid growth trend despite the current weakness in the world economy outside the US (Fig. 6). This series is a great weekly coincident indicator of actual S&P 500 revenues per share.

(2) Profit margin in record-high territory. We are estimating that the S&P 500 profit margin rose to 12.5% in 2024, up from 11.9% in 2023 and below the record high of 13.3% during 2021. We are projecting that the profit margin will rise to a record high of 13.9% this year and 14.9% in 2026 (Fig. 7). That’s consistent with our productivity-led Roaring 2020s scenario. We are encouraged to see that the S&P 500 forward profit margin rose to a record high of 13.7% during the January 23 week (Fig. 8).

We are also expecting that Trump 2.0 will include a cut in the corporate tax rate from 21% to 15% later this year. What about the rise in interest rates? Corporations refinanced much of their long-term debt at record lows during the pandemic. Indeed, the net interest paid by nonfinancial corporations as a percentage of their after-tax profits fell to 7.6% during Q3-2024, the lowest since Q4-1955 (Fig. 9). This series might start rising in 2025, but not enough to offset the positive impact on the profit margin of higher productivity growth and a lower tax rate, in our opinion.
 
(3) Coincident economic index bullish for earnings. As noted above, given the economic weakness overseas, we are encouraged to see that S&P 500 forward earnings is on a solid uptrend and at a record high. It continues to track the US Index of Coincident Economic Indicators (Fig. 10).

It is interesting to see the recent divergence between the forward earnings of the S&P 500 and that of the S&P 500 Air Freight & Logistics industry (Fig. 11). The latter series reflects global economic activity, and it has been falling since early 2022 when the Fed started to tighten monetary policy, Russia launched its invasion of Ukraine (which depressed Europe’s economy), and China’s property market imploded. Yet by early September 2023, the S&P 500 forward earnings was rising to new record highs!

Strategy II: Concentration Update. We are assuming that the forward P/E of the S&P 500 will remain between 21.0 and 22.0 this year, and probably next year too. That’s because we believe that the Magnificent-7 stocks will remain magnificent, maintaining a collective forward P/E around 30.0, while the rest of the stocks in the index, the “S&P 493,” continue to trade collectively around a 20.0 multiple—in other words, the levels they trade at now (Fig. 12).

The S&P 500 is likely to remain concentrated. The S&P 500 Information Technology and Communication Services sectors currently account for a record 41.4% of the market capitalization of the S&P 500 (Fig. 13). They also account for a record 35.1% of the forward earnings of the S&P 500.

The current market cap of both these sectors together is $21.2 trillion. They include five of the Magnificent-7 stocks, all but Amazon and Tesla, which are included in the S&P 500 Consumer Discretionary sector. However, the collective market capitalization of the Magnificent-7 is currently $18.0 trillion (Fig. 14).

Strategy III: What Could Possibly Go Wrong? Might DeepSeek deep-six the Magnificent-7? In last Thursday’s Morning Briefing, Jackie wrote about China’s AI ambitions and observed the following: “The latest startup capturing headlines is DeepSeek. The company shocked the tech industry when it reportedly spent only $5.6 million over two months to develop its latest LLM, which outperformed rival US LLMs from Meta and ChatGPT, a January 21 SCMP article reported. The company kept costs down by using less powerful Nvidia H800 chips. DeepSeek was spun out of High-Flyer Quant, a Chinese quantitative hedge fund. High-Flyer was developing AI to help it research stocks, and both firms are headed by Liang Wenfeng.”

Jackie scooped CNBC, which posted an article on Friday morning titled “How China’s new AI model DeepSeek is threatening U.S. dominance.” The key conclusion for stock investors was the first paragraph: “A little-known AI lab out of China has ignited panic throughout Silicon Valley after releasing AI models that can outperform America’s best despite being built more cheaply and with less-powerful chips.”

Not much is known about DeepSeek. It’s a Chinese company with a website that claims: “DeepSeek-V3 achieves a significant breakthrough in inference speed over previous models. It tops the leaderboard among open-source models and rivals the most advanced closed-source models globally.” The company’s technical report about this LLM is also available online.

One skeptic on LinkedIn views this development as a plot by the Chinese Communist Party to undermine American AI innovation. He observes that the reported costs to train the LLM are suspiciously low. The fact that it is available on an open-source basis suggests that the Chinese aim to be the low-cost producers of AI, reducing the competitiveness of US developed private AI systems.

Jackie also scooped The Wall Street Journal, which posted an excellent article on this subject at 12:00 a.m. Sunday morning titled “Silicon Valley Is Raving About a Made-in-China AI Model DeepSeek.” Marc Andreessen, the Silicon Valley venture capitalist who has been advising President Trump, in an X post on Friday raved: “Deepseek R1 is one of the most amazing and impressive breakthroughs I’ve ever seen—and as open source, a profound gift to the world.”

In our Sunday morning QuickTakes, we concluded the following about the impact of DeepSeek on the Mag-7:

(1) “This might be bad news for the Mag-7 that have plans to dominate the AI market with their (expensive) AI services. On the other hand, it might mean that AI systems will be more accessible and cheaper. If so, the best way to play AI might be the S&P 493 companies that will be cutting their costs and boosting their productivity using this new technology.”

(2) “It might be good news for the Mag-7 that can learn from DeepSeek to design AI systems with cheaper GPUs. That would reduce their capital spending and boost their profits. It might not be a happy development for Nvidia.”

We are even more confident in our technology-driven, productivity-led Roaring 2020s scenario and are sticking with our S&P 500 targets of 7000 for 2025, 8000, for 2026 and 10,000 for 2029.
 
Strategy IV: Will 2024 Laggards Be the Leaders in 2025? If it turns out that AI systems can be developed at a much lower cost than suggested by the enormous AI-related capital spending by American AI companies, and especially the Magnificent-7, then these stocks would be vulnerable to a selloff, which would depress the stock market given their weight in the S&P 500. However, such a selloff would be a good opportunity to jump into both the S&P 007 and the S&P 493, which would benefit from the availability of more affordable AI technologies. The S&P 493 have lagged the performance of the Magnificent-7.

We are assuming that US AI companies will achieve what DeepSeek has done as soon as possible; they’ll likely be scrambling to do so. Right now, Elon Musk is busy undercutting Stargate. It is an AI infrastructure joint venture among SoftBank, OpenAI, and Oracle that Trump announced last week on January 21. Their respective companies will invest $100 billion in total for the project to start, with plans to pour up to $500 billion into it in the coming years. Musk questioned whether the venture has the money to back up their ambitions. On Thursday, Trump shrugged off the controversy, saying that Musk “hates one of the people in the deal,” namely Sam Altman of OpenAI.

Perhaps DeepSeek’s accomplishment means that AI systems can be designed much more cheaply than envisioned by Stargate. That would be a positive for everyone.

Movie. “American Primeval” (2025, ++) is a Netflix series that has been condemned by the LDS Church because it depicts Brigham Young, the founder of the Utah-based Mormon faith, as an unscrupulous and violent fanatic. The series certainly isn’t a docudrama. Instead, it is a reminder of the violence of the Wild West with massacres aplenty, especially by the pioneers against Native American Indians. No one is disputing that aspect of the series. The series is beautifully filmed, constantly reminding us of the harmony and peacefulness of nature that was so often disturbed by all the violence of the Wild West. (See our movie reviews archive.)

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Trump Makes His Mark & China’s AI Players

January 23 (Thursday)

Strategy: Washington Whipsaws Industries. President Trump swept into the Oval Office and immediately swept out many of former President Biden’s executive orders, replacing them with new ones of his own. The policies Trump changed on the first day of his second term were wide-ranging, touching on energy, immigration, technology, and tariffs. The overarching themes include his desire to reduce government bureaucracy, increase American oil and gas production, and boost American competitiveness via tariffs.

Here’s a look at the new policies and the industries that should benefit:

(1) EV coddling is out. Unleashing American Energy is the Trump executive order that aims to level the “regulatory playing field” between EVs and gasoline-powered cars. The order wants the government to consider eliminating unfair subsidies and other “ill-conceived government-imposed market distortions that favor EVs.” It pauses the disbursement of funds through the Biden administration’s Inflation Reduction Act of 2022 and the Infrastructure and Investment and Jobs Act until they are reviewed by agency heads. In response, shares of Tesla were basically flat (down 0.5%) on Tuesday, while GM shares jumped 5.7% and Ford shares added 2.5%, outpacing the S&P 500’s 0.9% gain.

Conversely, the order tells agencies to slash the red tape in the energy industry. They should identify all regulations, orders, and other policies that would impose an undue burden on the identification, development, or use of domestic energy resources, including oil, natural gas, coal, hydropower, biofuels, critical minerals, and nuclear energy resources. It tells agencies to eliminate all delays in the permitting process.

That sent shares of Vistra, Cameco, and Constellation Energy up 8.5%, 3.7%, and 2.3%, respectively, on Tuesday. Vistra produces nuclear, coal, natural gas, and solar power, while Constellation has a large nuclear power fleet and Cameco is a uranium miner.

(2) Drill, Baby, drill. The Unleashing American Energy order also encourages the exploration and production of energy on federal lands and water. It restarts reviews of applications to build liquefied natural gas (LNG) export projects. The Biden administration had put those reviews on hold to assess the environmental impact of LNG plants. The order also eliminates obstacles for mining and the processing of minerals.

The Trump administration wants to open Alaska up to oil and gas exploration and production through the Unleashing Alaska’s Extraordinary Resource Potential executive order. It’s prioritizing the Alaska LNG project, which aims to deliver 3.5 billion cubic feet of natural gas a day through an 800-mile pipeline from Alaska’s North Slope, where the gas is produced, to the state’s South Central shoreline, where it will be condensed into LNG for export. The executive order has directed government officials to prioritize the permitting for all necessary pipeline and export infrastructure related to the project.

Trump’s Declaring a National Energy Emergency order allows the government to cut permitting requirements for energy projects, fast-track power plant construction, and loosen curbs on fossil-fuel exports. Projects to supply, refine, and transport energy throughout the West Coast and the Northeast US were highlighted. The WTI crude oil price has dropped 3.8% this week through Wednesday, and the natural gas futures price has dipped 1.7% (Fig. 1 and Fig. 2).

If Trump’s orders achieve their goals, the US may be swimming in oil, which could depress the price of “black gold” and the stocks of oil companies. Conversely, the Trump orders could jumpstart new oil and gas projects, benefitting companies selling the necessary picks, shovels, and services.

This helps explain why the S&P 500 Oil & Gas Exploration & Production stock price index has gained only 8.5% since September 10 (the date of the debate between former Vice President Harris and President Trump, after which stock market valuations started reflecting expectations of a Trump win), while the Oil & Gas Storage & Transportation stock price index has jumped 35.2%, and the Oil & Gas Equipment & Services index has added 18.2% (Fig. 3, Fig. 4, and Fig. 5). The S&P 500 and the S&P 500 Energy sector have gained 10.1% and 9.5% over the same period (Table 1).

(3) Wind energy is out. Another Trump executive order halts the issuance of any new federal leases or permits for offshore and onshore windfarms, pending a review that includes examining the impact on wildlife. While the order stops the construction of offshore wind turbines, it does not impede the construction of offshore oil and gas drilling rigs. A future report will assess the economic costs of intermittent energy generation and the effects of subsidies on the viability of the wind industry.

The Trump order also suspended the development of the Lava Ridge Wind Project, which was to include up to 400 wind turbines in Idaho. The Secretary of the Interior was tasked with reviewing the project and, if appropriate, conducting a new analysis of it.

(4) Shaking up trade. The America Trade First Policy executive order will evaluate the impact of the duty-free de minimis rule, which allows packages worth less than $800 to be imported without duties. Agency heads should consider the loss of revenue from the rule as well as the risk of importing counterfeit products and illegal drugs. Some believe the rule gives Chinese online retailers selling into the US, like Shein and Temu, an advantage over US retailers. About three million de minimis shipments enter the US every day, and about half are textile and apparel, a November 4, 2023 NYT article reported.

Other trade agreements are also to be reviewed, particularly those with China, Mexico, and Canada. Unfair trade practices will be identified, and countries that keep their currencies low relative to the dollar to gain an unfair trade advantage will be evaluated.

Trump has threatened to place a 25% tariff on goods imported from Mexico and Canada as soon as February 1. He’s reportedly unhappy about the number of US auto companies’ plants in Mexico and would like to see them moved to US soil, a January 21 WSJ article reported. The tariff threat is reportedly part of Trump’s plan to start negotiations on the US–Mexico–Canada trade agreement before it is up for review in 2026. Cars and car parts are the US’s largest imports from Mexico, followed by agricultural products, like fruits and veggies, and beer. Oil and gas are the US’s largest imports from Canada, a January 22 CNN article reported. Meanwhile, Canadian officials are considering their own tariffs on US bourbon, Florida orange juice, and oil.

(5) Tech is in. The CEOs of some of the largest technology companies attended the inauguration—including Sam Altman (Open AI), Jeff Bezos (Amazon), Elon Musk (Tesla), Sundararajan Pichai (Alphabet), and Mark Zuckerberg (Meta). And no wonder: Tech companies stand to make millions as the new president pushes the government into the 21st century.

As part of establishing the US DOGE Service (USDS), an executive order requests the USDS administrator to begin a Software Modernization Initiative to “improve the quality and efficiency of government-wide software, network infrastructure and information technology systems.” Inter-operability between agency networks and systems will be promoted along with ensuring data integrity, responsible data collection, and synchronization. Sounds like the perfect job for Elon Musk, who holds the position along with Vivek Ramaswamy, though he’s reportedly considering vacating the post to run for Ohio governor.

Unrelated to the executive orders, Trump announced in a press conference on Tuesday night that tech CEOs had committed to spend up to $500 billion over the next four years to build AI infrastructure in a joint venture dubbed “Stargate.” Stargate’s investors include Chat GPT, SoftBank, Oracle, and MGX, and its technology partners include Microsoft, Arm Holdings, and Nvidia. While the project was initiated under the Biden administration, Trump reintroduced it at his press conference, and Altman, SoftBank CEO Masayoshi Son, and Oracle Chairman Larry Ellison were in attendance. Shares of Oracle jumped 7.2% on Tuesday, with shares of Arm and Nvidia climbing 4.0% and 2.3%. Microsoft shares dipped 0.1%.

(6) Shrink government. Trump ordered a hiring freeze among federal civilian employees throughout the executive branch, with the exception of the military, immigration enforcement, national security, and public safety. He requested a report be produced within three months that details how to downsize the federal workforce through efficiency improvements and attrition—another policy that should benefit technology companies.

Trump also ordered all federal employees back to their offices—no more working from home.

Last but not least, no agencies are allowed to issue any new rules until they’re headed by a new presidential appointee.

(7) Odds ’n ends. The President also suspended the US Refugee Admissions Program. There are already lawsuits from Democratic-led states challenging Trump’s order to eliminate birthright citizenship—the right to be a US citizen if you were born in the US to parents who are not legal US citizens. And he withdrew the US from the United Nations’ Paris Agreement on climate change.

Lastly, another executive order aims to lower prices. One item targeted is the price of housing; to that end, agencies are tasked with increasing housing supply, though no details were given on how to achieve that goal.

Disruptive Technologies: China’s AI Ambitions. America’s AI and tech giants were on full display at President Trump’s inauguration. Less well known in America are the AI wizards in China. Despite US tech export restrictions, China has a growing cadre of startups and established tech companies just as focused on dominating the artificial intelligence (AI) market as their US competitors. Here’s a look at some of the players US AI companies are up against:

(1) Introducing Ernie. Ernie is a large language model (LLM) developed by Baidu, China’s largest search engine, according to Quartz. Ernie Bot is a chatbot service released in 2023 that’s based on the Ernie LLM. It’s considered China’s version of ChatGPT, which is not available in China.

Baidu believes that more than half of China’s state-owned enterprises use Baidu services for AI innovation. And Ernie’s LLM enterprise facing platform, Qianfan, has helped 150,000 clients develop 55 applications, an August 22, 2024 South China Morning Post (SCMP) article reported. IDC found that Baidu AI Cloud generates $49 million in annual revenue—giving it a 19.9% share of China’s industry-facing LLM market. At its heels is SenseTime, with a 16% share, followed by ZhipuAI, Baichuan, and 4Paradigm, the SCMP article stated.

(2) Other LLMs owned by big tech players. Qwen 2 is a LLM developed by Alibaba Group’s Cloud subsidiary and trained in 29 languages. Alibaba also has an image-generating model called “Tongyi Wanxiang.” Doubao is a LLM and an AI-powered chatbot developed by ByteDance, the parent of TikTok. And Hunyuan is Tencent’s LLM that can both generate images and text.

(3) The government is in the mix too. Partially state-owned iFlytek has developed the iFlytek Spawrk Big Model V4.0, which it claims has surpassed GPT-4.0 in language comprehension, logical reasoning, and mathematical ability.

Likewise, SenseTime is a partly state-owned but publicly traded company that focuses on using AI for image recognition, autonomous driving, and remote sensing. The company has been sanctioned numerous times by the US government for using its facial recognition technology in the surveillance and internment of the Uyghurs, a persecuted ethnic minority in China. The company’s generative AI model, SenseNova 5.0, introduced last spring, focuses on knowledge, mathematics, reasoning, and coding, an April 24, 2024 CNBC article reported.

(4) China’s Tigers make inroads. Four AI startups, each valued at more than $1 billion, together are known as the “four new AI Tigers,” an April 24, 2024 SCMP article reported.

Moonshot AI has developed a LLM and a popular chatbox, both called “Kimi.” Baichuan develops LLMs that rival OpenAI’s GPT-4 in Chinese language capability; its investors include Tencent, Xiaomi, and Alibaba Group Holding. Zhipu AI has a chatbot and a visual language foundation model; its backers include state-affiliated investors, Alibaba, Tencent, and Saudi Arabia’s Prosperity 7 Ventures. And MiniMax is an Alibaba- and Tencent-backed startup that has raised about $850 million in venture capital and is valued at more than $2.5 billion, a January 15 TechCrunch article reported. Its AI models focus on text, images, or speech. It’s in the US market with an AI character chatbot called “Talkie.”

(5) Introducing DeepSeek. The latest startup capturing headlines is DeepSeek. The company shocked the tech industry when it reportedly spent only $5.6 million over two months to develop its latest LLM, which outperformed rival US LLMs from Meta and ChatGPT, a January 21 SCMP article reported. The company kept costs down by using less powerful Nvidia H800 chips. DeepSeek was spun out of High-Flyer Quant, a Chinese quantitative hedge fund. High-Flyer was developing AI to help it research stocks, and both firms are headed by Liang Wenfeng.

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On Trump 2.0, Global Growth, Argentina & S&P 500 Profit Margins

January 22 (Wednesday)

Weekly Webcast. If you missed Tuesday’s live webcast, you can view a replay here.
 
Global Economy I: Tariff & Energy Turbulence. The DXY dollar index has whipsawed over the past 48 hours, ultimately falling 1.3% on Tuesday. Monday’s action was telling of the market’s sensitivity to headlines. The DXY fell around 1% early Monday on a report that President Trump wouldn’t enact tariffs on Day 1 of his new term, only to partially erase that move after Trump said he plans to impose 25% tariffs on Mexico and Canada by February 1. He also threatened more tariffs on China and reiterated the possibility of universal tariffs.

Despite the headline trading, Trump’s initial wave of executive orders didn’t veer off the path he signaled going into the inauguration. One takeaway is how much prospective policy and uncertainty are already baked into the dollar, which is up 15% over the past three years (Fig. 1).

Trump 2.0 has a predilection for tariffs, and they will come either as negotiating tools, pay-fors, or a combination of the two. Even if tariffs are seen as a tax on consumption, foreigners pay for at least part of it via a devalued currency.

Considering that US manufacturing and capacity have stagnated since China entered the World Trade Organization in 2001, the Trump administration thinks tariffs are necessary to rebalance global trade and end unfair practices abroad (Fig. 2). We tend to agree but are aware of possible negative unintended consequences such as trade and currency wars. Tariffs might boost manufacturing capacity in the US, which would be disinflationary over the long run, and supply chains are far more equipped to handle disruptions today than they were eight years ago at the start of Trump’s first term.

We are against tariffs in theory. However, in practice, they might successfully rebalance global trade and, in combination with supply-side policies, shore up domestic production. Here’s more on how we’re thinking about tariffs:

(1) China. China-targeted tariffs won’t be revealed until the new administration evaluates the trade deal struck during Trump 1.0. Likely, there will be debate over the merits of high tariffs limited to specific imports versus one that affects all goods, or even sweeping tariffs will capture third parties in Chinese supply chains, like Vietnam.

Notably, China’s exports to Vietnam have surged as tariffs have been ratcheted up, growing from $66 billion in 2015 to $157 billion as of Q3-2024 (Fig. 3). This is also a reason why we think tariffs on China will be successful—China needs to export to the US as it tries to export its way out of a property recession. Devaluing the yuan to offset the effect of tariffs isn’t a viable strategy for China this time around, either. Any further weakening will likely risk capital flight considering that China has already let the yuan weaken due to both its domestic recession and tariff risk. It’s down roughly 15% relative to the dollar over the past year (Fig. 5).

(2) Oil. On Monday, Trump declared a national energy emergency and withdrew from the 2015 Paris climate deal. He also signed executive orders to promote oil and gas development in Alaska, reversed protections of Arctic lands and U.S. coastal waters from drilling, did away with the electric vehicle mandate, suspended offshore wind lease sales, and unfroze new LNG export permits.

The WTI crude oil price fell 2.3% on Tuesday. It might’ve been down further had the Canadian tariffs not threatened Canadian oil, or had Trump not said that the US would fill its Strategic Petroleum Reserve “right to the top,” implying the purchase of roughly 300 million barrels.

We think Trump 2.0 will mostly be a negative for oil prices. In the most extreme scenario, global trade and economic growth are reduced by a trade war, weighing on oil prices. On the flipside, leases and permits for oil and gas drilling, as well as general deregulation, are likely to significantly boost oil supply. This would also give Trump another point of leverage as the US increasingly becomes a major energy exporter. We believe this is of the utmost priority for Trump 2.0.

Global Economy II: No Surprises in IMF’s Global Growth Forecast. We generally agree with the latest forecasts of the International Monetary Fund (IMF). Global real GDP growth is expected to slow from its pre-pandemic pace, according to the IMF’s January 2025 update. However, we expect that US economic growth will be better than projected by the IMF.

The IMF expects global growth at a stable, but lackluster, 3.3% y/y clip for both 2025 and 2026, slightly below the pre-pandemic average of 3.7%. The increase in the forecast for US growth was offset by weaker projections for other major economies. The IMF believes that risks to their US growth outlook are to the upside, too. However, the global forecast has more downside risk in the intermediate term, mostly due to policy uncertainty. While global financial conditions are largely accommodative, uncertain trade policy and fiscal instability remain challenges.

Global inflation is projected to ease, falling to 4.2% y/y in 2025 and 3.5% y/y by 2026. Advanced economies are expected to return to target inflation levels sooner than emerging markets.

Here’s a tour of the IMF’s projected growth rates around the world:

(1) The US economy stands out among developed nations with a revised real GDP growth forecast of 2.7% for 2025 and 2.1% for 2026, with risks tilted to the upside (Fig. 5). Upside risks to the US outlook include increased business confidence driven by deregulation and lower taxes under Trump 2.0. Should the animal spirits spark a revival in inflation, higher interest rates could become a risk scenario. In our productivity-led Roaring 2020s scenario, real GDP could exceed 3.0% this year, while inflation remains around 2.0%

(2) In the Eurozone, real GDP is expected to grow just 1.0% this year due to weakness in manufacturing and energy concerns. In 2026, growth is set to perk up to 1.4%, aided by looser financial conditions and improving confidence (Fig. 6). We agree.

(3) Real GDP growth in Japan and the UK are expected to remain weak, running below 2.0% y/y through 2026 (Fig. 7 and Fig. 8). We agree.

(4) China faces a dip further below the government’s 5.0% real GDP target to 4.6% growth in 2025, down from 4.8% in 2024, as weak domestic demand and a fragile trade environment threaten growth. An increasing retirement age and fading uncertainty can aid growth in 2026, but perhaps not enough (Fig. 9). Again, we agree.

(5) India’s GDP growth should stay solid at 6.5% projected for both 2025 and 2026 following the same in 2024 (Fig. 10). Ditto: We agree.

(6) In several regions of the globe, GDP growth is expected to pick up in 2025: the Middle East and Central Asia, Latin America and the Caribbean, and sub-Saharan Africa. It is forecast to slow in the emerging and developing countries of Europe. That all makes sense to us.

Global Economy III: Making Argentina Great Again. US President Donald Trump recently congratulated Argentina’s President Javier Milei for “making Argentina great again.” Billionaire US presidential advisor Elon Musk also has applauded Milei for reforming Argentina to within the vicinity of economic normalcy.

Some have called Milei’s results no less than an “economic miracle.” Investors agree: The MSCI Argentina stock market index has risen nearly 120% in local currency since Milei became president (Fig. 11). In our view, the Argentinian president has made great strides in lowering inflation and stimulating growth with his pro-free market policies. The emerging market still has a way to go before we would consider it to be a safe investment, however.

Argentina’s stock market is one to watch, especially if Milei can position his nation to remove its controls on the currency without destabilizing it.

Here’s more:

(1) Inflation cooling, but still hyper. When Milei took office in December 2023, Argentina’s inflation rate was 25.5% m/m and 211.4% y/y. It fell all the way down to 2.7% m/m and to 117.8% y/y in December 2024 (Fig. 12 and Fig. 13).

(2) Astronomical cost of borrowing falling. While the country’s central bank eased its policy rate from 118.0% during Q4-2023, it remains exceedingly expensive for Argentinians to borrow at 40.0% as of Q4-2024 (Fig. 14).

(3) Deregulation successes. Milei has managed to counter the central bank's interest-rate cuts by cooling inflation with austerity measures. Milei’s administration has cut spending and subsidies, bringing the national treasury out of its deepest deficit on record in December 2023 (Fig. 15).

(4) Deregulation challenges. Initially, the fiscal tightening slowed growth and worsened unemployment. But these upfront costs may already be subsiding. Through Q3-2024, growth has picked up on both quarterly and annualized bases, and the unemployment rate has fallen from that of the previous quarter (Fig. 16 and Fig. 17).

(5) Currency still controls. By the end of this year, Milei wants to end currency controls that have been in place for nearly a decade. Argentina’s currency management measures include limiting the purchase of foreign currency savings to $200 per month, taxing overseas travelers, curtailing the amount of US dollars used in exporting, and forcing exporters to exchange their dollars for pesos.

Since April 2022, the Argentinian peso has remained relatively stable, thanks to the controls. From a recent low during January 2024 to November 2024, the country's real broad effective exchange rate has appreciated by more than 50.0% (Fig. 18).

(6) Limits of unleashing the currency. Argentina’s government has set conditions to guide the timing for safely pulling back the currency regulation without creating a run on it. It wants monthly inflation to run at less than an increase of 2.5%, positive central bank reserves, and a 20% gap on market-to-government established exchange rates. Meeting each of these conditions seemed impossible last year, but Argentina is edging closer to doing so and easing the currency restrictions.

(7) Dollarization strides. To bolster currency competition, the central bank is making steps toward “dollarizing” the Argentinian economy. Effective on February 28, the central bank will allow payment intermediaries to accept debit-card transactions in US currency.

Strategy: Profit Margin Forecasts on the Rise. The S&P 500’s forward profit margin was at record-high 13.6% during the January 18, 2025 week, up 0.9ppt y/y from 12.7% a year earlier (Fig. 19). Corporate profitability should continue to improve even as Trump’s administration faces a big fiscal headwind. (FYI: The forward profit margin is calculated from forward earnings and revenues, which are the time-weighted averages of industry analysts’ consensus estimates for S&P 500 companies collectively for the current year and following one.)

Below, Joe reviews what occurred with the S&P 500’s forward profit margin during Trump’s first administration and where analysts’ revenue and earnings estimates have put forward profit margins lately:

(1) Trump 45 and 2018’s TCJA boosted profit margins. During Trump’s first administration, Congress passed the Tax Cut & Jobs Act (TCJA) in mid-2017, and it was implemented in 2018. At the end of 2017 before the TCJA took effect, the S&P 500’s forward profit margin was at a then-record-high 11.1%. Following the passage of TCJA, the S&P 500’s profit margin soared 0.9ppts to 12.0% in just three short months. It then peaked at 12.4% in September 2018 before settling back down to 12.0% as the global economy slowed before the pandemic.

(2) Trump 47’s tax cut options are limited. Trump has less room to cut corporate tax rates than during his first term. The US corporate tax rate is now already in line with those of major industrialized nations, but the massive spending of the past four years by the prior administration has limited Trump’s tax-cut options. According to the Tax Foundation, further reductions in the corporate tax rate would swell the federal budget deficit without doing much to improve economic or employment growth. So a renewal of the TCJA is more likely, and easier to pass instead of new legislation. This stable outlook for tax rates, along with reduced government regulations, will help corporations invest domestically and leverage the efficiencies and cost savings offered by AI and robotics.

(3) Many sectors still showing profit margin improvement. In what’s turning into a broad uptrend, the forward profit margin has risen y/y for eight of the 11 S&P 500 sectors (Fig. 20). Not all sectors’ forward margins are at record highs, but most are close. The biggest y/y improvements were recorded by Communication Services (up 2.0ppts to 18.6%), Financials (1.6ppts to 19.9%), Information Technology (1.2ppts to 26.9%), Consumer Discretionary (0.9ppt to 9.4%), and Utilities (0.9ppt to 14.4%).

Also improving y/y, but much less so, were the forward profit margins of the Industrials, Real Estate, and Materials sectors. Among the laggards, Energy’s forward margin fell 1.0ppts y/y to 9.6%, while those of Consumer Staples and Health Care were unchanged.

Joe recently added a table of forward profit margins for the S&P 500’s industries to our Performance Derby publication; see Table 17. Several S&P 500 sub-industries have made notable y/y gains. Within Communication Services, Interactive Media & Services rose 3.4ppts y/y to 27.2% and Movies & Entertainment gained 2.0ppts to 10.7%. In Financials, the biggest forward profit margin improvers over the past year are Multi-Line Insurance (5.6ppt to 15.4%) and Regional Banks (3.5ppts to 25.6%). The award for the highest forward margin of all S&P 500 industries goes to Semiconductors, residing in the Information Technology sector. Semiconductors’ forward margin has soared 5.7ppts y/y to a record-high 39.0%.

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Time To Recalibrate Our Three Scenarios?

January 21 (Tuesday)

YRI Weekly Webcast. Join our live webcast with Q&A Tuesday at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Strategy I: Waller’s Dovish Coo. Last week was a good week for bonds and stocks, especially after December’s cooler-than-expected PPI and CPI inflation reports on Tuesday and Wednesday, January 14 and 15. The week before was a bad week for bonds and stocks, especially after the release of December’s hotter-than-expected NM-PMI and employment reports on Tuesday, January 7 and Friday, January 10.

Last week, the bond yield peaked at 4.79% on Tuesday, just before the PPI was released. It fell to 4.62% on Thursday and edged up to close the week at 4.63% (Fig. 1). The S&P 500 bottomed at 5827.04 after the employment report a week ago, down 1.9% for the week (Fig. 2). It rallied last week to close at 5996.66, up 2.9% for the week.

Pushing the yield lower last Thursday were comments by Federal Reserve Governor Christopher Waller. In a mid-day interview on CNBC, he said inflation “is getting close to what our 2% inflation target would be.” Indeed, the CPI excluding shelter rose just 1.9% y/y during December and has been below 2.0% during 16 of the past 19 months (Fig. 3).

Waller concluded: “If we continue getting numbers like this, it is reasonable to think rate cuts could happen in the first half of the year ... I am optimistic that this disinflationary trend will continue, and we will get back closer to 2% a little quicker than maybe others are thinking.” Waller added that as many as three or four quarter-percentage-point rate reductions could be possible this year depending on how inflation behaves.

“If inflation is down and the labor market stays solid, you could think about restarting rate cuts several months from now ... I don’t think March could be completely ruled out,” Waller said, referring to the Fed's March 18-19 policy meeting. “If we make a lot of progress, you could do more.”

A week ago, after the employment report on Friday, the futures market signaled one 25bps cut in the federal funds rate (FFR) over the next 12 months. Now the market’s expectation is two such rate cuts (Fig. 4).

In any event, we still expect that the 10-year Treasury bond yield will range between 4.25% and 4.75% over the rest of the year. We continue to expect that yields above this range, closer to 2023’s high of 5.00%, will attract plenty of buyers. So far, so good.

We disagree with Waller’s assessment that the FFR remains restrictive and needs to be lowered further. However, he is a Fed governor and a voting member of the Federal Open Market Committee (FOMC), and we are not. (Message to the DOGE Boys: YRI reiterates our readiness, willingness, and ability to do the FOMC’s job for half the price.)

The Fed has achieved its dual mandate if inflation is on course to fall to 2.0%, as Waller believes, and the unemployment rate is currently 4.1% (Fig. 5). So why does the Fed need to lower the FFR any further? And doesn’t it matter that the bond yield has risen by as much as the FFR has been cut since September 18, signaling that the Bond Vigilantes think the Fed has made a mistake by easing (Fig. 6)?

Most Fed officials, including Waller, share the same conceit, namely that the neutral interest rate at which the dual mandate is achieved is around 3.0% as measured by the FFR. That’s their median projection for the FFR in the “longer run” (Fig. 7). The rest of the yield curve doesn’t seem to matter to them. The bond yield obviously matters a great deal to lots of borrowers. In fact, we believe that there are more reasons to believe that the neutral rate should be measured using the 10-year Treasury bond yield than the overnight bank lending rate.

This is especially true when the neutral rate is adjusted for inflation using the yearly percent change in the CPI. This adjustment makes more sense for a 10-year yield than for an overnight bank rate. Many more borrowers and lenders make their financial and economic decisions based on the former than the latter.

We can make the argument that the nominal neutral 10-year bond yield is 4.00%. The 10-year TIPS yield is currently 2.20% (Fig. 8). That’s about the same as the 2.00% average of the inflation-adjusted 10-year yield (using the CPI inflation rate) since the late 1950s. Add back the Fed’s 2.0% inflation target, and the result is a longer-run nominal yield of 4.00%, with the longer-run real yield at 2.00%. Perhaps the members of the FOMC should incorporate the opinion of the bond market in determining where the FFR should be.

Or maybe, the entire concept of the neutral interest rate is nonsense. All economists agree that it can’t be measured and that it is unlikely to be a constant like “pi” in mathematics. It will change as the economy changes. It is affected not only by monetary policy but also by fiscal policy.

Trump 2.0 is about to make significant changes in immigration, regulatory, energy, and trade policies. They’ll surely affect the magical, mystery neutral interest rate too. Waller addressed only one aspect of the new changes, reassuringly at that: “I don't think tariffs would have a significant impact or persistent effect on inflation.”

Sounds to us as though Waller is hoping that President Donald Trump will consider appointing him Fed chair when Jerome Powell’s term expires early next year.

Strategy II: Our Three Scenarios Reconsidered. We regularly assess the subjective probabilities that we assign to our three scenarios: the Roaring 2020s (55%), the Meltup 1990s (25%), and Stagflationary 1970s (20%). The last scenario, with the lowest probability currently, is our what-could-go-wrong “bucket.” Our main concern since early 2022 was that geopolitical crises might cause oil prices to soar as occurred during the 1970s. Along the way, we have included other potential bearish developments for the economy, as well as for the bond and stock markets, such as overly restrictive monetary policy, a US debt crisis, a Chinese debt crisis, and more recently tariff and currency wars.

The Fed has been easing since September 18 and leaning toward easing some more. Oil prices have remained amazingly subdued despite the conflicts in the Middle East and the war between Russia and Ukraine. Oil prices have increased recently after the outgoing Biden administration toughened sanctions on Russian oil exports, but the incoming Trump administration is expected to boost US oil production. The latest ceasefire agreement between Israel and Hamas is in place.

Meanwhile, last week’s drop in bond yields suggests that a US debt crisis isn’t imminent.

However, the Trump administration will likely announce hefty tariff hikes today, especially on China. Recent stimulus measures by the Chinese government seem to have boosted China’s real GDP at the end of last year (Fig. 9). During December, Chinese industrial production and real retail sales rose 6.2% and 3.7% y/y, respectively (Fig. 10). However, additional US tariffs on Chinese imports could exacerbate China’s property-led economic woes.

On balance, we are thinking about reducing the odds of the bearish scenarios in our bucket of what could go wrong. We aren’t doing that yet, but we are thinking about it. If we do so, then we will most likely increase the odds of the meltup scenario, assuming that Waller’s dovish cooing last Thursday represents the majority view of the FOMC. As we’ve been saying since August of last year, the Fed shouldn’t be stimulating an economy that doesn’t need to be stimulated. That’s especially so given that Trump 2.0 policies are only now about to be announced and may have lots of unanticipated consequences.

The bottom line is that we are still assigning a subjective probability of 80% to a continuation of the current bull market in stocks with our S&P 500 targets for 2025 and 2026 currently at 7000 and 8000.
 
Strategy III: The Wealth Effect. The consensus view among Fed officials seems to be that monetary policy remains restrictive, requiring more interest-rate cuts this year. This view doesn’t square with record-high stock and home prices. The resulting positive wealth effect is undoubtedly boosting consumer spending, especially of retiring Baby Boomers, who are enjoying the windfalls in the value of their stock portfolios and homes:
 
(1) The latest available quarterly data show that total household net worth was $168.8 trillion at the end of Q3-2024 (Fig. 11). Here was the value of their assets: equity shares directly and indirectly held by market value ($55.7 trillion), owners’ equity in household real estate ($35.0 trillion), pension fund reserves ($32.2 trillion), deposits and money market funds ($23.2 trillion), equity in noncorporate business ($15.6 trillion), debt securities ($6.3 trillion), and life insurance reserves ($2.1 trillion) (Fig. 12).

(2) Over the past 12 months through November, the median existing home price is up 4.1% (Fig. 13). Since the start of the pandemic in March 2020, it is up a whopping 47.3%.

(3) Over the past 12 months through the end of December, the market capitalization of the S&P 500 is up 24.4%, and it’s up 168.5% since the pandemic bottom on March 23, 2020 (Fig. 14).

(4) There certainly never has been such a huge positive wealth effect affecting so many millions of people as the Baby Boomers now are enjoying in their retirement years. They’re likely to spend much of that wealth and leave what’s left to their progeny. The Baby Boomers account for about half of the net worth of the household sector, i.e., $83.5 trillion, at the end of Q3-2024 (Fig. 15). The personal saving rate is likely to turn negative since they will be spending out of their retirement assets and nonlabor income rather than earned income.

Movie. “Nowhere Special” (2020, +) is a sad movie about John, a 34-year-old window washer whose wife has abandoned him and their three-year-old son. John is sick and has only a few months to live. So he must find the perfect family to adopt his young son. It’s a terrible situation, but John rises to the occasion for the sake of his son. (See our movie reviews archive.)

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California Insurance & Big Bank Earnings

January 16 (Thursday)

Financials I: California’s Insurance Mess. The California wildfires torched modest neighborhoods as well as ritzy ones, damaging or destroying more than 12,000 structures. Homes and cars have been lost, as have art and wine collections. Smoke has damaged homes that survived the fires, and displaced homeowners will need to find rental properties.

While the wildfires aren’t yet contained, there’s speculation that insured damages could reach as high as $50 billion, and total damages, including economic loss, could amount to $150 billion. Pushing up the price tag are the high-net-worth residences in many fire-scorched areas. The destruction of the 18-bedroom, $125 million mansion used in the HBO TV series “Succession” is the biggest loss to date. Making matters worse, California’s dysfunctional insurance market has left many homeowners with inadequate coverage or no coverage at all, as insurers have been pulling out of the state.

It’s widely believed that insurance companies and reinsurers that do have exposure to California will be able to absorb the losses. And it’s possible that the companies will use these fires to justify rate increases around the country in the future. But how insurers will fare if another large natural disaster strikes before this young year concludes is the big question.

Here are some details about California’s dysfunctional insurance market at a time of flux:

(1) Some insurers have fled the state. Seven of the 12 biggest home insurers have limited their exposure to California over the past two years. Some did so because they weren’t getting the rate increases they believed necessary to compensate for the potential risks. Others were spooked by the growing fire risk in the state. State Farm announced in March that it would not renew 72,000 home and apartment insurance policies in California, 69% of which were in Pacific Palisades, to reduce an overconcentration of risk in the area, a January 9 Insurance Journal article reported.

Nationwide, more frequent and larger catastrophes are becoming the norm. Last year, there were 27 disasters in the US that each cost more than $1 billion and had a total cost of $182.7 billion. That’s up from yearly averages of 23 disasters costing an average of $149.3 billion annually over the prior five years, 13 costing $99.6 billion the prior decade, and just 3 costing $22.0 billion back in 1980-89 (all dollar amounts CPI-adjusted), according to a January 10 report by NOAA’s National Centers for Environmental Information.

Prior to last year, California state regulators were requiring insurance companies to set their rates solely based on historical experiences and excluding reinsurance expenses. Late last year, they changed the rate-calculation formula to lure insurers back to the Golden State. Now forecasts of future damages and the costs of reinsurance may be built into rates. While the new state policy might have increased the insurance available for purchase, it may not have made insurance any more affordable.

(2) Some homeowners have fled insurance. Some homeowners reportedly do not have insurance or may be underinsured. For example, the LA Times reported that Francis Bischetti decided against getting homeowners’ insurance from Farmers Insurance for his Pacific Palisades home when the price jumped from $4,500 to $18,000 last year. California’s state-run Fair Access to Insurance Requirements (FAIR) Plan is an option for homeowners without commercial insurance. But a FAIR policy would have required Bischetti to cut down the 10 trees near his roof to lower the fire risk, also too expensive. The 55-year-old personal assistant lost his home to fire last week.

The number of policies issued by the FAIR Plan increased by 40.5% to more than 450,000 in the 12 months ended September 30, a January 9 WSJ article reported. In Pacific Palisades alone, the number of FAIR residential policies increased to 1,430 as of September 30, up from 773 a year earlier.

The FAIR Plan’s exposure in the Palisades area is almost $6 billion, and it buys around $2.0 billion to $2.5 billion of reinsurance. If it doesn’t have enough to cover losses, FAIR is able to assess the private insurance companies operating in California to raise the shortfall. Last year's rule changes allow companies to pass on some or all of that assessment to their customers, the WSJ reported yesterday. FAIR policy coverage is capped at $3 million, which given skyrocketing home prices in recent years, could be inadequate to cover replacement costs, a January 13 report from Fitch Ratings explained.

(3) Looking back to Tubbs. One of California’s last large fires occurred in 2017 in northern California, near Calistoga. It lasted more than 23 days, claimed 22 lives, burned about 37,000 acres, and damaged or destroyed 6,000 structures, according to a CoreLogic report. The insured property losses from that fire were $5 billion to $7 billion according to CoreLogic or $11.1 billion according to an AON estimate.

Even though banks allowed affected homeowners to postpone mortgage payments, default rates rose, and the price to rent or buy a home in the area rose far faster than the statewide average. Still, rebuilding did occur. Of the 3,043 residential units destroyed in Santa Rosa, 2,176 were rebuilt as of October 2022, another 440 are under construction, and 288 are in the permit review process.

(4) What’s next for affected residents? Already there are reports that landlords in the LA area are jacking up rents, even though there are California laws that restrict price increases to 10% or less during a declared emergency, a January 14 New York Post article reported. Among many examples, the article cited a five-bedroom property in Santa Monica that listed at $12,500 per month in February and was recently relisted at $28,000 per month.

Banks already have started to offer forbearance to mortgage holders affected by the latest fires. Chase Home Lending, Bank of Montreal, and others have announced they’ll be offering affected homeowners with mortgages the ability to temporarily pause their mortgage repayments, a January 13 Reuters article reported. Homeowners are on the hook for their mortgage regardless of whether they have homeowners’ insurance and regardless of whether the insurance entirely covers the cost of rebuilding the home.

Rising insurance costs didn’t stop people from buying expensive homes in California’s inventory-constrained market before the fire. Our guess: It won’t stop them in the future either, even though doing so might get even pricier.

(5) Companies to watch. State Farm had the largest exposure to California’s homeowners insurance market in 2023 ($2.7 billion in written premiums), followed by Farmers insurance (more than $2 billion), Liberty Mutual ($908 million), CSAA Insurance Exchange ($895 million), and Mercury Insurance ($839 million). Allstate, USAA, and Auto Club each had more than $700 million in exposure, a January 14 Fox Business article reported.

Insurance companies may be able to recoup some of their losses if they can successfully sue SoCal Edison and prove that its electrical equipment contributed to starting the fires. A number of insurers reportedly have requested that the utility preserve any evidence related to the Eaton fire, a January 14 article in Program Manager reported. A case may also be brought against the Los Angeles Department of Water and Power for failing to properly manage water supplies to fight the fire. A suit has been brought on behalf of Pacific Palisades residents and others affected by the fire.

The S&P Property & Casualty Insurance industry’s stock price index has risen 2.5% since last Friday, when it bottomed at 12.0% below its record high hit on November 27 (Fig. 1). It is a small reversal compared to the 13% annual gains the index has enjoyed over the past decade, supported by both revenue and earnings growth (Fig. 2 and Fig. 3).

Analysts have been expecting earnings to grow more modestly this year, as pricing in the insurance market was expected to soften after several years of sharp price increases. That may change in the wake of the California fires. Earnings grew 33.6% in 2023 and 49.6% last year but have been expected only to rise 9.4% this year and 7.1% in 2026 (Fig. 4). For now, the industry’s forward P/E, 12.4, is at the lower end of its decade-long range of 9-16 (Fig. 5).

Financials II: Banks Are Looking Good. Some of the nation’s largest banks, including JPMorgan Chase, Wells Fargo, and Citigroup, delivered largely positive Q4 earnings news yesterday. Bank managements painted a rosy picture of the quarter’s operating environment on their earnings conference calls: With unemployment low, consumers continue to borrow money and repay it on time for the most part. Investment banking and markets activities picked up steam, helped by the stock market’s gain last year.

Banks are paying slightly more for deposits, as consumers have higher-yielding alternatives, but they didn’t have to pay a Federal Deposit Insurance Corporation (FDIC) assessment last quarter, as they did in Q4-2023 to help the FDIC recover from losses on the failures of Silicon Valley Bank and Signature Bank.

Here's a deeper look:

(1) Investment banking gets a win. Investment banking and markets activity picked up in Q4 as the election receded into history, business confidence improved with the election of Donald Trump, and the stock market continued hitting record highs.

At JPMorgan, Q4 investment banking revenue rose 46% y/y to $2.6 billion, and Markets & Securities Services revenue was $8.3 billion, up 20%. Fixed-income markets revenue also jumped 20%, to $5.0 billion, and equity markets revenue surged 22% to $2.0 billion. The bank’s asset management arm benefitted from an 18% increase in assets under management to $4.0 trillion, helped by inflows and higher market levels.

At Wells Fargo, investment banking revenue surged 28% to $491 million, somewhat offset by the 5% decline in markets revenues. Rounding out the big three, Citigroup’s investment banking revenues gained 35% to $925 million.

(2) Sluggish loan growth. Given the economy’s strength, commercial loan growth has been relatively tepid and outpaced by slightly stronger consumer loan growth. Commercial banks’ total loans and leases grew 2.7% y/y for the week ending December 30 (Fig. 6). But commercial & industrial loans edged up only 0.7% y/y, while consumer loans jumped 2.0% (Fig. 7). Within consumer loans, credit cards increased a hearty 4.9% y/y, while auto loans continued to slide, down 2.4% (Fig. 8).

At JPM, global corporate and investment banking loans and middle-market loans each dipped 2% q/q. CEO Jamie Dimon on the conference call attributed the declines in loan growth despite general business optimism to factors that he doesn’t view as negatives: “wide-open capital markets,” small businesses’ healthy balance sheets, and perhaps continued caution.

(3) NII down, but credit improved. Now that interest rates have climbed, banks can no longer expect depositors to earn nothing on their money in the bank. At JPMorgan, net interest income (NII) dipped 3% y/y to $23.5 billion in Q4. The bank attributed the decline to lower rates, deposit margin compression, and lower deposit balances in its Consumer & Community Banking (CCB) division. Average deposits in CCB were down 4% y/y and flat q/q.

At Wells Fargo, NII income declined 7% y/y in Q4 to $11.8 billion. The bank’s earnings press release attributed the decline to “deposit mix and pricing changes, the impact of lower rates on floating rate assets, and lower loan balances, partially offset by lower market funding.”

Conversely, the bank benefited from a decline in provisions for credit losses. Provisions shrank to $1.1 billion in Q4 from $1.3 billion a year prior. The drop reflected a decline in allowances “across most loan portfolios,” partially offset by a higher allowance for credit card loans due to an increase in balances.

Banks are still returning to post-pandemic normalcy. The federal government gave out cash to help consumers during the pandemic. In many cases, that cash found its way into banks and cash balances have been coming down for the most part ever since (Fig. 9). Likewise, allowances spiked shortly after the pandemic began, and then they dropped sharply, as the government gave many consumers funding. Since 2022, allowances have crept back up, but the increases seem to be leveling off as the new year begins (Fig. 10).

(4) Banks hit new heights. JPMorgan, Citigroup, and Wells Fargo all are members of the S&P 500 Diversified Banks stock price index, which climbed 35.3% last year, outpacing the S&P 500’s 23.3% gain (Fig. 11). The industry’s revenue and earnings growth is expected to slow this year but remain positive. Revenue is forecast to grow 1.2% this year and 4.4% in 2026, while earnings are expected to increase by 3.4% this year and 14.4% in 2026 (Fig. 12 and Fig. 13). The industry’s forward P/E, 12.7, is near the top of its historical 8-14 range (Fig. 14).

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Updates On China, The UK & Earnings

January 15 (Wednesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
China: The Mother of All Trade Surpluses. China’s strategy to export its way out of a domestic demand problem has led to a $992 billion trade surplus in 2024. Exporters may be front-running likely tariffs under Trump 2.0 and buying up relatively cheap commodities. But we still view this as a sign of the unsustainability of China’s growth model. Here’s more:

(1) Export boom. Chinese exports rose 10.7% y/y in December, beating analyst expectations of 7.0% (Fig. 1). Imports rose 1.0% y/y, also better than the expected decline. China’s trade surplus therefore reached $104.84 billion in December alone.

(2) No sign of import boom. Growth in Chinese M2 money supply and bank loans both continue to fall (Fig. 2). Until China is able to stimulate its domestic consumer spending and bring retail sales growth above industrial production growth, it’s unlikely that the trade surplus will shrink meaningfully (Fig. 3). It’s also unlikely that China will be able to even fabricate its GDP growth to reach its target if this continues (Fig. 4).

(3) Yuan depreciating. The Chinese yuan dropped below the key 7.30 level to 7.33 versus the dollar (Fig. 5). While not a major depreciation, China had previously instructed state-owned banks to support the yuan at 7.30. China may be trying to front-run further weakness that's likely to occur as tariffs on Chinese goods are ramped up. However, China may have to deal with capital flight if its currency drops much more.
 
United Kingdom: What’s Boosting Gilt Yields. UK bond buyers are sending a clear signal to His Majesty’s Treasury: There’s no more room for new borrowing plans. As yields rise in the UK, they squeeze projected borrowing costs and essentially eliminate fiscal space.

UK long-term gilt yields have risen to multi-year highs in recent days. As of last Friday, the 10-year yield rose to 4.84%—the highest since 2008—and the 30-year yield rose to 5.41%, the highest this century (Fig. 6).

Yields are higher than when Prime Minister Liz Truss attempted to slash taxes without any offsets during her brief tenure in 2022 (a.k.a. the “Truss Moment”). However, they've lacked the velocity of that move. Then, the 30-year gilt yield gained 155bps in less than three weeks, from 3.45% on September 8 to 5.00% on September 27. The Bank of England (BOE) was forced to intervene with emergency UK gilt purchases.

The recent climb in yields has been an orderly march over months, not weeks. The 30-year gilt yield is up 91bps from 4.50% at the start of October. The global bond selloff has helped lift yields this time around as well (Fig. 7). Currently, there is no indication that the BOE will step in to calm markets with bond purchases.

Could this be a new normal for gilt yields? It’s possible given global, inflationary, and economic factors. BOE interest-rate cuts throughout the year may help drag yields down; however, that plan backfired for the US as Fed rate cuts helped boost long-term Treasury yields. If the UK government is forced to adjust its plans for more borrowing, that could also cause gilt yields to fall. It would put economic growth at risk though, too.

The UK sterling’s recent fall also could attract foreign capital inflows, reversing yields’ sharp rise. While rising yields and a falling currency recall an emerging-market-style loss in confidence, those facts more likely reflect the pound’s overvaluation relative to the dollar last year.

Let’s consider the forces putting pressure on gilt yields:

(1) Tracking global yields. Likely, some of the gilt yield rise reflects the path of global bonds, especially Treasuries. Expectations for stickier inflation are increasing globally, both due to a potential trade war sparked by Trump 2.0 but also easier monetary policy from most central banks. In the US, 10-year yields have risen 100 basis points (bps) since September 13, 2024 (Fig. 8).

(2) Wider UK spreads. The UK’s bond-market woes have been more pronounced than those of other Western countries, so there is some sovereign-specific risk being priced in. The spread between UK and German government bond yields, for instance, has risen to a multi-decade-high 230bps (Fig. 9).

(3) More borrowing. The rise in gilt yields began in October, when Chancellor Rachel Reeves laid out the Labour Party’s fiscal-year budget. Reeves became Chancellor of the Exchequer on July 2024, appointed by Prime Minister Keir Starmer following the Labour Party’s 2024 general election win.

In her first budget proposal, Reeves wrote in the FT on October 24 that she would use the October 30 budget to implement a new fiscal rule aiming to provide more investment for infrastructure. Separately, the FT said that she would aim to fund about 20 billion pounds per year of incremental investment with increased borrowing.

“Reeves has been eyeing changes to Britain’s domestic budget rules to make it easier to finance public investment, potentially by using a looser definition of public debt that allows a wider range of public assets to be offset against borrowing,” Reuters explained.

But any spending buffer in the next fiscal year budget that would have been “allowed” under the new fiscal rules could be eaten away by higher borrowing costs. In that case, Reeves would need to raise tax revenues to cover the additional spending. Not only would that likely be politically unpalatable but it could undermine economic growth.

Despite the bond market turmoil, economic growth remains the government’s top priority, Reeves said during a visit China this week. She added that the new fiscal rules set out in the October budget are “non-negotiable.”

(By the way, it hasn’t helped the credibility of the UK Labour Party that incoming US President Trump’s favored adviser Elon Musk has called for a national UK public inquiry into the recently uncovered UK coverup scandals. Starmer’s party prefers more local investigations.)

(4) Recession and stagflation concerns. Higher yields for this historically safe asset class normally would be considered an attractive investment. In this case, the markets are attributing higher risk to UK government bonds because the nation’s economic fundamentals are weakening.

The UK could be facing a recession, or worse, stagflationary conditions. Real GDP rose a mere 0.9% y/y and 0.1% q/q during Q3-2024 (Fig. 10). Meanwhile, both the UK headline and core CPI rebounded from a rate of 3.2% y/y and 1.7% y/y during September 2024 to 3.6% and 2.6% through November 2024.

(5) BOE’s cut to cuts. Long-term inflation risks are reflected especially in the rising 30-year UK gilt yields noted above. To combat these risks, the BOE raised its main interest rate from 0.10% to 5.25% over the period December 2021 to August 2023. The bank cut rates twice during 2024, bringing its main rate back down to 4.75% on economic growth concerns.

Recent forecasts for rate cuts have fallen from two or three to just one, indicating that the BOE sees sticky inflation as a persistent problem, pushing UK gilt yields up.

(6) BOE’s unwinding. Further, the BOE previously was a net buyer in the UK gilt market. The bank has reduced its holdings of gilts since March 2022, and it has yet to complete its unwinding of pandemic-induced gilt purchases (see chart).

Net selling by the BOE and the anticipated increase in the supply of government bonds have contributed to lower gilt prices.

(7) Sterling falls. Weakening fundamentals and higher capital outflows have pushed the sterling lower. The weaker currency should attract foreign buyers considering the sterling’s soundness. From September 30 until now, the UK currency has fallen almost 10.0% to $1.23 dollars per pound, the lowest in over a year (Fig. 11).

US Strategy: Don’t Be Surprised by Strong Q4 Earnings Surprises. Joe has been tracking the quarterly earnings forecast for S&P 500 companies collectively each week since the data series started in Q1-1994. Each reporting season brings a typical playbook: Industry analysts cut their estimates gradually until the final month of the quarter, when some companies warn of weaker results. The combination of falling forecasts for companies that have underperformed earlier expectations, steady forecasts for those holding good news close to their vests, and insufficient estimate increases so close to reporting time to balance out the lowered expectations invariably creates an “earnings hook” pattern in the charted estimate/actual data as reported earnings exceed the latest estimates—i.e., a positive earnings surprise.

In other words, the final month of quarters usually sets the stage for better-than-expected earnings reports. Will Q4-2024 prove true to form? Joe believes so. Below, he digests the consensus’ outlook for earnings growth and profit margins:

(1) Revisions as usual for the Q4-2024 estimate. During the last week of December, the S&P 500’s Q4-2024 EPS estimate of $61.80 was down 3.2% from $63.86 at the start of the quarter in October (Fig. 12). Nearly all of Q4’s decline occurred by mid-November, as EPS then stabilized until the end of the year. That decline was a pinch smaller than the 3.6% drop for Q3-2024 and matched the average quarterly decline of 3.2% over the past three years. It also compared favorably to the 3.9% average decline over the 123 quarters since consensus quarterly forecasts were first compiled 30 years ago.

Such “not-too-hot-not-too-cold” revisions activity implies yet another strong earnings surprise. With the earnings hook, Q4’s final earnings growth rate could be as high as 12%.

(2) S&P 500 earnings growth streak at six quarters. Analysts expect the S&P 500’s earnings growth rate to be positive on a frozen actual basis for a sixth straight quarter following three y/y declines through Q2-2023. They expect 8.2% y/y growth in Q4-2024, compared to 8.2% in Q3-2024, 11.3% in Q2-2024, and 6.6% in Q1-2024 (Fig. 13). On a pro forma basis, they expect a sixth straight quarter of positive y/y earnings growth, up 9.5% (versus 9.1% in Q3-2024, 13.2% in Q2-2024, and 8.2% in Q1-2024).

(3) Seven sectors expected to show y/y growth. Seven of the S&P 500’s 11 sectors are expected to record positive y/y percentage earnings growth in Q4-2024, the same number as in Q3-2024. Analysts expect three sectors to post small y/y earnings declines, but we think the typical surprise hook will flip those sectors to positive y/y earnings growth. That would push Q4’s final count of sectors with y/y earnings growth to 10, the most since easy y/y comparisons to pandemic-impacted results helped 10 sectors hit that mark in Q4-2021.

The seven sectors that analysts currently see posting positive y/y growth all are expected to record double-digit percentage gains. That’s up from five sectors with double-digit gains in the past three quarters through Q3-2024.

Communication Services has the highest expected y/y growth for a second straight quarter, 22.7%, ahead of Financials (18.0%), Information Technology (15.3), Consumer Discretionary (12.9), Health Care (12.1), Real Estate (10.7), and Utilities (10.5). Energy is the biggest laggard with a forecasted y/y earnings decline of 28.4%, well behind the Industrials (-3.4), Materials (-2.1), and Consumer Staples (-1.2) sectors.

(4) Y/y growth streaks: winners and losers. Health Care is expected to be positive for a third straight quarter and at another strong double-digit percentage rate. Boeing’s strike has hurt the Industrials sector, which is now expected to report a second quarter of falling earnings y/y after rising for 13 straight quarters through Q2-2024. Consumer Discretionary and Financials are expected to rise for an eighth straight quarter, followed by seven quarters of growth for Communication Services and Information Technology. Energy is expected to report falling y/y earnings during Q4-2024 for the seventh time in eight quarters. Materials is expected to mark its tenth straight y/y decline in quarterly earnings.

(5) Most MegaCaps still growing faster than the S&P 500. The Magnificent-7 group of stocks is expected to record y/y earnings growth of 19.9% in Q4-2024 (Fig. 14). That’s down from 27.6% during Q3-2024 and a peak of 28.1% during Q2-2023 when Nvidia’s easy comparisons finally aged out at nearly 600% y/y. Amazon is Q4’s biggest expected earnings grower, rising 50.4% y/y, ahead of Nvidia (37.2%), Alphabet (27.3), and Meta (24.7). Three Magnificent-7 companies became less-than-magnificent earnings growers last year and are expected to lag again in Q4: Tesla (4.8%), Apple (5.7), and Microsoft (6.9).

(6) S&P 493 earnings growth positive again without faster growing MegaCaps. S&P 500 earnings excluding the Magnificent-7, a.k.a. “the S&P 493,” are expected to rise 7.1% in Q4. That rate is still hobbled by Boeing’s strike, which caused S&P 493 earnings to rise just 3.9% y/y in Q3-2024 following gains of 7.6% in Q2 and 0.6% in Q1. The surprise hook could result in near double-digit percentage y/y growth for the S&P 493 in Q4-2024, which would be the highest rate since it rose 10.6% y/y 11 quarters ago in Q2-2022.

(7) Profit margin gains continuing. The S&P 500’s quarterly profit margin is expected to improve to a 12-quarter high of 13.1% in Q4 from 12.9% in Q3 (Fig. 15). That compares to the 13.5%-13.8% readings during Q2- to Q4-2021 when companies enjoyed immense pricing power amid supply-chain shortages. The collective profit margin for the S&P 493 is expected to edge up to a four-quarter high of 11.7% in Q4 from a Boeing strike-challenged 11.6% in Q3.

It seems a stretch now to expect the S&P 493’s profit margin to beat its 12.9% record highs of H2-2021. However, analysts currently expect it to improve to 12.7% by Q3-2025. That’s before any possible corporate tax rate cuts. Higher oil prices could see Energy sector earnings grow meaningfully during Q3-2025 for the first time in 10 quarters.

The Magnificent-7’s quarterly profit margin is expected to drop to 24.2% in Q4 from a record-high 25.5% in Q3. Here’s how the Magnificent-7’s expected Q4 profit margins stack up along with their Q3 margin actuals: Nvidia (54.9% in Q4-2024, 57.2% in Q3-2024), Meta (37.4, 38.6), Microsoft (34.0, 37.6), Apple (28.9, 26.3), Alphabet (27.2, 29.8), Tesla (9.6, 10.0), and Amazon (8.5, 9.7).

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Fed’s Switcheroos At FOMC & QT

January 14 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: Fed’s Ongoing Musical Chairs. There will be four new voters at the Fed’s January 28-29 meeting. All 19 members—including 7 Fed governors and 12 regional bank presidents—participate in each Federal Open Market Committee (FOMC) meeting. However, only the governors and New York Fed president have permanent votes to decide monetary policy actions; the remaining 11 presidents rotate annually for four voting spots. Considering the growing disagreement within the FOMC, it’s even more important to understand the voting dynamics.

We first noted the emerging dissent among FOMC participants in our August 22 Morning Briefing. Since, there have been two voted dissents. Governor Michelle Bowman dissented in favor of a smaller 25bps cut when the FOMC reduced the federal funds rate (FFR) by 50bps on September 18. Cleveland Fed President Beth Hammack, who joined in August, dissented in favor of no cut on December 18. However, Hammack is no longer a voter.

Also not voting this year are Atlanta Fed President Raphael Bostic, San Francisco Fed President Mary Daly, and Richmond Fed President Thomas Barkin. The new voters are Chicago Fed President Austan Goolsbee, St. Louis Fed President Alberto Musalem (who joined the FOMC in April), Boston Fed President Susan Collins, and Kansas City Fed President Jeffrey Schmid. Goolsbee was an alternate voter on the FOMC’s July decision, when the Cleveland Fed presidency was vacant.

Consider how the voting-rolls shakeup may influence monetary policy as the FOMC grapples with stickier inflation and the uncertainty of Trump 2.0:

(1) Ornithology. There are a couple like-for-like swaps in the voting shift. Goolsbee is one of the most dovish FOMC members, yet he can be thought of as replacing another dove in Daly. While Hammack, the only voter with the gusto to dissent at the last meeting, has departed, Musalem is another hawk. He recently told the WSJ that the Fed must be cautious about lowering rates further, as the labor market is in good shape and inflation is “still out of bounds.” We agree! It’s no surprise that Hammack’s and Musalem’s views more closely align with ours given their years of private-sector experience.

While Hammack dissented in December, the dot plot from the FOMC’s December Summary of Economic Projections suggested that four total FOMC participants favored no rate cut (Fig. 1). Musalem was likely one of those four. A recent speech by Collins suggests she is in favor of a pause. Schmid said he believes policy is roughly neutral at the moment, neither restrictive nor stimulative. He’s also a hawk in terms of balance-sheet policy, favoring a continued quantitative tightening (QT) policy to shrink the Fed’s asset holdings while also fully exiting the mortgage-backed securities (MBS) business and shifting toward shorter-duration Treasuries. More on that later.

Fed officials are likely just becoming more emboldened to depart from Fed Chair Jerome Powell’s view after the economy proved much stronger and long-term Treasury yields shot up while they were cutting the FFR. Barkin, who was a voter and decided not to dissent, said earlier this month that “the current labor market equilibrium is more likely to break toward hiring than toward firing.” That’s a huge difference from the FOMC minutes, which showed broad-based concern that the downside labor-market risks are greater than the inflation risks. He is also a believer in the productivity story and recently opined “so long as people keep their jobs and asset values remain solid, they should continue to spend.”

We think more FOMC members will start to echo Barkin’s tune. How can the Fed be worried about labor-market downside even though the supercore PCED rate is 150bps above the 2.0% target, unemployment is 4.1%, payroll growth was north of 250,000 last month, and the 10-year yield is above 4.76% (Fig. 2 and Fig. 3)?

(2) Disbarred. Fed Vice Chair for Supervision Michael Barr is stepping down from his post 18 months early to avoid a legal battle with Trump 2.0. Barr is a regulatory hawk who has drawn the ire and critique of not just Wall Street and free marketeers but also fellow Fed officials. Had President Trump sought to remove Barr early, Barr may have won on legal grounds, but only after a long and distracting legal fight. With Barr gone, there’s upside for banks. They may be discussed during big bank earnings calls later this week.

Barr has pushed an even stricter regulatory regime known as the “Basel III endgame,” which would have forced banks to hold even more capital to satisfy already onerous requirements from the first two Basel accords. Governor Bowman, and even Powell at times, have been vocal critics. It was already likely that Basel III would be watered down from Barr’s initial proposal. We wrote in our August 27 Morning Briefing, “the Basel III endgame regulatory framework will be relatively loose. Combined with the end of Chevron deference, financials may be entering a sustained period of more favorable regulatory change after a decade-plus of tighter oversight following the Great Financial Crisis (GFC).”

Notably, Trump does not have his pick of the litter to replace Barr. Because his term as governor is not up, Barr will remain on the FOMC, and a current Fed governor must be selected as vice chair. That leaves Christopher Waller and Bowman, the two Republican Fed governors.

Waller had a long spell as a hawk before joining Powell’s easing crusade. His dovish leanings may be reminiscent of Powell’s political pivot, in that he is attempting to play to Trump’s preference for lower interest rates.

Bowman is a monetary policy hawk but a regulatory dove. Having been a community banker, she is critical of the Fed’s stress tests and bank exams. She may be more aligned with incoming economic policymakers in Trump 2.0 who tend to be critical of the stimulative excess that comes from over-easy monetary policy, favoring deregulation to give the private sector room to innovate and grow.

Trump 2.0 may also shake up some of the government’s regulatory bodies, such as the Office of the Comptroller of the Currency (OCC), the Consumer Financial Protection Bureau (CFPB), and the Federal Deposit Insurance Corp (FDIC). All of these changes would be positive for big bank stocks, in our opinion.

Strategy II: Quantitative Tightening Playbook. Primary dealers, the large banks that help finance US Treasury auctions, have been pushing back their expected end date for quantitative tightening (QT). At the November FOMC meeting, participants expected QT would be done in May. In December, they pushed it back to June. We think QT can run until Q3 or Q4, but continuing it for that long will be increasingly difficult for the Fed. It is highly likely the FOMC will end QT at the first sign of trouble. Here’s more:

(1) Running on reserves. Bank reserves have barely budged despite two-plus years of balance-sheet runoff. There are $3.25 trillion of reserves in the US banking system, down from a peak of $4.19 trillion in September 2021 but roughly double pre-pandemic levels (Fig. 4). There are several reasons that reserves remain elevated: The Fed slowed its pace of balance-sheet reduction in June, relatively few MBS have matured due to low prepayments, and the multi-trillion dollars of money-market-fund assets in the reverse repurchase facility (RRP) financed much of the Treasury’s issuance.

With just $179 billion in the RRP, bank reserves could break below $3 trillion in the first half of this year (Fig. 5).

(2) Bond impact. The Fed allows $30 billion of Treasuries to mature each month without reinvesting the proceeds. However, it still reinvests the rest of the maturing securities, partly into newly auctioned longer-dated Treasuries. That increases the amount of duration on its balance sheet, leaving private-sector balance sheets a little lighter and able to buy riskier or longer-duration assets rather than finance 10-year Treasury notes (Fig. 6).

Arguably, this has helped keep financial conditions relatively easy. Still, runoff is runoff, and a full-fledged end to QT would support bond prices as the Fed reinvests all of its proceeds.

Additionally, we suspect a policy change sometime this year: All maturing MBS (there are currently $2.2 trillion on the Fed’s balance sheet) may be reinvested into Treasuries (Fig. 7). This would add another source of buying support for Treasuries and lower bond yields. As homebuyers adjust to higher mortgage rates and prepay/refinance old mortgages for personal reasons, higher prepayments can rapidly increase the amount of MBS maturing each month (Fig. 8).

An end to QT would also mean that big banks won’t have to absorb as much of the new Treasury bonds on their own balance sheets (Fig. 9).

(3) What could trigger the end of QT? The reduction in bank reserves could cause short-term interest rates to rise, similar to the repo rate spike in 2019. The FOMC will most likely terminate QT once it sees a marginal, yet sustained, increase in repo rates. However, the 10-year Treasury bond yield breaching 5% could be another trigger. If higher long-term yields put undue pressure on the economy, the Fed could use its balance-sheet policy to ease financial conditions by ending QT.

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The Recession Is Over, Again!

January 13 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy: Recalibrating the Fed. From March 2022 through August 2024, there was widespread concern that the tightening of monetary policy by the Fed over that period would cause a recession. It was the most widely anticipated recession that didn’t happen on record. Once the Fed started easing monetary policy on September 18, 2024, it was widely expected that the Fed would have to lower interest rates significantly to avert a recession. Now that scenario has lost its credibility, especially following Friday’s strong employment report for December.

The bond and stock markets have been recalibrating the outlook for the Federal Reserve’s monetary policy. The Fed cut the federal funds rate (FFR) by 100bps from September 18 through December 18 and signaled that more cuts are ahead in 2025. Bond market action suggests that investors have come around to our view that the Fed was stimulating an economy that didn’t need to be stimulated and that inflation was getting sticky north of the Fed’s 2.0% target. We argued that the economic and inflation data were signaling that the so-called neutral FFR was closer to 4.0%-5.0% than to 3.0%. We disagreed with the Fed’s view that the FFR was too restrictive when it was around 5.0%.

Our view has rapidly become the consensus view in recent weeks, especially after Friday’s strong employment report. That view can be described as a “higher-for-longer” interest-rate outlook, but “normal-for-longer” is the way we prefer to look at it. One of the reasons that we dissented over the past three years from the consensus forecast that a recession was coming is that we believed that the Fed’s monetary tightening simply brought interest rates back up to their normal levels in the years prior to the Great Financial Crisis and wouldn’t unduly stress the financial system, culminating in a recession (Fig. 1).

In his September 18, 2024 press conference, Fed Chair Jerome Powell said that the 50bps cut in the FFR announced that day by the Federal Open Market Committee (FOMC) was simply a recalibration of monetary policy: “So we know that it is time to recalibrate our policy to something that is more appropriate given the progress on inflation and on employment moving to a more sustainable level. So the balance of risks are now even. And this is the beginning of that process I mentioned, the direction of which is toward a sense of neutral, and we’ll move as fast or as slow as we think is appropriate in real time.”

We and our friends the Bond Vigilantes disagreed with the Fed’s recalibration. Our August 19 Morning Briefing was titled “Get Ready To Short Bonds?” We argued that the economy was in a soft patch that wouldn’t last too long. We predicted: “Bond investors may be expecting too many interest-rate cuts too soon if in fact August’s economic indicators rebound from July levels and the Fed pushes back against the markets’ current expectations for monetary policy. So we are expecting to see the 10-year Treasury bond yield back in a range between 4.00% and 4.50% next month.”

Much to our consternation, instead of pushing back against the markets’ expectations, the Fed cut the FFR by 50bps on September 18 and Powell signaled that more rate cuts were coming. We pushed back against the Fed. Our October 15 Morning Briefing was titled “Will Fed Get Stuck With Sticky Inflation?” We wrote: “By cutting interest rates despite strong economic growth, the Fed now risks overstimulating demand and reviving inflation. Services and wage inflation remain sticky, raising the risk that headline inflation gets stuck above 2.0%. The bond market agrees with our assessment that the Fed turned abruptly too dovish recently, boosting market expectations for long-term inflation higher.”

So now that the Fed has cut the FFR by 100bps since September 18, 2024, the 10-year bond yield is up 114bps since September 16, 2024 (Fig. 2). Even the 2-year Treasury note yield is up 91bps since September 24, 2024. Since the last FFR cut, on December 18, the number of additional 25bps rate cuts expected by the FFR futures market has declined from two to one over the next 12 months and none over the next six months (Fig. 3).

In early December, the stock market started to recalibrate the outlook for interest rates to higher-for-longer. Consider the following:

(1) The S&P 500 market-cap-weighted stock price index peaked at a record 6090.27 on December 6 and fell 4.3% through Friday’s close to 5827.04 (Fig. 4). It is 2.4% below its 50-day moving average. If it drops to its current 200-day moving average, that would be an 8.1% pullback from the peak.

The S&P 500 equal-weighted stock price index is down 7.5% from its November 29 peak and only slightly above its 200-day moving average (Fig. 5).

(2) The Nasdaq peaked at a record high of 20,173.89 on December 16 (Fig. 6). It is down 5.0% since then, to below its 50-day moving average. Its 200-day moving average is currently 17,881.5.

(3) The Russell 2000 peaked at 2442.03 on November 25, matching its high at the end of 2021 (Fig. 7). It is down 10.4% since then. So it is officially in a correction. We have not been keen on SMidCaps in general, and particularly not on the Russell 2000, because their earnings have been flatlining since 2022.

(4) Since Election Day, the following stock price indexes are down: the Dow Jones Industrials Average (-0.7%), the S&P 500 Equal-Weighted (-3.0), and the Russell 2000 (-3.2) (Fig. 8). Still up since then are the Magnifient-7 stocks (12.2) as well as the Nasdaq (3.9), Nasdaq 100 (3.1), and S&P 500 (0.8).

(5) We anticipated this stock market correction at the end of last year. In the December 17 Morning Briefing, we wrote: “With bullishness abounding, contrarian indicators are flashing red, and we see the potential for a market correction early next year.” Our major concern was that the stock market was discounting too many FFR rate cuts, while the bond market was signaling that the Fed had already cut the rate by too much. Friday’s stock market rout suggests that stock investors have recalibrated their interest-rate outlook to higher-for-longer, a.k.a. normal-for-longer.

The animal spirits unleashed when President Donald Trump won a second term in office on November 5 have been subdued by more realistic outlooks for both Fed policy and the policy stew cooked up by Trump 2.0.

(6) Another important development: Stock market sentiment is turning less bullish, which is a positive from a contrarian perspective. The Investor Intelligence and AAII bull/bear ratios have dropped sharply over the past couple of weeks and undoubtedly did so again this past week (Fig. 9).

(7) More downside for stock prices is likely this week if December’s CPI, which will be released on Tuesday, is as hot as the Cleveland Fed’s Inflation Nowcasting tracking model shows—i.e., a 0.38% increase in the headline rate. The core rate indicated is less than that, however, at 0.27%. These m/m increases would put December’s y/y readings at 2.9% and 3.3%.

However, the downside may be short-lived. We are still expecting that the Q4-2024 earnings reporting season, which starts this week, will show at least a 10% y/y increase in S&P 500 companies’ aggregate operating earnings per share. The analysts’ consensus is 8.2% currently (Fig. 10). The big banks will start the reporting off at the end of this week. Their results should be strong. In addition, their managements might discuss how deregulation under Trump 2.0 might boost their earnings.

US Economy: A Solid Labor Market. “The sky is falling! Get out of the way!” That was the reaction of the stock and bond markets on Friday to the stronger-than-expected employment report as investors rushed to sell both stocks and bonds. Is such good news for the economy really bad news for investors? Not in our opinion. Consider the following:

(1) December’s payroll employment increased 256,000, beating expectations after November’s increase of 212,000 was less than expected. Those surprises were mostly attributable to retail sales payrolls, which fell 29,200 in November and increased 43,400 last month. That was attributable to a late Thanksgiving holiday.

The three-month moving average of the monthly changes in total and private payrolls were 170,000 and 138,000 through December (Fig. 11). Those are in line with the paces of 2018 and 2019 and consistent with our view that the labor has normalized following the tight conditions during the pandemic years.

(2) Aggregate weekly hours rose 0.2% m/m to another record high last month, while average hourly earnings (AHE) increased 0.3% m/m (Fig. 12). As a result, our Earned Income Proxy for private-industry wages and salaries in personal income rose 0.5% to another record high. This augurs well for other measures of consumer income and consumer spending during December, which will be reported over the rest of this month (Fig. 13).

(3) AHE for all workers has been rising faster than consumer prices since early last year, suggesting that productivity growth has rebounded from the pandemic levels (Fig. 14).

(4) December’s unemployment rate edged down to 4.1% from 4.2% the month before. Layoffs and initial unemployment claims remain low. There are plenty of job openings. The only issue we see in the labor market is that the average weekly duration of unemployment has risen from 20.6 weeks during July to 23.7 weeks last month (Fig. 15). It may be taking longer to find a job because of skills mismatches.

Commodities: An Oily Policy Change. The price of a barrel of a barrel of Brent crude oil rose by $5.12 to $79.76 since the start of the new year through Friday’s close (Fig. 16). Initially, the rally was driven by cold weather in the US and Europe. In addition, the Chinese government announced plans for more fiscal stimulus to revive China’s economy.

Last week on Friday, the Biden administration imposed new sanctions on Russia. They target more than 180 vessels from Russia’s fleet of shadow tankers that Moscow has used to evade existing oil sanctions. They also blacklist two leading Russian oil producers, Gazprom Neft and Surgutneftegas, and their subsidiaries.

According to The New York Times report, Daleep Singh, the deputy national security adviser for international economics, said it was a “fair question” to ask why Mr. Biden waited until the end of the administration to impose such sanctions.

It might give the Trump administration more bargaining power over Russia in negotiating an end to that country’s war with Ukraine. It might also leave the new administration with an inflation problem that will further unsettle the bond and stock markets. Then again, Trump will probably counter by announcing lots of oil leases on federal land.

Movie. “The Substance” (- - -) (link) is a horrible movie starring Demi Moore as an aging TV celebrity with her own very popular exercise show. She learns that the network’s president intends to replace her with a younger and curvier performer. She takes a black-market drug that replicates her genes and produces a younger and fitter version of herself and gets her job back. It turns out she has made a deal with the devil that ends with the spilling of lots of blood. So the movie is a bit like mixing “The Picture of Dorian Grey” and “Carrie.” If you like horror films, you might enjoy this horrible one.

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AI, Metals & Solar

January 09 (Thursday)

Information Technology: AI Invades CES. Spotlighting the latest and greatest tech innovations, the annual Consumer Electronics Show, a.k.a. CES, is always a great way to kick off the new year. Many of the products showcased this year incorporate artificial intelligence (AI), making them “smarter.” So it was appropriate that the king of AI, Nvidia’s CEO Jensen Huang, gave the keynote address on Monday.

Here are some of his notable comments and a few of the interesting AI-infused products that caught our attention:

(1) Nvidia’s massive breadth. Nvidia may have started out as a semiconductor chip designer, but now it’s also designing software and hardware, creating an entire ecosystem for companies adding AI to their products.

Nvidia’s latest hardware offering is Project Digits, an AI supercomputer small enough to sit on a desk and connect to the laptop of a developer, engineer, or machine learning researcher. Users can run AI software on the supercomputer instead of paying to run AI programs in the cloud. Expected to hit the market in May, Huang described the supercomputer as a cloud platform that sits on your desk.

(2) An AI agent for everyone. Huang is convinced that AI agents will be used in every field to help people work faster and smarter. Knowledge workers will use AI research assistants to digest complex documents. Software developers will use software security AI agents to scan software for vulnerabilities and suggest corrective actions. In labs, virtual AI agents will screen medical compounds. In factories, video analytics AI agents will monitor traffic and reroute workers when necessary. AI agents will assist employees in sales development, customer service, financial analysis, employee support—the list goes on.

AI agents will gain acceptance because they will provide a competitive advantage. All Nvidia software engineers will use AI to ensure they’re coding fast enough, Huang noted in a Q&A session with analysts.

(3) Welcome to the data factory. Nvidia is collecting and organizing traditional data and using them to create synthetic data. Both traditional and synthetic data will be used to train AI agents and robots in Nvidia’s “data factory.” For example, the company developed the Nvidia Cosmos by having it watch 20 million hours of video about nature, humans, and anything to do with the physical world. Based on those real scenarios, it can also create synthetic data to create even more scenarios. It can then use its real and synthetic data to train robots that need to navigate in the world, whether working in a warehouse or driving an autonomous vehicle.

“The ChatGPT moment for general robotics is right around the corner,” Huang said in the keynote. Robots could be the largest industry ever. Every person has a cell phone, but there may be more than one robot per person, especially in countries where the population is declining. Huang also believes that all cars will be autonomous, creating a huge demand for data centers.

For those concerned that the growth in the AI market has peaked, Huang noted that over the next four years computers and servers will need to be upgraded. AI will use software and provide services that haven’t existed before. And AI will require “data factories” that don’t exist. This will all be “capex heavy.” The implication: no end in sight to Nvidia’s continued stratospheric success.

Nvidia investors apparently weren’t convinced, however, as the company’s shares dropped 6.2% to 140.14 on Tuesday after hitting a record high on Monday (Fig. 1). The selloff might have reflected classic buy-the-rumor-sell-the-news thinking or investors might have been spooked by the backup in interest rates. Or perhaps it’s just time for the shares to take a breather since they’ve climbed 185.4% over the past year.

The growth in the company’s forward revenues and operating earnings have both been remarkable, as has its ability to maintain a forward profit margin north of 55% (Fig. 2, Fig. 3, and Fig. 4). Nvidia’s forward P/E of 32.6 is certainly higher than the S&P 500’s forward earnings multiple of 21.6, but it looks reasonable relative to the company’s expected forward earnings growth of 53.1% (Fig. 5 and Fig. 6).

(4) AI gadgets galore. Beyond Nvidia, CES showcases gadgets that are fun, though not necessarily necessary. News that caught our eye included an item on the Spicerr, a smart spice dispenser that eliminates the need for measuring spoons, “learns” users’ flavor preferences, and tailors recipes and spices to match.

Robot vacuums have gotten smarter. The Roborock Saros Z70 has an arm to move small objects out of its path, and the SwitchBot K20+ has a platform that can carry a fan, a tray to deliver food, or a security camera.

We also thought CortiSense looked interesting. It can test spit to measure a person’s cortisol levels to track stress, metabolism, and immune function. Also addressing health is Withings’ Omnia, an AI powered, full-length mirror in development that evaluates a person’s weight, heart, and lungs. It can take an electrocardiogram and measure blood pressure, heart rate, Vo2 max, and sleep quality. Using this data, Omina can make recommendations on how to improve one’s health.

But the product that could really make a difference is the LeafyPod, an AI-powered smart watering planter. Information entered into an app lets the planter know what type of plant it’s holding, the season, and the planter’s location. With a reservoir holding four weeks’ worth of water, the planter adjusts watering based on how the soil and plant react to the first few watering sessions. It might just be enough to turn Jackie’s brown thumb green.

Materials: Starting the Year with A Bounce. The prices of industrial metals are starting the year on a positive note. Some are benefitting from optimism that China’s economic stimulus will work this time around, others from anticipated heightened demand thanks to planned increases in US hydrogen production and solid global car sales. In some cases, supply constraints are also supporting prices.

Here’s how industrial metals have performed ytd and y/y through Tuesday’s close: platinum (7.7%, 0.4%), copper (4.4, 9.6), tin (3.0, 21.9), palladium (2.1, -10.8), lithium (0.6, -18.8), steel (0.1, -34.9), lead (0.0, -6.1), aluminium (-1.5, 11.7), iron ore (-3.9, -30.3), and zinc (-3.9, 11.6) (Fig. 7 and Fig. 8).

Let’s take a look at what’s driving the leaders early in this new year:

(1) Tin. Tin’s strong gains last year continued into the first week of 2025 (Fig. 9). Demand for the metal—which is used in electronics (semiconductors and solar panels), chemicals and cars—has remained strong. Meanwhile, supply has faced disruptions in major producing countries Myanmar and Indonesia.

(2) Platinum. Platinum tops the leader board this year after stagnating in 2024 (Fig. 10). The metal is used in gasoline-powered cars’ catalytic converters, in the production of hydrogen, in certain industrial processes (e.g., making glass and the manufacture of LED screens), and of course in jewelry.

Concern that the European Union would stop selling cars with combustion engines by 2035—forcing the adoption of electric vehicles (EVs)—is abating. BMW has begun to push back on that plan, arguing that it’s no longer realistic and that it could increase the region’s dependence on China’s EV batteries. Demand is also expected to increase under the push during the Biden administration to encourage the production of hydrogen in designated regional hubs. Whether that program continues under President-elect Trump remains to be seen.

(3) Copper. The price of copper has shown signs of life, presumably on hopes that China’s fiscal and monetary stimulus will keep the country’s industrial production chugging along (Fig. 11). The commodity had been a beneficiary of China’s new housing construction over the past decade. When that came to a halt in recent years, a major source of demand dried up.

Fortunately, copper is also used in many elements of the clean energy economy, including EVs and data centers. In addition, new supplies of the metal have been tight partially due to the closure a year ago of one of the world’s largest mines in Panama. Its owner, First Quantum, was unable to agree to tax terms that appeased Panama’s national government. A new Panamanian government may reopen negotiations this year.

Disruptive Technologies: Here Comes More Sun. When we think of solar energy, what leaps to mind are the large, clunky panels that typically sit on rooftops or solar farms. But scientists now have developed thinner and more flexible materials that can absorb and generate solar energy from the sides of buildings, car roofs, even the tops of beach umbrellas. Here’s a quick look at some of the latest developments:

(1) A solar paint job. Mercedes-Benz is developing a paste containing solar cells that can be applied to a car’s surface. The photovoltaic material is thinner than a human’s hair and is 20% energy efficient. It generates energy both while the car is operating and when it’s turned off.

“Solar paint has a high level of efficiency and contains no rare earths or silicon—only non-toxic readily available raw materials. It is easy to recycle and considerably cheaper to produce than conventional solar modules,” a company November 22 press release states. When used on a mid-sized SUV, the paint can propel the car for about 20 miles a sunny day in Germany.

Each body panel covered with the novel paint must be wired into a power converter that sends the electricity to the battery or motor, explained a November 22 MotorTrend article. The solar material is then covered by a “nanoparticle-based paint that allows 94 percent of the sun’s energy to reach the photovoltaic coating …”

(2) Perovskite goes live. We introduced perovskite in the August 1 Morning Briefing, noting that it’s more efficient than silicon, but unstable. First Solar acquired a European company focused on producing perovskite films in 2023, and last year it was awarded $6 million by the Department of Energy to develop a perovskite film that’s 27% efficient, topping the 20% efficiency of most solar panels.

It’s not alone. US startups CubicPV, Caelux, Swift Solar, and Tandem PV each are working on perovskite-silicon thin films, and numerous universities are researching the area, a September 19 PV Magazine article reported.

Japan’s Sekisui Chemical may be ahead of the pack. It plans to begin selling perovskite solar films via its existing facilities this year for use on roofs and the exterior walls of factories, warehouses, and other buildings, a December 26 WSJ article reported. The company also plans to mass produce perovskite solar cells through a subsidiary, in which the government-owned Development Bank of Japan will own a 14% stake. The government will subsidize half of the project’s anticipated $2 billion cost.

UK firm Oxford PV has reported that its residential-sized solar panels that use perovskite on silicon have achieved efficiency of 26.9%. The improved efficiency will reduce the number of solar panels used on a roof to provide the same output, which lowers the cost of the system and could mean that owners of roofs in partial shade now have solar options, a CleanTechnica article explained.

(3) Solar at CES. As solar materials become more flexible, they can be applied to a growing range of objects. At CES, Anker showcased its Solix Solar Beach Umbrella with perovskite solar cells that generate energy to chill sodas and sandwiches in the Solix EverFrost 2 Electric Cooler, a January 6 article in The Verge reported. The cooler, which can also run on batteries, has a price tag that ranges from $699-$1,000.

For those who can embrace their inner geek, there’s EcoFlow’s Power Hat. The wide-brimmed floppy hat is covered with solar cells that can charge a smartphone in three to four hours. The $129 hat uses passivated emitter and rear contact monocrystalline silicon, The Verge reported on August 3.

Aptera unveiled its futuristic, two-seater car that runs on solar and battery power at CES. The three-wheeled car has solar cells covering its shell that provide up to 40 miles of solar-powered range each day and a battery that boosts the car’s range up to 400 miles, a January 6 article in The Verge reported. Here’s a video of the CES launch. Production and deliveries are expected by the end of this year.

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Updating Global Economy & S&P 500 Earnings

January 08 (Wednesday)

Global Economy I: Eurozone. Over the past couple of weeks, the Eurozone’s economic data have been a mixed bag. The economic fundamentals of Southern European tourist destinations like Spain and Italy have improved. Meanwhile, stalwarts such as France and Germany continue to struggle with political strife and macroeconomic deterioration. Here’s what the latest economic releases tell us:

(1) The Eurozone economy is limping along. The Eurozone economy is growing at a snail’s pace. The HCOB Composite Purchasing Managers' Index (PMI) for the Eurozone marginally improved to 49.6 in December 2024 but remains below the 50-point mark that separates expansion from contraction (Fig. 1). The manufacturing sector remained especially weak (45.1), while the services sector rebounded into expansionary territory (51.6).
 
Flash Eurozone consumer confidence, however, fell in December 2024 to below its long-term average. Real GDP grew just 1.0% y/y in Q3-2024.

To spur recovery, the European Central Bank (ECB) further cut interest rates in December 2024 by 25bps to 3.0%. Headline CPI inflation cooled to 1.7% y/y in September before rising again, to 2.4% in December. It remains above the ECB’s 2.0% target (Fig. 2).

The markets still expect the ECB to cut interest rates by an additional 75bps over the next year, based on overnight index swaps tied to the benchmark euro short-term rate (ESTR) (Fig. 3). That would put the ECB deposit rate to 175bps lower than the federal funds rate (FFR) based on what the markets expect the Fed to do, per 12-month FFR futures.

We believe the gap between US and European benchmark rates could widen from around 150bps today to more than 200bps by 2026. That’s because we expect US growth to beat expectations, while the ECB may have to cut rates swiftly to shore up growth in the Eurozone, especially as Brussels clamps down on fiscal spending. This is also one of the reasons that European stock indexes have done relatively well despite the weak economic outlook.

Rate cut expectations have pressured the euro down 5.3% against the dollar over the past year, which boosts profits earned abroad by European businesses when they are converted into euro. Lower rates will also help indebted telecom and manufacturing businesses refinance and invest.

(2) Spain leads the pack. Spain’s real GDP grew 3.3% y/y in Q3-2024, well exceeding recent economic growth for the collective Eurozone (1.0%) as well as for France (1.2), Italy (0.4), and Germany (-0.3) (Fig. 4). Spanish real GDP growth is expected to increase by 2.9% this year, per the International Monetary Fund, lifted by immigration, tourism, foreign investment, and public spending.

Spain’s relative performance is attributable to its tilt toward a service-oriented economy, but its manufacturing sector is also expanding. The HCOB Spain Manufacturing PMI rose to 53.3 in December 2024 from 53.1 in November 2024, remaining above 50.0 for the 11th straight month (Fig. 5).

Businesses are boosting inventory and jobs as demand is strengthening. The number of registered unemployed people in Spain dropped in December 2024 to the lowest figure since July 2008 (Fig. 6).
 
(3) Germany trails the pack. Germany’s economy needs a confidence boost from the February 23 early elections after Chancellor Olaf Scholz’s Social Democratic coalition fractured in November. Conservative opposition leader Friedrich Merz is likely to become the new chancellor and is open to reversing constitutional restrictions on pro-growth spending and investment.

“The weakness of the German economy has become chronic,” the Ifo reported along with the results of its recent surveys. The Ifo Business Climate indicator for Germany fell to 84.7 in December 2024, the lowest level since May 2020 (Fig. 7). Results for the Expectations Index fell sharply to 84.4, while the Current Conditions Index slightly rose to 85.1.

Germany's HCOB Manufacturing PMI (final) was 42.5 in December 2024, further contracting from readings of 43.0 in both October and November (Fig. 8). Declines were seen in output as demand for new orders slowed. Companies cut jobs and inventories.

Germany's unemployment rate remained at 6.3% in December 2024, matching the August 2024 low. Consumer sentiment remained exceptionally weak.

(4) France is struggling as well. Like Germany, France is in political paralysis. Prime Minister Michel Barnier resigned after losing a vote of confidence, leaving President Emmanuel Macron to appoint a successor, who will lack a majority until elections are constitutionally permitted in June.

France’s recent economic indicators are telling a similar story to Germany’s, unfortunately. The HCOB France Manufacturing PMI (final) sharply dropped to 41.9 in December 2024 from 43.1 in November 2024 (Fig. 9). Businesses cut employment amid persistently weak demand.

(5) Italy’s economy is slowly improving. December brought an uptick in the HCOB Manufacturing PMI (final) to 46.2 from 44.5 in November (Fig. 10). Construction output jumped 3.4% y/y in October, nearly double September’s 1.8% y/y growth rate.

Producer prices deflated in November at a slower pace than they did the prior month. Consumer and business confidence indicators didn’t change much in December 2024 from the previous month’s weak readings.

Global Economy II: Asia. The overall economic picture of Asia’s major economies likewise is mixed. India’s stands out as a stable engine of economic growth, while Japan’s economic fundamentals look potentially promising. South Korea’s latest survey data suggest a dim view of its economy amid political upheaval. Here’s more:

(1) India leads Asian economies. The Reserve Bank of India (RBI) expects India’s real GDP growth to approach the government’s 7.0% target during its fiscal year 2025-26 (Fig. 11). The region remains the world’s fastest growing economy. With the India MSCI trading at 22.6 times forward earnings, however, investors certainly are paying for that growth.

India’s annual inflation rate is expected to run at 4.8% in 2025, which is higher than the RBI previously expected. But it is not expected to run hot enough for the bank to raise interest rates. The RBI has held rates at 6.5% since February 2023.

The HSBC India Manufacturing PMI (final) fell to 56.4 in December, the softest expansion in 2024 (Fig. 12). However, new orders, purchases of inventory, and jobs creation remained strong, while output growth slightly weakened. Both the HSCB Composite and Services PMIs further expanded in December 2024.

(2) Japan’s economy is improving. Japan’s domestic consumption is growing as wages are rising. Retail sales increased by 2.8% y/y in November, up from 1.3% the previous month. The Jibun Bank Japan Composite PMI rose from 50.1 in November to 50.5 in December (Fig. 13).

Japan's real GDP growth rate turned slightly positive in Q3-2024 to 0.4% y/y, following a 0.9% decline in Q2-2024.

Inflation in Japan has been inching higher. The annual headline consumer inflation rate climbed from 2.3% in October to 2.9% in November (Fig. 14).

The Bank of Japan decided last month to keep its key interest rate at 0.25% after placing it there in July 2024. Before that, the bank had last changed the rate when it was raised out of negative territory in March 2024. One out of the eight voters on the bank’s board dissented in December, however, preferring an additional 0.25bps increase. Appetite to tighten monetary policy has waned after the yen strengthened rapidly over the summer, hurting Japanese stocks and sparking inquiries from Japanese politicians.

(3) Confidence in South Korea’s economy has nosedived. Recent data suggest that consumers and businesses are highly concerned about the South Korea’s political future after President Yoon Suk Yeol was impeached on December 14 following a failed martial law decree.

South Korea’s Composite Consumer Sentiment Index plummeted to 88.4 December 2024 from 100.7 in November 2024 (Fig. 15). The Business Survey Index for South Korea's manufacturing sector also dropped from November to December. Industrial production and retail sales both fell on an annual basis in November from the previous month’s levels.

South Korea's economy grew 1.6% y/y in Q3-2024, slowing from 2.3% in Q2-2024.

Global Economy III: ABCs. We usually view Australia, Brazil, and Canada as a unit because these commodities producers’ economies tend to be driven by global commodities markets. Looking at these countries’ respective economic indicators over the past couple of weeks, however, shows diverse reasons for their recent underperformance.

The main thing that these economies currently have in common is that none of their economic fundamentals look particularly attractive. Their political situations are equally unnerving. Here’s a quick look:

(1) Australia’s economy is suffering from weak demand for its exports. Exports for several of Australia’s key commodities have fallen in recent months, including iron ore, coal, and natural gas (Fig. 16). Australia’s Judo Bank Manufacturing PMI (final) fell to 47.8 in December 2024, the eleventh consecutive month of deteriorating manufacturing conditions (Fig. 17).

The Westpac-Melbourne Institute Consumer Sentiment Index in Australia fell to 92.8 in December 2024, reversing two months of increases.

On the political front, Prime Minister Anthony Albanese has faced criticism as the next election approaches with an uncertain timeline.

(2) Brazil’s central bank is intentionally stunting economic growth. Record grain harvests and strong domestic consumption caused the IBC-Br, an indicator of economic activity in Brazil, to soar to a record high during October 2024 (Fig. 18). Brazil’s unemployment rate fell to 6.1%, the lowest on record, for the three months ended November 2024, supported by strong fiscal spending.

Robust economic activity and elevated inflation in Brazil have caused the country’s central bank to raise its Selic rate by 100 bps to 12.25% on December 16. Rising interest rates and concerns about persistent inflation resulted in December’s six-month-low reading of 92.0 (sa) for Brazil’s FGV-IBRE Consumer Confidence Index (Fig. 19). The S&P Global Brazil Manufacturing PMI fell to 50.4 in December 2024, the slowest expansion since August.

(3) Canada’s economy is muddling along with fingers crossed. Canada’s economic outlook is uncertain owing to potential trade policy changes under incoming US President Donald Trump; more targeted potential tariffs than expected would be a relief. Canada’s Prime Minister Justin Trudeau resigned on Monday as the country braces for potential trade challenges under Trump 2.0.

Recent economic indicators in Canada show anemic growth both for businesses and households. The CFIB’s Business Barometer for Canada dropped from 59.8 in November 2024 to 56.4 in December 2024. Domestic retail sales gained a slight 1.5% y/y during October 2024.

Despite the softness, manufacturing activity accelerated, according to S&P Global’s PMI data, as producers attempted to get ahead of potential new US tariffs on global exports.

The Bank of Canada lowered its main interest rate by 50bps in December 2024 to total 175bps of cuts from 5.0% since June 2023.

Strategy I: 2024 Market Data in Review. It was another great year for the US stock market indexes. Many indexes traded at record highs, especially after Trump’s election released the animal spirits.

The Magnificent-7 stocks, with a collective market-capitalization gain of 46.3%, easily outperformed the S&P 500’s 24.4% rise and beat the index for the 11th time in 12 years. The S&P 500 without the Magnificent-7 (a.k.a. the “S&P 493”) lagged despite a healthy gain of 15.7%. The “SMidCaps” likewise rose but lagged their larger-cap counterparts: The S&P MidCap 400 rose 12.2% for the year; the S&P SmallCap 600 gained 6.8%.

Last year’s best price performers did well not because they’re bigger but because their fundamentals continued to improve markedly to new record highs. Below, Joe details the strides that the companies in each index collectively made in forward fundamentals last year (forward revenues and earnings are the time-weighted averages of analysts’ consensus estimates for the current and following year; the forward profit margin is derived from forward revenues and earnings):

(1) Forward revenues. The Magnificent-7’s forward revenues forecast soared 15.8% last year, more than double the 6.3% rise for the S&P LargeCap 500 and triple the S&P 493’s 5.3% gain (Fig. 20). The S&P MidCap 400 posted a decent gain in forward revenues too, of 5.4% to a record high. But the S&P SmallCap 600 lagged considerably with a forward revenues decline of 2.2%. SmallCap’s forward revenues is now 5.2% below its September 2022 record high (Fig. 21).

(2) Forward earnings. Forward earnings forecasts rose to record highs in 2024 for all but the SMidCaps. The Magnificent-7’s forward earnings soared 35.6% last year, ahead of the S&P LargeCap 500 (12.0%), S&P 493 (8.3), and the S&P MidCap 400 (3.8) (Fig. 22). Once again, the S&P SmallCap 600 lagged all these indexes last year, but with a 0.9% decline in its forward revenues (Fig. 23).

(3) Forward profit margin. The Magnificent-7’s forward profit margin expansion last year was no less than stunning: The margin started the year at a record 21.6% and finished at a new record high of 25.4%.

The S&P 500’s forward profit margin began 2024 at 12.7% and improved steadily to 13.4% in September, surpassing its prior record high of June 2022. It ended the year a point higher at 13.5% (Fig. 24).

The S&P 493’s forward profit margin rose from 11.6% at the year’s start to a 20-month high of 12.0% in September before ending 2024 at 11.9%. That’s a healthy gain considering that some sectors’ margins shrank (Industrials, Energy, and Health Care).

The SMidCaps’ margins expanded, but barely (Fig. 25). The S&P MidCap 400’s forward profit margin inched just 0.1ppt higher last year to 8.2%, well below its record high of 9.1% from June 2022. The S&P SmallCap 600’s forward profit margin edged up 0.2ppt to 6.4%, 0.8ppt below its 7.2% record high from February 2022.

Strategy II: YRI’s New Breadth Measures. While it’s easy for investors to track an index’s performance since the data are broadly disseminated, knowing how much a few very large companies, such as the Magnificent-7, have distorted the overall index’s performance isn’t so easy.

That’s why Joe recently created a breadth database covering the S&P’s three market-cap indexes. It tracks each company’s forward revenues, earnings, and profit margin, as well as their price and valuation. We like to track an index’s breadth over a 13-week period since it captures the estimate revisions analysts make over the course of a quarterly reporting cycle. Here’s what Joe found:

(1) The percentage of companies with rising forward earnings has weakened for the LargeCap and MidCap indexes from their two-year highs in Q3 (Fig. 26). Nearly 74% of the S&P 500 LargeCap companies have higher forward earnings over the past three months, down from 81% recently. That’s well above the current readings for MidCap (53.6%) and SmallCap (50.8). SmallCap’s measure has trailed those of both MidCap and LargeCap over the long term since 1998; but the index has been on a path to broader improvement since late 2023, when it dropped to its lowest non-crisis level since the tech meltdown of 2001.

(2) We see the same general result when looking at the forward profit margin’s breadth. It too has waned recently for LargeCap and MidCap and is also on a stalled upward path for SmallCap (Fig. 27). Nearly 59% of LargeCap companies saw their forward profit margin improve q/q, down slightly from 63% recently. MidCap has 52% of its companies rising, and SmallCap’s measure has improved to the 50% mark for the first time in over a year.

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Labor Market Remains In Good Shape

January 07 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Economy I: Positive Labor Market Revisions Coming. We’ve remained positive on the labor market throughout last year and now into the new year, even as it has concerned many strategists and some participants on the Federal Open Market Committee (FOMC). There are, of course, the usual pessimists who continue to warn about a looming recession. But plenty of sober minded economists also feel that the labor market is skating on thin ice. These worries began in July when the so-called Sahm Rule recession indicator triggered. They were exacerbated in August when the Bureau of Labor Statistics (BLS) revised payroll growth down by 818,000 to 2.08 million net new jobs created for the 12 months ended March 2024. This was a result of the BLS’s preliminary Quarterly Census of Employment and Wages (QCEW) revision. The final revision is due this February—more on what to expect below.

Since then, hiring has moderated, and it has taken a bit longer for unemployed workers to find a new job. To us, this has not signaled cracks in the labor market’s foundation that presage a wave of layoffs. We believe it represents a healthy normalization of the labor market after having just experienced one of the tightest job markets on record. Recent data support our optimistic interpretation. Consider the latest from the Census Bureau, as well as the state of the labor force heading into 2025:

(1) Quarterly Census of Employment and Wages. In data released last month, the Census Bureau incorporated new techniques to count immigrants. It found that several million more immigrants came into the US than initially estimated over the past few years, in turn driving the fastest population growth in decades. The Census Bureau initially estimated that 2.14 million new migrants came into the US during the years ended June 2022 and June 2023. The latest data show 3.98 million over 2022 and 2023, representing 85% of total population growth (Fig. 1). And in the year ended June 2024, another 2.79 million international immigrants came into the US, or 84% of the year’s total population growth.

These updated immigration estimates will affect certain metrics in the BLS's household survey of employment, including the labor force participation rate and unemployment rate. However, the BLS refrains from revising historical household data. Nonetheless, the large upward revision from the Census Bureau should ultimately filter into household employment and labor force growth this year. This could close the puzzling gap between household and payroll employment growth, as the former has plateaued while the latter has risen to new record highs (Fig. 2).

We suspect the updated data may feed into the final revision of the BLS’s Quarterly Census of Employment and Wages (QCEW) next month, potentially reversing the bulk of the preliminary downward revision. The labor force may very well already constitute a record 170 million Americans, and payroll employment could be revised to a record 160 million.

On the heels of the first QCEW revision, we wrote in our August 22 Morning Briefing: “Many illegal immigrants aren’t counted in the BLS’s Quarterly Census of Employment and Wages (QCEW). That’s because employers don’t always pay state unemployment insurance (UI) taxes on those undocumented workers: Studies indicate that only about half (or optimistically up to 75%) of these workers are captured by UI. Using the Congressional Budget Office’s (CBO) estimated net immigration of 3.3 million in fiscal 2023 (and its estimate that 65% of that figure represents illegal immigrants), we can assume that between 283,140 and 566,280 of workers weren’t counted by the QCEW. That’s based on 80% employment, two-thirds labor force participation, and between 50%-75% of workers captured by state UI. That takes monthly payroll growth to a range of 197,000 to 221,000. Not bad.”

The Census Bureau’s estimates of 2.29 million immigrants in 2023 and 2.79 million in 2024 still undershoot the Congressional Budget Office’s estimate of 3.3 million for each year, so there’s a chance that the updated QCEW and household data will still be on the soft side. Regardless, the story is that jobs growth continues to be strong despite higher interest rates.

(2) Labor force. The wave of early retirements by Baby Boomers during the pandemic left a gap in the US labor force. A falling birthrate and increasing death rate are also symptoms of an aging population. The native-born labor force shrank in November for the first time since 2021, which may be the start of a trend (Fig. 3). Foreign-born workers now account for 19.2% of the labor force, up from around 17.1% before the pandemic (Fig. 4). The actual figure likely already exceeds 20.0%.

(3) Unemployment. The unemployment rate has risen from 3.4% in April 2023 to 4.2% as of November (Fig. 5). We wouldn't be worried about a marginally higher rate, as the rapid growth of the labor force has been behind much of the increase. Increasing native-born labor force participation and new immigrants looking for work naturally cause higher unemployment. This was missed by many adherents to the Sahm Rule recession indicator.

We’ve referred to the Sahm Rule as “technical analysis of macroeconomic data” (“TAMED” for short) because it says little beyond the fact that unemployment tends to spike rather than gradually rise when the economy is hit by a credit crunch that causes a recession. In fact, that’s partly why we dismissed the Sahm Rule’s triggering back in July when the unemployment rate gradually rose from a historical low to 4.3%, which was 0.5% higher than the lowest three-month average over the previous 12 months (Fig. 6). It since has un-triggered, sending a false positive.

Workers reentering the labor force accounted for 30.7% of total unemployment in November, outpacing permanent job losers (26.5%), as it has since late 2021(Fig. 7).  Not only are new immigrants looking for jobs, but more and more Americans are encouraged enough by their job prospects to look as well. These positive labor force contributions helped trigger the Sahm Rule rather than layoffs.

(4) Payroll growth. Another source of pessimists’ angst is the Birth/Death adjustment. The BLS uses this model to account for payrolls added by new businesses that may not be captured in its survey. Some argue that these additional jobs have been overstated. In our opinion, the Birth/Death model accurately accounts for the surge in business innovation and entrepreneurship since the pandemic. Indeed, new business applications jumped from 425,000 in October to 449,000 (sa) in November, the most since December 2023 and well above pre-pandemic levels (Fig. 8). We expect applications to continue rising thanks to optimism over a lower corporate tax rate and deregulation under Trump 2.0.

While some of these applications may be for single-person businesses, applications for businesses that the Census Bureau deems to have a high propensity to hire paid employees surged to a near-record high in November (Fig. 9). The Birth/Death adjustment could very well support our expectation for the three-month gain in payroll employment to increase to 200,000 by January's employment report.

Economy II: From Labor Force Boom to Productivity Boom? We are betting on a productivity boom. Not one in the future, but the current one. It started from the cyclical lows of just 0.5% productivity growth in 2015, per the 20-quarter moving average (Fig. 10). While productivity growth rose to around a 2.0% annualized rate as of last year, we believe the boom is in the early innings and could reach 3.5%- 4.0% by the end of the decade.

In light of the incoming deceleration in population and labor force growth, this is especially important for understanding the overall economic trajectory. Here’s what’s driving our expectations:

(1) Productivity versus labor force. Productivity increases when workers produce more output for every hour they work. That productivity rate times the number of hours worked equals real GDP growth. Increasing hours worked was a major contributor to strong real GDP growth over the past two years (Fig. 11).

However, average weekly hours have been relatively flat around 34.3, slightly below pre-pandemic levels (Fig. 12). So the increase in hours worked was due entirely to more people working. Therefore, immigration drove aggregate hours worked higher and accounted for a large chunk of economic growth in 2023 and 2024. Even higher-than-thought immigration suggests that hours worked was larger than believed, and therefore productivity may have been lower. We don't think this will affect productivity growth much, however. That's because even after the initial QCEW release depressed hours worked, productivity growth was revised a bit lower after GDP growth was also revised lower.

Data revisions tend to happen in the same direction, i.e., negative (positive) revisions in one area of the economy tend to presage negative (positive) revisions in another. We're expecting these upward population revisions to make a positive impact on the data.

(2) Immigration cessation. The record immigration across the southern border dramatically slowed last July as President Biden clamped down on the border during the election campaign (Fig. 13). This likely will fall further with President Trump back in office beefing up border security and making deals with Latin American countries to prevent migration at its source.

Much lower immigration will lower payroll employment growth, though it will likely keep the unemployment rate subdued, as fewer workers will be looking for jobs.

(3) Productivity doubling. Widespread adoption of technologies like AI, automation, robotics, and perhaps quantum computing should continue to make workers more productive and offset the much slower labor force growth. Why do we expect companies to invest heavily in new tech? The shortage of skilled workers creates an investment imperative to augment current staff. It's one of the positive symptoms of a full-employment economy.

Improving the capital stock has been a primary driver of the productivity growth boom thus far. Now, labor composition will also help. Immigration has been a relative drag on productivity in recent years. As experienced Baby Boomers exited the labor force, new immigrants entered, many facing myriad barriers to job success (e.g., related to language, housing, work-status stability, and work experience). This improved GDP growth by growing the labor force but did not enhance productivity. Those workers will grow more experienced as they spend time in the US, therefore helping to support real wage growth rather than suppressing it (Fig. 14).

We also think total factor productivity, or how well workers use high-tech capital, will improve. Workers are becoming better at using AI and other automations each day. Moreover, hybrid work environments that enhance productivity are becoming the norm. Workers can collaborate and create new innovations in the office 2-3 times per week, while minimizing commute time and increasing remote capabilities. Skilled workers, such as parents with children, can also remain in the workforce for longer. The gig economy is another fallback for workers to stay employed even when personal issues prevent full-time employment.

(4) The Roaring 2020s. Our expectations for possibly 4.0% annual productivity growth this decade may seem extreme in the context of the post-Great Financial Crisis malaise. But historically and in context of the current tech boom, it’s reasonable to expect. Indeed, it is the basis of our Roaring 2020s base-case outlook.

Of course, we allow for the possibility that certain prospects could derail our Roaring 2020s scenario—such as stickier inflation, high stock-market valuations, trade wars, and a number of other bearish concerns. It’s because we acknowledge these possibilities that we don’t attribute higher than a 55% probability to the Roaring 2020s scenario.

However, rising productivity growth can drive corporate profit margins to new highs, support workers’ real wages, and depress inflation. Productivity is the best formula for economic growth and can maximize per-capita prosperity. We’re counting on it to drive the S&P 500 to 10,000 by 2029.

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Risks & Reward In 2025

January 06 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Strategy I: January Barometer & Effect. As goes January, so goes the year? That's the premise of the January Barometer. It has a track record of being right more often than it has been wrong. During 42 of the 59 years from 1965 through 2024, January’s monthly percent change has been in the same direction as the yearly percent change (Fig. 1). Both time periods had positive signs in front of the numbers during 29 of those years and negative signs during 11 of those years.

There is also the January Effect, which suggests that the month tends to be a good one for stocks because investors often sell their securities at a loss during December to offset their capital gains for the year and lower their tax bills, only to buy back those stocks in January.

Put the two January phenomena together, and the result is that Januarys tend to be up months for the stock market. Indeed, the month has been the fourth best month of the year, with an average m/m gain of 1.2% from 1928 through 2024 (Fig. 2).

But wait a minute: Only three of the 12 months have averaged negative returns since 1928. That’s because the stock market tends to rise over time. So most months, including January, have been up on average simply because stock prices have an upward bias over time! Doesn't that imply that it is better simply to stay invested for the long run than to trade these two January statistical regularities, which don't always pan out?

Furthermore, doesn’t the fact of a January Effect imply a negative December Effect from tax selling? December is known for its Santa Claus rallies! December has been up 1.3% on average since 1928, making it the third best performing month of the year. There are 12 months in the year, and the stock market has been up during 49 of the 60 years since 1965.

Strategy II: What Could Go Right. We are biased by the stock market’s bullish bias. We tend to be permabulls because bear markets are infrequent and are usually relatively short compared to bull markets, which tend to last for some time. Since January 1978, the S&P 500 is up 66.6-fold (Fig. 3). In that entire 47-year period, there were just six bear markets that lasted only a bit more than one year on average. Bear markets tend to be caused by recessions. There have been only six of them since 1978, lasting just 14 months on average (Fig. 4). (See our Stock Market Historical Tables: Bull & Bear Markets.)

As we’ve previously noted, we regularly follow the growlings of the permabears as an efficient way to assess what could go wrong for the economy and the stock market. Very rarely do we find that they’ve missed all the things that could go wrong, while we frequently find that they’ve mostly ignored an assessment of what could go right. (See our December 23, 2024 QuickTakes titled “Permabulls Versus Permabears.”
 
The S&P 500 peaked at a record high of 6090.27 on December 6. It ended 2024 at 5881.63. The index ended the first week of the new year at 5942.47, just below its 50-day moving average (Fig. 5). The Nasdaq peaked last year at a record 20,173.89 on December 16 and bounced off its 50-day moving average last week to close at 19,621.7 (Fig. 6).

On balance, we expect that the next few weeks could be choppy for the stock market before the S&P 500 and Nasdaq resume climbing to new record highs during the spring.

Here is a list of what could go right in early 2025, followed by a review of what could go wrong:
 
(1) Q4's earnings reporting season over the next few weeks might be better than expected. They usually are when the economy is expanding. The analysts' consensus estimate for Q4 earnings growth is 8.2% (Fig. 7). There were typical upside earnings surprises during the previous three earnings seasons. There should be another during the Q4 earnings season. Leading the way should be banks, semiconductors, cloud computing, retailers, and restaurants.

(2) CES 2025 is this week. The Consumer Electronics Show, or “CES” for short, kicks off Monday evening and runs through Friday, January 10. This highly anticipated industry tradeshow features the biggest tech players from across the globe showcasing their latest consumer technology with daily product launches, keynotes, activations, and demos. It will undoubtedly be all about AI. Indeed, Nvidia founder and CEO Jensen Huang will deliver a keynote address Monday at 6:30 p.m. Nvidia produces the GPU chips that power AI.

Nvidia’s stock price is up 12.1% from a recent low of $128.91on December 18 to $144.47 on Friday partly on expectations that Huang’s comments will be bullish. They should be. Last Friday, January 3, Microsoft announced plans to spend $80 billion this fiscal year building out data centers, underscoring the intense capital requirements of artificial intelligence. That’s up from $50 billion last year. On Friday, the S&P 500 rose 1.3%, led by a 4.5% jump in Nvidia, on the news from Microsoft.

Much of the spending on data centers by cloud infrastructure providers goes toward high-powered chips from companies including Nvidia Corp. and infrastructure providers such as Dell Technologies Inc. The massive AI-enabled server farms require lots of power, which prompted Microsoft to strike a deal to reopen a reactor at the Three Mile Island nuclear power plant in Pennsylvania, the site of a notorious partial meltdown in 1979. Amazon and Google also have signed nuclear power agreements.

(3) GDP. Q4's GDP will be reported on January 30. Along the way, the Atlanta Fed's GDPNow tracking model is likely to show a growth rate running around 2.5%-3.0% (saar). The January 3 GDPNow estimate was revised down to 2.4% from 2.6% following the release of December’s national manufacturing purchasing managers index (M-PMI). But real consumer spending is still tracking at a solid 3.0%. The weakness was in capital spending on equipment, down 5.3%. However, intellectual property, which includes software, remains strong at 5.2%.

The M-PMI data for December showed that the overall index rose to 49.3 last month from 48.4 in November. So it remained below 50.0 for the ninth straight month and 25 of the past 26 months (Fig. 8). However, both new orders (52.5) and production (50.3) rose above this level. Employment fell (from 48.1 to 45.3). We think this might show that productivity is increasing in manufacturing.

(4) Consumers. Despite the weakness in manufacturing employment, initial unemployment claims remained low at 211,000 during the December 27 week, and continuing unemployment fell by 66,000 to 1.844 million during the previous week (Fig. 9). Just as encouraging is that the jobs-plentiful series in the consumer confidence index survey rose to 37.0% during December from a recent low of 31.3% during September (Fig. 10).

Consumers are still spending. The Redbook retail sales series shows a solid increase of 5.5% y/y through the week of December 27, 2024 (Fig. 11). It has a good correlation with the comparable growth rate for monthly retail sales excluding food services. Consumers also responded to auto dealer discounts. The seasonally adjusted annualized rate for total new-vehicle sales rose to an estimated 17.2 million units in December, up from 16.6 million in November (Fig. 12).

On the other hand, construction spending may be starting to lose its mojo. It has been moving sideways at a record high for the past eight months through November, reflecting a similar development in the construction of manufacturing structures, which has been soaring for the past couple of years (Fig. 13 and Fig. 14).

Strategy III: What Could Go Wrong. The outlooks for the economy and earnings in the new year are good, but valuation multiples are stretched. They must be discounting expectations that the current economic expansion will last for quite a while, which we think is a realistic possibility given our Roaring 2020s base-case scenario.

If we compare the current secular bull market in the S&P 500 since 2010 to the one that started early in the 1980s, we find that the former is closely tracking the latter (Fig. 15). This suggests that the stock market has plenty of upside over the rest of this decade, as it had during the second half of the 1990s—if it continues to closely track the previous one. The only problem is that valuations are much higher this time around: The S&P 500’s forward P/E at the end of 2024 was 21.6, well above around 13.0 in 1994 (Fig. 16). The Buffett Ratio is currently around 3.0, well above around 2.0 at the peak of the 1999 tech-led bubble that was followed by the tech wreck in the early 2000s (Fig. 17).

Again, with a little help from the permabears, here is a list of what could go wrong in early 2025, casting doubt on the outlook for a long expansion and causing valuation multiples to shrink:
 
(1) Trump 2.0 has too many known unknowns currently. The stock market is anticipating that the incoming administration’s new policies will probably be bullish on balance. We agree with that assessment, but it may take some time to know that. There will be lots of new policy initiatives introduced and perhaps implemented by executive orders once President Donald Trump is inaugurated on January 20.

It’s hard to know how they’ll collectively affect the economy and whether they might produce negative unintended consequences. Higher US tariffs could boost inflation and could trigger retaliatory measures by trading partners. Mass deportation of illegal immigrants could disrupt some industries’ labor pools and put upward pressure on wages. Extending income-tax-rate cuts for consumers should bolster economic activity but could be inflationary. Deregulation and a lower corporate tax rate should also be stimulative and might fuel disinflation. Trump’s energy policies are also likely to be disinflationary.

The most widely unanticipated scenario is that Trump 2.0 will cause stagflation. That would be a bearish scenario for stocks, for sure. We include it in our bucket of bearish risks to which we assign a 20% subjective probability.

(2) Interest rates might move higher. Perhaps the greatest known unknown is how the Fed and the bond market will respond to Trump 2.0. In his December 18 press conference, Fed Chair Jerome Powell said that the Fed doesn’t know what policies Trump 2.0 will include or how much they will impact the economy and financial markets. He also suggested that the Fed might pause lowering the federal funds rate partly because of this uncertainty.

Meanwhile, the Bond Vigilantes have been challenging the Fed’s three-monkeys cluelessness about the economy, inflation, and Trump 2.0. Since the FOMC started cutting the federal funds rate on September 18—lowering it by a total of 100bps through December 18—the 10-year bond yield has risen by as much (Fig. 18). The Bond Vigilantes are protesting that the Fed is stimulating an economy that doesn’t need to be stimulated, that inflation remains above the Fed’s 2.0% target, and that Trump 2.0 might both revive inflationary pressures and boost the federal deficit.

The risk for stocks is that the Bond Vigilantes will be right, sending the yield back to 5%, which was last year’s high. In this scenario, the Fed might be forced to raise the federal funds rate, reviving fears of a recession. Valuation multiples would surely melt down quickly in that case. Again, we put this scenario in the 20% risk bucket.

Movie. Blitz (+) (link) stars Saoirse Ronan as a mother of a young boy who is evacuated to the British countryside when the Germans bombed London during World War II. He jumps off the train, determined to return home. Along the way he dodges several harrowing perils attributable to the blitz. There are plenty of scenes that recreate the devastation caused by the bombardment. But the story line and the acting aren’t compelling.

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AI, Earnings & More AI

December 19 (Thursday)

Strategy I: AI’s Influence on 2024. The 2024 gains in the S&P 500 were truly amazing, especially since they defied the expectations of many folks at the start of the year that a recession would cast a pall over the financial markets in 2024. Instead, artificial intelligence (AI) took off, the elections went off without a hitch, and the economy was much more resilient than widely expected (except by us). Even the Federal Reserve decided the economy is strong enough to reduce its interest-rate-cut forecast to only two cuts next year instead of the four cuts that was expected previously.

Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Communication Services (44.1%), Information Technology (39.3), Consumer Discretionary (38.2), Financials (30.1), S&P 500 (26.9), Utilities (20.2), Industrials (19.1), Consumer Staples (15.9), Real Estate (5.1), Energy (2.6), Materials (2.2), and Health Care (1.7) (Fig. 1).

Look back over the past two years, and the results are even more impressive, with the S&P 500 gaining 57.6%. Here’s the performance derby for the S&P 500 and its 11 sectors from January 2, 2023 through Tuesday’s close: Communication Services (122.4%), Information Technology (117.8), Consumer Discretionary (94.9), S&P 500 (57.6), Financials (43.0), Industrials (38.2), Real Estate (13.8), Consumer Staples (13.4), Materials (12.7), Utilities (8.0), Health Care (2.0), and Energy (-2.3) (Fig. 2).

Investors can credit AI for the voracious demand for Nvidia’s semiconductor chips; the need for server space offered by Amazon, Google, and Microsoft; and the software being developed by newcomer OpenAI as well as Meta Platforms and the thousands of other small developers that collectively have created a whole new business that didn’t exist three years ago. Even the normally sleepy utilities sector benefited from the surge in demand for electricity to run the servers handling the AI programs.

Let’s take a deeper dive into what drove this year’s gains:

(1) AI benefits chips. Nvidia remains the rockstar of tech, with a share price that has risen 163.3% ytd, driving the S&P 500 Information Technology sector’s Semiconductor industry price index up 84.4% ytd (Fig. 3 and Fig. 4). The company’s earnings growth rate continues to shock and awe. Even after its remarkable recent growth, analysts are calling for Nvidia’s forward earnings to grow 56.3%, which makes its forward P/E of 31.2 seem reasonable (Fig. 5 and Fig. 6).

Demand for chips involved with AI also helped to lift the shares of Broadcom, up 115.2% ytd, and Marvell Technology, up 86.1%. Those chipmakers who missed the AI boat didn’t fare nearly as well: AMD’s shares fell 15.2% ytd, and Intel’s lost -59.3%.

(2) AI benefits servers. The voracious need for computation power to run AI has benefited the bottom lines of server providers scattered across three different sectors. Amazon’s share price has risen 52.1% ytd, helping to lift the S&P 500 Consumer Discretionary sector’s Broadline Retail industry index 51.6% ytd. Microsoft shares have gained 20.9% ytd, helping to propel the Information Technology sector’s Systems Software industry index 25.4% higher this year.

Finally, the shares of Google’s parent Alphabet have appreciated 39.9% ytd. Google and Meta, which has its own generative AI program and rose 75.0% this year, both reside in the S&P 500 Communication Services sector’s Interactive Media & Services industry, with a price index up 51.5% ytd.

(3) AI keeps the Magnificent-7 rising. Five of the Magnificent-7 names—Amazon, Alphabet, Meta, Microsoft, and Nvidia—directly benefit from AI, and that has helped the Magnificent-7 rise a collective 52.4% ytd through Tuesday’s close (Fig. 7). Those seven stocks represent 31.2% of the S&P 500’s market capitalization, essentially matching the all-time high hit on July 9 (Fig. 8).

The index has also gained from Tesla shares, with a 93.1% ytd gain, helped by the cozy relationship between CEO Elon Musk and President-elect Donald Trump. Tesla is working on a new generative AI program, while Apple is hoping AI makes Siri much smarter (more on that below). Apple shares have risen 30.4% ytd, helping to knock the price index of its industry up by nearly that much: Technology Hardware, Storage & Peripherals has gained 29.1% ytd (Fig. 9).

The Magnificent-7 stocks collectively enjoy a forward profit margin that’s far wider than the S&P 500, 25.4 vs 13.5 (Fig. 10). And analysts’ consensus earnings forecasts make for forward earnings growth of 19.1%, which also is loftier than the S&P 500’s 14.3% forward earnings growth (Fig. 11). Even after this year’s strong stock price appreciation, the Magnificent-7 stocks’ forward P/E is 30.9, around the midpoint between its 2020 high and 2023 low (Fig. 12). (As a reminder, the forward profit margin we derive from forward earnings and forward revenues. Forward earnings and revenues are the time-weighted average of analysts’ consensus estimates for the current and following year. The forward P/E is the multiple using forward earnings.)

Strategy II: A Look Ahead at Earnings. Peering into 2025, analysts again expect earnings for the S&P 500 companies collectively to grow by a solid 14.3%, up a touch from this year’s estimated 10.0%. But a look under the hood shows that there are some pretty large swings in the index’s sectors and industries that are expected to enjoy the most earnings growth next year (Table 1).

Here's a quick look at some of the big movers:

(1) Tech reigns supreme. The S&P 500 Information Technology sector remains among the fastest growing sectors in the index, with analysts forecasting above-average earnings growth of 20.4% this year and 21.7% growth in 2025. The big change occurs in the Communication Services sector, where earnings growth slows from 24.4% this year to 14.9% next year. The fastest earnings grower in 2024, Communication Services’ earnings will grow more slowly than four other S&P 500 sectors in 2025 if estimates come to fruition.

The sector’s Interactive Media & Services’ earnings are forecast to decelerate from 42.5% growth this year to 12.0% growth in 2025. The change can be attributed to the slowdown expected in Meta’s earnings growth rate, from 52.4% in 2024 to 12.0% next year, while Alphabet’s earnings growth is expected to be much steadier at 15.8% in 2025, down only a bit from this year’s 16.6%.

(2) Health Care for those who dare. After Technology, the S&P 500 sectors growing their earnings the fastest are Health Care, Materials, and Industrials. The beaten-up Health Care sector is expected to see a rebound in earnings growth, from 5.0% this year to 20.1% in 2025, propelled by both the Pharmaceuticals (21.6% in 2024 and 33.1% in 2025) and Biotechnology (-12.1%, 30.9%) industries.

After Health Care, analysts are expecting big earnings growth improvement in both the Materials (-8.2% in 2024, 18.3% in 2025) and Industrials (0.5%, 18.2%) sectors. Industrials should benefit from Boeing’s swing from losses to profits, as the airplane manufacturer has restarted its assembly lines after its workers’ strike. And analysts seem to be optimistic about a rebound in many of the Materials industries, including Copper (-0.7%, 37.6%), Commodity Chemicals (-16.8%, 33.1%), and Construction Materials (-5.3%, 24.8%).

(3) A tougher road ahead. Analysts are calling for earnings growth to decelerate in the S&P 500 Financials sector from 13.5% this year to 7.4% in 2025. Earnings for the Diversified Banks industry are forecast to grow a mere 2.3% in 2025, and the earnings growth rate in the Consumer Finance industry is expected to slow sharply from 21.9% this year to 4.9% in 2025.

The Energy sector’s earnings are expected to return to growth in 2025, rising 4.6%, after a sharp downturn this year, -18.9%. Growth expectations for its component industries remain low, with analysts calling for 2025 earnings growth of 1.5% for the Integrated Oil & Gas industry and 4.0% for the Oil & Gas Exploration & Production industry.

Disruptive Technologies: AI Invades Apps. Most AI-related press focuses on the amazing things that generative AI programs like ChatGPT and Claude can do. But AI programmers are also focused on churning out AI-infused applications that do everything from draw to handle personal finances. It’s a fast-growing area that’s attracting dollars and developers, and it reminds us of the surge in app development following the introduction of the iPhone.

Here’s a quick look at the growing area of business apps that can make operating a business more efficient than ever before. These tools, highlighted in two LinkedIn posts (here and here), help to even the playing field between large corporations and small startups, as their cost is often minimal.

(1) An AI app can do that. Developers have infused AI into all manner of business applications. Managers looking for insights about their business can use Julius, an AI app that analyzes a business’s data and presents it in charts and graphs. When it’s time to put that data into a presentation, managers can turn to Gamma or Decktopus AI.

Want to increase your business’s presence on Twitter? Try Tweet Hunter. It uses AI to offer content ideas, help write tweets faster, analyze Twitter traffic and identify sales leads. Prefer using LinkedIn? Turn to Taplio, which uses AI to create content, schedule posts, and track performance to engage and grow your audience.

Looking to improve your headshot on the company website? Upload everyday pictures to HeadshotPro or BetterPic, and they will take the best elements of each of the pictures and create a professional looking headshot. The AI programs let users pick the clothing, pose, and background used in the headshot.

Website need an upgrade? Use Chatsimple to create a chatbot that can answer customers’ questions and generate sales. Prefer communicating with customers via newsletter? Beehiiv.com helps develop newsletters and turn web visitors into subscribers, while also attracting advertisers. And to keep your schedule in order, turn to BeforeSunset.

(2) Dust off the ping pong tables. The numerous new AI app startups have caught the attention of San Francisco real estate agents. “Remote work fatigue” has more of the younger crowd itching to return to the office and leave their cramped apartments, a December 6 CNBC article reported.

The San Francisco vacancy rate remains elevated, at 34.9% in Q3, but “artificial intelligence companies will continue as a driving force in the San Francisco market, fueling significant VC funding and leasing activity,” according to a Cushman & Wakefield report quoted in the article.

(3) Big guys building AI apps too. Large companies are racing to infuse AI into existing and new apps. Salesforce is introducing Agentforce 2.0, which empowers companies to build autonomous AI agents that can answer complex questions using their company’s information in Slack, CRM, and in the Salesforce data cloud. The new software will be available to customers in February.

Salesforce is using Agentforce 2.0 on its website’s help page and has found that Agentforce solves 83% of customers’ questions without a human, halving the number of issues that require human intervention, a December 17 company press release stated. Adecco used it to build a Recruitment Agent to screen candidates and schedule interviews. Salesforce plans to hire 2,000 people to sell its AI software to clients, CEO Marc Benioff said in a December 17 CNBC article.

Apple is hoping that the 3.4 million third-party app developers who have created apps for the iPhone will alter their apps to include Apple Intelligence, Apple’s recently released AI offering. By doing so, Apple’s Siri would potentially be able to execute an action in a developers’ app, an October 4 CNBC article explained.

For example, Superhuman is an email app that plans to incorporate Apple’s AI system. Users of the new program would be able to say, “Hey Siri, when does my flight depart?,” and the app will search the user’s email to find the information. Now that sounds like something we could use!

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Three Challenged Central Banks

December 18 (Wednesday)

Global Central Banks I: ECB’s Hawks in Doves’ Clothing. “Is that all you’ve got?” That must have been the question on the minds of investors in European financial markets upon hearing the news of the European Central Bank’s (ECB) 25bps cut in its deposit facility rate on Thursday, December 12. With this latest cut, the bank has lowered the rate by 100bps over recent months, dropping it to 3.0% (Fig. 1). Such a modest additional cut won’t do much to solve the Eurozone’s pressing problems, which include economic, fiscal, and political turmoil.

ECB President Christine Lagarde justified the miniscule move in her press conference that day and tried to quell market participants’ concerns further in a post-meeting follow-up. A few days later, on Monday, she all but promised further rate cuts. The central bank’s stance remains “restrictive,” Lagarde said, but they could “soften” it.

Consider the following:

(1) Lagarde’s justification. In her December 12 press conference, Lagarde defended the 25bps cut, emphasizing that “the central bank cannot be the jack of all trades” and putting the onus for stimulus on fiscal policymakers. She reiterated that the ECB’s focus is price stability. With services inflation still too high, she argued that moving rates toward neutral is premature (Fig. 2).

(2) Headline inflation. During her presser, Lagarde downplayed the fact that Eurozone headline inflation had decreased to 2.3% y/y in November, signaling that the bank’s lack of loose policy may persist despite broader inflation trends. The ECB projects that headline inflation will fall below its 2.0% target by 2026.
 
(3) Not yet neutral. Rate watchers anticipate a 50bps cut at the ECB’s January meeting. That would put the rate at the upper end of the 1.75%-2.50% range that Lagarde has identified as the neutral level at which interest rates are neither restrictive nor stimulative.

(4) Shrinking balance sheet. Besides monitoring where rates land, we are watching the impact of the bank’s termination of its pandemic emergency purchase program. As of December 13, the bank’s balance sheet stood at 6.4 trillion euros, well above pre-pandemic levels (Fig. 3). We suspect that officials may aim to shrink it toward the 4.7 trillion euros seen before 2020.

Global Central Banks II: Eurozone’s Swan Song? Behind the ECB’s de minimus monetary policy move last week may be a desire to put the onus to revive the Eurozone’s economy on the region’s fiscal policymakers. Lagarde suggested as much on a recent press tour that included an interview in The Financial Times and an op-ed in The Economist.

Sounding frustrated during her December 12 monetary policy presser, she reiterated that the European Union (EU) must swiftly act on the recommendations for the bloc’s future governance and economic growth set forth by former ECB head Mario Draghi (see here) and former Italian Prime Minister Enrico Letta (see here). But unfortunately, the leaders of the EU’s largest member nations can’t agree on policy for their own states let alone the union. Nevertheless, she and her cohorts are willing to support drastic measures to keep the bloc from imploding.

Not only is the region’s economy in dire straits but it’s also facing a potential trade war with the US under the incoming Trump administration.

Here is more:

(1) “[I]f we cannot all agree in the EU, then it should be a qualified majority, and if we cannot have a qualified majority, we should go for enhanced co-operation,” Lagarde noted in the FT interview. The latter option sounds tamer than it is in practice: Used as a last resort, “enhanced co-operation” permits a minimum of nine member states to move ahead on integration initiatives without express permission from all member states.

(2) During Lagarde’s Q&A, when asked about the rise of far-right parties within member states and potential plans to leave the EU and the euro currency, Lagarde all but equated that approach to World War II: The EU was founded on “the step of a horrible period of time when member states, currently sitting at the same table, were at each other’s throats, and that caused the killing and the dying of many, many, many Europeans,” she said.

The exaggerated analogy strikes a note of desperation, no? Lagarde’s ardent push for centralized fiscal policy, backed by only a handful of member nations, could be a desperate attempt to prevent the Eurozone’s collapse. Ironically, “enhanced co-operation” might pull some member nations further apart.

Global Central Banks III: Cautiously Hawkish BOJ. Recent economic data suggest further rate hikes by the Bank of Japan (BOJ). The bank’s previous one caused a stir, as it triggered an unwind in yen carry trades. That’s left investors wary of the potential for more market instability in the event of more rate hikes.

The BOJ is one of only three G-20 central banks still in a rate-hiking cycle (Fig. 4). While further hikes are expected in the coming months, BOJ Governor Kazuo Ueda recently emphasized the need to wait to see both domestic wage growth and geopolitical developments before deciding.

Here’s more:

(1) Policy pivot. In March, the BOJ raised interest rates out of negative territory and suspended its yield-curve-control policy. In July, the bank announced plans to reduce its purchases of JGBs (Japanese government bonds) and raised the target rate to 0.25% (Fig. 5 and Fig. 6).

(2) Focus on wages. The BOJ is watching domestic wage growth as a key trigger for further tightening. Real wages have been rising by around 2.5%-3.0% y/y, and inflation remains above the central bank’s 2.0% target (Fig. 7 and Fig. 8). Japan’s Q3 GDP also showed stronger-than-expected growth (Fig. 9).
 
(3) Ueda’s caution. In a November 18 speech, Ueda emphasized that while he expects inflationary pressure from wages to increase, the underlying inflation trend remains below the bank’s target. He said that global economic conditions and geopolitical risks, especially in Ukraine and the Middle East, could influence Japan’s policy outlook.

Global Central Banks IV: No Big Bang for PBOC. China’s economic recovery faces significant challenges, with domestic consumption struggling while industrial production remains strong. Retail sales grew by just 3.0% y/y, the slowest in three months, while industrial output rose by 5.4% y/y (Fig. 10). This contrast presents a difficult dilemma for officials heading into 2025.

Despite a weak property market, China has maintained growth through its low-priced exports. However, the US’s ongoing protectionist policies could complicate this approach. A recent shift in language from “prudent” to “moderately loose” signals a subtle policy pivot by the People’s Bank of China (PBOC).

China’s central planners don’t appear eager to boost consumption by cutting interest rates much more. They seem more likely to rely on fiscal policy and targeted central bank financed asset purchases to support economic growth, especially in the distressed local government sector.

Consider the following:
 
(1) Moderately loose. Chinese officials are set on “moderately loose” monetary policy. In a speech last week at the Central Economic Work Conference (CECW), at which China’s leaders decide economic policies for the following year, Chinese President Xi Jinping highlighted the need for “appropriate” reductions in the reserve requirement ratio and interest rates to support liquidity and economic growth. This language doesn’t seem to us to signal a “whatever-it-takes” mode.

(2) Fiscal focus. Reuters reported yesterday that Chinese leaders agreed to raise the budget deficit from 3% of GDP to 4% next year, a record high. The article’s anonymous sources also said that the real GDP growth target would be kept around 5%.

It is well known that China has a debt overhang, with reports of debt greater than 300% of GDP. However, much of that leverage exists in local government financing vehicles or in bank loans (Fig. 11). In terms of China’s central government debt, it was 98.6% of GDP as of Q2, less than the US government’s debt as a percent of GDP (Fig. 12). So while the Chinese Communist Party (CCP) is forced to refinance and clean up its local balance sheets, there is plenty of fiscal space for the central government to achieve these goals.

(3) Bond yield signaling deflation. Supporting the consumer sector with debt issuance would boost Chinese bond yields. The 10-year yield is trading around 1.75%, a record low, for myriad reasons (Fig. 13). Expectations for low economic growth and inflation (perhaps even deflation) are weighing on long-term yields. China’s CPI has hovered around zero, with the government setting a 3.0% ceiling (Fig. 14).

But with a busted property sector and weak stock market, households and businesses that lack access to foreign assets have few places other than the Chinese bond market to store their wealth. Increased bond issuance could solve a lot of problems for China, including raising yields to levels the CCP is comfortable with.

(4) PBOC’s caution. Compared to the Fed’s and ECB’s aggressive rate reductions during the pandemic, the PBOC’s rate cuts have been more restrained (Fig. 15). Market expectations are for a modest 50bps cut in 2025, though this may depend on economic conditions. In July, the PBOC reduced its prime interest rates by 20bps to 3.35%. Among other measures, the bank initiated 1 trillion yuan ($140 billion) in asset purchases during September. In November, China released a 10 trillion-yuan debt package to support municipal finances long term.

Perversely, the CCP is less willing than the US to use populist fiscal stimulus measures that transfer wealth to the hoi polloi. For now, weak copper, iron, and hard commodity prices broadly suggest China’s domestic demand continues to be weighed down by the property bubble’s burst (Fig. 16).

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Thinking About 2025

December 17 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: The 2025 Bull Market. Most investment strategists have joined our camp heading into next year. We were among the most bullish forecasters for 2023 and 2024 (Fig. 1 and Fig. 2). Most economists have given up waiting for the “Godot” recession to finally show up. We are still bullish, but that is no longer a relatively contrarian position. We project a 15% gain for the S&P 500 next year, but Barron’s latest cover story, “Why The Stock Market Could Gain Another 20% in 2025,” describes an even more optimistic outlook.

As we have pointed out recently, several contrarian indicators are flashing orange, if not red, which could set the stage for a market pullback or correction early next year. We do not anticipate a protracted or deep stock market rout given that we view the economy as not only in good shape but improving.

Until a few months ago, the diehard hard-landers believed that “long and variable lags” from the tightening of monetary policy from March 2022 through August 2024 would slowly but surely weigh on economic growth. Our contention long has been that this notion is misguided because it ignores the Credit Crisis Cycle. Higher interest rates only cause a recession once they break something in the financial system; that rupture causes a credit crisis, which morphs into a credit crunch and then a recession.

That domino effect was interrupted during the latest tightening round because the Federal Reserve/Treasury department/FDIC triumvirate stemmed the mini regional banking crisis in March 2023 by quickly providing a liquidity facility and insuring all depositors of the failed banks. So the economy was able to continue expanding without cuts in the federal funds rate. Now that the Fed has begun easing even before any slowdown in economic growth, it's even more difficult to make the long-and-variable-lags argument.

While there seem to be fewer and fewer bears left these days, a few remain on the prowl. We commend our bearish brethren because they often sniff out nearly everything that could go wrong. We thank them for their thorough work. That allows us to spend more time on what could go right.

We acknowledge the concerns of the bears by assigning a 20% subjective probability to a cauldron of bearish possibilities: a US debt crisis that causes the economy and stock market to stumble, a geopolitical oil shock, a global trade war, or any other problem that pops up. We see much greater reason to be bullish, however, applying a 25% probability to a stock market meltup and a 55% probability to our Roaring 2020s scenario.

Our meltup scenario would likely result from overly loose monetary policy causing the stock market to discount our economic forecasts, laid out below, too quickly. In fact, that may be what the market is undergoing as we speak. Still, we believe the Roaring 2020s can drive the US economy and stock market, not only through the end of the decade but perhaps into the 2030s.

Strategy II: Great Economic Outlook. Let’s run through our base-case expectations for economic growth over the year ahead:

(1) Consumer spending. We continue to believe the US consumer is in very good shape, not running out of the mythical pandemic excess savings. Strong real wage gains and record nonlabor income (e.g., dividends, proprietorships, interest, and rentals) are fueling spending (Fig. 3 and Fig. 4). Meanwhile, rising asset prices of stocks and homes are allowing Americans to save less and spend more of their income (Fig. 5). This is particularly prevalent among Baby Boomers; they hold a record $80 trillion of the $154 trillion in total US household wealth, yet many have no income from wages (Fig. 6).

(2) Corporate spending. Business formation and innovation are driving hiring and capital spending. Applications for new businesses with a high propensity to have employees on payroll accelerated to 157.7 thousand (sa) in November, nearly matching September 2023’s post-pandemic record (Fig. 7).

On an inflation-adjusted basis, companies are spending record amounts on high tech, such as R&D ($665 billion, saar, inflation adjusted), information procession equipment ($533 billion), and software ($770 billion) (Fig. 8). High tech now represents half of all nominal capital spending in US nominal GDP (Fig. 9). And the NFIB’s (National Federation of Independent Business) survey of small business owners showed the percent saying it was a “good time to expand” and they “expected to increase capital spending in the next three months” both surged to multiyear highs in November (Fig. 10). Expectations for a lower corporate tax rate and deregulation under Trump 2.0 have boosted business confidence immediately and unleashed the animal spirits.

(3) Productivity growth. As we detailed in yesterday’s Morning Briefing, we are expecting productivity growth to accelerate toward 3.0%-3.5% over the rest of this decade, driving real GDP higher even as a slowdown in labor force growth causes hours worked to increase only marginally (Fig. 11). Importantly, productivity driven growth is much less inflationary, as it keeps unit labor costs (ULC) low while tending to boost real wage gains and corporate profit margins.

Corporate outlays on high tech, combined with a labor market short of skilled labor, will help fuel productivity gains.

Strategy III: Sticky Inflation. Since the summer of 2022, we have been disinflationists. Debbie and I said that we expected the core PCED inflation rate to reach 2.0% by the end of 2024. However, we believe the Fed’s soon-to-be 100bps of rate cuts may have halted that process. Core services and shelter inflation remain sticky, which could keep the PCED in the 2.5%-3.0% range instead of falling to the Fed’s target. The core CPI was 3.3% y/y in November, while the core PCED was 2.8% in October and likely remained there last month (Fig. 12). So even a month or two of hotter inflation could see the core PCED a full percentage point above the Fed’s target, which could cause the markets to flinch if it convinces investors that the Fed might reverse course and hike interest rates.

Another risk is that goods prices begin to inflate after deflating for several quarters, putting downward pressure on overall inflation. However, we remain broadly optimistic on the inflation outlook, as the productivity growth boom we expect would suppress ULC.

Strategy IV: Fed Pause Ahead. While the Fed has been cutting the federal funds rate (FFR), the Bond Vigilantes have raised long-term Treasury yields by roughly the same amount (Fig. 13). The question for the Fed is, why cut the FFR further if bond yields may rise and the economy is doing well?

It seems that many on the Federal Open Market Committee (FOMC) have been asking themselves the same question. Nick Timiraos’ latest WSJ story details the internal dissent:

“Some needed little convincing to start big. Others were uneasy. Past reductions of a half point coincided with more dramatic financial stress. Bowman, who had been warning of latent risks of more-stubborn inflation, knew when she saw those policy briefing materials that she wouldn’t be able to support Powell’s proposal. She ended up casting a dissenting vote—the first since 2005 by a Fed governor.

“To avoid multiple dissents and win over colleagues who shared her reservations, Powell convinced them that he could sell the decision in subsequent public remarks as a recalibration made from a position of strength, and not the start of a panicky sprint to lower rates.”

We noted the emerging dissent among members of the FOMC in our August 22 Morning Briefing. Fed Chair Powell is very likely to signal a pause in further FFR cuts after the widely expected 25bps cut on Wednesday. If inflation rebounds significantly, the Fed’s credibility may be impaired. We’re rooting for productivity driven disinflation but recognize the risk that tax cuts and deregulations boost demand and therefore the level of interest rates that would contain inflation. Powell said the Fed cannot model the effects of the next administration’s fiscal policy this early. But the trillion-dollar annual net interest costs that the Congressional Budget Office forecasts will be an issue unless major changes are enacted (Fig. 14 and Fig. 15).

Commentary from other Fed officials may begin to cite the potential impacts of Trump 2.0 on the inflation outlook very soon.

Strategy V: Bullish Stock Market Forecast. Our base case is for the S&P 500 to rise roughly 15% to 7,000 by the end of next year. We’re expecting revenues to grow 5%, profit margins to widen from 12.3% to 13.9%, and earnings per share (EPS) to increase from roughly $240 to $285. We reach our price target by applying a 22 forward P/E to our 2025 forward EPS target of $320 (Fig. 16 and Fig. 17).

Here’s more on what we expect the market’s internals to look like:

(1) Valuation. Of course, a 22 forward P/E is not cheap. However, strip out the Magnificent-7 stocks, and the rest of the S&P 500 is trading at 19.6 times forward earnings (Fig. 18). Historically cheap? Not exactly, but below the blowoff-top highs that concern investors.

(2) Margins. We’re expecting the S&P 493 profit margins to widen as these companies begin to benefit from the high-tech spend and increased productivity growth, which will drive earnings higher (Fig. 19). Thus far, only the Mag-7 have widened profit margins materially.

(3) Sectors. We continue to recommend overweighting cyclical S&P 500 sectors such as tech-related ones (e.g., Information Technology and Communication Services) as well as Financials and Industrials. Benefitting from high-tech spend and margin expansion, these sectors appear poised to outperform under Trump 2.0 policies.
 
Strategy VI: Recessions Abroad. Not only do the US economy and stock market look good historically, but they look great compared to those abroad. In short, China is in dire straits, and Europe is a mess. Politically, economically, and financially, the setup is much better domestically. We maintain our “Stay Home” equities strategy, advising overweighting US equities relative to those in the rest of the world, as we have since at least 2010 (Fig. 20). It’s worked out well thus far.

Here’s more:

(1) China. Chinese 10-year government bond yields are now below 1.8% (Fig. 21). The Chinese government has committed to easy monetary policy and thrown various stimulus measures at its markets, but none have convinced investors that they can boost the economy out of the property rubble (Fig. 22).

(2) Europe. France’s government recently collapsed, replacing the prime minister who serves under President Emmanuel Macron. German Chancellor Olaf Scholz lost a confidence vote yesterday. The French fiscal thrust is getting reined in by the EU, and German business confidence is plummeting (Fig. 23).

The euro may fall to parity with the US dollar by year-end (Fig. 24). We prefer US and alternative assets (we continue to recommend long dollar and long gold positions) relative to foreign assets.

Strategy VII: Geopolitical Flares. The geopolitical tension over the past two years has failed to elicit much response from oil prices (Fig. 25). Energy supply is not only abundant but likely to increase during Trump 2.0, while demand is depressed by weakness in China and Europe. The overthrow of Syria’s Assad underscores Russia’s waning influence and struggles against Ukraine. It also highlights Israel’s success in the Middle East as it weakens Iranian-backed terrorist organizations on the other side of its borders.

We think the Trump administration will seek to end both conflicts quickly, which would likely weigh on oil prices further. The risks associated with hot wars, however, will be replaced by those associated with trade wars given the new administration’s trade policies.

The extent to which a trade war could spark further conflagration between the US and other nations, as opposed to successfully encouraging more pro-US policies abroad, remains to be seen, but we are optimistic. The US economy flourished under Trump 1.0, and tariffs did not bring the end of days (or strong inflationary pressures). We expect it to do even better under Trump 2.0.

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Inflation: The Good, The Bad & The Ugly

December 16 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Inflation I: The Good. In our Roaring 2020s scenario, a productivity growth boom boosts real GDP growth, keeps a lid on inflation, drives up real labor compensation, and widens profit margins. Last week’s Productivity and Costs report compiled by the Bureau of Labor Statistics (BLS) mostly included revised data for Q3-2024, which mostly supported this upbeat outlook.

The most significant revision was in unit labor costs (ULC), which determines the underlying inflation rate in the labor market. It is calculated by BLS as hourly compensation divided by productivity. Q3’s ULC in the nonfarm business sector was revised down 1.1 percentage points to an increase of 0.8% (saar), reflecting an equivalent downward revision in hourly compensation to an increase of 3.1%. ULC increased 2.2% y/y, down from the 3.4% prior preliminary estimate (Fig. 1).

The y/y headline PCED inflation rate closely tracks the y/y ULC inflation rate (Fig. 2). The former was up just 2.3% through October, while the latter rose 2.2%. Both are down from over 6.0% in 2022. In other words, the decline in the ULC inflation rate was the major reason that consumer price inflation has moderated since its summer 2022 peak.

During the summer of 2022, Debbie and I predicted this moderation in the PCED inflation rate (Fig. 3). We expect it will remain in the current 2.0%-3.0% range through the end of 2025 and probably through the end of the decade. However, we have some concern that the Fed’s current monetary easing campaign might revive inflationary pressures in coming months by boosting demand for goods and services at the same time as fiscal policy remains very stimulative.

Regarding fiscal policy, Trump 2.0’s impact on inflation is a “known unknown.” Tax cuts would also boost demand for goods and services. Tariffs would likely cause a one-time increase in the inflation rate unless they are offset by a stronger dollar. Deregulation should be mostly disinflationary. Reductions in federal government spending would also be disinflationary, but they aren’t likely to be significant enough to affect inflation much either way. More energy production could help hold down not only energy prices but prices broadly.

All these crosscurrents could make for a confusing and volatile inflation story next year. However, we are betting that productivity gains will keep a lid on ULC inflation and therefore overall inflation in 2025, and through the end of the decade, and possibly through the 2030s. Now let’s focus on the latest productivity and ULC data in the context of our Roaring 2020s scenario:

(1) Productivity growth booms. Productivity growth is very volatile on a quarterly basis (Fig. 4). It is less so on a y/y basis. However, it is easier to see productivity’s major growth cycles by focusing on its 20-quarter percent change at an annual rate in the series provided by the BLS for the nonfarm business sector (Fig. 5).

Based on the available data, there have been two major productivity growth busts—during the Great Inflation of the 1970s and during the first half of the 2010s after the Great Financial Crisis. There have been three distinct productivity growth booms including one in the late 1950s, another during most of the 1960s, and one during the second half of the 1990s. We think that a fourth one started during Q4-2015, when the trailing growth rate was just 0.6%. It rose to 1.9% by Q3-2024.

That’s almost a four-fold increase. However, at 1.9%, the rate is only back to slightly below its historical average of 2.1%—so far. As we’ve previously explained, we expect the current phase of the Digital Revolution to boost the trailing average of productivity growth we use to 3.5%, plus or minus 0.5%, by the end of the decade. This forecast might seem delusional, but it is consistent with the previous booms.

(2) Productivity and real GDP. Productivity is defined as real nonfarm business output divided by hours worked in the nonfarm business sector. The growth rate of this measure of output closely tracks the growth rate of real GDP, both on a y/y basis (Fig. 6). During Q3-2024, they were up 2.8% and 2.7%, respectively.

The arithmetic of real GDP is very simple: Its growth rate is the sum of the growth rates of productivity and hours worked. On average, since the start of the data in 1948, output is up 3.4%, while productivity is up 2.1% and hours worked is up only 1.3% (Fig. 7).

Productivity growth has been a major contributor to the growth rate of the economy. If it were to grow 3.5% with hours worked up 1.0%, real GDP would grow 4.5%. Is that conceivable? It is in our Roaring 2020s scenario. As noted above, it was achieved (and then some) during the previous productivity growth booms (Fig. 8)!

(3) Productivity and hours worked. The average annual growth rate of hours worked has slowed significantly to only 0.6% over the past five years (Fig. 9). We think this reflects a structural shortage of labor, especially skilled workers, which is one of the main reasons we believe that the economy is in the early stages of another productivity growth boom. This one has a lot going for it, especially lots of technological innovations that can augment the productivity of the available labor force in almost every conceivable business.

(4) Productivity and price inflation. We’ve previously observed that one of the major flaws of the Phillips Curve model of inflation is that it ignores productivity. The model posits an inverse correlation between the unemployment rate and the inflation rate. This is a very Keynesian perspective that assumes that demand for goods and services drives the economy and inflation. When demand is strong (weak), the unemployment rate is low (high), driving up (down) wage inflation and price inflation.

In fact, there is an inverse correlation between productivity growth and the unemployment rate (Fig. 10). Tight (loose) labor markets will drive up (down) wage inflation, but that pressure on prices tends to be offset by rising (falling) productivity. In the current productivity growth boom, we expect that the tight labor market will stimulate more productivity growth.

(5) Productivity and labor costs. As noted above, ULC is equal to hourly compensation divided by productivity. In a competitive labor market, inflation-adjusted hourly compensation tends to be determined by productivity (Fig. 11). The so-called productivity-pay gap almost disappears when the price deflator used is the nonfarm business price deflator rather than the CPI. That makes sense since employers’ compensation decisions are based on the prices they receive for their output, not on consumers’ overall cost of living.

Not surprisingly, the 20-quarter percent change at an annual rate in real hourly compensation closely tracks the comparable growth rate in productivity (Fig. 12). In other words, the current productivity growth boom that started at the end of 2015 has been reflected in improved real hourly compensation since then, and real compensation is one of the best measures of purchasing power and the standard of living.

(6) Productivity and profit margins. There should be a close correlation between the growth rate in productivity (using our trailing series) and the level of the profit margin, defined as pre-tax profits from current production as a percent of nominal GDP (Fig. 13). There was a very close fit between the two from the 1950s through the 1980s. The fit was less tight during the 1990s and 2000s. It’s been an inverse correlation since 2010. We don’t know why. We do know that the profit margin has remained on an upward trend despite the weakness in productivity during the five years following 2010. It should remain on that trend now that productivity growth is on an upward trend too since late 2015.

The GDP measure of the profit margin on an after-tax basis closely tracks the S&P 500 profit margin (Fig. 14). Both have remained on uptrends since the early 1990s. They both suggest that productivity growth might have been stronger since 2010, when it diverged from these measures of the profit margin. In any case, our Roaring 2020s scenario should be bullish for the profit margin of the S&P 500, which we expect to see at new record highs over the next few years (Fig. 15).

(7) Bottom line. Productivity is like fairy dust. It makes everything better. When its growth increases, that boosts real GDP’s growth rate, moderates inflation, allows real hourly compensation to rise faster, and lifts profit margins. That’s what the Roaring 2020s is all about.

Inflation II: The Bad. So, what could possibly go wrong with our happy base-case scenario? It could be undone by one of the other scenarios we could see but view as less likely.

We are still assigning a 55% subjective probability to the Roaring 2020s, 25% to a 1990s-style meltup, and 20% to a bearish “cauldron” that includes a geopolitical calamity—with the recognition that geopolitical crises don’t seem to perturb the US economy or stock market anymore.

What other “toil and trouble” simmer in this wicked cauldron, to quote Shakespeare’s three witches in Macbeth? A tariff and currency war are in this pot. So is a US Treasury debt crisis. Also in the cauldron is a possible rebound in the inflation rate that would force the Fed to stop easing monetary policy, or possibly to tighten monetary policy again.

And what about inflation in the meltup scenario? It has already been fueled by the Fed with an unnecessary 75bps cut in the federal funds rate since September 18. Additional cuts would pour more gasoline on the fire. The resulting positive wealth effect attributable to new highs in the prices of stocks, houses, real estate, bitcoin, and gold could also fuel consumer price inflation. That would force the Fed to raise interest rates, which would turn the meltup into a meltdown.

For now, the latest inflation news suggests that inflation might be getting stuck just north of the Fed’s 2.0% target:

(1) The latest core consumer price inflation as measured by the latest CPI for November and PCED for October showed increases of 3.3% and 2.8% (Fig. 16). The comparable PPI measure showed consumer prices up 3.4% during November. When it was reported last week, there were significant upward revisions in this third measure of inflation, which unlike the other two doesn’t include rent paid by consumers.

(2) The supercore components of these three measures of consumer price inflation track services less shelter and remained relatively hot over the past couple of months at 4.1% (CPI), 4.0% (PPI), and 3.5% (PCED) (Fig. 17).

(3) November’s survey of small business owners by the National Federation of Independent Business showed that 24% are raising prices and 28% are planning to do so (Fig. 18). Those are low readings compared to the spike during 2022. But they are still relatively high compared to the pre-pandemic history of both series.

Inflation III: The Ugly. Reflationists have observed that inflation during the first half of the 2020s has traced out a similar pattern to that of the first half of the 1970s, when it also surged and then moderated. They warn that it might now trace out a second inflationary wave as happened during the second half of the 1970s (Fig. 19). This scenario is one of the ingredients in our bearish cauldron. During the 1970s, two geopolitical crises in the Middle East caused oil prices to soar, resulting in the Great Inflation of the 1970s.
 
The current decade already has had two geopolitical crises with the potential to drive up oil prices, yet oil prices remain subdued (Fig. 20). That’s because global oil supply remains ample, while global oil demand remains subdued.
 
Movie. “Maria” (+) (link) is a biopic directed, written, and produced by Pablo Larrain about Maria Callas, the world's greatest opera singer. He previously had produced “Spencer” about Lady Diana and “Jackie” about Jackie Kennedy Onassis. All are worth seeing. In this film, Angelina Jolie admirably portrays Maria during the last days of her life in 1970s Paris. There are lots of reflections on her life, including her relationship with Aristotle Onassis. Of course, the remarkable beauty and range of her operatic voice is what stands out most in her career and in this movie.

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China, Retail & Hydrogen

December 12 (Thursday)

China: The Cold War Intensifies. US officials were sorely mistaken if they thought they could impose sanctions on China without eliciting a response. The Chinese government has been going toe-to-toe with the Biden administration, imposing their own restrictions and penalties on US companies and personnel in reaction to any restrictions or penalties the US government announces. This dance precedes the inauguration of President-elect Donald Trump, who has threatened to impose 60% tariffs on Chinese imports, and it’s sure to continue.

China is taking on the US at a time when its economy remains sluggish. Even promises of additional stimulus resulted in a mixed response from the financial markets. The country’s CSI 300 has rallied 16.3% ytd, but the yield on China’s 10-year bond, at 1.85%, remains near a record low (Fig. 1 and Fig. 2).

Here's a quick look at the ongoing China-US game of cat and mouse as well an update on some of China’s recent economic data:

(1) The US/China dance. Nvidia is in the unenviable position of being caught between two squabbling superpowers. This week, China’s State Administration for Market Regulation opened an investigation into whether Nvidia’s $6.9 billion acquisition of Mellanox Technologies, an Israeli manufacturer of computer networking components, violated China’s monopoly regulations. The deal was initially approved in April 2020 under the condition that the companies would continue to supply GPUs and network equipment to China. Nvidia could face a $1 billion fine.

Why reexamine a four-year-old deal? The obvious motive is retaliation for US restrictions on sales to China of high-end GPU chips used in AI training—like those Nvidia makes—and high-bandwidth memory chips. The US added 140 Chinese entities to its trade blacklist, including large domestic chip toolmakers and semiconductor manufacturing plants.

In addition to investigating Nvidia’s acquisition, China has banned exports to the US of gallium, germanium, antimony and other metals used in making semiconductors. Prior to the ban, the US imported almost all of its gallium, about half of its germanium, and 80% of its antimony, mostly from China.

PVH, which owns the Tommy Hilfiger and Calvin Klein brands, is also in a pickle. Western governments have banned or restricted the purchase of products from companies in the Chinese region of Xinjiang due to mass arrests and the forced labor of the Uyghurs. Last fall, China’s Ministry of Commerce announced that it is investigating whether PVH took “discriminatory measures” against products from Xinjiang when it stopped buying garments and cotton from the region so that it wouldn’t be subject to the Western ban.

If found guilty, the company could face a halt to its imports and exports from China, restrictions or bans on investments in China, restrictions or bans on PVH employees entering or working in China, or fines, a September 24 NYT article reported. Even before a decision has been made, influential personalities who had endorsed Tommy Hilfiger and Calvin Klein have stopped working for those brands. The potential impact is not small: In 2023, PVH generated about 6% of its revenue and 16% of its earnings before interest and taxes from China.

The tit-for-tatting has entered the military arena as well. After Taiwan President Lai Ching-te visited Hawaii and Guam, China launched military exercises that included nearly 100 Chinese warships and vessels in the waters surrounding Japan, South Korea, and Taiwan.

The diplomatic core is also involved. The US State Department said it would impose visa restrictions on officials involved with the jailing of 45 activists for subversion under Hong Kong’s national security law. The activists were involved with an unofficial “primary” election in 2020, which was deemed to be a plot to overthrow the Hong Kong government. China responded by imposing visa restrictions on “US personnel who have behaved poorly on Hong Kong-related issues,” a December 10 South China Morning Post article reported.

(2) A game of endurance. Looking ahead, the US is in a strong economic position to outlast China in this game of tit-for-tat. That said, China’s population may be more willing than US consumers to deal with any inconveniences arising from this cold war.

China recently reported that its imports fell 3.9% y/y in November, the biggest drop in 14 months. Exports rose 6.7% y/y, but that’s only around half of October’s 12.7% y/y increase (Fig. 3).

The economy’s weakness continues to drag down prices. In November, China’s consumer price index (CPI) rose 0.2% y/y. Excluding food & energy, it fell 0.3% (Fig. 4). Likewise, China’s producer price index (PPI) fell 2.5% in November, following a 2.9% decline in October (Fig. 5).

China’s purchasing managers indexes (PMIs) continue to show expansion (readings above 50.0) but barely. The manufacturing PMI was 50.3 in November, up by 0.2 from the October level, with new orders rising to 50.8. China’s nonmanufacturing PMI, which represents service and construction activity, fell to 50.0 from 50.2 in October (Fig. 6).

But the government has enacted stimulus measures that are working, notably financial incentives that sent electric vehicle sales surging 52% in November, this South China Morning Post article reported.

China’s Politburo said on Monday that it will “implement more proactive fiscal policy next year and focus on boosting domestic demand and consumption,” a December 10 WSJ article reported. The country also plans to adopt a “moderately loose” monetary policy and to stabilize the housing market.

The news met with mixed reaction among investors: The Chinese stock market initially rallied on Monday but declined on Tuesday.

Consumer Discretionary: Not Very Cheery. Lululemon Athletica and Dollar General each serve different segments of society. Lululemon serves high-income fitness buffs as a retailer of premium athletic wear, while Dollar General caters to low-income shoppers hunting for deals in its dollar stores.

Lulu enjoyed a surge in international sales during its fiscal Q3 (ended October), but its US business was lifeless. Meanwhile, Dollar General’s low-end consumer has been pinching pennies. Neither retailer seemed to expect a surge of US consumer spending over the holiday season.

Let’s take a look:

(1) Exercising abroad. Sales of Lululemon gear are taking off overseas. The company’s Q3 total revenue increased 9% y/y, bolstered by a 39% jump in mainland China, a 27% jump in the rest of the world (segmented as “Asia Pacific and Europe” and “Middle East and Africa”), but only 2% in the Americas. Within the Americas, US revenue growth was flat. Lulu plans to continue its international expansion by opening next year company-owned stores in Italy and franchising operations in Denmark, Belgium, Turkey, and the Czech Republic.

(2) Strong dollar bites. Lulu’s results may be pinched by the stronger dollar, reflecting the stronger US economy relative to mostly weak ones in the rest of the world. The US dollar index is up 2.2% y/y (Fig. 7). China’s yuan is 1.1% lower relative to the dollar y/y, and the euro is 0.2% lower (Fig. 8 and Fig. 9).

When Lululemon gave its Q4 revenue forecast of $3.475 billion to $3.510 billion, an 8%-10% y/y increase, it noted that the range includes an incremental $20 million negative impact of foreign-exchange-rate fluctuations.

(3) Talking tariffs. Lululemon officials discussed the impact of Trump 2.0’s expected new tariffs. The company sources about 3% of goods from China, less than 1% from Mexico, and nothing from Canada. “If tariffs were levied on imports from all countries into the US, that would obviously have a more significant impact on our costs,” said CFO Megan Frank.

(4) Tough times on the low end. Dollar General executives described their core customer as remaining “financially constrained.” Consumers bought more consumables, items like food and necessities, and shied away from discretionary items like home, seasonal, and apparel goods. Sales of private-label goods did very well, and the best performing category was goods selling for $1.

While same-store sales were positive in each of the quarter’s three months, consumers spent more heavily in the first three weeks of both August and September. That implies budget pressure, observed CEO Todd Vasos on the company’s earnings conference call. Consumers, he said, “continue to face significant financial pressure, as they are less able to stretch their budgets [to] the end of the month.”

Despite the gloomy talk, Dollar General’s net sales increased 5% in Q3 y/y to $10.2 billion, but Q3 operating profit declined 25.3% to $323.8 million, hurt by $32.7 million of hurricane-related costs, labor costs, and depreciation and amortization.

(5) Shrink is shrinking. While losses from shrink remain higher than Dollar General executives would like, shrink is approaching pre-pandemic levels. Shrink has gone from being a headwind to a tailwind.

(6) A peek into holiday sales. Executives at both companies gave brief comments regarding holiday sales. The Lululemon brass was optimistic that more “newness in its assortment” would boost growth in the US. “We’re off to a good start to the holiday and happy with our regular price performance over the Thanksgiving weekend,” said CEO Calvin McDonald on the company’s earnings conference call.

The folks at Dollar General noted that November sales came in slightly above the midpoint of their expectations. For the full year, the retailer now expects diluted earnings per share of $5.50-$5.90, the top end trimmed from its previously announced $5.50-$6.20 range. The results include about $43 million in hurricane-related costs.

Disruptive Technologies: Has Hydrogen’s Heyday Passed? There was a flurry of interest in hydrogen projects last year when the Biden administration earmarked billions in promised funding. But as is often the case, the initial excitement has faded. Funding has come in slower than expected, and costs are higher than expected. Some proposed projects are falling by the wayside, but the survival of the strongest projects is probably a good thing for the industry.

We’re still optimistic that scientists and engineers will find an economical way to produce hydrogen from excess solar and wind energy, and that over time this new source of green energy will become an important element of the US energy mix.

Here are some details behind recent industry headlines:

(1) Trump uncertainty weighs. President Biden ushered in the Hydrogen Production Tax Credit, which includes a 10-year federal tax credit of up to $3 per kilogram for clean hydrogen produced after 2022 in facilities that begin construction prior to 2033. Under the Infrastructure Investment and Jobs Act, another $9.5 billion is earmarked to fund hydrogen projects, but the vast majority of those funds have not been distributed.

Now there's concern that the incoming Trump administration will reverse Biden's efforts to help develop the hydrogen industry. Any funding that hasn’t been distributed could be reallocated through federal budget reconciliation by the new Trump administration, a November 27 article in Environment Health News reported. The new administration could also eliminate the hydrogen tax breaks. Conversely, Trump has promised to speed up permitting, which could help many of these large projects cut through red tape.

(2) Hostility toward the hubs. The Biden administration designated seven hubs to increase the production of hydrogen, and some are facing difficulties. In Pennsylvania, the Mid-Atlantic Clean Hydrogen Hub has encountered opposition from environmental groups, rising costs in producing green hydrogen, and a lack of certainty around Treasury Department rules on federal financial incentives for hydrogen production. Critics are also aggravated by the government’s lack of transparency.

Some of the companies that committed to the Mid-Atlantic Hub have dropped out. Messer, a multinational industrial and medical gas company, backed out of plans to build electrolysis facilities in Delaware and Pennsylvania, while sHYp no longer plans to build an electrolysis facility in Wilmington, a December 6 Inside Climate News article reported. From the demand side, HRP Group, a real estate development company, has delayed plans to use hydrogen for power and steam generation in its new buildings.

(3) Areas of growth remain. Some hydrogen projects are moving ahead. Almost 20 US utilities have proposed mixing 20% hydrogen with 80% natural gas to reduce carbon emissions. In Texas, companies like Air Liquide are planning to use underground cavities that once held oil to store highly pressurized hydrogen. The company, however, uses the state’s ample natural gas supplies to produce “grey” hydrogen. Environmentalists would hope companies would use the state's solar and wind power to produce green hydrogen instead.

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Tariffs, Europe & Earnings

December 11 (Wednesday)

Global Economy I: Tariffs vs the Dollar. The greenback might be the saving grace for US consumers and producers. The dollar is up 2.9% since the November 5 election (Fig. 1). Ostensibly, that appreciation is mostly due to expected tariffs, and the dollar would likely rise further if and when tariffs are enacted. A stronger dollar effectively offsets the price effects of a tariff, thereby making foreign countries “pay” the tariff by receiving fewer dollars for their imports to the US.

Theoretically, American consumers and some producers would “pay” the tariff if the dollar remained unchanged, or if other countries sold their appreciating foreign exchange (FX) reserves to offset currency devaluation. Dollars are the most commonly held reserve currency, at 58% of global FX reserves (Fig. 2).

The first scenario seems unlikely based on Trump 1.0 and current market dynamics. The second scenario is plausible, though foreign governments have limited ability to protect their currencies indefinitely. That’s evidenced by Japan’s struggle to defend the yen against the dollar over the past year or so. And most countries lack Japan’s economic and balance-sheet strength.

Trump espouses the benefits of a weaker dollar, putatively to support American exporters. So if a weak-dollar policy is pursued through negotiations in a “Mar-a-Lago Accord” (think: Plaza Accord of 1985), then new tariffs could be inflationary.

Let’s review how consumers and business might be impacted by potentially sweeping tariffs:

(1) Inflation redux? US consumers’ real wages were crushed during the pandemic recession. Labor market frictions meant that all those seeking jobs didn’t get one immediately, so fiscal stimulus was needed to offset lost wages. Then as workers found employment, high inflation meant that their wages didn’t stretch as far. Real wages shrank as costs rose for food and most essential goods, squeezing the budgets particularly of lower- and middle-income households (Fig. 3).

Finally, as of 2023, real wage growth has been positive (Fig. 4). The employment-to-population ratio is near record highs with near-record prime-age labor force participation. So workers can bargain for higher wages at the same time that goods prices are deflating (Fig. 5 and Fig. 6). In other words, middle America has enjoyed two strong years after being thrashed by policy choices from 2020-22. But workers still feel burned by depressed real wage growth, and any further affronts to their purchasing power will likely sour consumer sentiment.

(2) Producers appeased. Tariffs could raise input costs, but corporate profit margins surged to a record high under Trump 1.0 (Fig. 7). Deregulation and another corporate tax rate cut, along with the marginal impacts of favorable trade deals with allies, should more than offset the impacts of more expensive inputs. That’s especially true as Europe and China’s recessions depress global commodity prices.

Moreover, we expect already strong productivity growth to continue rising, which will put downward pressure on producers’ unit labor costs. This will benefit both producers and consumers as lower costs of production get passed on to consumers via lower prices for goods.

All things considered, we aren’t worried about tariffs creating an inflationary wave, even if the dollar doesn’t strengthen enough to fully offset their impact.

Global Economy II: What’s Wrong? Homegrown political turmoil along with fiscal instability have joined geopolitical crises as significant risks to global financial markets. Consider the following recent developments:

(1) South Korean President Yoon Suk Yeo’s martial law stunt is the latest example of the “Korean discount,” which has pushed stock valuations to just 8 times forward earnings.

(2) The Bond Vigilantes have set their sights on French debt, driving French 10-year OAT yields up to near 3.0% last week, rates now comparable to debt-laden Greece’s 10-year yields (Fig. 8).

(3) Europe remains in disarray, as we've noted before (see, for example, the Morning Briefings of November 20 and December 4). European Central Bank President Christine Lagarde addressed solutions in The Economist last week with an op-ed titled “How to turn European savings into investment, innovation, and growth.” Lagarde's main concern is the weakness in productivity and private investment across European nations (Fig. 9).

Europe’s stagnation is the result of insufficient leadership from its major economies. The economic woes in Germany and France have compounded the Eurozone’s challenges and shrunk its growth prospects. The European Commission forecasts just 1.5% and 1.3% real GDP growth, respectively, for the European Union and euro area next year.

(4) The global tariffs that are expected under Trump 2.0 are worrisome for some emerging market economies, particularly Mexico. We recently discussed Mexico’s populist shakeup, which raises concerns about growing corruption at the top (see the November 6 Morning Briefing).

(5) Meanwhile, India’s once-bright global growth trajectory has been dimmed by a slowdown in public expenditure as the country sorts out its homegrown political drama. India’s economy grew just 5.6% y/y in Q3, a significant slowdown from the 10.2% pace during the final quarter of 2023 (Fig. 10).

Despite concerns about frothy valuations in domestic markets, these political upheavals are further reason to stay home in US stocks. Let’s take a closer look at the most pressing issues in foreign economies:

(6) What’s wrong with Germany? Germany’s economic troubles point increasingly to structural weaknesses rather than just a cyclical downturn.

Last week, the OECD lowered its real GDP growth forecast for Germany in 2025 to a mere 0.7% from 1.1%, following a likely no-to-little-growth ending to 2024 (Fig. 11). Deteriorating demand caused Germany’s service-sector PMI to contract in November for the first time since February (Fig. 12). German industrial production fell in October, with energy and auto production declining further (Fig. 13). Production dropped 1.0% m/m and 4.7% y/y. Incoming industrial orders fell 1.5% in October.

Volkswagen and other industrial giants are planning to shut down German factories and cut jobs. German consumer confidence has also dropped sharply, the GfK Consumer Climate Indicator fell 4.9 points in December to -23.3 (Fig. 14).

The political instability in Germany is likewise unsettling. Chancellor Olaf Scholz’s ruling coalition recently fractured. A snap election is expected in February. The probable next leader, Friedrich Merz, is expected to ease fiscal constraints by issuing new debt to stimulate the economy. We believe the German economy could use fiscal support. Forming a new majority coalition to govern effectively could take until spring, though, leaving the country politically paralyzed in the interim.

(7) What’s wrong with France? France is also in political limbo until June, when elections are constitutionally allowed. After a vote of no confidence, French Prime Minister Michel Barnier resigned last week. President Emmanuel Macron will appoint a successor soon, but the next French leadership will struggle to accomplish much without majority support in the parliament.

France’s economic outlook is dim. Real GDP growth expected to stall in 2025 and consumers are increasingly pessimistic (Fig. 15). In November, household consumer confidence dropped to 90 points from 93 in October, remaining well below the long-term average (Fig. 16).

(8) What’s wrong with South Korea? South Korea’s political turmoil accelerated dramatically last week when President Yoon declared martial law on December 3 in an apparent attempt to block the opposition’s 2025 budget bill, which included major government cuts. South Korea’s parliament voted unanimously to cancel the decree just hours after it was issued.

Yoon’s power grab was motivated by fears that the cuts would leave South Korea vulnerable to threats from North Korea. He’s now facing renewed impeachment calls from opposition lawmakers (after an initial failed impeachment vote). Critics argue that martial law should be invoked only in times of extreme crisis, not to suppress political opposition.

The political instability has compounded South Korea’s economic challenges. The country’s semiconductor, steel, and chemical sectors are suffering from overcapacity due to China’s market flooding, and factories are closing. China is effectively exporting deflation to South Korea, which is exacerbating the situation (Fig. 17). Trump’s potential global tariffs could further disrupt South Korea’s economy, deepening its economic woes.

With the political outlook remaining uncertain, weak fiscal spending and declining investor confidence are likely to stifle South Korea’s economic recovery (Fig. 18).

Strategy: S&P 500 Q3 Revenue, Earnings & Margin Results. With just three S&P 500 companies left to report Q3 results, S&P and I/B/E/S last weekend compiled their near-final Q3 revenues and earnings-per-share data for the companies in the S&P 500 and its 11 sectors. Using the revenues and earnings actuals, we can also derive their profit margins.

The results according to S&P and those according to I/B/E/S often don’t match up owing to their different methodologies. But let’s see how the S&P 500 and its sectors did during Q3, according to each data series:

(1) S&P 500 Q3 revenues & EPS. S&P 500 companies’ aggregate operating earnings per share rose to a record high of $63.30 during Q3 for a second straight quarter according to I/B/E/S (Fig. 19). Earnings rose 8.4% y/y and growth was positive for a fifth straight quarter (Fig. 20).

S&P’s version of operating earnings per share was a record high $59.40 during Q3, up 13.7% y/y and positive for a seventh straight quarter. Since Q1-1993, the two series have diverged an average of 5.2%. During Q3, I/B/E/S’s operating EPS actual figure of $63.30 was 6.6% higher than S&P’s $59.40. That continues the trend since Q4-2022 of relatively small divergences between the two actuals.

During Q3, S&P 500 revenues per share rose to a record high of $500.80, its first since Q4 -2023 (Fig. 21). Revenues rose 6.9% y/y, up from 5.8% during Q2 and the fastest rate of growth since Q2-2023 (Fig. 22).

(2) Q3 revenue & earnings growth by sector. More S&P 500 sectors grew revenues y/y in Q3 than earnings. Revenues growth was positive for nine of the 11 S&P 500 sectors (Fig. 23). That’s down from 10 sectors in Q2, which was the highest count since Q4-2022. Earnings growth was positive in Q3 for just seven sectors, unchanged from Q1 and Q2 (Fig. 24).

Here are their y/y earnings and revenue growth rates for Q3-2024: Communication Services (28.3% earnings growth, 10.2% revenues growth), Information Technology (18.5, 16.5), Utilities (15.4, 4.3), Health Care (15.3, 12.3), S&P 500 (8.4, 6.9), Consumer Discretionary (6.6, 4.4), Consumer Staples (5.7, 2.6), Financials (5.6, 17.9), Real Estate (-8.8, 5.2), Industrials (-11.0, -1.6), Materials (-11.3, 0.3), and Energy (-26.7, -4.9).

(3) Record- or near-record high revenues in Q3 for many sectors. The S&P 500’s Q3 revenues was at a record high for the first time since Q4-2023, powered by a relatively broad swath of its 11 sectors. New record highs for quarterly revenues occurred in Q3 for six sectors: Communications Services, Consumer Staples, Financials, Health Care, Information Technology, and Real Estate. Remaining close to their highs were Consumer Discretionary and Industrials.

(4) Record-high EPS for five sectors. Q3-2024 marks a breakout quarter for the S&P 500, as these five sectors posted record-high EPS: Communication Services, Consumer Discretionary, Consumer Staples, Information Technology, and Real Estate. During Q2-2024, none of the sectors hit that mark for a second straight quarter.

(5) Record-high profit margin for two sectors. The S&P 500’s quarterly profit margin rose q/q for a third straight quarter to a nine-quarter high of 12.6% in Q3 from 12.4% in Q2 (Fig. 25). The profit margin improved q/q for just four of the 11 sectors, down from six in Q2, but Communication Services (20.1%) and Consumer Discretionary (10.0) delivered post-pandemic or record highs, the first for any sector since Q3-2023. Among the remaining nine sectors, Utilities (17.4%) improved to a 12-quarter high, Energy (8.5) fell to 13-quarter low, and Real Estate (25.8) dropped to a seven-quarter low. Information Technology’s 25.9% margin is the highest overall and exceeded Real Estate’s in Q3 for the first time ever.

Here are the sectors’ profit margin results: Information Technology (25.9% in Q3-2024, 25.8% in Q2-2024), Real Estate (25.8, 30.0), Communication Services (20.1, 15.8), Utilities (17.4, 13.8), Financials (13.8, 14.6), S&P 500 (12.6, 12.4), Consumer Discretionary (10.0, 9.3), Industrials (9.3, 10.5), Materials (9.0, 11.1), Energy (8.5, 9.2), Health Care (8.2, 8.3), and Consumer Staples (7.0, 7.0).

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Fed’s Blackout & Foreign Bond Buyers

December 10 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
The Fed: Dual Dilemma. Last week’s November employment report brought further proof that the summer slowdown in the labor market was a blip. We expect this week’s November CPI data to show that inflation has been sticking too high above the Fed’s 2.0% target. With both sides of the Fed’s dual mandate (stable prices and full employment) heating up, it’s increasingly likely that the Fed has cut the federal funds rate (FFR) by too much, too soon. We suspected as much when we raised the odds of a stock market meltup following the Fed’s 50bps cut in September. The bond market did too, as long-term bonds sold off and yields surged (Fig. 1).

A week ago, Fed Governor Christopher Waller said he doesn’t regret the September cut, which he chalked up to taking out insurance against softer employment and inflation data. He also equated himself to an MMA fighter who keeps getting inflation in a chokehold, only for it to slip away. But if the economy is stronger than the Fed thought and inflation hasn’t been tamed, why should the Fed cut the FFR any further?

Fed Chair Jerome Powell and other Federal Open Market Committee (FOMC) members have pointed to the neutral FFR as their North Star. Despite the fact that the neutral rate that neither stimulates nor dampens the economy is unknowable and unobservable, the FOMC seems convinced that it is lower than the current 4.50%-4.75%.

Astronomy aside, the reasoning for a 25bps cut on December 18 might simply be because markets expect one. The CME FedWatch tool shows an 87% probability of a cut, and FFR futures show at least one more in the first half of 2025 (Fig. 2).

Unless a December cut is accompanied by a very hawkish press conference by Powell—which he has not delivered since becoming a dove at August's Jackson Hole speech—it could send the stock market melting up even higher. That would increase the likelihood of a stock market correction early next year and risk overheating the economy.

Our recommendation to the Fed is to stand pat at the December 17-18 FOMC meeting. The committee should take the time to see how the economy evolves in the coming months following Trump’s win. Powell asserted at November’s FOMC meeting that the Fed cannot (or will not) model the new administration’s fiscal policy until it has been implemented. But while the effects of tax cuts and tariffs are uncertain, we do know that they are very likely to be at odds with easing monetary policy given that inflation is too high, real GDP growth is strong, and the labor market is near full employment. Alas, our warnings have gone unheeded since September, despite similar views shared by a few FOMC members.

Consider the possibilities for monetary policy as we head into 2025:

(1) Nirvana rate. The FOMC will release its updated quarterly Summary of Economic Projections (SEP) next week. It’s likely that members’ FFR projections will rise along with the increase in market expectations since the last release in September (Fig. 3). The dispersion of their views will remain wide, but the median projected path of policy is very likely to shift higher. Projections of the longer-run FFR are also likely to increase, which could see the median rise to 3.0%. We think the nominal neutral FFR is closer to 5%, while the FOMC’s highest projection as of September is 3.8%. So monetary policy is likely to become increasingly stimulative as the Fed cuts toward this nirvana level that it believes will neither expand nor contract the economy.

(2) Economic forecasts. Changes in the Fed projections of GDP, the PCED inflation rate, and unemployment also provide a window into how the FOMC’s views of the economy have shifted. Prevailing economic data suggest the median year-end projection for GDP will increase from 2.0% for the next two years (Fig. 4). Views of the PCED are likely to remain sanguine and show a gradual glide to 2.0% (Fig. 5). Unemployment projections are likely to be lowered, at least over the near term (Fig. 6).

The September SEP showed the Fed expected the FFR to end 2025 at 3.4%. Depending on the FOMC’s updated view of how many cuts it foresees over the next year along with its macroeconomic outlook, we can parse potential policy reactions to economic surprises next year. For instance, if growth is stronger (weaker) or the PCED is higher (lower) than the FOMC expected, then the FFR is likely to be higher (lower) than the forecast.

(3) Economic reacceleration. Depending on Wednesday’s CPI report for November, the Fed may be cutting the FFR in December to a full percentage point lower than where it was four months ago even though supercore CPI (services excluding shelter) stands above 4.5% y/y and nominal wage growth is 4.0% y/y (Fig. 7 and Fig. 8).

Wage growth doesn’t seem likely to slow, either. Small businesses’ plans to raise workers’ compensation over the next three months surged from 18% in July to 28% in November’s NFIB small business survey (Fig. 9). This series is correlated with the employment cost index (ECI), the Fed’s preferred gauge of labor costs. So it’s likely that the ECI will get stuck at historically high levels rather than those consistent with 2.0% consumer inflation. That is also likely to keep supercore CPI elevated given the importance of labor costs to services excluding housing.

Meanwhile, the number of small businesses with job openings or planning to increase employment over the next three months also increased in November (Fig. 10). The labor market is not just resilient but reaccelerating under expectations for a lower corporate tax rate and deregulation under Trump 2.0.

(4) Balance-sheet policy. Minutes from the Fed’s November meeting showed that the FOMC may consider a technical adjustment to the rate paid on the overnight reverse repurchase facility (ONRRP) soon. That could extend the runway for how long quantitative tightening (QT) could continue.

Recall, the RRP is the facility that swelled to more than $2 trillion in 2022 and 2023 as money-market funds flush with cash parked assets there to earn a rate that was at one point 5.30%. The ONRRP rate is currently set 5bps above the bottom of the FFR target range. It was raised in June 2021 to prevent short-term money market rates (like the FFR) from sometimes leaking below it. Now, quantitative tightening (QT) is putting some pressure on bank reserves and therefore adding stress to money markets.

We still think QT will end sometime in the second half of 2025, as the RRP has largely been drained and reserve balances will start to fall much quicker. That's of course barring any adverse effects of the debt ceiling being reinstated in January. The GOP sweep in November should allow for a smooth negotiation process, but we will write about the potential impacts of any debt limit debacle in the coming weeks.

(5) Blackout period. The FOMC is in a blackout period ahead of its December 17-18 meeting, meaning that it cannot provide guidance for no FFR cut if a hot CPI changes their minds. Powell would have to phone The Wall Street Journal’s Nick Timiraos to put a front-page story out.

But considering Powell’s apparent confidence that pivoting to dovishness in August was the right move, even a cautious FOMC may cut the FFR by 25bps and in public comments assure the markets that the Fed remains data dependent and is unlikely to cut rates further.

Will the Fed wake up to the economic realities or will the elusive neutral-rate fantasy continue to guide monetary policy? We shall see.

Bonds: Global Yield Hunters Buying in the US. The 10-year US Treasury yield has fallen from 4.46% a month ago to 4.17%. The drop has aligned with the decrease in the Citigroup Economic Surprise Index (CESI) (Fig. 11). However, we still think the 10-year yield is a bit too low considering our expectations for strong economic growth and sticky inflation.

Our current 10-year yield target range is between 4.25% and 4.75%. We are expecting the 10-year TIPS yield to stabilize around 2.00% based on solid economic growth, while the inflation premium ranges between 2.25% and 2.75%, based on inflation getting stuck slightly above the Fed’s 2.0% target.

So why have yields recently dropped slightly below our forecasted range? In addition to the (temporary) weakness in the CESI, foreign buyers hunting for yield are likely putting downward pressure on long-term Treasury yields.

Consider the following:

(1) Global yields. Disinflation (and deflation) and slow GDP growth overseas are weighing on global bond yields. Few developed countries have 10-year debt yielding 3% or more (Fig. 12). British gilt yields are less than 15bps higher than Treasury yields yet are accompanied by far less stable political and fiscal outlooks. Chinese debt continues to yield less than 2.0% (Fig. 13). So foreigners have few options outside of the US for safe and relatively high-yielding bonds.

(2) Treasury International Capital System (TICS). Treasury data, known as TICS, shows that foreign purchases of Treasury notes and bonds are running at a three-month annualized rate of $608 billion through September (Fig. 14). There was another $475 billion (three-month annualized) in US corporate debt purchased over this period (Fig. 15).

(3) China. China is one of the few countries shedding Treasuries (Fig. 16). China’s $1.3 trillion stockpile, as of 2013, is now down to $772 billion. However, the fall has been accompanied by a rise in Treasuries bought by Belgium, Luxembourg, and the UK, which are global financial centers where China can accumulate Treasuries without showing them in its official account. That said, China is also one of the countries stocking up on gold, so it may be funding those purchases by selling Treasuries. China’s central bank expanded its gold reserves in November after a six-month pause in purchases, Bloomberg has reported. Gold represents roughly 5.9% of China’s total foreign reserves, up significantly over the past few years but still a fraction of its holdings (Fig. 17).

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Roaring 2020s Tour Deep In The Heart Of Texas

December 09 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

US Strategy: Dr Ed on Tour. Taylor Swift’s “The Eras Tour” ended yesterday in Vancouver. The extraordinary singer started this sixth concert tour in Glendale, Arizona on March 17, 2023. The tour consisted of 149 shows spanning five continents. Two of my daughters enjoyed her show in Toronto last month.

My “Roaring 2020s Tour” started in Dallas, Texas last Tuesday morning. That afternoon, after a great Tex-Mex lunch with a few accounts, I traveled to Fort Worth to meet with more accounts. A car service took me to Austin that night for my gig there on Wednesday. It was on to San Antonio for a small group dinner that evening at Bistr09. Then I was off to Houston to stay at the Houstonian Hotel for a group breakfast on Thursday. Next I flew to San Diego to speak at the NIRI Senior Roundtable Annual Meeting on Friday morning.

I enjoyed my discussions with our accounts. They all are pleased with the bull market in stocks. They are also rooting for our Roaring 2020s scenario. But they are nervous that stocks aren’t cheap now that valuation multiples are near previous bull market peaks. Their main concern for the fundamentals is that President Donald Trump might start a trade war. Everyone is also wondering whether the new administration will succeed in reducing the size, regulatory powers, headcount, and budget deficits of the federal government. In addition, a few people noted that mass deportation of illegal migrants might hamper some industries that rely on these workers. Everyone is uneasy about making so many policy changes at the same time. That could have unintended negative consequences for the economy and the financial markets.

Debbie, Eric, Joe, Melissa, and I share these concerns and are focusing our team’s research efforts on these mostly “known unknowns.” Our current assessment is that on balance Trump 2.0 will support our Roaring 2020s scenario for the remainder of the decade. To be politically fair, our scenario has unfolded very well under the current administration’s mix of policies favoring business regulations, open borders, lots of deficit-financed spending, and onshoring incentives.

Our central investment thesis is that the economy and stock market are resilient; they have a long history of performing well notwithstanding Washington’s meddling and regardless of which party has the White House (Fig. 1 and Fig. 2). We the People of the United States make this country work, not the elected and unelected federal government officials in Washington. The US stands out among nations because it’s among the few that are prospering, and it’s doing so because entrepreneurial capitalism is flourishing. That’s what makes it exceptional.

European economies are stagnating under the regulatory regime of the European Union. Immigration has heightened a clash of civilizations within the region, exacerbating political partisanship. The region also has an increasingly geriatric profile. And Europe’s transition to clean energy has been costly and ineffective.

China began its shift toward a more market-oriented economy in 1978 under the leadership of Deng Xiaoping. The resultant economic boom started to fizzle in recent years as the Chinese Communist Party clamped down on capitalism, fearing that too many entrepreneurs were becoming too wealthy and powerful. A property depression and a rapidly aging population are also weighing on the country’s economy.

America’s entrepreneurial spirit and comparative advantage is widely recognized in the realm of technological innovation, financed by a highly developed venture capital industry. That’s very evident in the US and global stock markets. The S&P 500 Information Technology and Communication Services sectors combined account for 40.1% of the S&P 500 market capitalization (Fig. 3). That’s the same market-cap weighting those two sectors represented just before the Tech Wreck of 2000. However, this time, such a large proportion of the broad index’s market cap is more justified because the sectors together account for 35.0% of the earnings share of the S&P 500 compared to 24.0% back then.

This is one of the main reasons why the US MSCI stock price index has dramatically outperformed the All Country World ex-US stock price index since 2010 (Fig. 4 and Fig. 5). Furthermore, the US MSCI now accounts for a staggering 74% of the market capitalization of the All Country World MSCI (Fig. 6).

Less well known about America’s entrepreneurial juices is that there are over 30 million nonfarm sole proprietorships in America (Fig. 7). Proprietors’ income in personal income totaled $2.0 trillion (saar) during October (Fig. 8). Furthermore, the pace of new business applications has been hovering just above 5.0 million on a 12-month-sum basis since the pandemic (Fig. 9). That’s up from around 3.3 million before the pandemic.

US Economy I: Labor Market Looks Good to Us. We’ve said it before, half in jest: Any data series that does not support our story must be bad data or it will be revised to show we were right after all.

Over the past two months, the household measure of employment is down 723,0000, while the payroll measure of jobs is up 263,000. Ignore the former. It makes no sense. The rapid pace of business applications certainly must create plenty of jobs. That’s why we believe the payroll jobs survey’s data are more representative of the state of the labor market than that of the household employment survey. Consider the following:

(1) The former is up 518,000 over the past three months and 2.27 million over the past 12 months (Fig. 10). The latter is down 293,000 over the past three months and down 725,000 over the past 12 months. The number of jobs has been growing at a solid rate, while the number of people employed has been basically unchanged over the past 12 months. The ratio of the two has been increasing for a long time, and especially faster since the pandemic (Fig. 11).

(2) The household survey includes among the employed agricultural workers, self-employed workers whose businesses are unincorporated, unpaid family workers, and private household workers. These groups are excluded from the establishment survey. It’s likely that more of the self-employed are incorporating as sole proprietorships; they then would be included in payroll but not household employment. The response rates to the employment surveys have been falling. More respondents to the household survey may not be responding to phone calls because they are flooded with robocalls.

(3) With the exception of the household employment survey data, November’s employment report looked fine to us. Our Earned Income Proxy (EIP) for private-industry wages and salaries in personal income rose 0.8% as aggregate hours worked and average hourly earnings each rose 0.4% (Fig. 12, Fig. 13, and Fig. 14). Those increases put all three at record highs! The strength in our EIP augurs well for the holiday shopping season.

(4) Employment gains were relatively widespread by industry last month (Fig. 15). The only major decline was in retail trade with a decrease of 28,000. That might have been attributable to the late Thanksgiving this year. It fell on November 28.

Payroll employment rose to a record high in construction, educational services, financial activities, health care & social services, leisure & hospitality, professional scientific & technical services, state & local government, and wholesale trade.

Aggregate weekly hours rose in manufacturing, suggesting that industrial production rose during November (Fig. 16).

(5) The labor force declined by 413,000 during October and November and is up by only 159,000 over the past 12 months. The y/y growth rates of the 12-month averages of the working-age population and the labor force both were down to just 0.7% during November (Fig. 17). That slowdown is partly attributable to Baby Boomers, who started turning 65 years old in 2011 and have been increasingly retiring (Fig. 18).

We believe that business managers are successfully increasing the productivity of their younger workers as the Baby Boomers drop out of the labor force.

US Economy II: Consumers Still Consuming. The latest estimate by the Atlanta Fed’s GDPNow tracking model shows Q4’s real GDP rising by 3.3% (saar), bolstered by a 3.4% increase in real consumer spending (Fig. 19). Friday’s employment report should boost both estimates when the GDPNow’s update is released on Monday.

During November, retail motor vehicle sales rose to 16.5 million units (saar), the best pace since May 2021 (Fig. 20). That was led by a big increase in light truck sales, which now account for a whopping 82.1% of retail motor vehicle sales. This is consistent with our view that consumers are still consuming with gusto and economic growth may be accelerating.

Memo to Fed: Don’t do it again. You’ll regret it if you do.

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Energy, P/Es & Influencing Shoppers

December 05 (Thursday)

Energy: Wright-Sizing Oil. President-elect Donald Trump may be known for wanting to “drill, Baby, drill,” but his supporters in the oil and gas patch may have different ideas. The world has plenty of oil and gas, and adding to supplies risks lowering prices. The global market has so much oil that OPEC has kept almost six million barrels a day of production off the market for multiple years.

The price of a barrel of Brent crude oil, at $73.62, is near its lows of the past three years (Fig. 1). That doesn’t exactly incentivize oil and gas companies to race out and drill new wells. Trump’s nominee to head the Department of Energy (DOE), Chris Wright, knows that full well as the CEO of Liberty Energy, a supplier to the fracking industry.

That said, the industry does have a laundry list of changes it would like to see made under the new Trump administration. They’d like Trump to restart granting liquid natural gas export licenses and open more federal land for drilling. They’d like to eliminate President Biden’s rules on tailpipe emissions. And instead of increasing green energy, they’d like Trump to focus on increasing demand for oil and gas.

Let’s take a look at the state of the energy sector and what the future might hold under Trump and Wright:

(1) Swimming in oil. Plenty of oil is being produced both domestically and abroad. The US is the world’s largest producer of “black gold,” producing a record 13.2-13.5 million barrels per day (mbd) since early June (Fig. 2). US production has benefitted from technological advancements in fracking that make the process much more efficient. Even though the US is producing record volumes of oil, the number of oil rigs in use is closer to the historical lows than it is to the highs (Fig. 3).

On the global stage, OPEC+ members have been holding back much potential production since 2022 to bolster the price of oil. The organization could be selling an additional 5.86mbd of production; but given the current price of oil, OPEC is expected to announce at today’s meeting the extension of its production cuts through Q1, a December 3 Reuters article reported. We’ll be watching to see how much longer OPEC+ members are willing to lose market share to the US and other producers that are increasing production.

Adding to the pressure on oil prices has been the lack of demand growth from China and OECD countries. Gasoline demand in China has been falling due to the growing number of electric vehicles (EVs) on the road, the country’s slow economic growth, and its declining population. China consumed an average of 3.2mbd of gasoline in August, down 14% y/y, according to a US Energy Information Administration report.

New policies under President-elect Trump could have an outsized impact on the oil market. A trade war with China could put downward pressure on economic growth and oil demand. Conversely, if Trump and his hawkish Secretary of State nominee Senator Marco Rubio enforce sanctions on Iran and Venezuela, supply from those nations could fall by roughly 1mbd, a December 3 Barron’s article estimated.

(2) New folks running the show. In addition to Rubio, there will be a new cast of characters in the Trump administration influencing energy policy. Wright, the nominated DOE leader, stands to have the biggest impact on energy industries. He has an interesting take on global warming, which he lays out in this video. While he acknowledges that carbon dioxide has increased and that it may cause global warming, he doesn’t believe global warming has caused weather to grow more extreme. Monetary losses due to global weather events as a percentage of GDP is flat, he says, and deaths from extreme weather are down even as the US population has increased.

Wright implies that instead of spending to mitigate climate change, humanity would be better off spending to eliminate poverty and ensure prosperity. Hydrocarbons have been key to improving out standard of living, as they’re needed to make plastics and fertilizer and to fuel industrial processes, including the production of windmills, solar panels, and batteries.

The government has spent billions of dollars on wind and solar power sources, and they still represent a small slice of the global energy pie. Wright would prefer the government to focus on energy supplies that are secure, reliable, and affordable. That said, Liberty has invested in “new energy” sources including Fervo Energy, an advanced geothermal company that uses fracking technology to unlock the earth’s heat to make power. It has also invested in a sodium-ion battery technology company and owns an equity stake in Oklo, a small modular nuclear reactor company. Wright sits on Oklo’s board of directors.

(3) What might change. In a November 15 interview, Harold Hamm, CEO of Continental Resources and avid Trump supporter, laid out a laundry list of changes that the oil and gas industry would like to see under the Trump administration. Topping the list: eliminating the “impediments put in place by the Biden administration to slow or halt oil and gas leasing activity on federal lands or in the Gulf of Mexico.”

Hamm also would like to see: 1) simpler and streamlined permitting processes for building pipelines, downstream facilities, and infrastructure like housing; 2) reversal of the Biden administration’s “pause” on the issuance of new liquid natural gas export licenses to non-free-trade-agreement countries; 3) less interference by federal agencies in the day-to-day operations of the industry; 4) continuation of certain Inflation Reduction Act policies, including the tax credit for capturing and storing carbon; and 5) the elimination of tax breaks for wind and solar power.

If confirmed as Energy secretary, Wright would oversee the Loan Program Office’s $6 billion budget for loan guarantees, control a $2 billion program to retrofit older factories to make EVs, and control $6 billion in grants for battery companies, according to an E&E News article.

Lobbyist, politician, and Fox News commentator Sean Duffy was nominated to head the Department of Transportation (DOT). Trump supporters would like his team to roll back the latest Corporate Average Fuel Economy (a.k.a. CAFE) standards, which complement the emissions standards set by the Environmental Protection Agency. DOT planned to boost fleetwide fuel economy to 50.4 miles per gallon in 2031 from 46.7 miles per gallon in 2026. The DOT also presides over a $7.5 billion program to place EV chargers along major highways and to seed local EV networks.

(4) A look at the numbers. With the price of oil in the $70-per-barrel area, the Energy sector stock price index has underperformed the S&P 500 ytd. Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Communication Services (37.7%), Information Technology (36.3), Financials (33.8), Consumer Discretionary (27.7), Utilities (26.2), S&P 500 (26.8), Industrials (24.2), Consumer Staples (17.5), Energy (12.1), Real Estate (9.7), Materials (9.6), and Health Care (7.4) (Fig. 4).

That said, the S&P 500 Energy stock price index appears to be testing the upper end of its three-year trading range (Fig. 5). Analysts following companies in the sector’s industries expect slight y/y revenue declines this year and next of 1.4% and 1.5% (Fig. 6). But they see a dramatic swing in earnings next year, from an 18.8% decline in 2024 to 4.8% growth in 2025 and 16.7% growth in 2026 (Fig. 7).

Strategy: A Look at P/Es. As we approach the last stretch of 2024, it’s a good time to examine where forward P/Es stand today compared to one year ago (Table 1). The S&P 500 stock price index has climbed more than 25% so far this year, but its forward P/E has expanded only modestly, to 22.3 from 18.9, because forward earnings have increased too. (FYI: Forward earnings is the time-weighted average of analysts’ consensus operating earnings estimates for the current year and the following one; the forward P/E is the multiple based on forward earnings.)

The S&P 500 Information Technology sector started the year with the highest forward P/E of the 11 S&P 500 sectors outside of Real Estate. It ends the year with a forward P/E that is still the highest except for Real Estate’s but that has increased only a touch, to 28.4 from 26.2. Many of the Information Technology’s component industries saw their already lofty valuations continue to increase over the course of the year.

Here are some examples: Application Software (34.3, 32.0), Systems Software (32.0, 31.2), Semiconductors (27.6, 23.2), and Communication Equipment (21.0, 15.1). One interesting exception is the Semiconductor Equipment industry, which has a forward P/E that shrunk to 18.9 from 21.5 at the start of the year. Threatened bans on exporting advanced semiconductor chips and equipment to China took a toll on the industry’s valuation.

Some of the S&P 500 industries with the largest jumps (5.0pts or more) in forward P/Es this year have nothing to do with technology, including: Automobile Manufacturers (37.4, 27.9), Consumer Staples Merchandise Retail (34.4, 24.6), Movies & Entertainment (32.7, 27.4), Construction Materials (30.5, 24.5), Electrical Components & Equipment (27.3, 20.2), Aerospace & Defense (27.0, 20.7), Home Improvement Retail (25.8, 18.5), Oil & Gas Storage & Transportation (23.4, 15.3), Communication Equipment (21.0, 15.1), Construction Machinery & Heavy Trucks (17.8, 12.4), Consumer Finance (15.7, 9.9), and Oil & Gas Refining & Marketing (14.9, 8.7).

P/Es improved markedly this year for many industries in the Financials sector, but most rose less than 5.0pts. Consider the numbers for: Asset Management & Custody Banks (19.0, 14.5), Investment Banking & Brokerage (16.6, 11.9), Diversified Banks (13.6, 9.4), and Regional Banks (12.7, 8.7).

Given the strong stock market rally in 2024, only a handful of industries saw their forward P/Es shrink this year. The S&P 500 Gold industry saw the largest forward P/E drop, to 10.6 from 19.6, when the year kicked off. While the price of gold has increased by 28.5% ytd, the stock price index of S&P 500 Gold industry (with a sole constituent company, Newmont) is basically flat ytd (Fig. 8 and Fig. 9). The company missed expectations for Q3 revenue and earnings, and its capital expenditures jumped sharply.

Other industries that saw their forward P/Es compress over the course of this year include Soft Drinks (20.4, 20.9), Oil & Gas Equipment & Services (12.7, 13.9), Brewers (10.3, 11.0), and Broadcasting (9.1, 9.9). While the Drug Retail industry’s forward P/E hasn’t budged one way or the other, it remains at the bottom of the barrel at 5.9.

Disruptive Technologies: Social Shopping. Social media is playing an ever-greater role in influencing purchases. Just over half (52%) of the 900 people aged 18-54 surveyed said they had purchased a holiday gift because it was recommended by an influencer on social media, according to a December 3 press release by The Influencer Marketing Factory. Social media platforms were the top source of holiday gift inspiration (30%), followed by recommendations from friends and family (24) and advertisements (21).

YouTube was the most influential site according to 24% of respondents, followed by Instagram (21%), TikTok (21), Facebook (20), and Pinterest (10). Consumers were more likely to buy a product if the influencer offered product reviews and demos (24%), discounts and exclusive offers (23), holiday-themed content (17), or “unboxings” (16)—i.e., videos of content creators sharing their impressions as they first open a product’s box.

Most respondents (64.3%) need to see a product promoted by an influencer two to three times before purchasing it. Only 17.4% of respondents said they had purchased a product promoted by an influencer just one time. Consumers said they were motivated by discount codes (25%) and honest reviews (24). At least some things don’t change!

Corrigendum: We regret that in yesterday’s Morning Briefing, “billion” incorrectly appeared in six places instead of the intended “trillion.” The corrected copy is linked here.

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On France, Financial Stability & LargeCaps Vs SMidCaps

December 04 (Wednesday)

Global Economies: Pass the Bordeaux. France’s government is on the brink of collapse. The far-right National Rally party said on Monday that it was ready to trigger a no-confidence vote in the government over a proposed budget that includes $63 billion in tax hikes and spending cuts.

We wrote in our June 26 Morning Briefing titled “EU’s Foundation Cracking?” that France faces two major issues: domestic political instability and overdrawn expansionary fiscal policy. Both are coming to a head now, and investors are readily fleeing French assets.

Consider these signs of distress:

(1) Bond spreads. Greek 10-year yields briefly fell below French OAT yields on Monday. Both are trading around 2.9%, or just over 80bps more than German bund yields (Fig. 1).

The difference between French and German bond yields is now roughly 15bps higher than when Emmanuel Macron and Marine Le Pen faced off in France’s 2017 presidential election. Greece’s 10-year yield was around 6.75% at that time; it had reached as high as 38.9% in the middle of the 2012 Eurozone crisis.

(2) Debt dilemma. The EU requires governments to maintain budget deficits below 3% of GDP and total debt below 60% of GDP. The rules were suspended during the pandemic and after the Russia/Ukraine war kicked off, but they’re back in play. French debt has reached 111% of GDP, and the budget deficit is running at 5.5% of GDP (Fig. 2 and Fig. 3).

France has enjoyed better growth than most of the Eurozone nations since the pandemic (Fig. 4). That spurt is likely over.

(3) Bread and circuses. Hosting the Paris 2024 Olympic games provided a short-lived and relatively small boost to the French economy. France’s S&P Global NM-PMI jumped from 50.1 to 55.0 in August, before falling to 49.6 by September (Fig. 5). It has since fallen to 45.7 as of November. The manufacturing PMI remained well below 50.0 since February 2023.

The Fed: In Banks We Trust. Created following the 2008 financial crisis, the Federal Reserve’s quarterly Financial Stability Report (FSR) is intended to monitor financial system vulnerabilities to shocks. According to the November report, US financial stability is okay but not great. Thankfully, bank capital is in good shape and so are the credit markets. But the Fed’s report still presents a laundry list of concerns.

On balance, we are more optimistic than the Fed on most points of concern. Below, we highlight the latest FSR’s major red flags and our thoughts on each:

(1) Asset valuations. Not wrong to be concerned, the Fed observes that the forward P/E ratio for the S&P 500 index is historically high. Equities are the largest asset market monitored in the Fed’s report at $64.4 trillion through Q2-2024.

The last time that the S&P LargeCap 500’s valuation approached where it is now (near 25) was during the late 1990s tech bubble. But the fact of a historically high P/E doesn’t mean that valuations must stretch further for equity prices to rise. Earnings are a factor too. Likely, many investors share our expectation that the new administration’s policies will be a net positive to domestic corporate earnings. But this is likely not yet reflected in analysts’ official estimates.

For example, Goldman Sachs recently called Trump’s impending tax cuts an “upside risk” to its S&P 500 earnings forecasts to the tune of 20.0%, according to a November 19 Business Insider article.

Depressed valuations in the S&P SmallCap 600 and S&P MidCap 400 indexes (collectively, the “SMidCaps”) are a result of weaker earnings growth but present a runway for stock price appreciation. Forward P/Es for the S&P 400 and S&P 600 indexes suggest these stocks may have more upside than those in the S&P 500 should earnings per share turn higher under Trump 2.0 (Fig. 6, Fig. 7, and Fig. 8). We are more bullish on earnings growth broadening out from the Magnificent-7 stocks to the “S&P 493” than to the SMidCaps, for now.

(2) Commercial real estate (CRE). Current CRE prices on the books may not fully reflect the deterioration in market prices, observes the Fed. CRE is the fourth largest asset market (behind equities, residential real estate, and Treasuries) monitored in the Fed’s report, at $21.9 trillion through Q2-2024.

Commercial property owners may be waiting on the sidelines rather than listing fallen assets and realizing losses. The pandemic-induced work-from-home (WFH) trend battered the office sector.

We agree with the Fed’s report that there is a lag to be mindful of in CRE prices. Is it possible, however, that the WFH trend already has been absorbed? Maybe. US CRE prices fell 8.8% in 2023, according to the International Monetary Fund’s stability data. This followed a less than 1.0% loss in 2022 and a 15.8% gain in 2021 (Fig. 9).

We also see a few reasons for optimism regarding the CRE market.

For one, lower interest rates driven by the Fed’s latest rate-cutting cycle are sure to stoke buyers’ interest and present refinancing options for owners. The latest Fed’s Senior Loan Officer Opinion Survey indicates that demand for CRE loans remains weak but is markedly improved from Q2-2023 (Fig. 10).

For two, many CRE owners may find ways to repurpose less desirable office buildings. Senior living options will become more in demand over the next decade as the Baby Boomers age. Large data centers required to operate artificial intelligence are another compelling option for repurposing unused office space.

For three, many large companies recently have called their employees back to the office, or else!

(3) Auto and credit card delinquencies. Turning from asset valuations to borrowing by businesses and households, the FSR indicates some concerns about consumer credit, specifically auto loans and credit cards. Yet the recent rise in delinquencies for these loans is likely not systemic.

These borrowers represent just a small share ($2.9 trillion) of the total of all credit markets ($41.5 trillion) in the Fed’s purview.

(4) Insurers and hedge funds. Life insurers’ leverage continued to hold a significant portion of illiquid and high-risk assets. In Q1-2024, hedge fund leverage approached the highest recorded since data tracking began in 2013. The asset size of these markets is not inconsequential at $20.9 trillion combined, especially compared to the $27.7 trillion in assets at banks and credit unions.

These markets are in the business of complex risk management and concern us too.

(5) ‘White swan’ events. We are not as concerned as the report suggests the Fed is about any near-term risk of an unexpected US recession. But we do include on our worry list most of the Fed’s near-term risks: rising geopolitical tensions (including in the Mid East), adverse cyber events, and fiscal and monetary policy uncertainty.

So while we share some of the Fed’s concerns, we do take solace in the Fed’s analysis of the capital stability and resilience of the larger banks.

Strategy: What’s in Style Now? All three of the S&P market-capitalization indexes had suffered bear market declines of 24%-27% before bottoming near the end of 2022. Since then, all three have attained new record highs this year.

The S&P LargeCap 500 index took 24 months to reach a new record-high price in January 2024. Its path to a new record high was shorter than the S&P MidCap 400’s 28 months (from November 2021 to March 2024). But it wasn’t until investors’ spirits soared the day after the November 5 elections that the S&P SmallCap 600 was swept to a new record high—along with many US stock market indexes—after 36 months (Fig. 11)! That was SmallCap’s lengthiest recovery to a record high since the period following the Great Financial Crisis (44 months).

With Trump soon to return as POTUS, Joe provides an early read on where investors have been allocating their investment dollars:

(1) SMidCap and cyclical sector price indexes are leading so far. The S&P 600 SmallCap price index has soared 7.9% since November 5 through Monday’s close (Fig. 12). That’s ahead of the 6.4% surge for the S&P MidCap 400 and the 4.6% rise for the S&P LargeCap 500.

The SMidCap sectors have dominated too. Among the top 10 performers of the 33 S&P 500/400/600 sectors, eight are in the SMidCap indexes. These are the top 10 performing sectors: MidCap Energy (11.3%), MidCap Financials (11.3), LargeCap Consumer Discretionary (10.4), SmallCap Financials (10.1), SmallCap Information Technology (9.1), SmallCap Industrials (9.1), LargeCap Financials (8.7), SmallCap Materials (8.4), MidCap Consumer Discretionary (8.4), and SmallCap Consumer Staples (8.2).

Despite Trump’s background in Real Estate, that sector has performed poorly along with Health Care. These are the worst performing S&P 500/400/600 sectors since the election: LargeCap Health Care (-0.7), MidCap Health Care (-0.4), LargeCap Materials (0.8), LargeCap Real Estate (1.1), MidCap Real Estate (1.1), and SmallCap Real Estate (1.6).

(2) Will future forward earnings justify current valuation? When the S&P 500 LargeCap’s price index first returned to a record high in mid-January, forward earnings had already been making new record highs for four months since September 2023 (Fig. 13). Past cycles have had forward earnings attain new record highs after the price indexes did so. That’s the pattern the SMidCaps are following now. The S&P 400 MidCap price index returned to a record high in March, but its forward earnings was still 6% below its June 2022 record high. Fast forward eight months to today, and MidCap’s forward EPS is now less than 2% from a new record.

The S&P SmallCap 600 index has a steeper and longer path back to record-high forward earnings. Following the election, SmallCap’s forward EPS was at an eight-month low of 11.8% below its June 2022 record high. Judging by SmallCap’s post-election gain of 7.9% so far, investors are betting that Trump’s policy changes will propel SmallCap’s forward earnings back to record highs sooner rather than later.

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Does The Stock Market Have A Valuation Problem?

December 03 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: Valuation & Growth. As we’ve seen over the past three years, stock investors don’t like recessions, not even the no-shows. There was much anxiety about an imminent recession from January 3, 2022 through October 12, 2022, as reflected by the 25.4% drop in the S&P 500 over that period. Over that period, industry analysts confirmed investors’ fears by lowering their consensus expectations for the operating earnings per share (EPS) of the S&P 500 companies by 0.2% and 1.9% for 2022 and 2023. These were very modest cuts, so the forward earnings estimate based on the analysts’ annual estimates rose 5.8% (Fig. 1). (“Forward” earnings is the time-weighted average of the analysts’ consensus estimates for the current year and following one; the forward P/E is the multiple based on forward earnings.)

Nevertheless, recession fears caused investors to slash the forward P/E for the S&P 500 from 21.7 at the start of 2022 to 15.3 on October 12, 2022 (Fig. 2). That was a 29.5% drop that was only partially offset by the 5.8% increase in forward earnings. The result was a P/E-led bear market.

Bear markets tend to bottom with forward P/Es well below the historical average of 15.8 (Fig. 3). But the latest one bottomed at a relatively high forward P/E because investors started to anticipate that recession fears might start to abate, as the economy proved remarkably resilient in the face of the significant tightening of monetary policy from March 2022 through August 2023.

So from 15.3 on October 12, 2022, the forward P/E rebounded impressively to 22.3 during the final week of November this year. That 45.8% increase in the S&P 500’s valuation multiple was bolstered by a 15.5% increase in the forward EPS. The result has been a solid bull market, so far, that has kept pace with the previous eight bull markets (Fig. 4).

The point of this walk down Memory Lane is that the valuation multiple is a significant determinant of the stock market’s gains and losses. Through investors’ willingness to buy and sell at particular valuation levels, they amplify and anticipate changes in the consensus analysts’ expectations for EPS.

In our opinion, the key driver of the forward P/E is investors’ perception of how much and for how long earnings can grow before the next recession depresses earnings and the valuation multiple. Economic growth drives earnings growth, and investors’ expectations for both drive the forward P/E.

Investors will pay a higher P/E the longer they believe that the economic expansion will last. That’s because time is money. The longer the expansion, the longer that earnings have to grow to justify the current multiple (Fig. 5 and Fig. 6). That helps to explain the dramatic rebound in the forward P/E during the current bull market. When fears of a recession during 2022 became recognized as unfounded over the past three years, the rapid rise in the valuation multiple reflected investors’ increasing confidence that the economy and earnings would continue to grow despite the tightening of monetary policy.

So now what? The Fed has been cutting the federal funds rate since September 18. That certainly reduces the risk of a recession caused by the tightening of credit conditions and increases the odds of a long expansion.

If the tightening of monetary policy is no longer a risk to economic growth, what else might be? Perhaps a geopolitical crisis that causes oil prices to soar, as happened a couple of times during the 1970s? So far, the geopolitical crises since 2022 haven’t boosted the price of oil, which has been mostly falling since then.

That leaves a tariff war as a potential cause of a recession now that President Donald Trump is back and ready to slap tariffs on all of America’s trading partners. So far, stock investors aren’t fazed by Tariff Man, whom they believe is speaking loudly and carrying a big stick as a negotiating tactic. We agree.

Strategy II: Stretched Valuations. So now that we have explained why today’s high valuations might be justified, we must acknowledge that they are stretched by historical standards. We wouldn’t like to see them go any higher because that would force us to raise the odds of a 1990s meltup scenario from our current subjective probability of 25%.

Let’s review the latest readings on various valuation metrics:

(1) Trailing P/E. The four-quarter trailing P/E of the S&P 500, using reported earnings, rose to 27.1 during Q3-2024, well exceeding the 19.6 average since the late 1930s (Fig. 7). It bottomed at 20.5 during Q3-2022, above its historical average. It’s not a useful valuation measure, though, since it tends to soar during recessions as earnings fall faster than stock prices.

(2) Buffett Ratio. Many years ago, Warren Buffett mentioned that he likes to follow the ratio of the total value of US corporate equities at market value divided by nominal GDP (Fig. 8). The Buffett Ratio rose to a record-high 2.96 during Q2-2024. A useful weekly proxy ratio is the price of the S&P 500 index divided by the forward revenues per share of the index (i.e., forward P/S) (Fig. 9). It rose to a record 2.99 during the final week of November. Previously, Buffett noted that readings above 2.0 suggest that the market is getting overvalued. That might explain why he has been raising so much cash in the portfolio he manages for Berkshire Hathaway.

(3) Forward P/E. The forward P/E of the S&P 500 rose to 22.3 at the end of November (Fig. 10). That’s not at a record high, unlike the forward P/S ratio, because the S&P 500’s forward profit margin has been rising, boosting the growth of earnings relative to sales. Nevertheless, it’s closing in on the record high of 25.0 recorded during the Tech Bubble of 1999.

The S&P 500’s forward P/E has been boosted by the collective forward P/E of the Magnificent-7, currently 29.1, while the forward P/E of the remaining S&P 493 companies is at 19.5. Similarly, the median forward P/E of the S&P 500 was 19.8 during November (Fig. 11).

(4) Fed Model. The Fed’s Stock Valuation Model compares the forward earnings yield of the S&P 500 to the 10-year Treasury bond yield. The two were highly correlated from the mid-1980s through the late 1990s (Fig. 12). They’ve diverged greatly since then. The model may be worth monitoring again now that the forward earnings yield at 4.46% is almost identical to the 10-year Treasury bond yield.

(5) Real earnings yield. The spread between the S&P 500 earnings yield based on reported earnings and the Consumer Price Index inflation rate tends to be negative during recessions and bear markets (Fig. 13). It has been slightly positive for the past six quarters.

Strategy III: Overweight the US Consumer. Wagering against the US consumer tends to be a bad bet. Americans spend during boom times and even spend to feel better when their financial situation is worsening. But many investors and strategists have staked their chips against the consumer since the Fed began raising interest rates in 2022. They thought that the federal government’s pandemic-time stimulus sent directly to consumers had padded consumers’ pockets enough to fuel a spending deluge. Once those “excess savings” ran out and rates rose, surely delinquencies would follow. Even the credit-worthiest of consumers would be forced to retrench. Or so the thinking went.

That scenario never materialized, despite dire warnings that it would derail the economy and cause a recession. We saw a different narrative playing out: Rising real wages, increased income from higher rates, and a very positive wealth effect would allow consumers to keep spending. Baby Boomers in particular would “dissave” as they retired during the pandemic, and soaring home and stock values emboldened them to spend more.

A number of indicators have suggested consumers would soon run out of gas. The Citigroup Economic Surprise Index even turned lower recently, largely due to weaker-than-expected consumer spending data (Fig. 14). This lowered the 10-year Treasury bond yield by some 20bps to around 4.20%. However, we think this soft patch resulted from bad October weather and should be reversed in the coming months. We remain bullish on the outlook for consumer spending, particularly as a result of lower taxes under Trump 2.0. In addition, we expect that wages will continue to rise faster than prices as productivity growth remains robust.

Consider the current state of the consumer as we prepare for those tailwinds:

(1) Consumer sentiment. Consumer expectations for business conditions in the University of Michigan’s Consumer Sentiment Index (CSI) have been extremely downbeat since April 2021. The CSI plummeted during the pandemic, then rebounded through Q1-2021 before cratering to historical lows. While most indicators became depressed once the Fed began tightening monetary policy, the CSI is heavily tied to inflation. Consumer price inflation rose to 4.1% by April 2021 and continued climbing from there.

Now as inflation is falling and the real wages growth is continuing, the CSI is starting to rise (Fig. 15). Online survey methods and partisanship may keep the index lower than usual during this cycle, but the future expectations component could rise from November's current 76.9 closer toward its pre-pandemic average of around 85.0 in Q1-2025.

The Conference Board’s Consumer Confidence Index (CCI) tends to be more sensitive to labor market conditions. The CCI rose to a 16-month high in November, increasing from 109.6 to 111.7 (Fig. 16). That’s consistent with our long-held belief that the labor market remains in good shape. Many false alarms of labor market weakening this year were due to its normalization from record tightness during the pandemic.

Speaking of records, an all-time-high 56.4% of consumers expect stock prices to increase over the next year, per the CCI (Fig. 17). We expect Trump 2.0 and the stock market’s performance to boost consumer sentiment through Q1-2025 and beyond (Fig. 18).

(2) Consumer spending. October's real personal consumption expenditures increased just 0.1% m/m. Spending on goods rose less than 0.1% m/m, and spending on services increased 0.2% m/m. We're expecting this to rebound in November owing to the improvement in sentiment as well as the return to work of striking and weather-impacted workers.

Meanwhile, real retail sales rose 0.4% in October to a new record high from an upwardly revised 0.8% increase in September (Fig. 19). Falling gas prices and a 0.2% m/m decline in goods prices further boosted real purchasing power (Fig. 20). We expect Trump’s deregulatory agenda and drill-baby-drill energy policies to further support this trend. The anticipatory animal spirits are already kicking in—the Atlanta Fed’s GDPNow model is currently estimating Q4 real consumption growth of 3.4%.

(3) Consumer income. Real disposable personal income rose 0.4% m/m during October. Because a large portion of that income was saved, consumer spending didn’t increase as much. We believe the trend of rising real wage growth and nonlabor income supporting more spending remains intact (Fig. 21).

(4) Consumer credit. Consumer delinquencies are rising, but just to pre-pandemic levels that are historically low (Fig. 22). Consumers broadly have been able to clean up their balance sheets since the pandemic, while rising incomes have lessened their relative debt load. As a percentage of disposable personal income, consumer credit outstanding remains well below pre-pandemic levels (Fig. 23). We aren’t worried about a reacceleration in credit-fueled spending, particularly as consumer credit growth is falling back toward pre-pandemic levels of around 5% y/y (Fig. 24).

While layoffs have remained low, hiring has fallen in recent quarters. We mostly attribute this to a normalization from the wave of job changes. However, as business owners become more certain and optimistic, we expect animal spirits to boost job openings, hiring, and therefore more consumer spending. Our bullishness on the consumer, labor market, and broader economy reflects our Roaring 2020s thesis, which we continue to believe is the most likely outcome in the coming years.

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Live Long & Prosper!

December 02 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Baby Boomers I: Huge Nest Egg. One of the many reasons that we have been bullish on the US economy and stock market is that we’ve been bullish on American consumers. We’ve focused on the resilience of the Baby Boomers, especially now that they are retiring with the largest retirement nest eggs of any generation in world history. We’ve often observed that if there was an Olympics in consumption, Americans would win gold, silver, and bronze, for sure. We’ve observed that when Americans are happy, they go shopping. When they are unhappy, they go shopping even more often because it releases dopamine in their brains, which gives them a happiness rush.

The Baby Boomers are mostly happy, and they certainly have the wherewithal to go shopping. They are especially happy now because as they’ve been retiring, the values of their homes and stock portfolios have continued to rise to record highs. Many have paid off most or all of their mortgages, and they no longer must pay exorbitant college tuitions. They are trying to stay healthy by keeping fit. They see their health care providers frequently for every little ailment. They are eating out at restaurants, traveling, and helping their children and grandchildren meet the high cost of living.

In short, the Baby Boomers are mostly living the good life. Many watched Star Trek during their wonder years and have followed the advice of Spock (the Vulcan, not the doctor): “Live long and prosper.” Let’s have a look at their demographic profile and net worth, and compare them to the other generational cohorts:

(1) The stars are born and aging. The Baby Boomers were born between 1946 and 1964 (Fig. 1). The number of births totaled 76 million during that period. They will be 61-79 years old next year. This generation was preceded by the Silent Generation (1928-45, 52 million, 80-97 years old). It was followed by Gen X (1965-80, 55 million, 45-60 years old), Millennials (1981-96, 62 million, 29-44 years old) and Gen Z (1997-2010, 57 million, 15-28 years old).

Births have always exceeded deaths in the United States, especially during the Baby Boom (Fig. 2 and Fig. 3). That caused a big bulge in the working-age population that boosted the labor force when the Boomers turned 16 years old from 1961 to 1980 (Fig. 4). That bulge boosted the senior population and senior labor force starting in 2011 when the oldest Baby Boomers turned 65 (Fig. 5).

The youngest of them will become seniors in 2029 (Fig. 6). From January 2011 through October 2024, the population of seniors increased by 21 million to a record 60.3 million. The number of former workers no longer in the labor force rose by 16 million over this period to 48.1 million.

(2) Record net worth. As we’ve frequently observed over the past few years, Baby Boomer households have about half of the net worth of the household sector. At the end of Q2-2024, their net worth totaled a record $79.8 trillion, or 52% of the record total $154.4 trillion in the net worth of the household sector (Fig. 7). In 1990, they had a 20% share, while the Silent Generation had an 80% share, which is now down to 10% (Fig. 8).

(3) Lots of equity. At the end of Q2-2024, the Baby Boomers held a record $23.0 trillion in corporate equities and mutual funds, accounting for more than half the share of the household sector in this asset category (Fig. 9 and Fig. 10). The total net worth of the household sector in corporate equities and mutual funds has more than quadrupled to $42.4 trillion since the Great Financial Crisis (GFC).

Households also have total equity in noncorporate businesses of $15.5 trillion, with $7.8 trillion held by the Baby Boomers (Fig 11 and Fig 12).

(4) Real estate. At the end of Q2-2024, the value of household real estate rose to a record-high $48.2 trillion (Fig. 13). Household owners’ home equity rose to a record $35.1 trillion, with $17.3 trillion of that total attributable to the Baby Boomers (Fig. 14).

(5) Pension entitlements. Also, at the end of Q2-2024, household pension entitlements totaled $17.6 trillion, with $9.8 trillion of that sum going to Baby Boomers (Fig. 15).

(6) Liquid assets. The household sector has an enormous amount of liquid assets. Total deposits and money market mutual funds (MMMF) amounted to $17.3 trillion at the end of Q2-2024, with the Baby Boomers owning nearly half of that, or $8.4 trillion (Fig. 16). Deposits were at $13.4 trillion, while MMMF were at a record $3.9 trillion (Fig. 17 and Fig. 18).

(7) Liabilities. Baby Boomers currently have only $2.6 trillion in mortgage loans, down from a peak of $5.3 trillion during Q1-2008 (Fig. 19). In recent years, mortgages have increased the most among Millennials, to $5 trillion currently.

Baby Boomers also don’t have much consumer credit, which totaled $1.0 trillion at the end of Q2-2024 (Fig. 20). More burdened by this debt are GenX members ($1.7 trillion) and Millennials ($2.2 trillion).

Baby Boomers II: Spending, Not Saving. The Baby Boomers are the richest generation ever. They are retiring, and many are living longer than previous generations have. We are projecting that the personal saving rate will turn slightly negative over the remainder of the decade as more Baby Boomers retire. That’s because the retirees will no longer have any earned income from working, though some might have nonlabor income from interest, dividends, rental income, and proprietors’ income (Fig. 21). The sum of these rose to $7.0 trillion (saar) during October. Notice that Baby Boomers are benefitting from high interest rates, which are boosting their interest income.

The personal saving rate is inversely correlated with the ratios of household net worth divided by disposable personal income (DPI) as well as household owners’ equity in real estate divided by DPI (Fig. 22 and Fig. 23). The correlation is better with the latter ratio than the former. That makes sense since more households have more of their wealth in their homes than in their stock portfolios. In any event, when their net worth rises relative to their DPI, consumers tend to save less.

Both ratios show that when the Baby Boomers first started to work, the saving rate was high, exceeding 10%. As the homes and equities they purchased rose in value from the early 1980s through late 2010, the saving rate fell. The saving rate spiked following the GFC and again in reaction to the Great Virus Crisis.

Both ratios are near their record highs, which explains why the personal saving rate is low at 4.3% during Q3-2024. We expect to see negative readings of -2.0% to -4.0% over the remainder of the decade.

Baby Boomers III: Boosting Consumption & Employment. Not surprisingly, some of the fastest growing components of personal consumption reflect the Baby Boomers’ spending on health, restaurants, entertainment, and travel (Fig. 24, Fig. 25, and Fig. 26). These industries are posting record sales and reporting record employment.

Baby Boomers IV: They Aren’t All Empty Nesters Yet. Many of the Baby Boomers are also providing some financial support to their young adult children. Indeed, many younger people can’t afford to buy a house, so they are living at home or sharing an apartment with roommates. Census data show that in 2024, 30.2% of people between the ages of 25 and 34 years old are living in their parents’ home (Fig. 27).

The third annual review of parental patronage by savings.com (dated May 21, 2024) found that 47% of parents with grown children provide them with some form of financial support (not including adult children with disabilities). This is a rate similar to that in last year’s report. On average, parents providing financial support give $1,384 to their children monthly. That’s more than twice what the average working parent in the study contributed to his/her own retirement savings monthly ($609 on average). Among parents who financially support adult children, 46% give them money for vacations and discretionary spending and 18% help their adult kids pay off credit cards.

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Trump, Bessent & The Bond Vigilantes

November 26 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Fixed Income Strategy I: ‘Trump Put’ for Bond Vigilantes? The 10-year Treasury bond yield has finally found a reason to stop ascending. It rose 79bps since the Federal Open Market Committee’s September 18 meeting (from 3.62% to 4.41% as of Friday’s close). We chalked up the climb to a mixture of stronger economic growth, higher inflation expectations, and heightened fiscal supply concerns under Trump 2.0. Yesterday, the 10-year yield fell 14 bps to 4.30% (Fig. 1). What changed? Nothing fundamental. Rather, President Trump’s selection of hedge fund manager Scott Bessent as US Treasury Secretary seems to have pleased the Bond Vigilantes.

Wall Street and the financial media widely view Bessent as a steady hand over what is an increasingly volatile bond market. His proposed “3-3-3” policy—i.e., 3% real GDP growth, federal deficits not exceeding 3% of nominal GDP, and 3 million additional barrels of oil or equivalents—is reminiscent of Prime Minister Shinzo Abe’s “three-arrows” plan to revitalize the Japanese economy over a decade ago.

The drop in the 10-year’s yield also means that at least 10bps of its climb could be attributed to government deficit worries, which one might describe as “term premium.” That is the extra yield that compensates investors for taking duration risk, and typically helps create an upward sloping yield curve. As the term premium deflated, so did the spread between the 2-year and 10-year bond yields. The US Treasury yield curve fell flat yesterday after having turned positive in September.

We think Bessent’s 3-3-3 plan might boost US economic growth and improve the perilous fiscal outlook. But Trump and Bessent are inheriting a much different fiscal and economic backdrop than Trump 1.0 did. Let’s consider the differences and how they impact outlook for the bond market:

(1) Trump 1.0 vs 2.0. Inflation was subdued during Trump’s first term. Headline and core CPI were just 1.6% and 2.1%, respectively, in October 2016. Today, they are 2.6% and 3.3%, while the so-called supercore CPI is north of 4.0% versus 2.3% back then (Fig. 2). The 10-year yield was 1.85%; today it is 4.31%. So the federal net interest expense was much more manageable then. Now it will continue to grow in excess of $1 trillion per year, even if yields fall back to their September 2024 lows (Fig. 3). The federal debt level has grown from 104% of GDP back in October 2016 to 121% of GDP, while the fiscal deficit has doubled from 3.1% of GDP to 6.0% (Fig. 4).

Fiscal expansion and higher inflation were important after years of flagging economic growth following the Great Financial Crisis (GFC). Today, the financial markets want continued brisk growth without high inflation or too much additional Treasury supply.

(2) Bonds in a hot economy. Today’s bond market reflects a much hotter economy, perhaps one on the brink of overheating thanks to the 75bps of federal funds rate (FFR) cuts since September 18. Stronger-than-expected economic growth has been the main driver of both short-term and long-term bond yields, in our opinion.

The rise in the 10-year Treasury bond yield is highly correlated with the improvement in the Citigroup Economic Surprise Index (Fig. 5). Solid economic data led the FFR futures market to price-out earlier expectations for more rate cuts (Fig. 6). Inflation expectations also played a role in lifting yields. Breakeven inflation—or the difference between nominal and inflation-protected Treasury bond (a.k.a. TIPS) yields—has risen by dozens of bps as the Fed has slashed the FFR by 75bps since September (Fig. 7).

The bond market clearly thinks that the so-called neutral FFR that neither accelerates nor depresses inflation is closer to 5.00% than to 3.00%, so the current FFR may accelerate the economy and possibly inflation. That’s why the 2-year Treasury yield has risen faster than the 10-year one. By cutting the FFR too much, too soon, the Fed is risking inflation not reaching the 2.0% target anytime soon.

So tax cuts and deregulation will have to spur enough growth to offset the drag from federal spending cuts under the newly created Department of Government Efficiency (DOGE) while also preventing inflation from flaring up as a result of higher tariffs. We think accelerating productivity growth will help Trump 2.0. Productivity growth was negligible in 2015. It has been on a new upward trend starting with Trump’s first term that we expect to drive overall economic growth through the rest of the decade (Fig. 8). That should keep a lid on unit labor costs and therefore inflation as well.

(3) Treasury supply. During Trump 1.0 (before the pandemic), the fiscal deficit expanded by 1.5%. The 3-3-3 plan implies at least a 3% reduction in the fiscal deficit from current levels. That could be difficult to achieve considering that mandatory federal government spending represents 84% of overall outlays (Fig. 9). Of course, that doesn’t mean there isn’t a massive amount of government waste, fraud, and unnecessary spending across agencies. Elon Musk and Vivek Ramaswamy have their work cut out for them as co-heads of DOGE, but the government has been in desperate need of liposuction for decades.

More pressingly for Bessent, Treasury bills represent 22.1% of overall Treasury debt (Fig. 10). Treasury Secretary Janet Yellen’s “solution” to placate the Bond Vigilantes has been to fund the deficit with T-bills, roughly tripling the total amount outstanding to $6.2 trillion since the pandemic (Fig. 11). Demand for bills to fund pandemic spending was obvious, with $2.2 trillion of those bills hitting the bill market since last May. Only $750 billion or so was needed to refill the Treasury General Account after having spent it down due to debt-limit related extraordinary measures. Bessent called out this faulty strategy in a recent WSJ op-ed:

“Mr. Trump must also address government borrowing. U.S. interest expense exceeds the defense budget. Treasury Secretary Janet Yellen has distorted Treasury markets by borrowing more than $1 trillion in more-expensive shorter-term debt compared with historical norms. Terming out that debt in favor of a more orthodox borrowing profile may increase longer-term interest rates and will need to be deftly handled. The only way to return to a prudent borrowing strategy without upsetting financial markets is restoring investors’ faith in the economy and preserving the dollar’s global role.”

(4) Treasury demand. With no additional Fed purchases of Treasuries, there’s been plenty of demand from other sources. Notably, the relentless money-market fund purchases of bills can no longer be funded from the Fed’s overnight reverse repo facility (ONRRP). Roughly $2.2 trillion of excess liquidity (a clear sign that the government overstimulated the economy during the pandemic) made its way to money-market funds and then to the Fed’s ONRRP to earn risk-free daily interest. That cash pile is now down to $200 billion after most of the cash funded the surging Treasury bill purchases (Fig. 12).

Foreign investors, hedge funds (e.g., “households”), and asset managers have largely filled the gap left by the lack of Fed quantitative easing (Fig. 13). Banks also are big buyers of Treasuries to meet capital requirements enacted after the GFC, now holding roughly $4.4 trillion (Fig. 14).

Fixed Income Strategy II: When Will the Yield Curve Normalize? The spread between yields on 2-year relative to 10-year Treasury bonds, a.k.a. the yield curve, has re-inverted. What will it take to get a normal curve, and what would a normal curve mean for bond yields? Consider the following:

(1) Inversion. The yield curve tends to invert as the Fed hikes the FFR, which the bond market thinks will eventually cause a financial crisis and a recession, leading to a rate cutting cycle (Fig. 15). During the most recent round of tightening, the Fed nipped an emerging mini regional banking crisis in the bud, averting a widespread crisis and a recession.

(2) Normalization. In past tightening cycles, a crisis would lead the Fed to slash the FFR, causing the yield curve to normalize as the long-term outlooks for economic growth and inflation improved. The yield curve has reached a peak of +150bps to +300bps in the aftermath of past recessions (Fig. 16).

The futures market suggests that the FFR will settle around 3.7% over the next couple years. Assuming that is the long-run neutral rate, the 2-year yield would be around the same, leading to a 5.20%-6.70% 10-year yield.

We do not subscribe to this view. Our target for the 10-year yield is 4.25%-4.75%, based on expectations for around 2.25%-2.75% real GDP growth and 2.00%-2.25% inflation. That suggests either that the FFR will be lower than 3.7% or that economic growth will prove more resilient to elevated short-term interest rates. We are in the latter camp.

Productivity growth, combined with the overall shift away from capital intensive goods toward the high-tech and services sector, will likely continue to drive the overall economy even if the FFR settles around 4.00%. The yield curve may be flatter in this scenario than it has been during past easing cycles, perhaps settling around +50bps, closer to where it was during the latter half of the 1990s. This is especially true given that the Fed will likely cease quantitative tightening over the next year, which would remove a source of upward pressure on long-term yields.

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Is Trump 2.0 Bullish Or Bearish?

November 25 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Trump 2.0 I: Lots of Moving Parts. So far, it has been the Roaring 2020s for the US economy and US stock market. Real GDP is at a record high, and so is the S&P 500. That’s impressive considering that the global economy was hit by a pandemic at the start of the decade, there was a radical regime change from Trump 1.0 to the Biden administration in 2021, the Fed raised interest rates significantly from March 2022 through August 2024, and there have been two major geopolitical crises that remain unresolved. Oh, yes: There was also that widely anticipated recession that never happened.

The economy has been resilient. Will it remain so during Trump 2.0? That’s the #1 question that Eric and I have been fielding ever since Election Day resulted in a Republican sweep.

The naysayers continue to raise doubts about the resilience of the economy. Some of them concede that they were wrong about expecting a recession in response to the tightening of monetary policy over the past three years. However, they blame their error on fiscal policy, which they (now) correctly observe has been very stimulative but doubt it will be for long. (We’ve identified several additional reasons for the economy’s resilience over the past three years.)

Since the start of 2022 through October of this year, total federal government spending is up $192 billion (using the 12-month sum) to $6.9 trillion (Fig. 1). Government spending on Health, Medicare, and Social Security rose $623 billion to a record $3.3 trillion over this period. There was a big drop in government spending on income security by $806 billion to $0.7 trillion, but that was almost completely offset by a $139 billion increase in defense spending to a record $0.9 trillion and, even more significantly, by a $510 billion increase in net interest outlays to a record $0.9 trillion (Fig. 2).

Focus on those numbers for a minute. The decline in the government’s spending on pandemic-related income support after the contagion abated has been largely offset by the government’s outlays on net interest as the federal debt and interest rates have soared (Fig. 3). Most of those interest payments have boosted personal income. Since January 2022 through September of this year, personal interest income has soared by $432 billion to $1.94 trillion (Fig. 4). Over the same period, personal nonmortgage interest payments rose $278 billion to $0.6 trillion.

The bottom line is that federal government spending remains very stimulative, and so do government deficits. Government spending that is deficit financed rather than paid for with tax revenues is more stimulative than spending based on a pay-as-you-go budget rule.

In the past, the ratio of federal government spending to federal budget receipts tended to fall during economic expansions (Fig. 5). It tended to rise during recessions and recoveries. This time, the ratio rose from 1.2 during summer 2022 to 1.4 during October of this year even though there was no recession. In other words, fiscal policy, which was usually countercyclical during periods of economic growth, has been procyclical this time, stimulating a growing economy.

Now that President Donald Trump and his Republican Party have won a clean sweep on Election Day, the question is whether fiscal policy will remain stimulative or turn restrictive. Nondiscretionary spending (including net interest outlays) accounts for roughly 85% of total outlays (Fig. 6). It will certainly go up, and so will defense spending. The corporate tax rate is likely to be cut, and so are individual income taxes on tips, overtime, and Social Security. All of those tax cuts will widen the federal deficit. It’s possible that the Republicans will reduce some of the spending authorized by the so-called Inflation Reduction Act.

Notably, in Trump 2.0, fiscal policy isn’t just about government spending and tax revenues. It is also about revenues raised from higher tariffs, which might increase the risks of a global trade war. It is also about deregulation, which should be stimulative by lowering the costs of doing business. The administration’s goal of reducing the size and scope of the federal government will pare the government’s headcount, which could weigh on payroll employment. Deportation is another major policy issue that could reduce the labor force with inflationary consequences unless productivity offsets the resulting labor shortage. Last, but not least, is the question of whether Trump’s energy policies will boost oil and gas production, thus keeping a lid on their prices.

In other words, there are lots of moving parts in Trump 2.0. On balance, we expect that Trump 2.0 will boost productivity and economic growth, keep inflation subdued, shrink the size of the federal government, slow the growth of government spending, and narrow the federal deficit. On second thought, we don’t expect all that will happen, but we do believe it all has a good chance of happening, and we hope it mostly does. There’s certainly no shortage of “known unknowns” in the outlook under Trump 2.0. Nevertheless, our base case for the remainder of the decade, with Trump 2.0 running Washington over the next four years, remains the Roaring 2020s.

As we’ve often observed in the past, we are constantly amazed by how well the US economy has been able to perform despite Washington’s meddling.
 
Trump 2.0 II: Taxes, DOGE, Tariffs, the Fed & Bond Vigilantes. As noted above, there are lots of moving parts to Trump 2.0. Here are some of our more specific observations on this matter:

(1) Under Trump 1.0, the Tax Cut and Jobs Act (TCJA) included a sharp reduction in the corporate tax rate from 35% to 21% (Fig. 7). Individual income tax rates were also lowered. Most of the provisions of the act were implemented in 2018. Total federal government receipts were at $3.34 trillion during the 12 months through December 2017 and little changed at $3.33 trillion in 2018 before climbing to $3.50 trillion during 2019 (Fig. 8). The decline in corporate tax receipts during this period was more than offset by higher individual and payroll tax receipts.

Under Trump 2.0, most of the provisions of the TCJA, which are set to expire in 2025, are likely to be extended. In addition, the corporate tax rate is expected to be cut to 15%. Taxes on tips, overtime pay, and Social Security might also be cut.

(2) All these measures will bloat the federal deficit and risk inciting the Bond Vigilantes. Hopefully, Trump’s new team of economic advisors will alert the President to this prospect, much as President Bill Clinton’s advisors warned him about the need to placate the Bond Vigilantes. Clinton did so. Trump may be signaling that he gets it by appointing cabinet secretaries that are set to cut their departments’ budgets and headcounts rather than to bloat them. That could weigh on payroll employment, though federal government payrolls haven’t been a source of employment growth, holding steady around 3.0 million employees for many years.

Trump has also created the Department of Government Efficiency (DOGE), headed by Elon Musk and Vivek Ramaswamy. They have been tasked with reducing waste and fraud in the federal government. Previous presidents have attempted to do so without much success. The problem is that about 85% of the federal budget is for mandatory spending including Social Security, Medicare, health care, income security, national defense, and net interest outlays. That leaves about $1 trillion in nondiscretionary government spending. Nevertheless, rooting out waste and fraud in all categories of government spending could produce a significant reduction in overall spending.

(3) Trump also intends to impose a 10%-20% tariff on US imports to raise revenues. Under Trump 1.0, federal government revenues from customs duties doubled from about $40 billion in 2017 to almost $80 billion in 2019 (Fig. 9). A 10%-20% tariff on all US imports of goods and services would generate $400 billion to $800 billion in revenues (Fig. 10). That’s assuming that these higher tariffs don’t reduce imports significantly or start a global trade war.

(4) Finally, here’s a friendly word of caution to the President: If you beat up on Fed Chair Jerome Powell to lower the federal funds rate, the Bond Vigilantes will only get madder. At his last press conference on November 7, Powell once again stated that “fiscal policy is on an unsustainable path” and “the level of our debt relative to the economy is unsustainable.” He indicated that once the new administration provides enough information on fiscal policy, the Fed’s staff will “start to model it” and “estimate the likely effects on the economy.” It is certainly conceivable that the Fed’s economic model will signal that Trump 2.0 is likely to boost economic growth while increasing the risk of higher inflation.

The Bond Vigilantes haven’t needed a model to come to the same conclusion. The 10-year Treasury bond yield has soared from 3.62% on September 18 to 4.41% on Friday. Of that 79bps increase, the TIPS yield rose 49bps and the inflation premium rose 30bps (Fig. 11 and Fig. 12).

Trump now needs to win over the Bond Vigilantes to make Trump 2.0 a success. He has proudly observed that the stock has been rising since he won the election on November 5 (Fig. 13). He should also watch the bond yield, which could impact the stock market’s valuation multiple. When he won his first term on November 8, 2016, the forward P/E of the S&P 500 was 16.0 (Fig. 14). Last week, it was 21.9. He should know that there is more downside than upside in the P/E over the next four years unless his policies win over the Bond Vigilantes.

Movie. “The Last Rifleman” (+ +) (link) is a heartwarming true story about an Irish soldier who survived the Normandy invasion. Pierce Brosnan ably plays Artie Crawford, the World War II vet who lives in a nursing home in Northern Ireland. After his wife passes away, he sets off by himself to France to attend the 75th anniversary of the D-Day landing. Along the way, he finds some peace of mind as he comes to terms with his traumatic experience.

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Health Care, Energy & AI Apps

November 21 (Thursday)

Health Care: The Kennedy Curveball. President-elect Donald Trump nominated Robert Kennedy Jr., known for challenging the safety of vaccines, to head Health and Human Services (HHS), a huge organization that encompasses an alphabet soup of agencies including the Food and Drug Administration (FDA), the National Institutes of Health (NIH), the Centers for Disease Control and Prevention (CDC), Medicare and Medicaid, and the Office of the Surgeon General. Trump reportedly has asked Kennedy—whose presidential campaign slogan was “Make America Healthy Again”—to clean up the corruption at the federal agencies, to return them to the “gold-standard science,” and to end the chronic disease epidemic.

While critics might write Kennedy off as a crackpot who had a worm living in his brain, Kennedy made some interesting points on a June 27 Joe Rogan podcast. Children are suffering from chronic diseases ranging from autism and diabetes to allergies and eczema. Common today, these ailments were rare when 70-year-old Kennedy was young, he asserts.

Kennedy believes that these chronic diseases are occurring more often because of toxic substances in the environment and that those substances should undergo testing that’s free from the influence of their manufacturers. Among the potential culprits are pesticides; perfluorooctane sulfonic acid (PFOS, a chemical present in many water supplies that’s used in products like non-stick cookware, stain-resistant carpets and fabrics; food packaging, and fire-fighting foam); mercury-containing vaccines; glyphosate (an ingredient in weedkiller Roundup); WiFi devices and cell phones; and chemicals in our food.

With a budget of more than $3 trillion and 80,000 employees, HHS is full of civil servants who might resist Kennedy’s ideas. Trump, who boasts about the speed and success of Covid vaccines and often dines on McDonald’s fare, may object as well.

But investors aren’t sticking around to find out whether Kennedy can push his ideas through the bureaucracy. The Health Care sector has lagged far behind the other 10 sectors in the S&P 500 ytd through Tuesday’s close: Communication Service (34.8%), Information Technology (33.7), Financials (31.8), Utilities (26.4), S&P 500 (24.1), Consumer Discretionary (23.0), Industrials (21.5), Consumer Staples (14.1), Energy (13.2), Real Estate (8.4), Materials (6.8), and Health Care (3.4) (Fig. 1).

The moves in the S&P 500 Biotechnology and Pharmaceutical stock price indexes are even more notable: They rose 16.3% and 21.5%, respectively, from the start of the year through August 23, when Kennedy suspended his presidential bid and endorsed Trump. Since then, the indexes have tumbled sharply. The Biotech index is now down 1.7% ytd through Tuesday’s close, and the Pharma index is only up 4.4% (Fig. 2).

Here are some of Kennedy’s views on health espoused before his HHS appointment:

(1) Pharma under a microscope. Kennedy has railed against pharmaceutical companies advertising directly to consumers, noting that the US and New Zealand are the only countries to allow the practice. He questions whether news channels dependent on drug advertising can cover health issues unbiasedly.

Kennedy would like to cap drug prices so that companies can’t charge Americans substantially more than Europeans pay, according to Kennedy’s September 5 op-ed in the WSJ.

He’d presumably like to see additional testing of vaccines and appears to question why drug companies should be shielded from liability related to their vaccines. And Kennedy would like to eliminate conflicts of interest at the FDA, noting that 75% of the agency’s budget comes from the new drug application fees paid by pharmaceutical companies.

The S&P 500 Pharmaceuticals industry is forecast to have solid revenue growth of 7.9% this year and 4.9% in 2025, while earnings surge by 21.6% this year and 33.1% in 2025 (Fig. 3 and Fig. 4). Despite the expected strong earnings growth, the industry’s forward PE has shrunk to only 15.2, down from a peak of 19.4 in mid-July (Fig. 5).

(2) Boost nutrition. Kennedy believes that much of the chronic illness in this country is due to the chemicals in our foods and Americans’ poor eating habits. He’d like to prohibit folks from using the funds they receive from the Supplemental Nutrition Assistance Program benefits, commonly known as food stamps, to buy soda or processed food.

Kennedy would reevaluate the standards set regarding the use of pesticides and chemicals. “As of 2019, the US allowed 72 pesticides that the European Union bans. We also allow chemicals in food and skin care [products] that the bloc doesn’t,” he notes.

Kennedy would also reform crop subsidies, presumably reducing them on corn, soybeans, and wheat. Because these crops are artificially cheap, unhealthy products made from them—such as high-calorie soybean oil and high-fructose corn syrup—are ubiquitous in processed foods.

The S&P 500 Soft Drinks stock price index, which was up 8.4% ytd through August 23, is now down 1.6% ytd through Tuesday’s close (Fig. 6). The industry’s revenues are forecast to grow 1.2% this year and 3.8% in 2025, while its earnings are expected to grow 6.5% in 2024 and 5.7% next year (Fig. 7 and Fig. 8). The industry’s forward P/E has shrunk to 19.8, down from 26.3 in 2022 (Fig. 9).

(3) Dr. Oz joins the fight. President-elect Trump announced on Tuesday that he chose Dr. Mehmet Oz to run the Centers for Medicare and Medicaid Services. A cardiologist and Columbia University professor emeritus, Oz is more commonly known as a former talk show host.

In announcing his appointment, Trump said that Oz will work closely with Kennedy “to take on the illness industrial complex, and all the horrible chronic diseases left in its wake.” Oz will also focus on disease prevention and on cutting waste and fraud in the country's most expensive government agency.

Energy: Playing Politics with Natural Gas. President-elect Trump nominated Chris Wright to be the next Energy Secretary. Wright owns Liberty Energy, a company that pumps sand and water underground to frack wells. He’s widely expected to reverse a Biden administration pause on exports of liquified natural gas (LNG) to non-free-trade (NFT) agreement countries enacted in January. Biden put the pause in place so that the Department of Energy (DOE) could evaluate how additional exports would impact both the price of natural gas sold domestically and the environment.

The DOE review was expected to take months and then be followed by a public comment period. The immediate impact of the decision affected 17 LNG projects with applications pending before the DOE, a January 26 FT article reported. The Texas Attorney General and officials in 15 other states filed a lawsuit to void the LNG ban. On July 2, a federal court judge paused the Biden ban while the lawsuit proceeds. But further litigation may be unnecessary under a Wright-led DOE. The new administration can reverse the ban just as easily as Biden enacted it.

A permanent ban on exports to NFT countries could mean that more natural gas would be sold domestically, increasing supplies in an already oversupplied market. When Biden instituted the ban on January 26, the price of natural gas was $2.71 per MMBTU; a month later, on February 28, it had fallen to a low of $1.89. The price climbed into the summer air conditioning season and then fell back below $2.00 in August. Since then, the price has headed higher, hitting $3.00 as of Tuesday (Fig. 10). Its price gains may be attributable to the escalating conflict in Ukraine as well as the high likelihood that the ban will be overturned under the new Trump administration, allowing exports to continue increasing and potentially reducing domestic supplies of natural gas.

Disruptive Technology: Crazy for AI Apps. Developers who have embraced artificial intelligence (AI) have created a growing list of AI apps to make our lives easier and to entertain us. The industry generated $1.4 billion of revenue in the first half of this year, twice what it generated during the same period in 2023. The growth is expected to remain robust, climbing sixfold over the next few years from an estimated $3.1 billion this year to $18.8 billion in 2028, according to a September 30 report in the Business of Apps.

ChatGPT remains the most popular AI app based on two lists compiled by Sensor Tower in July for Andreessen Horowitz. One list ranks the top 50 AI apps by the number of monthly visits, and the other ranks the apps by number of unique users. After ChatGPT, the next four names on the lists are very different. The top five apps ranked by monthly visits are: Chat GPT, Character.ai, Perplexity, Claude, and SUNO. The top five ranked by active users are ChatGPT, Microsoft Edge, Photomath, NOVA, and Bing.

Here’s a look at some of the trends in AI apps:

(1) Competition among assistants. The Andreessen Horowitz report notes the increasing competition among AI assistants. Like ChatGPT, Character.ai, Perplexity, and Claude each are apps that can answer questions and act as AI assistants. The report also noted that apps focused on creativity have gained in popularity. SUNO is an app that helps you create music and then displays it for others to access.

(2) Educational AI takes off. Microsoft has two products ranked among the top five on the most active users list, specifically Microsoft Edge, the AI-powered web browser that replaces Internet Explorer, and Bing, Microsoft’s search engine. Educational apps also were popular. Photomath lets users take a picture of a math problem and then provides step-by-step solutions to it. Meanwhile, Nova uses ChatGPT to help students with their homework and research.

(3) Bytedance arrives. Members of Congress should note that a number of apps owned by Bytedance, parent of TikTok, have gained in popularity. Gauth, an education platform; Coz, a bot builder; Doubao, a general assistant; Hypic, a photo and video editor; and assistant Cici appeared on one or both of the top 50 lists.

“Bytedance launched an R&D division, Flow, focused on generative AI applications in late 2023, and has been debuting new AI applications in the U.S. (and abroad) under other corporate names since early 2024,” the report states.

(4) Beauty in the eye of the app. Two new apps, LooksMax and Umax, take a user’s photo, rate the user, and give them tips to become more attractive. “Umax also generates pictures of what the user would look like as a 10/10, while LooksMax analyzes the user’s voice for attractiveness,” the report states.

We can just imagine the problems these apps could cause, particularly among the teenage crowd.

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Europe Is A Mess

November 20 (Wednesday)

Europe I: World War 2.5. Eric and I have been looking for historical analogies to the current decade. Today, we need to consider a new historical analogy, i.e., the 1930s, which led up to World War II, which started on September 1, 1939, when Germany invaded Poland. The rest, as they say, is history. They also say that “history doesn't repeat itself, but it often rhymes.” Mark Twain said it first.

We can make room for this unhappy prospect in our three-scenarios framework. We currently assign a 20% subjective probability to a 1970s-style geopolitical crisis, 25% to a 1990s-style stock market meltup, and 55% to 1920s-style Roaring 2020s boom times, led by productivity growth. We recently stuffed a possible US debt crisis into the first scenario. Now we can also add a 1930s-style calamity into this catchall bucket for everything that could go seriously wrong.

Consider the following developments on the Western front (as viewed from Russia):

(1) On August 6, Ukraine launched a surprise attack on the Kursk region of western Russia, which has struggled to respond quickly and effectively to Ukraine's offensive. Russian President Vladimir Putin doesn’t have enough troops to defend his country at the same time as he is invading Ukraine.

(2) On October 18, US Select Committee on Intelligence Chairman Michael R. Turner appealed to President Joe Biden to respond immediately to reports suggesting that North Korean troops could soon be fighting alongside Kremlin forces. According to Bloomberg, unnamed sources believe Pyongyang may deploy as many as 100,000 troops.

(3) On November 4, US officials told the Reuters news agency that North Korean troops were engaged in combat in the Kursk region of Russia.

(4) On November 6, Russian lawmakers voted to ratify a mutual defense treaty with North Korea, first proposed during Russian President Vladimir Putin's visit to Pyongyang in June.

(5) On November 17, President Joe Biden authorized the first use of US-supplied long-range missiles by Ukraine for strikes inside Russia. The weapons are likely to be deployed initially against Russian and North Korean troops in defense of Ukrainian forces in the Kursk region of western Russia, the officials said.

(6) On November 18, CNN reported, “Sweden and Finland have updated guidance to their citizens on how to survive war, as NATO allies bolster defense measures against the backdrop of the Ukraine conflict. Both nations joined the transatlantic alliance in the past two years, after Russia invaded its neighbor. Many European countries have since ramped up military spending to bolster long-term security in the region.”

(7) On November 19, Russian President Vladimir Putin lowered the threshold for a nuclear strike in response to a broader range of conventional attacks. Russia had been warning the West for months that if Washington allowed Ukraine to fire US, British, and French missiles deep into Russia, Moscow would consider those NATO members to be directly involved in the war in Ukraine.

(8) On November 13, incoming President Donald Trump met with President Joe Biden. We presume that they discussed the latest escalation in the Ukraine/Russia war. Putin must presume the same.

For now, we are maintaining our 20% subjective probability of the 1930s/1970s-style scenario.

Europe II: Rudderless. No bloc functions at its best when its economic engines are sputtering. That’s what’s happening in Europe, and there are plenty of reasons why.

Before we get to the causes, two symptoms are an underperforming stock market and a devalued currency. European stocks have underperformed the US stocks in eight of the last ten years. The MSCI Eurozone has been trading sideways since March 2024, and its investors now await confirmation of a Trump 2.0 global trade war with Europe at the front lines (Fig. 1). Nearly at parity to the US dollar, the euro has sunk on expectations that the European Central Bank (ECB) will lower interest rates on growth concerns while the US strengthens (Fig. 2).

A deus ex machina has entered the scene, but we have low confidence in his ability to right this ship. Former Italian Prime Minister and former ECB President Mario Draghi has drafted a plan to save the bloc from its demise, as we wrote in our September 11 Morning Briefing. Buried in the details of Draghi’s long-winded plan is a new Department of Government Efficiency for the European Commission. That sounds coincidentally familiar to tech billionaire Elon Musk’s Trump-appointed role heading up a new department, the Department of Government Efficiency (DOGE). In a post on X, Musk applauded Draghi’s efforts, calling the critique “accurate.” Musk commented: “Things should be default legal, rather than default illegal” to “revitalize growth and strengthen competitiveness” in the Eurozone.

We are all for removing red tape, but implementing drastic changes in a deeply fractured Eurozone will be like trying to pivot the Titanic without a rudder. We just don’t see enough chance of a turnaround in the plan or investment opportunities in the Eurozone’s equity valuations to warrant a holiday stock-shopping trip across the pond (Fig. 3).

Regarding the headwinds keeping Europe’s economy adrift, some are specific to two of the region’s major economies, Germany and France. Let’s start with those:

(1) Political disarray in Germany. German Chancellor Olaf Schulz finds his government at a crossroads after having fired his finance minister on November 7, effectively dissolving his parliament’s three-party coalition composed of the Social Democrats (SPD), the pro-business Free Democrats (FDP), and the environmentalist Greens Party. Former Finance Minister Christian Lindner sealed both his and the collapsed government’s fate when he recently wrote a paper outlining budget proposals that Schulz’s SPD and Greens fundamentally would never accept.

Schulz’s initial response before letting Lindner go was to offer a compromise if the FDP would agree to lift Germany’s “debt brake,” which limits Germany’s fiscal debt. The deal was one that Schulz knew the FDP would never take. Now a vote of no confidence in Schultz’s government is likely in or around January. If Schultz loses the vote, fresh parliamentary elections will be held around March, leaving the failed government in limbo until then.

(2) German industrial production hasn’t found a bottom. Germany’s industrial production fell 4.6% y/y in September as its large manufacturers announced closures and the governing coalitions collapsed, according to data released early in November (Fig. 4). Production remains below its pre-pandemic level. Recovery in production has been especially trying for German auto manufacturers (Fig. 5). Exports also fell in September.

(3) German autos on the skids. Ahead of Trump’s 2.0 tariffs, German auto companies already are doing poorly due to rising energy costs, competition from Chinese electric vehicles (EVs), and weakened demand for EVs globally. Reflecting the frailty of Germany’s auto sector, Volkswagen is set to close three German factories, cutting costs by an unprecedented $4.3 billion.

(4) Gridlock in France. French President Emmauel Macron lacks much power without a majority in parliament. He called for a dissolution of parliament at the end of July; having lost that vote, he can’t do so again until at least a year has passed after the last vote. The leftist party New Popular Front holds the most seats in parliament without an absolute majority, followed by Macron’s centrist party and the far-right National Rally in third.

(5) Trump’s tariffs loom. If Trump follows through on his campaign promises to put a blanket 10%-20% tax on all global imports (with a harsher rate for Chinese imports), German exports to the US could drop by an estimated 15%. This could plunge Germany’s economy deeper into the recession that is expected this winter even without the tariff imposition.

(6) No Roaring 2020s productivity boom. Other than the entrepreneurial spirit, there are several reasons why productivity growth is so much stronger in the US than in Europe (Fig. 6). A stringent regulatory regime and higher taxes discourage company formation and technological investment, for instance. While US real fixed investment in equipment was marginally higher ($525 billion) in 1995 than the Eurozone’s (€391 billion), US investment has accelerated to $1.549 trillion as of Q3. Eurozone gross capital formation, meanwhile, has grown to only €611 billion (Fig. 7).

The fragmentation across Eurozone countries’ real economic markets and financial markets is another barrier. It’s also very difficult to fire workers in the Eurozone, which is one reason why productivity plummets during recessions (Fig. 8). A very inelastic labor force naturally leads to inefficiencies; much better is a labor force in which workers flow freely to where they’re needed most.

(7) No wind in the sails for energy. By 2027, Europe is “dead set” on removing Russia as a cheap source of energy in response to the war in Ukraine “even as purchases of Russian liquefied natural gas increase,” noted an oilprice.com article. Europe also is actively reducing its coal generation and looking to replace it with wind and solar.

Europe’s hoped-for and well invested green energy transition won’t scale up in time for winter. Moreover, green energy solutions like wind turbines and solar generation are problematic given their intermittency problem—i.e., a lack of wind and sun at times when energy is needed most, such as winter. Solar generation drops more than 50% in the wintertime.

(8) ECB’s hands are tied. A few more interest-rate cuts by the ECB won’t likely be enough to revive growth in the Eurozone. In October, the ECB lowered its main interest rate to 3.25% (Fig. 9). The bloc’s central bankers recently called for rates to be lowered to a neutral level they peg at around 2.0%. But if global tariffs or a winter energy crisis were to revive Eurozone inflation, it would cause quite a predicament for the dovish central bankers.

(9) Not enough babies. A problem for future decades is the drop in fertility rates across the Eurozone. Responding to an infographic showing fertility data by country, Musk posted on X that “Europe is dying.” Birth rates for 2022 were lower than the 2.1 rate needed to replace the population, according to the data’s source report (by Eurostat and the Institute for Health Metrics and Evaluation). France’s birth rates have fallen to the lowest since post-WWII.

Strategy: Will 2025 Bring Rising Estimates? Analysts typically lower their consensus forecasts steadily as years progress, with only eight exceptions since 1995 (Fig. 10). This year is not likely to be the ninth, owing partly to the recent drop in oil prices and Boeing’s strike. But 2025 could be, suggests Joe’s data.

Below, Joe reviews how the analysts following S&P 500 companies have adjusted their 2025 forecasts so far this year, looking at aggregate revenues, earnings, and the implied profit margins for the S&P 500 and its 11 sectors, both for 2025 and for the 12 months ahead (i.e., “forward” data, captured by time-weighting the analysts’ consensus estimates for the current year and following one):

(1) 2025 revenues and earnings forecasts unchanged ytd. The S&P 500’s consensus aggregate 2025 revenues forecast is now flat ytd after being up around 1% following the Q2 earnings season. Typically, the following-calendar-year forecasts would be about 1%-2% lower by now. Five sectors have posted gains in their 2025 consensus revenues forecasts so far: Information Technology (9.2%), Communication Services (4.0%), Health Care (3.7), Real Estate (0.8), and Financials (0.4) (Fig. 11). Many of the rest have continued to experience revenue estimate cuts in recent weeks, dropping their ytd declines to new lows: Industrials (-5.3), Consumer Discretionary (-3.5), Energy (-2.7), Materials (-1.8), Consumer Staples (-0.5), and Utilities (-0.6).

The S&P 500’s consensus aggregate earnings forecast for 2025 is also unchanged ytd instead of declining as is typical. These five sectors have higher 2025 earnings forecasts ytd, beating the S&P 500 by that measure: Communication Services (8.9%), Information Technology (8.2), Utilities (2.5), Financials (2.0), and Real Estate (0.7) (Fig. 12). Among the biggest laggards are Energy (-21.4), Industrials (-6.5), Materials (-6.3), Consumer Staples (-3.6), Health Care (-3.1), and Consumer Discretionary (-0.5). Since Q3 ended, most of the winners continued to improve as most laggards dropped further behind.

(2) Forward revenues and earnings up broadly, led by four sectors. Consensus forward forecasts typically move higher as the year progresses and more of the following year’s (typically higher) estimates get folded in. The S&P 500’s aggregate forward revenues forecast has gained 5.0% ytd as nine of the 11 sectors’ forward revenues also moved higher. These four top the S&P 500 by this measure: Information Technology (18.5%), Health Care (9.9), Communication Services (9.4), and Financials (5.4) (Fig. 13). Among the biggest laggards ytd are the Energy (-4.2%), Industrials (-0.3), and Materials (0.6) sectors.

Looking at the forward earnings for the S&P 500 and its 11 sectors, Energy is the lone sector with forward earnings down ytd (Fig. 14). The S&P 500’s forward earnings has risen 11.3% ytd, more than its usual 8.0%-9.0% by this point in the year. The leading sectors: Information Technology (23.4%), Communication Services (22.5), Consumer Discretionary (14.5), and Financials (12.6).

(3) Forward profit margin recovery also broad. It has been a very good year so far for forward profit margins, which we derive from forward earnings and revenue estimates. The S&P 500’s profit margin improved 6.0%, powered by four sectors’ gains: Communication Services (11.9%), Consumer Discretionary (11.3), Financials (6.8), and Utilities (6.7). Only the forward margins of Health Care (-2.5) and Energy (-13.7) have fallen ytd (Fig. 15).

Here is a summary of the ytd percent changes in forward revenues, earnings, and profit margin forecasts: S&P 500 (upward revisions of 5.0% to revenues estimates, 11.3% to earnings estimates, 6.0% to profit margins), Communication Services (9.4, 22.5, 11.9), Consumer Discretionary (2.9, 14.5, 11.3), Consumer Staples (2.9, 3.7, 0.7), Energy (-4.2, -17.3, -13.7), Financials (5.4, 12.6, 6.8), Health Care (9.9, 7.1, -2.5), Industrials (-0.3, 5.2, 5.5), Information Technology (18.5, 23.4, 4.1), Materials (0.6, 4.6, 4.0), Real Estate (4.5, 10.2, 5.4), and Utilities (2.2, 9.0, 6.7).

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On Sticky Inflation & Robust Consumers

November 19 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
US Economy I: Is 2.0% Inflation a Done Deal? Both headline and core CPI inflation rates rose in October. Federal Reserve Chair Jerome Powell has often said the path to the Fed’s 2.0% target is likely to be “bumpy,” suggesting that the latest data and perhaps coming reports won’t prevent the Fed from cutting interest rates further. Yet it doesn’t look like one-off or transitory factors are driving inflation higher. In our opinion, there is a real risk that inflation is getting stuck above 2.0%. The bond market and federal funds rate (FFR) futures market appear to be sniffing this out.

We’re not worried about a second wave of high inflation, as happened in the 1970s (Fig. 1). In fact, we see just 20% odds of an inflationary geopolitical shock upending the financial markets. However, there is a risk though that long-term bond yields remain elevated due to higher inflation expectations. An even bigger worry is that the Fed’s credibility could be shaken if this persists for several quarters causing inflation expectations to become unanchored rising from around 2.0%-2.5% currently. That’s not an expected outcome for the time being, but the risk to the financial markets is large enough that it is worth considering.

Here’s how we’re thinking about the inflation picture:

(1) Supply. Supply-side inflation largely eased by last year. The latest New York Fed’s Supply Chain Pressure Index signaled easing from the pandemic snarls had faded, allowing CPI goods prices to fall (Fig. 2). China’s property depression has also depressed the country’s exports prices as the Chinese dumped goods in global markets to stimulate their economy.

Meanwhile, in the US, housing continues to be an issue in the CPI. October’s shelter CPI increased to 4.9% y/y from 4.1% six months ago (Fig. 3). The index tends to be slow to pick up new lease rents inflation, which has been falling. As a result, many inflation watchers expected shelter CPI to continue disinflation. Yet it has been rising on a three-month annualized basis since July, suggesting it’s unlikely to fall below 4.0% anytime soon. Arguably, this is a problem of the Fed’s own making. Because interest rates were lowered to zero during the pandemic, many homeowners are reluctant to give up mortgages at rates around 3%, depressing existing home sales and boosting home prices to record highs (Fig. 4).

(2) Demand. It’s an open question how much inflation would have fallen on its own without the Fed raising interest rates, given the supply-driven inflationary pressures. There’s also debate over the extent by which stimulatory fiscal policy increased demand and exacerbated inflation. Regardless, economic growth has remained strong over the past two years even as inflation slowly fell toward 2.0%. Now the Fed is lowering interest rates, and the fiscal deficit may widen under Trump 2.0 as tax cuts come quicker than federal spending cuts. There may not be much more room for economic growth to accelerate without boosting inflation unless productivity growth continues to improve as we discuss below.

In fact, there’s already evidence that consumer spending on goods is increasing. Real core retail sales hit a new record high in September and likely reached another record last month (Fig. 5).

PPI personal consumption services, which already exclude shelter, have accelerated as well, to 3.9% on a three-month annualized basis from 0.9% in September (Fig. 6).

(3) Sticky prices. CPI services less shelter, or the “supercore” CPI, increased from 4.3% in August to 4.5% y/y in October. That’s two months of increases from already historically high levels. Fed Chair Powell referred to supercore inflation as possibly the best indicator of underlying inflation in the economy back in November 2022. What’s changed?

Wage growth appears to be accelerating too. Average hourly earnings for private workers rose from 3.6% in July to 4.0% in October (Fig. 7). Workers suffered from cumulative inflation since the pandemic, and the labor market is tight enough to demand higher wages.

(4) Bonds. Breakeven inflation expectations are rising, helping to push up long-term bond yields (Fig. 8). Strong growth has also pushed up real rates, or those on inflation-protected TIPS. The FFR futures market sees less reason for additional rate cuts, pricing in a long-run rate of around 3.7% and less than three 25bps cuts over the coming year (Fig. 9).

We think further rate cuts could push up demand and see the CPI settle closer to 2.5% than 2.0%. This suggests that the current federal funds rate is currently at its “neutral” rate. It seems our view is shared by some on the Federal Open Market Committee (FOMC). Dallas Fed President Lorie Logan said this in a speech last Wednesday: “When I look at the available evidence, though, I see substantial signs that the neutral rate has increased in recent years, and some hints that it could be very close to where the fed funds rate is now.”

(5) Productivity. Despite the above, we’re still not worried about a second wave of inflation. That’s not because we believe the neutral FFR that’s neither restrictive nor stimulative is much lower than the current 4.50%-4.75%. Rather, our Roaring 2020s scenario (55% subjective probability) is rooted in our expectation that productivity growth will boost real GDP while keeping a lid on unit labor costs inflation.

Q3’s productivity data was revised upward significantly over the past few years. The 20-quarter percent change at an annual rate in productivity confirms that a productivity growth boom started during Q4-2015, when it was just 0.5%, rising to 1.9% by Q3-2024 (Fig. 10). We are expecting to see this growth rate rise to 3.0%-4.0% during the second half of the Roaring 2020s.

(6) External risk. We believe geopolitical risks that could lift goods and energy prices are lower under Trump 2.0. China’s stimulus efforts appear to be falling flat and failing to revive global oil demand. America’s reliance on OPEC+ countries is also reduced now that it is a major net energy exporter (Fig. 11). Trump’s deregulation push is likely to further encourage domestic oil and gas production as well.

As long as productivity growth continues to rise, we don’t see inflation rebounding as it did during the 1970s; back then, productivity growth fell almost to zero by the end of the decade.

US Economy II: Consumers Off to the Races? As noted above, consumer spending has been quite strong. Retail sales rose 0.4% in October after an upwardly revised 0.8% increase in September (from a preliminary increase of 0.4%), meaning real personal consumption expenditures (PCE) were stronger than the reported 2.2% (saar) in Q3 and will likely increase faster in Q4 (Fig. 12).

Widespread fears that the depletion of pandemic “excess savings” would slow consumer spending failed to account for several tailwinds. Strong productivity growth has supported real wage growth, while higher interest rates, rents, and dividends have boosted nonlabor income (Fig. 13). We expect even stronger consumer spending up ahead.

Consider the following:

(1) Credit. According to the New York Fed, total household debt rose to a record $17.9 trillion in Q3 (Fig. 14). While consumer delinquencies are rising, they’ve only returned to pre-pandemic levels so far and remain low relative to history (Fig. 15). That makes sense considering that income growth has been so strong. Consumers broadly have been able to clean up their balance sheets since the pandemic, though deleveraging as a percentage of disposable personal income stopped in Q2 (Fig. 16). With incomes rising at a brisk pace and low credit outstanding relative to disposable personal income, there’s plenty of room for consumers to finance major purchases like homes, autos, furniture, and appliances (Fig. 17).

(2) Personal savings. A large upward revision to the personal savings rate extinguished fears that the consumer would soon tap out. However, we weren’t worried about low savings in the first place, as households tend to dissave when their net worth is increasing thanks to rising home and stock prices (Fig. 18). Frankly, we wouldn't be surprised if the savings rate turned negative by 2026. That’s because, generally speaking, Baby Boomers—who collectively own $80 trillion of US households’ $154 trillion of net worth—are enjoying their retirement years and spending, many without any wage income coming in (Fig. 19).

(3) Hiring. While layoffs have remained low, hiring has fallen (Fig. 20). We believe this is mostly due to fewer workers quitting their jobs as they settle in after a wave of job changes in the past few years. Additionally, businesses may have been reluctant to hire with so much uncertainty surrounding the election. Indeed, the NFIB Small Business survey’s uncertainty index rose to a record high recently (Fig. 21). We expect this measure to plummet as small business owners grow more certain and confident, which may result in more hiring. That would boost consumer confidence and incomes and likely drive even more spending.

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Trumped

November 18 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Trump I: A Brief Discourse on Gridlock. I was rooting for gridlock to win the election because I am an old-fashioned Madisonian Constitutionalist. I am also biased by my chosen profession as an investment strategist. I think that gridlock is better for the economy and the stock market. I believe many investors agree with me. For decades, the stock market has been trending upward regardless of which party held the power in Washington (Fig. 1). Bear markets have occurred with both Republicans and Democrats in the White House. Nevertheless, investors have often viewed political gridlock in Washington as generally bullish. That makes sense because it protects the nation from political extremism. In any event, I’ve frequently observed that investors shouldn’t let their political leanings affect their investment decisions.

The framers of our Constitution created a system of checks and balances that was designed to result in political gridlock more often than not. Many of the Founding Fathers were lawyers. Specifically, 25 of the 56 signers of the Declaration of Independence were lawyers. Additionally, 35 of the 55 delegates who attended the Constitutional Convention of 1787 had legal training. All those lawyers created a constitutional system that was purposefully designed not to work usually; that was for the good of the citizenry, to protect us from our own extremist tendencies. Of course, it is also a system that provides lots of jobs for lawyers!

A fundamental flaw in the Constitution is that it doesn’t provide for any limit on our national debt. A balanced budget requirement would have forced Congress to raise taxes to pay for more spending. Politicians long ago recognized that raising taxes is not a good way to get reelected, while spending more on their constituencies is a winning strategy for sure. In other words, they discovered the magic of deficit financing their ever-increasing spending to win the next election. That approach undermines the benefit of any political gridlock because legislators on both sides of the aisle readily spend more on their pet projects. Why not? Doing so costs them nothing in political capital: They don’t have to alienate voters by raising taxes in order to spend away. Everyone gets what they want!

Here are some relevant thoughts on this subject from our founders:

(1) Thomas Jefferson believed that public debt was one of the greatest dangers to be feared. He warned that to preserve the people's independence, “we must not let our rulers load us with perpetual debt.”

(2) James Madison emphasized the importance of ensuring that government appropriations should always match public engagements. He was concerned about the burden of debt on future generations.

(3) Alexander Hamilton acknowledged that a national debt could be beneficial if it was not excessive and was managed properly. However, he also warned about the dangers of accumulating arrears of interest, which could harm public credit.

Trump II: Gridlock Has Been Trumped. The first two years of Donald Trump’s presidency corresponded with the 115th United States Congress, which lasted from January 3, 2017 to January 3, 2019. The Republican party held majorities in both the House of Representatives and the Senate. But the party’s Senate majority was a narrow one, which sometimes made it challenging to pass legislation without some Democratic support. And because the late Senator John McCain (R-AZ) was absent for much of 2018, the party’s majority was effectively 50-49 for a large part of that year. In the elections of November 2018, the Republicans expanded their edge in the Senate to 53-47 but lost control of the House to the Democrats.

Trump is back and with a clean sweep again. Both the House and Senate will have Republican majorities during the first two years of his second term. The Republicans could screw it up again, as they did in 2017 and 2018. This time, they might be able to maintain enough party discipline to pass most of Trump’s legislative agenda, which would constitute a radical change from the policies of the previous administration. This includes lowering the corporate tax rate and selected individual tax rates and spending more on national defense and border security. Congress will also have to sign off on some of Trump’s plans to reduce the size of and even eliminate some government bureaucracies. He might have more freedom to use executive orders on trade policies and deregulation.

Trump III: Tax Cuts, Tariffs & Deficits. The stock market’s initial reaction to the outcome of the November 5 elections was favorable (Fig. 2). That was partly because Trump’s win was uncontested; there had been widespread fears that the presidential outcome might be contested. So the uncertainty of the election has now been replaced by policy uncertainty under Trump 2.0.

Stock investors initially chose to accentuate the positives of tax cuts and deregulation. The Trump administration undoubtedly will prioritize tax cuts and deregulation (including firing lots of regulators and bureaucrats). On balance, these measures should be positive for earnings, the economy, and stock prices.

During Trump 1.0, the corporate statutory tax rate was cut from 35% to 21% (Fig. 3). This boosted the profit margin of the S&P 500 by about one percentage point to a new record high and lifted S&P operating earnings per share by about $5 in 2018 (Fig. 4 and Fig. 5). Trump 2.0 will probably include another cut to 15%, which could boost S&P 500 EPS by around $3.

On the negative side for stocks will be Trump’s trade policies, which will include increasing tariffs by 10% on all imports and 60% on imports from China. He has threatened to slap a 25% tariff on imports from Mexico if the country doesn’t help to stem the flow of migrants into the US. These tariffs might be inflationary, at least when they are first imposed. If they trigger trade wars, they could depress global economic growth and be deflationary. That would be bearish for stocks, of course.

Indeed, when we discuss our Roaring 2020s scenario, the pushback is that the Roaring 1920s ended badly because of trade wars unleashed by the Smoot-Hawley Tariff, which Congress passed during May 1930. Donald Trump has compared himself to President William McKinley (1897-1901), particularly in terms of tariff policies. Trump has praised McKinley for his use of tariffs to protect American industries and generate revenue, even referring to him as “the Tariff King.”

Trump is also planning on deporting illegal migrants. That could worsen the labor shortage in the US and drive inflation up. On the other hand, Trump’s newly appointed “border czar,” Tom Homan, has stated that the deportation plan will prioritize deporting criminals and national security threats first. Homan emphasized that the operation will target “the worst of the worst” to ensure a focused and effective approach.

Trump’s policies, including tax cuts and increased spending, are projected to add approximately $7.5 trillion to the national debt over the next decade. This increase stems from around $10.2 trillion in deficit-increasing measures and $3.7 trillion in deficit-reducing efforts, along with $1.0 trillion in interest costs. During his first term, Trump’s policies added about $8 trillion to the national debt, but that included pandemic relief measures. That’s all according to the bipartisan Committee for a Responsible Federal Government (CRFG).

The CRFG has estimated that President Trump’s proposed spending increases and cuts would roughly cancel each other out. However, renewing the Tax Cuts and Jobs Act (TCJA), which was enacted during his first term on December 22, 2017, would tip the scale: “Under Trump’s plan, revenue would fall to 16.1 percent of GDP in FY 2035 rather than rising to 18.0 percent. The combined budget impact of his proposal to extend and modify the TCJA, along with several large new tax cuts, would be significantly higher than the revenue generated from increased tariffs and reduced energy tax breaks.”
 
Trump IV: By the Numbers. Trump has said that his proposed new tax cuts will be paid for by increasing tariffs. He has implied that they wouldn’t boost inflation or the federal government deficit. He counters inflation concerns by saying he will increase US production and exports of oil and gas, which will lower energy prices worldwide and offset any inflationary consequences of higher tariffs. That’s plausible. On the geopolitical front, lower energy prices would also help to weaken Russia and Iran.

On the other hand, higher tariffs won’t be enough to make a significant dent in the federal government budget deficit if Trump renews the TJCA. The CRFG estimates that extending the TCJA provisions set to expire at the end of 2025 could significantly increase the federal debt. Estimates suggest that extending these provisions would add approximately $3.9 trillion to the deficit through 2035, or $4.5 trillion including interest. This would increase the national debt by about 11% of GDP by 2035.

Trump has created a Department of Government Efficiency (DOGE) headed by Elon Musk and Vivek Ramaswamy. The commission aims to streamline federal operations, cut wasteful expenditures, and eliminate bureaucratic inefficiencies. The work of DOGE is expected to conclude by July 4, 2026, coinciding with the 250th anniversary of the US Declaration of Independence. Musk has suggested that DOGE could potentially reduce the US federal budget by $2 trillion.

Nondiscretionary spending, also known as “mandatory spending,” includes programs that are required by law to be funded, such as Social Security, Medicare, and Medicaid. This category makes up a significant portion of the US federal budget: In the fiscal year ended September 2023, mandatory spending totaling approximately $3.8 trillion accounted for about 69% of total federal spending.

Discretionary spending, on the other hand, requires annual approval by Congress and includes funding for defense, education, and transportation, among other areas. In fiscal 2023, discretionary spending was about $1.7 trillion, making up the remaining 31% of the federal budget.

Here are some more numbers that put Trump’s plans into perspective:

(1) Inflation. On its website, the Bureau of Labor Statistics notes that it “does not include tariffs in estimates derived for the US Import and Export Price Indexes. However, tariffs may still have an impact on the index values as market participants change behavior on the basis of stockpiling, substitution, and pass-through effects. Data users can track the US Import and Export Price Indexes before, during, and after tariff announcements to gain insight on tariff-based price changes.”

There’s no sign that tariffs imposed under Trump 1.0 had any measurable impact on the core CPI (Fig. 6). That’s because imports of goods account for only about 12% of nominal GDP (Fig. 7). The planned 10% across-the-board tariff and a doubling of the effective tariff on Chinese imports to 60% probably won’t have any significant impact on measures of headline inflation if Trump succeeds in depressing oil prices by boosting US energy production.

(2) Tariffs & government revenues. Over the 12 months through October, the Treasury collected just $84 billion in customs duties from tariffs (Fig. 8). That was just 2% of US imports of goods and services. A 10% across-the-board tariff would raise $423 billion (Fig. 9). That could cover most of the loss of revenues from a cut in the corporate tax rate and perhaps also the elimination of taxes on tips and overtime pay. It’s doubtful that it would also replace the revenues lost by eliminating taxes on Social Security. Then again, a 20% tariff, which Trump mentioned a few times, would generate over $800 billion per year in revenues, assuming that it doesn’t start a trade war.

(3) Government spending. Over the past 12 months through October, federal government spending totaled $6.9 trillion (Fig. 10). Nondiscretionary spending on Social Security, Medicare, health, income security, and net interest together represented $4.9 trillion of that total, leaving exactly $2 trillion in discretionary spending, which includes $890 billion that is spent on defense.

In other words, Musk and Ramaswamy might find slim pickings when they look for areas of government spending to cut. They might find ways to generate more revenues by cutting so-called “tax expenditures.” These are special provisions of the tax code such as exclusions, deductions, deferrals, credits, and tax rates that benefit specific activities or groups of taxpayers. They cost the government well over $1.0 trillion in revenues.

(4) Deportations. During President Ronald Reagan's administration, deportations were relatively high, with 3.5 million in his first term and 4.4 million in his second. President George H.W. Bush saw a slight increase to 4.7 million. Under President Bill Clinton, deportations surged, reaching 5.4 million in the first term and peaking at 6.9 million in the second. The George W. Bush administration maintained high numbers, with 5.3 million in the first term and 4.8 million in the second. President Barack Obama’s first term saw 3.2 million deportations, decreasing to 2.9 million in his second term. Under Trump, the count was 2.1 million. Under Biden as of 2022, deportations numbered 2.8 million. (Source: Infographic based on US 2022 Yearbook of Immigration Statistics, Department of Homeland Security.)

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Consumers, China & COP29

November 14 (Thursday)

Consumer Discretionary: The Holidays Are Looking Jolly. Our Thanksgiving turkey hasn’t even been bought, and already the neighbors have their outdoor Christmas lights shining. They’re not alone in jumping the gun. Stores’ shelves have been piled high with holiday goods even before kids polished off their trick-or-treating candy.

That said, most of the ingredients are in place for consumers to drive relatively strong holiday spending. Wages are up, and gas prices are down. Interest rates are surprisingly high and may put a damper on large purchases that rely on debt financing, as they did in Home Depot’s Q3. But otherwise, sales of toys, sweaters, and the like should be solid.

The season is starting off on the right foot. October’s core retail sales, which exclude restaurants, car dealerships, and gas stations, rose 0.83% m/m and 4.6% y/y, according to a National Retail Federation (NRF) report. That’s an improvement over the 0.28% m/m decrease in September. The NRF’s survey is based on credit- and debit-card purchase data compiled by Affinity Solutions.

Bank of America Institute’s Holiday Survey suggests that consumers plan to spend $2,100 in addition to what they typically spend on obligations and necessities this holiday season, up 7% y/y. A National Retail Federation report projects holiday spending will climb between 2.5%-3.5% y/y. And the folks at Visa expect holiday sales to rise 4.0% y/y this season.

Here are some more details about consumers’ health this holiday season and a look at Home Depot’s earnings:

(1) Incomes are up. Consumers have a little more cash in their pockets this year with the unemployment rate remaining low at 4.1% and wages rising faster than inflation. YRI’s real Earned Income Proxy (EIP) rose 0.3% in September to $6.9 trillion (Fig. 1). (The EIP is calculated by multiplying nonfarm payrolls times average weekly hours times average hourly earnings in total private industries times 52.)

(2) Gas prices are down. The cost to fill up a car’s tank has fallen from elevated levels in 2022, freeing consumers to spend more on discretionary items. The retail price of a gallon of gasoline has headed south since spiking up to $4.98 in 2022. For the week ended November 11, the average retail price of gas nationwide was $3.18 a gallon (Fig. 2).

Consumers also appear to be benefiting from more fuel-efficient vehicles because the number of miles driven is at a record high while the amount of gasoline used remains well below peak levels (Fig. 3).

(3) High interest rates hurt. Home Depot’s earnings report presented a picture of relatively healthy consumers who are ready to spend when they don’t have to borrow to do so. Excluding the impact from hurricanes, Home Depot’s Q3 performance “exceeded” management’s expectations. “As weather normalized, we saw better engagement across seasonal goods in certain outdoor projects. But … we continue to see pressure on larger remodeling projects driven by the higher interest-rate environment and continued macroeconomic uncertainty,” said CEO Ted Decker in the company’s earnings conference call.

Q3 sales rose 6.6% y/y thanks to an acquisition and hurricane sales, while US same-store sales declined 1.2%. Power, outdoor garden, building materials, indoor garden, and paint departments posted positive same-store sales. Conversely, big-ticket same-store sales (i.e., purchases over $1,000) fell 6.8% y/y. “We continue to see softer engagement in larger discretionary projects where customers typically use financing to fund the project, such as kitchen and bath remodels,” explained Billy Bastek, Home Depot’s executive vice president merchandising, on the call.

The Federal Reserve’s two recent rate cuts totaling 0.75ppt have yet to result in lower mortgage rates. Instead, mortgage rates are up about 0.60ppt since the first cut in September, and housing turnover, at about 3%, is at a 40-year low. “[B]ut this is a market after all, and markets return to equilibrium and remodeling will as well. We just don’t think we’re quite there yet,” said Decker.  Remodeling will resume either because interest rates drop or because consumers get used to the current interest-rate environment and stop postponing projects.

China: Glimmers of Hope. The Chinese government has announced several financing programs to bolster the country’s ailing real estate market. While lower interest rates and smaller down payments can’t fix the country’s serious demographics problem, the government’s actions may be enough to put a floor under the housing market. Home sales appear to have stopped falling in some of the country’s largest markets, and that may beget improved consumer confidence and retail sales down the road.

Let’s take a deeper look:

(1) October sales improve. Some of China’s largest developers reported strong October sales, albeit off of depressed September sales. China Vanke reported a 23% m/m jump in October’s contracted sales to $3.0 billion; Longfor Group’s sales jumped 37% m/m; and China Jinmao saw a 66% m/m increase, a November 9 South China Morning Post (SCMP) article reported.

Keep in mind that one banner month can’t offset the sales declines that developers have experienced for much of the past four years. In fact, sales are still deeply negative ytd through October versus the same period last year, with Vanke’s down 35.2%, Longfor’s down 44.2%, and Jinmao’s down 38.5%.

The high-end property market in China’s major cities has been strong as well. It took only three hours for Sunac China Holdings to sell all of the units offered in its latest Shanghai luxury project. Sunac’s contracted sales jumped fourfold m/m in October. But even in the luxury markets, ytd sales through October are miserable compared with a year earlier—Sunac’s ytd sales fell 42.2% y/y.

(2) More help expected. China’s government has launched many different plans to get its economy chugging along again. The most recent program, announced last week, allows local governments to swap $1.4 trillion of special purpose debt for their off-the-books—or “hidden”—debt over the course of the next five years, a November 8 WSJ article reported. The new debt could carry lower interest rates and longer maturities than the debt being replaced, increasing local governments’ financial liquidity but not reducing their debt loads.

Like other programs, the debt swap program disappointed investors who were hoping for fiscal stimulus aimed directly at boosting consumer spending. The government announced in October plans to provide credit to renovate one million apartments in urban shantytowns. Another $550 billion in loans is being provided to complete unfinished apartments and ensure delivery of homes. An earlier program allowed local governments to buy up housing inventory.

The government also is allowing Chinese homeowners to refinance their mortgages and take advantage of lower interest rates. Since the beginning of 2022, China’s central bank has cut the rate off of which mortgages are priced—its five-year loan prime rate—by 0.8ppt. Regulators also cut the minimum down payment on a second home to 15% from 25%.

The Chinese government plans to boost fiscal stimulus again next year and unveil tax policies that support “healthy development” of the real estate market, a November 8 SCMP article stated. But investors’ hopes for the fiscal support believed necessary remain higher than what the government has been willing to provide so far.

(3) Mixed results. Chinese stocks took off in anticipation of government stimulus, but they have given back a portion of those gains because the latest government support again failed to target consumer demand.

The Shanghai Shenzhen CSI 300 stock price index soared 34.7% from its five-year low on September 13 to an 80-month high on October 8, before retracing some of that advance and closing at 4110.89 as of Tuesday’s close (Fig. 4). The Shenzhen Real Estate Stock price index followed a similar path, and both indexes remain far off their record highs.

On a positive note, the manufacturing component of China’s official purchasing managers index edged up to 50.1 in October, marking the first time in six months that it entered expansion territory (Fig. 5). Conversely, in an ominous sign, China’s M1 fell 6.1% last month and imports declined by 3.7% (Fig. 6 and Fig. 7). While consumer prices edged higher in October, by 0.3% y/y, producer prices remained negative, falling 2.9% y/y (Fig. 8).

China needs its exports to continue to find homes in the world’s markets (Fig. 9). Regarding US markets, that prospect is dimmed by incoming President Trump’s threats to impose 60% tariffs on imports of Chinese goods. The yuan has continued to fall against the dollar, and China’s 10-year government bond yield remains near record lows at 2.1% (Fig. 10 and Fig. 11). Investors may have to wait until the government’s next major meeting in March before learning whether greater fiscal support is in the offing.

Disruptive Technologies: More on Climate Tech. The United Nations’ annual conference on climate change, COP29, opened on Monday in Azerbaijan, a country where, ironically, half of all exports are oil and gas.

The conference is having a rocky start. The presidents of the US and China are skipping the event. So is European Commission President Ursula von der Leyen. French President Emmanuel Macron, who has been critical of Azerbaijan’s military offensive against Armenian separatists, is opting out. And German Chancellor Olaf Scholz is staying home to deal with the collapse of his ruling coalition government.

That said, more than 50,000 government delegates, lobbyists, academics, and media representatives are flying in to attend—yet another irony.

Despite rising temperatures and the alarming lack of rain in the northeastern US this fall, financing for climate technology has declined as investors opt instead to fund the latest, shiny new thing: artificial intelligence technology. Globally, new funding for climate technology fell 51.5% during the first three quarters of 2024 compared to the same period last year, according to a Bloomberg report. Conversely, capital for AI has climbed 49.4% over the same period.

Nonetheless, here are some interesting new technologies being developed to help the environment:

(1) Scrubbing the air. Norwegian company SINTEF (a.k.a. Stiftelsen for industriell og teknisk forskning) has developed a continuous swing adsorption reactor (CSAR), which “uses a heat pump and a vacuum pump to efficiently capture CO2,” a November 12 article in Popular Mechanics reported. It uses electricity to operate its pumps, making it easier to install in existing plants compared to other CO2 capture systems that require heat to be generated.

The system was successfully tested in a Norwegian plant that burns household waste to generate electricity. The CSAR captured roughly 100 kilograms of CO2 per day and will next be permanently installed at a Spanish cement factory.

(2) Greener fertilizer. RTI International is developing green ammonia technology “produced using renewable energy to split water into hydrogen and oxygen. The hydrogen then combines with nitrogen from the air to create ammonia,” a November 11 WRAL article reported. This process throws off far less emissions than traditional methods, which use fossil fuels to produce ammonia. Green ammonia could be used as fuel to propel ships, power machinery, or produce electricity or it could be turned into fertilizer.

(3) Flying cleaner. LanzaJet is turning corn, sugar cane, and other inputs into alcohol and then turning the alcohol into jet fuel, explains an October 1 MIT Technology Review article. The company opened its first commercial jet fuel factory in Georgia in January and has buyers lined up for all the fuel produced in that factory through 2034, including British Airways, one of its investors.

Burning LanzaJet’s fuel will still produce CO2 and other greenhouse gasses when burned, but some of that is offset when the corn or sugarcane is grown. The company estimates its fuels could cut the climate impact from burning traditional fuel in half. LanzaJet still needs to prove it can scale its operations and bring down the cost of its fuel. In general, alternative jet fuels cost 2.8 times more than traditional jet fuel.

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Trump Tariffs 1.0 & 2.0

November 13 (Wednesday)

US Trade I: Tariffs, Solution or Risky Gambit? Tariffs are meant to raise revenue and protect the competitiveness of domestic industries. In President Trump’s ideal scenario, tariffs offset lower tax revenues and prevent the federal deficit from widening, while also providing him with leverage to negotiate more favorable bilateral deals. Tariffs can backfire as a means to these ends, however, as retaliation from trading partners can decrease total imports and exports, dragging on government revenues and hurting domestic exporters.

One of the major risks to our Roaring 2020s outlook is a trade war that reduces global economic growth. That’s not a likely scenario, but it could have large impacts. The Smoot-Hawley Tariff of 1930 led to the Great Depression and plunged the stock market into the Great Crash. (see Chapter 2 of Predicting the Markets).

In short, what Trump’s final trade policies will look like is uncertain at this point, but it’s never too early to consider the potential impacts:

(1) Revenues. Tariffs raised $84 billion in customs duties over the 12 months ended September (Fig. 1). That represents 1.6% of total federal receipts (Fig. 2). That’s a fraction of what taxes on individual income ($4.9 trillion, 49% of total), payrolls ($1.7 trillion, 34%) and corporations ($530 billion, 11%) bring in.

(2) Proposed tariffs. The proposed 60% tariffs on all Chinese imports and 20% on the rest of the world are likely intended to be used as bargaining chips rather than revenue raisers. The leverage may be used, for example, to prevent Chinese goods from circumventing tariffs through other nations.

The tariff rate on Chinese imports (and China’s rate on US exports) was roughly 20% last year, per the Peterson Institute for International Economics, before President Biden raised tariffs again in September (more on that below). So assuming the rate is now 30%, Trump’s most hawkish proposal only doubles the status quo. Here’s some back-of-the-envelope math: Imports from China were only $438 billion over the 12 months ended September. Adding back the $100 billion or so that comes through other countries’ borders, and assuming no loss in trade volumes, a 60% tariff would raise $323 billion. That’s just 6.6% of total federal receipts.

A blended 60% tariff rate on China and 20% tariff on the rest of the world comes out to a roughly 26% tariff rate. That would bring in around $1.1 trillion of revenue, based on current import volumes (Fig. 3). That would offset lowering the corporate tax rate from 21% to 15%. But for context, it would just about equal the government’s net interest expense, leaving the primary budget deficit unaffected (Fig. 4).

(3) Economic impacts. We’re less worried about the inflationary impact of tariffs than about the deflationary impact that would result from a slowdown in global growth. The global economy slowed before the pandemic as Trump’s first trade war kicked off in 2018. That’s when our Global Growth Barometer, which is based on an index of raw industrials prices and the price of oil, peaked and started to fall (Fig. 5). Global industrial production growth also had turned negative before the pandemic hit (Fig. 6).

We’re hoping that tariffs will be used as a tool to negotiate better deals, and to protect key industries with national security and economic importance like semiconductors. We think it’s unlikely that tariffs can raise a meaningful amount of revenues that somehow shrink the deficit—that would have to come from spending cuts.

Our biggest fear is that a trade war slows the global economy. We still don’t think that’s likely, however. That prospect is included in a scenario to which we ascribe only a 20% subjective probability, a geopolitical and/or domestic debt crisis. Additionally, we see 55% odds of our Roaring 2020s scenario and 25% of a 1990s-style meltup of the stock market.

US Trade II: Tracking Tariffs. The Tax Foundation’s June 2024 Tariff Tracker reviews the tariffs imposed by the Trump 1.0 and Biden administrations, illustrating their profound global impacts on output for a wide range of manufacturing industries as well as prices paid by US households for consumer goods.

The Trump administration initiated tariffs on goods such as steel, aluminum, washing machines, solar panels, and various Chinese imports. Most of these remained in force under Biden, with adjustments that lowered impacts on imports from Europe and raised them on those from China.

Since the tariffs were imposed in March 2018, imports of affected goods have declined, most steeply from China. But reduced imports from China were largely offset by increased trade with other nations. (See Tax Foundation chart titled “Imports Subject to Section 301 Tariffs Remain below Pre-Trade War Levels”).

Let’s take a walk down tariff memory lane and evaluate the contribution of different types of tariffs to the roughly $79 billion in total tariffs imposed under these trade policies (based on trade values when implemented and excluding retaliatory tariffs):

(1) Section 301 under Trump: Chinese imports ($77 billion). Section 301 tariffs on Chinese imports account for $77 billion of the US’s $79 billion tariff total, with China’s retaliatory measures impacting over $106 billion of American exports.

In March 2018, Trump imposed tariffs on up to $60 billion in Chinese goods, starting with $50 billion at 25%, adding a 10% tariff on $200 billion more in September, and later raising that to 25%. A 15% tariff on $112 billion followed in September 2019 and was reduced to 7.5% in December 2019. Further tariffs were paused under a “Phase One” deal.

(2) Section 301 under Biden ($3.6 billion incremental). In May 2024, Biden completed a mandatory review of the Section 301 tariffs and not only retained them but also imposed new rates of 25%-100% on $18 billion of imports for an additional tax increase of $3.6 billion (see White House Fact Sheet).

The following is an abbreviated list of the increases in Section 301 tariff rates imposed under Biden. These increases apply to a small share of the total $70 billion-plus collected in tariffs under Section 301 and are not a comprehensive list of all products subject to it. But the list helps to give a sense of where the Section 301 rates stand and what industries Biden targeted.

Current Section 301 tariffs applied to Chinese steel and aluminum products were raised from the current average of 7.5% to an average of 22.5%. (Imports of Chinese steel and aluminum are also subject to the Section 232 tariffs discussed below.)

Additionally, the tariff rate on semiconductors increases from 25% to 50% by 2025; electric vehicles from 25% to 100% in 2024; lithium-ion EV batteries from 7.5% to 25% in 2024; lithium-ion non-EV batteries from 7.5% to 25% in 2026; battery parts from 7.5% to 25% in 2024; natural graphite and permanent magnets from 0% to 25% in 2026; certain other critical minerals from 0% to 25% in 2024; solar cells from 25% to 50% in 2024; ship-to-shore cranes from 0% to 25% in 2024; syringes and needles from 0% to 50% in 2024; certain personal protective equipment from 0%-7.5% to 25% in 2024; and rubber medical and surgical gloves from 7.5% to 25% in 2026.

Tariff increases in 2024 took effect in September (with exclusions for solar equipment retroactive to January 1). The United States Trade Representative provided for a comment period, which resulted in a few modifications to the above outlined here.

(3) Section 232: Steel and aluminum ($2.7 billion). Tariffs on steel, aluminum, and derivative goods now contribute $2.7 billion in tariffs annually, while retaliatory measures from affected countries target over $6 billion in US exports.

In March 2018, President Trump imposed global tariffs of 25% on steel and 10% on aluminum. In 2020, he expanded them to cover derivatives of these metals.

Several countries secured exclusions or quotas: Australia, Brazil, South Korea, and Argentina obtained exemptions, while tariffs were lifted for Canada and Mexico by May 2019. In 2021-22, the Biden administration transitioned to tariff-rate quotas for the EU, Japan, and the UK, allowing limited imports at zero tariffs but maintaining rates on excess quantities.

(4) WTO dispute with the EU. Under Trump, after a nearly 15-year dispute, the World Trade Organization (WTO) authorized the US to impose up to 100% tariffs on $7.5 billion of EU goods. Starting in October 2019, the US set a 10% tariff on aircraft and 25% on agricultural and other products from the EU. In 2021, however, the Biden administration struck a five-year suspension agreement on these tariffs.

(5) Section 201: Solar panels and washing machines. In January 2018, Trump imposed tariffs on washing machines for three years and on solar panels for four. The Tax Foundation excludes these from its tariff totals given the broad exemptions and small magnitudes.

Washing machine tariffs, extended through early 2023, have expired. Biden extended the solar panel tariffs through 2026, with temporary exemptions for imports from four Southeast Asian nations. In 2024, Biden removed exemptions for bifacial solar panels and ended temporary Southeast Asian exemptions.

Technical note: A 2019 Congressional Research Service FAQ noted that Congress has sole authority over regulating foreign commerce and previously has authorized the president to adjust tariffs through trade laws, including Section 232 (if quantities of imports or circumstances pose a threat to US national security) and Section 301 (if a trading partner is violating trade policies or engaging in unreasonable practices, e.g., China).
 
US Trade III: Trump 2.0 on Mexico. “Donald Trump is poised to smash Mexico with tariffs,” was the title of a November 7 article in The Economist. Although Trump’s Mexican tariff threats are easy to dismiss as bluster, the implications for Mexico are real. Even partial implementation of his policies could have lasting effects on trade and migration across North America.

Here’s more:

(1) Trump’s Mexican agenda. If Mexico does not curb illegal migration into the US, Trump 2.0 has said that he will immediately impose a 25% tariff on all Mexican imports. At a rally on November 4, Trump said that his first phone call as president would be to Mexican President Claudia Sheinbaum: “I will impose tariffs if [Mexico doesn’t] stop this onslaught of criminals and drugs coming into our country.”

(2) Mexican fallout. Mexico heavily benefits from trade with the US, which accounts for 83% of its exports—roughly a third of its GDP. A 25% tariff on its goods would hit hard, raising prices in the US and risking a recession in Mexico. During Trump’s first term, Mexico thrived under tariffs imposed on China, attracting American companies looking for alternatives. However, now those same companies are pausing their investments in Mexico, fearing the potential consequences of further US protectionism.

(3) USMCA concerns. Even if Mexico avoids the blanket tariffs, the US-Mexico-Canada Agreement (USMCA)—a deal Trump himself negotiated—could be in jeopardy. Trump has hinted that as president he would revisit the agreement in 2026, particularly due to frustration over Chinese “backdooring” in Mexico. Recent changes to Mexico’s judicial system could also breach the USMCA, putting it at risk.

(4) Migrant demands. Trump demands that Mexico accept “safe third country” status for migrants, a stance Mexico has firmly rejected. This, along with the potential for US action against Mexican gangs involved in drug trafficking, could force Mexico into a corner.

Strategy: Record-High S&P 500 Quarterly EPS in Q3. With 92% of the S&P 500 companies having reported September-quarter results through midday Tuesday, the S&P 500’s “blended” quarterly EPS, which is composed of a mix of actuals for companies that have reported and estimates for those that haven’t, is $62.61. That’s a record high, and for a second straight quarter (see our web pub “S&P 500 Quarterly Metrics”). The 8.1% surprise from the consensus Q3 mean at the time of each company’s report is an acceleration from Q2’s 4.7% beat (Fig. 7). Q3’s blended actual EPS is also up from a consensus forecast of $60.96 at the start of the month before reporting season began (Fig. 8).

With 8% of the companies left to report, the S&P 500’s blended y/y earnings growth rate for Q3 is 7.2%. Q3 marks the fifth straight quarter of positive earnings growth for the S&P 500, though it’s down from Q2’s rate, when growth peaked at 10-quarter high of 11.3% y/y. On a proforma same-company basis, S&P 500 earnings rose 8.6% y/y in Q3, which is also a deceleration from 13.2% in Q2.

Joe also puts the S&P 500’s 11 sectors under his analytical lens. Below are his remarks on the sectors’ Q3 results just reported and current EPS growth expectations for Q4 up ahead:

(1) Q3 sector EPS growth. While the S&P 500’s earnings growth rate has slowed sequentially q/q in Q3, many sectors continued to deliver rising earnings. While Information Technology fell a hair short of its Q4-2023 record-high EPS, these four sectors hit that mark in Q3-2024: Communication Services, Consumer Discretionary, Consumer Staples, and Utilities.

Eight sectors recorded positive y/y earnings growth in Q3, down from nine sectors in Q2. Among the laggards, Boeing’s strike vectored the Industrials sector toward its first y/y earnings decline since Q4-2020; Energy’s earnings fell at a double-digit percentage rate for the fourth time in five quarters; and Materials’ posted its ninth straight quarter of declining earnings.

Here’s how the sectors have stacked up so far on a proforma basis: Communication Services (25.5%), Information Technology (17.0), Utilities (15.6), Health Care (14.6), S&P 500 ex-Energy (11.3), Consumer Discretionary (10.9), S&P 500 (8.6), Financials (8.5), Consumer Staples (3.7), Real Estate (1.3), Industrials (-5.7), Materials (-7.2), and Energy (-25.9).

(2) Q4 EPS growth expectations remain strong. There has been increasing chatter about Q4-2024 EPS expectations declining at a faster rate than in recent quarters, but consensus y/y growth expectations are holding up well. Since 1993, the S&P 500’s Q4 EPS has exceeded Q3’s two-thirds of the time, but we believe it will miss slightly in Q4 even as Boeing’s employees return to work (Fig. 9).

On a positive note, seven of the S&P 500 sectors are expected to record double-digit y/y percentage earnings growth in Q4. That’s up from five doing so from Q1- to Q3-2024 and is the highest since Q4-2021, when eight sectors easily did so due to the pandemic-depressed year-earlier earnings in Q4-2020.

Here’s how the sectors’ consensus quarterly proforma earnings growth rate forecasts look now for Q4-2024: Communication Services (22.1%), Financials (17.3), Information Technology (14.6), Health Care (14.5), S&P 500 ex-Energy (12.6), Consumer Discretionary (12.3), Utilities (11.3), Real Estate (10.4), S&P 500 (10.0), Materials (3.2), Consumer Staples (-0.1), Industrials (-1.9), and Energy (-24.8).

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A New Day In America

November 12 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Strategy I: Roaring Ahead. In Sunday’s QuickTakes, Eric, Joe, and I raised our outlook for S&P 500 earnings as well as our price targets for the index. We did so because we believe that Trump 2.0 represents a major regime change from Biden 1.0 (or was that Obama 3.0?). The corporate tax rate will be lowered from 21% to 15%. Personal income from tips, overtime, and Social Security might not be taxed. Many onerous regulations on business will be eliminated. This was already set to happen when the Supreme Court ruled earlier this year that business could challenge regulatory overreach in court.

In addition, today’s major geopolitical crises might be settled sooner rather than later. That certainly is reflected in the weakness in the price of gold as well as the price of oil in recent days (Fig. 1 and Fig. 2).

We expect that better economic growth will boost federal government revenues and that Elon Musk will succeed in slowing the growth in federal government spending. GDP growth might actually keep pace with mounting government debt.

The Fed’s cut in the federal funds rate (FFR) by 25bps on November 7 together with the 50bps cut on September 18 suggest to us that Fed officials are oddly oblivious to the strength of the economy, the backup in bond yields, and the outlook for more fiscal stimulus. If Fed officials continue to cut the FFR, they risk a rebound in price inflation rates and a meltup in the stock market.

We concluded the QuickTakes note with: “So, we are changing the subjective probabilities of our three scenarios as follows: Roaring 2020s (55%, up from 50%), 1990s-style meltup (25%, up from 20%), and 1970s-style geopolitical and/or domestic debt crisis (20%, down from 30%).”

Strategy II: Roaring Earnings. We’ve updated our YRI Earnings Outlook, which is posted on our website, to reflect our increasing confidence that our Roaring 2020s scenario remains on track and might be on a faster track:

(1) Revenues. Revenues per share for the S&P 500 companies in aggregate should total $1,950 this year, we estimate, up 4.2% from last year’s level. We are expecting increases of 5.1% next year and 4.9% in 2026 (Fig. 3). That’s a fairly conventional outlook as long as the global economy continues to grow, with strength in the US offsetting weakness elsewhere in the world, especially China and Europe.

(2) Earnings. We are lowering our S&P 500 earnings per share (EPS) forecast for this year from $250 to $240 mostly because of strikes and hurricanes. That’s still up 8.4% y/y. On the other hand, we expect that Trump 2.0 will boost earnings over the next two years. So we are raising our 2025 EPS projection from $275 to $285 (up 18.8%) and our 2026 EPS estimate from $300 to $320 (up 12.3%) (Fig. 4).

We expect that the percent of S&P 500 companies with positive 12-month percent changes in forward earnings will increase sharply from the current 77.1% reading as analysts adjust their spreadsheets for Trump 2.0’s corporate tax cut (Fig. 5). Since the start of 2023, almost all of the increase in S&P 500 aggregate forward earnings has been attributable to rising estimates for the Magnificent-7’s earnings (Fig. 6). We expect to see a broadening of the companies and industries for which analysts raise their sights in 2025. (FYI: Forward earnings is the time-weighted average of analysts’ consensus estimates for the current year and the following one; ditto forward revenues. Forward profit margins we derive from forward earnings and revenues.)

(3) Profit margin. We’ve lowered our S&P 500 forward profit margin projection in 2024 to 12.3% along with our earnings estimate as mentioned above (Fig. 7). However, we are now more confident that the profit margin will rise to new record highs of 13.9% in 2025 and 14.9% in 2026. Tax cuts, deregulation, and faster productivity growth should make that happen.

(4) Valuation & stock price targets. We are raising our projected S&P 500 forward P/E range through the end of 2026 to 18-22 from 16-21 (Fig. 8). The October 28 Morning Briefing was titled “Valuation In A Resilient Economy.” We argued that stock valuation multiples are driven by investors’ expectations for the longevity of economic expansions. As they became less fearful of a Fed-led recession during the past three years, multiples rose. Multiples may stay elevated if investors conclude that a recession is less likely over the rest of the decade now that monetary policy is easing while fiscal policy remains stimulative.

Multiplying our forward EPS estimates by our projected forward P/E ratios yields the following bullish year-end projections for the S&P 500 stock price index: 6100 in 2024, 7000 in 2025, and 8000 in 2026 (Fig. 9).

(5) S&P 500 at 10,000 by 2029? We had been projecting 8000 for the S&P 500 by the end of the decade. Under the circumstances, we expect that Trump 2.0 has the potential to drive the index up to 10,000 by then (Fig. 10).
 
US Economy: Productivity Growth on Boom Track. Q3’s preliminary productivity stats were all consistent with our Roaring 2020s scenario. We expect productivity growth to be even better under Trump 2.0 thanks to deregulation, tax cuts, and the continued shortage of skilled workers.

One quirk in the Q3 productivity data: They were accompanied by revisions to previous quarters and years, based on the 2024 update to the National Income and Product Accounts (NIPA) from the Bureau of Economic Analysis. Productivity growth was revised lower and unit labor costs (ULC) increased in both Q1 and Q2. However, both measures were revised for the years 2021-23 to show higher productivity growth and lower ULC.

Like a lot of economic data since the pandemic, productivity and ULC have been subject to sharp revisions. But nothing has changed in the sense that improving productivity growth should continue to support economic growth, wider corporate profit margins, better real wage growth, and lower labor costs. Here’s more:

(1) Productivity. The general trend of productivity growth, based on the 20-quarter percent change, continues to be higher (Fig. 11).

Productivity growth increased from 2.1% (saar) in Q2 to 2.2% in Q3, thanks to higher output growth (3.5% vs 3.0%) and in spite of a larger increase in hours worked (1.2% vs 0.9%) (Fig. 12). However, Q2 productivity growth was revised down from 2.5% to 2.1%, as output growth was taken down from 3.5% to 3.0% and the increase in hours worked declined from 1.0% to just 0.9%.

Meanwhile, the annual averages for previous years’ productivity growth were revised higher: 2023’s was raised from 1.4% y/y to 1.6%, 2022’s was upped from -1.9% to -1.5%, and 2021’s was increased from 1.7% to 2.0%.

On a y/y basis, Q3’s productivity growth (2.0%) and output (2.8%) are below their averages of 2.1% and 3.4% since the late 1940s (Fig. 13). We expect both to increase toward, if not surpass, their long-term averages in the coming quarters. Based on analysts’ very elevated long-term growth expectations for stock market earnings, that’s not only plausible but highly likely (Fig. 14).

(2) Unit labor costs. Upward revisions to hourly compensation raised ULC from historical lows. ULC increased 1.9% (saar) and 3.4% y/y in Q3 (Fig. 15). Still, those are levels generally consistent with 2.0% inflation (Fig. 16).

ULC was revised lower for the last three years but higher for 2024. Hourly compensation was revised from 3.0% to 4.6% (saar) for Q2 and came in at 4.2% for Q3. The ULC revisions don’t alter our outlook. While it is true that better productivity growth directly lowers ULC, productivity growth is also highly correlated with real hourly compensation (Fig. 17). The wage growth of more productive workers tends to beat increases in consumer prices. So real hourly compensation is catching up to productivity growth, which makes sense and should continue to support strong consumer spending in our Roaring 2020s scenario.

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The Fed: Neutral Or Bust?

November 11 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

US Economy I: Looking For R-Star. Federal Reserve Chair Jerome Powell mentioned the word “neutral” 9 times at his Thursday press conference. He also mentioned the words “strong” or stronger” to describe the economy 20 times. There is a glaring contradiction in Powell’s unsubstantiated claim that the federal funds rate (FFR) remains restrictive and needs to be lowered to its neutral rate and his assessment that the economy is strong.

With upward revisions to economic data and strong growth since the Fed cut the FFR by 50bps on September 18, Powell used his version of the neutral FFR story as justification for Thursday’s 25bps cut. The neutral FFR is also sometimes referred to as “r*,” or “R-Star.” It’s the FFR that would coincide with full employment and stable inflation at the Fed’s 2.0% target over the long run.

The problem with using r* as the North Star for monetary policy is that it is unmeasurable and not constant. It’s like an electron according to the Heisenberg Uncertainty Principle in physics: As soon as you think you’ve pinpointed where it is, it’s moved. The neutral rate might be useful only as a theoretical concept for discussing how the economy changes over time, rather than as a guide for setting short-term interest rates. In any case, Chair Powell and his colleagues on the Federal Open Market Committee (FOMC) believe that monetary policy remains restrictive since the FFR theoretically is still above this known unknown mystical level.

Here are some points Powell made that shine light on how the FOMC is thinking about the neutral rate and path of monetary policy:

(1) “The precise timing of these things [interest rate cuts] is not as important as the overall arc of them, and the arc of them is to move from where we are now to the sense of neutral, a more neutral policy. We don’t know exactly where that is, we only know it by its works. We’re pretty sure it’s below where we are now.”

Essentially, Powell told the financial markets not to focus as much on the meeting-by-meeting decision as on where interest rates are headed over the long run. Unfortunately, there’s no way to gauge where the FFR will ultimately end up after this round of cutting is done. Market expectations have been all over the place (Fig. 1). After Powell’s dovish speech at Jackson Hole, the futures market thought the FFR would eventually be cut to around 3.0%. By the Fed’s September rate cut, the markets expected the FFR to be cut below 2.8%. As of Friday, 3.7% appears to be the finishing point.

Meanwhile, the FOMC’s September 18 Summary of Economic Projections shows the 19 FOMC meeting participants’ estimates range from 2.37% to 3.75% (Fig. 2). Collectively, their median estimate is to lower the FFR to 2.9% over the next couple of years. So they all agree it is lower, but they disagree on how much lower. In our opinion, the “strong” performance of the economy combined with full employment and near-target inflation strongly suggest that the FFR was at its neutral level before the September 18 rate cut.

It’s unfortunate that no reporters asked Powell how the FOMC knows that monetary policy is restrictive if the economy is doing so well.

(2) For a Fed chief promising to deliver more rate cuts, Powell seemed remarkably optimistic on the economy: “This is a strong economy. It’s actually remarkable how well the U.S. economy has been performing with … strong growth, a strong labor market, inflation coming down. We’re … really performing better than any of our global peers.”

With the FOMC so data dependent, it would be nice to know the metrics Fed officials are using to determine whether the economy is slowing or heating up. Cutting rates more than necessary could certainly heat up a hot economy and fuel a stock market meltup; Powell didn’t address any of that. There are certainly pockets of weakness in the economy, particularly in residential and commercial real estate and in some manufacturing industries. But because the Fed has achieved its dual mandate of moderating inflation and full employment with the FFR quite high, the economy is likely closer to neutral than the Fed thinks. The economy’s diminished sensitivity to interest rates, strong productivity growth, and the persistent federal budget deficit all support this notion.

If we were running the Fed, we certainly wouldn’t use r* as reasoning for any actions. Nevertheless, it’s one blunt tool the Fed has at its disposal to justify further FFR cuts.

US Economy II: Our Questions for Powell. Aside from the r* question, there are a few other questions we would’ve asked Powell on Thursday:

(1) What level of bond yields would worry you? Powell dismissed the recent runup in bond yields. In the past, FOMC officials have noted that rising long-term yields can do the Fed’s work for them by tightening financial conditions. The 10-year Treasury yield has increased from around 3.6% to 4.3% since the Fed’s September meeting, a noticeable difference (Fig. 3). Here’s what Powell had to say:

“It appears that the moves are not principally about higher inflation expectations, they’re really about a sense of more likely to have stronger growth and perhaps less in the way of downside risks.”

Powell also mentioned last year’s mini debt crisis as reason to not panic:

“If you remember, the 5% 10-year, people were drawing massively important conclusions only to find ... three weeks later that the 10-year was 50 basis points lower. So  ... it’s material changes and financial conditions that last, that are persistent, that really matter. And we don’t know that about these... right now it’s not a major factor in how we’re thinking about things.”

Powell’s reluctance to worry much about long-term yields has some precedent. The 10-year yield followed a similar path after the first rate cut in 1995, an easing cycle that similarly was aimed at achieving a soft landing rather than responding to a recession (Fig. 4). That rise in yields proved transitory as the Greenspan-led Fed cut the FFR by 75bps over six months, and economic growth continued without reviving inflation.

Nevertheless, Powell might be too dismissive of the increase in bond yields at the same time as the Fed started a new monetary easing cycle by lowering the FFR. Might it be that the Bond Vigilantes perceive that the Fed is enabling a continuation of excessively stimulative fiscal policy? He blew that concern off by mentioning the word “model” four times—as in: “We don’t know what fiscal policy will be until we know it; only then can we model it.” In his own words:

“Let’s say Congress is considering a rewrite of the tax laws, doesn’t matter what’s in the content. So, we would follow that. At a certain point, we’d think we see the outline, so we’d start to model it. And then we’d wait, and we’d wait, and then at a certain point the staff would brief the FOMC and say …‘[T]hese are the likely effects.’”

(2) At what level are inflation expectations “unanchored”? When a reporter from The Economist followed up to ask specifically about the increase in breakeven inflation—the difference between yields on nominal and inflation-protected TIPS—Powell said it was mostly consistent with the Fed’s target:

“So we would be concerned if we … thought we saw longer-term inflation expectations anchoring at a higher level. That’s not what we’re seeing. … I looked at the … 5-year earlier today, and it’s … consistent with two percent PCE inflation ... [W]e will not allow inflation expectations to drift upward. But that’s really why we reacted so sharply back in 2022 … to avoid that.”

Breakeven inflation has increased (Fig. 5). The contract that Powell mentions, which is tied to the five-year average inflation rate for the period five to ten years in the future, has increased to 2.58%. The ten-year breakeven inflation rate is up to 2.33%. Both are historically normal but are certainly higher than they were when the Fed cut rates in September, i.e., at 2.3.4% and 2.10%, respectively. The problem with allowing inflation expectations to rise rapidly is that if they become unanchored and get too high, they can be incredibly difficult to rein in and can lead to actual inflation. Powell knows that but was remarkably unconcerned at his presser last Thursday.

(3) What’s the best way to measure inflation? The Fed’s preferred measure of inflation is the annual percentage change in the core PCED, which was 2.7% in September. However, the Fed has often used alternative measures to “better” describe current inflation. In November 2022, this was the supercore (core services excluding housing) inflation rate (Fig. 6). Today, it appears to be the three- or six-month change in the core PCED rate (Fig. 7).

“If you look at 3- and 6-month core PCE, you’ll see they’re around 2.3% ... we really have made significant progress. And we expect there to be bumps. For example, … the last three months of last year their core PCE readings were very, very low, probably unsustainably low. So that’s why … forecasts generally see a couple of upticks toward the end of the year. On the other hand, the January reading certainly looks like an example of residual seasonality, as we saw last year. So, when that falls out of the 12-month calculation in February, we should see it staying down.”

We agree that inflation is heading in the right direction. The issue with measuring inflation in this way is that it dismisses annual price resets, which tend to occur in January. But consumers and businesses certainly notice these price changes! Looking through various price increases adds up over time, creating the cumulative inflation that consumers and small business continue to cite as their most pressing issue.

Powell also mentioned that supercore inflation, which was 3.2% y/y in September, is “back to the levels they were at the last time we had sustained 2.0% inflation, which happens to be in the early 2000s for a period of 5, 6, 7 years.”

Goods and energy prices have benefited from China’s export glut and weak domestic demand (Fig. 8). But based on the latest spending data, consumer demand for goods is rebounding in the US (Fig. 9). China is also stimulating its economy through various measures, including a $1.4 trillion refinancing package for local governments announced on Friday. So there’s potential for goods prices to rise. On the other hand, US net energy exports should continue to rise under the new Trump administration, weighing on oil prices (Fig. 10 and Fig. 11).

(4) What determines the strength of the labor market? Powell several times said the labor market was strong. But he also said that the labor market is not a source of inflationary pressures because “a broad set of indicators suggests that conditions in the labor market are now less tight than just before the pandemic in 2019.”

Powell mentioned a few key metrics. He described the unemployment rate as “notably higher than it was a year ago, but [it] has edged down over the past three months and remains low at 4.1% in October.” Nominal wage growth “has eased over the past year,” and the jobs-to-workers gap “has narrowed.”

In our opinion, the labor market is stronger than it was before the pandemic. The cooldown from record tightness can make it seem weaker than it actually is, which caused many economists wrongly to project a hard landing or outright recession after the Fed began raising rates. But there are more job openings per unemployed worker now, after a record number of openings were filled (Fig. 12). Labor supply still hasn’t fully met labor demand (Fig. 13). Layoffs remain historically low (Fig. 14). Business applications are also settling at a much higher level than pre-pandemic, suggesting job openings will remain elevated (Fig. 15).

(5) Do any FOMC officials favor a pause after this meeting? We suspect this question will be answered in FOMC officials’ speeches in the coming days. We were surprised that the vote to cut the FFR was unanimous after Governor Michelle Bowman dissented in the September 18 FOMC meeting.

(6) What paths of policy are the FOMC considering? Powell said the Fed will determine the pace of easing based on how the economy progresses. In his words, “[W]e’re trying to steer between the risk of moving too quickly and perhaps undermining our progress on inflation or moving too slowly and allowing the labor market to weaken too much. We’re trying to be on a middle path …”

The only certainty is that the Fed is cutting the FFR. How quickly and to what point are open questions. We would suggest a pause in December to assess the economy. This would also provide time for gauging the markets’ reactions to the range of potential new policies under President Trump’s administration. Should the Fed decide to continue cutting the FFR despite a strong economy that’s about to be boosted by deregulation and tax cuts, the possibility of a stock market meltup would increase. In fact, one might already be underway.

Movie. “Disclaimer” (+ +) (link) is a psychological thriller. The TV series is about a famed documentary journalist, Catherine Ravenscroft, played by Cate Blanchett, who is shocked by the lurid details revealed in a book based on a series of events that to took place while she was on vacation with her husband and young son in Italy several years previously. Her husband had to return to London for his job and left the two of them at the Italian beach resort. A young man drowned saving Catherine’s son from a similar fate when she fell asleep on shore. The parents of the young man are heartbroken and seek revenge for the loss of their son. The voice-over is annoying, but the twists and turns are worth the ride.

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AI, Cardboard & More AI

November 7 (Thursday)

Information Technology: AI Adopters & Developers. What intrigues investors about many of the MegaCap-8 stocks (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla) is the double exposure they have to artificial intelligence (AI). Not only do they sell products optimized by AI, boosting their revenues, but they’re deploying AI throughout their operations, gaining efficiencies that expand their profit margins and lift their earnings. AI allows them both to offer superior products and become more productive at the same time.

Here’s a quick rundown of what Meta and Amazon had to say on their recent earnings conference calls on all things AI related:

(1) Meta: An AI evangelist. Meta has used AI extensively in improving existing products and in new product offerings as well. Meta AI has made more than 500 monthly active improvements to Meta’s AI-driven feed and video recommendations. Those changes have led to an 8% increase in time spent on Facebook and a 6% increase in time spent on Instagram, CEO Mark Zuckerberg said on Meta’s October 30 conference call.

Meta AI is a chatbot powered by Llama, a company’s large language model that rivals ChatGPT. Meta AI answers questions from any of the 3.2 billion users of Meta’s products each day. Meta’s Business AI is used to create content, and its AI Studio can create AI characters. Meta’s AI tools were used to create more than 15 million ads over the last month, and businesses using image generation saw a 7% increase in conversions. “It’s clear that there are a lot of new opportunities to use new AI advances to accelerate our core business that should have a strong ROI over the next few years,” Zuckerberg forecast.

Meta is using AI internally as well. The parent of Facebook and WhatsApp expects AI will help it become more efficient, reduce costs, and increase productivity over time, particularly in content moderation. None of this comes cheap. Meta plans to spend $38 billion to $40 billion on capital expenditures this year, and it will spend “significantly” more next year as well.

(2) Amazon’s AI. Amazon is using AI to help its advertisers. “We’re continuing to support brands of all sizes with our generative AI-powered creative tools across display, video and audio, including our video generator that uses a single product image to curate custom AI-generated videos,” said CEO Andy Jassy on the company’s earnings conference call last week. “While we’re generating a lot of advertising revenue today, there remains considerable upside.”

The company’s cloud service, Amazon Web Services (AWS), also offers a host of AI services to clients. Amazon SageMaker helps customers manage AI data, build AI models, experiment with AI, and deploy it to production. Amazon Bedrock offers a broad selection of generative AI models. Amazon Q is a generative AI-powered assistant for software development.

“In the last 18 months, [AWS] has released nearly twice as many machine learning and GenAI features as the other leading cloud providers combined. AWS’s AI business is a multibillion-dollar-revenue run-rate business that continues to grow at a triple-digit, year-over-year percentage. [It] is growing more than three times faster at this stage of its evolution than AWS itself grew—and we felt like AWS grew pretty quickly,” said Jassy.

Amazon is also using AI across its retailing businesses. Rufus is a generative AI-powered shopping assistant. There are AI shopping guides that simplify product research for customers. Project Amelia is an AI system that helps companies selling products on Amazon boost productivity and growth. AI has been added to the Kindle’s Scribe note-taking function, it will be used to update Alexa, and it will be a “big piece” of Amazon’s robotics network.

And like Meta, Amazon is deploying AI internally. For example, Amazon coders who used Q saved $260 million and 4,500 developer years when migrating over 30,000 applications to new versions of the Java JDK. Also not cheap: Amazon’s 2024 capital spending will come to about $75 billion.

(3) Amazon & Meta’s charts. While Amazon and Meta both have embraced AI, their businesses are extremely different primarily because of Amazon’s exposure to retailing. Meta’s shares are at record highs, having risen 61.7% ytd through Tuesday’s close, and they’re up 543.8% from an eight-year low in November 2022 (Fig. 1). Amazon’s stock price, on the other hand, is up 31.3% ytd and 144.8% from its four-year low in December 2022 (Fig. 2).

One of the biggest differences between the two companies is their profit margins: Amazon’s forward profit margin at 9.2% is dwarfed by Meta’s forward profit margin of 34.8% (Fig. 3 and Fig. 4). Amazon’s forward earnings forecast has soared 98.5% y/y, well above Meta’s 53.2% increase (Fig. 5 and Fig. 6). But oddly enough, despite Amazon’s lower forward profit margin, it has a loftier forward P/E than Meta does: 33.6 versus 23.1 (Fig. 7 and Fig. 8).

(FYI: Forward earnings and revenues are the time-weighted average of industry analysts’ consensus estimates for this year and next; the forward profit margin we derive from forward earnings and revenues.)

Materials: Checking Out Cardboard. The share prices of paper manufacturing companies International Paper (IP) and Packaging Corporation of America have had a banner year, climbing 59.2% and 42.8% ytd through Tuesday’s close, respectively. The industry in general has benefitted from rising cardboard prices, and IP specifically should benefit from its restructuring program. Strength in the cardboard industry can signal the economy is healthy, particularly if prices are rising because businesses and consumers need more boxes to ship their goods.

Here’s a look at International Paper’s Q3 results and the state of the industry:

(1) Box prices rising. Large paper manufacturers began raising prices at the start of this year for both linerboard—the sheets used on the outside edges of cardboard—and the fluted medium that goes between the linerboard. Cardboard prices last rose sharply in 2021 and 2022 thanks to the pandemic-fueled demand for goods and companies’ desire to bulk up inventories to meet that demand. Cardboard prices subsequently fell sharply as companies trimmed inventories and customers pulled back spending on goods, opting instead to spend more on services.

Inventory destocking appears to have run its course this year. While shipments are still far below 2022 levels, cardboard prices began to rise once again. Manufacturers increased the price of 42lb unbleached kraft linerboard from roughly $825 in November 2023 to north of $900 in June, according to a June 24 Fastmarkets article.

(2) Improving IP. International Paper has undergone a lot of change this year, including the appointment of a new CEO, Andy Silvernail. He has laid out a wide-ranging restructuring program that includes considering strategic options for the company’s global cellulose fibers business, shuttering plants in areas with excess capacity, and acquiring London-based packaging company DS Smith for $7.2 billion.

“We will drive profitable growth by being the low-cost producer and the most reliable and innovative sustainable packaging solutions provider in North America and EMEA,” said Silvernail on the company’s October 31 earnings conference call.

IP’s Q3 adjusted earnings of 44 cents a share were lower than the 64 cents a share earned a year earlier but well above Wall Street’s 26 cents consensus. Sales rose a modest 1.6% y/y to $4.7 billion. The company’s industrial packaging business revenues climbed 3.7% y/y to $3.9 billion, while revenue in the division that’s being evaluated for sale, Global Cellulose Fibers, declined 2.1% y/y to $710 million.

During the quarter, cardboard prices rose, but volume dipped. “Higher prices across the portfolio, including benefits from our packaging go-to-market strategy, were supported by a moderately improving box demand environment. We also had higher operating costs and lower volumes due to seasonality and commercial actions to improve profitability,” said Silvernail in an earnings press release. On the conference call, he highlighted stable to moderately improving demand in North America, offset by some softening in Europe. Wall Street analysts are calling for the company to earn $1.20 a share this year, up from 87 cents last year, and $3.00 a share in 2025.

(3) A look at the industry. International Paper is a member of the S&P 500 Paper & Plastic Packaging Products & Materials industry. Its stock price index—which has jumped 27.5% ytd and 53.4% from its recent low in June 2023—has almost returned to peak levels last seen in June 2021 (Fig. 9). The industry suffered through negative net earnings estimate revisions for nearly two years from September 2022 until June, but analysts’ estimate revisions turned net positive in July and have remained that way since (Fig. 10).

Both revenues and earnings are forecast to improve sharply next year. Revenues are expected to flip from a decline of 0.3% this year to a 6.9% increase in 2025, and earnings are forecasted to fall 4.4% this year before surging 33.2% in 2025 (Fig. 11 and Fig. 12). The industry’s forward P/E at 17.5 is higher than at most times in the past; but as earnings improve, it may fall closer to its historical average of 16.4 (Fig. 13).

Disruptive Technology: AI’s Power Problem. The electricity needed to power AI programs is growing so rapidly that there’s mounting concern about how utilities will meet the demand. Higher costs for electricity could stunt the growth of AI development or make AI programs available only to those with deep pockets. Engineers are working on ways to rework how semiconductor chips work, how server farms operate, and even when AI programs run to help slow electricity demand growth.

Here are just a few of the solutions they’re evaluating:

(1) Changing chips. Training AI models and using them consume substantial energy when huge volumes of data are moved between computing and memory chips. Researchers are working on shortening the distance data must travel by performing some computing functions within memory chips, an October 17 article in Nature reports. Lowering chips’ energy consumption becomes increasingly important if programmers hope to push AI applications out of servers and “to the edge” onto computers and cell phones with limited battery capacity.

Other researchers are exploring the use of analog computing instead of digital computing as a more energy efficient way to run AI programs. Analog devices can store more data in a given area and are more energy efficient, but their error levels can be higher than digital alternatives. EnCharge AI is working on developing an analog static random access memory chip, which can reportedly run machine learning algorithms at 150 tera operations per second (TOPS) per watt, six times faster than the 24 TOPS per watt capability of a comparable Nvidia chip. Nvidia counters that converting the data from digital to analog and other issues reduces the energy savings.

And at Northeastern University, researchers used a combination of GPU and CPU chips instead of just using GPU chips when processing AI models. Doing so decreased energy use by 10%-20% yet didn’t increase how long it took the model to respond to an inquiry, an October 5, 2023 MIT publication reported.

(2) Changing data center rules. GPUs are energy hogs when unchecked. Researchers at MIT’s Lincoln Laboratory Supercomputing Center limited the amount of power that a GPU was allowed to draw. They found that when the energy consumed by the GPU was reduced by 12%-15%, the time it took to complete a task increased by 3%, which may be a tradeoff worth making, the MIT article stated.

Another benefit: The supercomputers ran 30 degrees Fahrenheit cooler and at a more consistent temperature, reducing the stress on the cooling system and potentially increasing the lifespan of the equipment. Other server farms are opting to schedule certain jobs that generate excess heat at night or during the winter to reduce their systems’ cooling needs.

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Global Bonds, Emerging Markets & S&P 500 Margins

November 6 (Wednesday)

Global Economy I: Global Bond Selloff. The Bond Vigilantes are multinational, as Europe has suffered collateral damage from the US Vigilantes’ fight with the Fed. Long-term sovereign debt yields are rising across developed economies, despite much slower growth and lower inflation than in the US (Fig. 1).

On one hand, perhaps this presents an income opportunity in global sovereign debt. On the other, the volatility may be too much to stomach for such a “safe” asset class. Let’s unpack what’s going on in global bond markets:

(1) United Kingdom. Gilt yields have tracked moves in the US Treasury market quite closely for the past two years. The 10-year gilt now yields more than 4.5%—a one-year high—versus 4.3% for the comparable Treasury bond. The Bond Vigilantes set up a nice outpost in London when they booted Prime Minister Liz Truss out of office in 2022 (after she served just two months) due to her concerning debt-fueled spending plans.

Now UK Chancellor Rachel Reeves has a new fiscal plan to increase spending by £70 billion per year through 2030, financed by a mix of borrowing and higher taxes. The plan has heightened inflation concerns, but the Bank of England is still widely expected to cut rates for the second time this year on Thursday (Fig. 2). Both the UK and US bond markets appear to be in similar boats.

(2) Germany. 10-year German bunds are yielding 2.4%, up from around 2.0% at the start of October. All things considered, that’s quite high. Real GDP has been declining on a y/y basis for a full year, the IFO business survey is in recession territory, and industrial production has been declining since June 2022 (Fig. 3 and Fig. 4). Germany’s debt load is also quite low, at just 63% of GDP. Its federal deficit is currently running at 2.6% of GDP, below the EU’s 3.0% cap (Fig. 5 and Fig. 6).

Yet the global bond selloff is raising yields. Perhaps the German Bond Vigilantes are worried that German wages and salaries rose at a record-high 5.7% y/y in August, while consumer inflation remains elevated at 2.4% (Fig. 7).

(3) Italy and France. It used to be very risky to own Italian debt. Investors were compensated for that risk with higher yields than available on other Eurozone bonds. Now 10-year BTPs yield just 128bps more than German bunds (Fig. 8). That’s relatively close to the 75bps that French OAT yields trade above bunds.

In France, the success of Marie Le Pen’s right-wing party has raised the compensation investors demand to own French debt. By most measures, France actually has quite a large debt load, but investor demand for safe-haven assets helps to bid up OATs and suppress yields. France’s economic growth has also been much stronger than some of its neighbors’, up 1.3% y/y in Q3 and not dipping negative since the pandemic (Fig. 9).

(4) China. The Chinese Communist Party (CCP) has struggled to encourage economic growth with its stimulus plans to date. Industrial profits remain negative, though industrial production and retail sales are ticking higher (Fig. 10). However, the 10-year government bond yield is around record lows of 2.1% (Fig. 11). With the property market (and consumer confidence) collapsed, investors remain pessimistic on China’s growth prospects (Fig. 12).

(5) Japan. The 10-year JGB yield has fallen from 1.1% in July to around 0.9%, as the expectations for tightening by the Bank of Japan have fallen. The difference between US Treasury and JGB yields therefore has widened, putting pressure on the yen versus the dollar (Fig. 13).

Global Economy II: IMF’s Underwhelming Forecasts for EMs (Ex India). The International Monetary Fund’s (IMF) October 2024 World Economic Outlook paints a lukewarm picture of global economic growth prospects, with global real GDP pegged at a steady 3.2% for both 2024 and 2025. Headwinds stem from cautious monetary policies and rising geopolitical tensions.

Advanced economies are weighing down the global forecast, with their real GDP growth projected at just 1.8% in 2024 and 2025. Emerging markets (EMs) and developing economies are projected to outpace the developed world with 4.2% growth for both years—still not much to celebrate. And EMs outside of India are expected to grow at paces typically associated with advanced economies, not dynamic EMs.

Let’s dive into the IMF’s forecasts for some key EM players, each navigating unique challenges and opportunities:

(1) India. The global growth leader, India’s economy is set to expand by 7.0% in 2024, tapering to 6.5% in 2025. Strong public investment and robust domestic demand fuel the exceptional pace.

(2) China. Facing headwinds in its property sector and weakening global demand, China’s growth forecast has been trimmed to 4.8% for 2024 and 4.5% for 2025, both below Beijing’s 5.0% target.

(3) Brazil. Benefiting from stable commodity exports, Brazil is expected to grow by 3.0% in 2024 and 2.2% in 2025.

(4) Taiwan. Taiwan’s economy should see growth of 3.7% in 2024 and 2.7% in 2025, supported by its pivotal role in global semiconductors.

(5) Australia. The IMF projects growth of 1.2% in 2024 and 2.1% in 2025 with commodity exports and resilient domestic demand supporting the economy.

(6) South Korea. Predicted to grow by 2.5% in 2024 and 2.2% in 2025, South Korea benefits from semiconductor exports and demand for electric vehicles, despite military tensions with North Korea.

(7) Mexico. With one of the weakest forecasts among major EMs, Mexico’s growth is projected at just 1.5% in 2024 and 1.3% in 2025, as political instability weighs on economic prospects.

Global Economy III: Time To Reduce EM Risk? EM equities have shown notable strength recently, buoyed by supportive global financial conditions and targeted policy measures. But despite the IMF’s lukewarm global growth outlook—India excluded—the current environment suggests a cautious approach to EMs.

Valuations in EM stock markets aren’t all that compelling. More protectionist US trade policies and increasing global tensions broadly are potential headwinds, as we highlighted in our October 30 Morning Briefing. Jolts to China’s economy and markets from the government’s recent stimulus likely won’t build sustainable momentum.

Here’s more:

(1) EM index performance. The MSCI EM equity index (in US dollars) has rebounded impressively since its October 26, 2023 low, gaining 24.0% (Fig. 14). At a sub-15 P/E multiple, the index trades near its historical average. Analysts’ consensus revenue per share has been flat since mid-2020 (Fig. 15). But forward profit margins improved to 8.2% by early November from February’s 6.8%. Forward earnings per share are slightly up since late last year (Fig. 16).

(2) EM index composition. Notably, Chinese firms represent more than a quarter of the MSCI EM equity index’s composition at 27.3%, followed by Taiwanese stocks at 19.0% and Indian stocks at 18.8%.

(3) EM bond outflows. With the Fed’s pace of easing likely to slow, EM bond ETFs faced October outflows as investors reassessed global risks. The iShares J.P. Morgan USD EM Bond ETF saw its largest outflows since March, Bloomberg data show, indicating rising caution around EM debt.

Global Economy IV: Mexico’s Dangers. As the dust settles after Mexico’s latest elections, the political landscape is turning rougher, with heightened volatility in equity markets expected as President Claudia Sheinbaum aggressively reinforces her predecessor’s policies. Recently, we asked whether Mexico was becoming “un-investable.” Today, we remove the question mark.

We’re not alone in re-evaluating Mexico’s investment appeal. The MSCI Mexico Index has traded below its 200-day moving average since June, when electoral risks started to loom large (Fig. 17). Meanwhile, the peso has quickly sunk to its weakest levels against the dollar since mid-2022.

(1) Constitutional reforms. Recent reforms have weakened Mexico’s governmental checks and balances, undercutting its investment appeal. The National Regeneration Movement—a.k.a. Morena—has swiftly pushed laws through Congress with minimal debate, including a controversial measure to make Supreme Court judges subject to election that invites influence by organized crime at the judicial level.

(2) Judiciary restrictions. Effective November 1, a new law restricts the Supreme Court from overturning constitutional amendments passed by two-thirds majorities in Congress and state legislatures. Pushed by Morena’s legislative majority, the changes are grounded in Sheinbaum’s and Morena’s belief that elected officials should remain unchallenged by the judiciary. Until now, the judiciary was the only branch not under Morena’s control.

(3) Morena’s party line. Committed to following former President Andrés Manuel López Obrador’s (AMLO) agenda, Sheinbaum is likely to continue eroding judicial independence. Under AMLO, Morena tried but failed to prioritize state-owned utilities over private ones in energy markets.

With Mexico’s stock market liquidity already limited, its ranks of outperformers may grow even thinner as these legislative changes take root.

US Strategy: Strong Q3 Margin Improvement. With 383 of the S&P 500 companies having reported their Q3 earnings through midday Tuesday, the Q3-2024 earnings season is nearly 77% complete. The aggregate revenue and earnings surprises so far are among the strongest since the pandemic recovery in 2021, and profit margins show improvement even with the lower results from Boeing and the Energy sector. Revenues for the 383 reporting companies are ahead of forecasts by 1.6% (a five-quarter high), and the earnings beat is a very healthy 7.9% (Fig. 18 and Fig. 19).

However, the aggregate Q3 y/y revenue and earnings growth rates for the 383 reporting companies has slowed from Q2’s pace—to 4.6% from 5.2% for revenues and to 9.1% from 13.3% for earnings growth.

On a very bullish note, 74% of companies have positive y/y revenues growth, the most in nine quarters (Fig. 20). And 68% have positive y/y earnings growth, matching the highest readings of the past 11 quarters (Fig. 21).

Below, Joe dissects the results to uncover the underlying trends in the S&P 500 and weighs in with his thoughts:

(1) Magnificent-7. With all but superstar Nvidia reporting Q3 results so far, it was a better quarter for the group than Q2. Tesla had the sole top-line miss, but all six companies’ earnings beat estimates. On a blended basis (using actuals for the six companies that have reported and a forecast for Nvidia), the Magnificent-7’s aggregate earnings surprise was 10.8% and its y/y earnings growth 24.6%—both well above the S&P 500’s. The group’s y/y revenue growth of 5.0% rate is also ahead of the S&P 500, though its 1.6% revenue surprise only matches the index’s.

Among the six Magnificent-7 companies that have reported, three had double-digit percentage earnings surprises and y/y earnings growth: Alphabet, Amazon, and Meta. Here are the Q3 earnings surprises and y/y earnings growth rates for the Magnificent-6: Amazon (25.2% earnings surprise, 52.1% y/y earnings growth), Tesla (23.2, 9.1), Alphabet (14.9, 36.8), Meta (14.8, 37.4), Microsoft (6.5, 10.4), and Apple (2.4, 12.3).

Most of the Magnificent-6 companies continued to record relatively strong revenues growth during Q3: Microsoft (1.7% revenues surprise, 16.0% y/y revenues growth), Alphabet (2.3, 15.1), Amazon (1.1, 11.0), Meta (0.8, 18.9), Apple (0.4, 6.1), and Tesla (-0.8, 7.8).
 
(2) S&P 500 profit margins moving higher. The S&P 500’s Q3 reporters to date collectively had a Q3 profit margin of 13.1%, well above the 12.3% consensus forecast and up from 12.5% a year earlier (Fig. 22). That would be a record high if we put a mask on the S&P 500’s 13.5%-13.8% readings during the supply-chain disruptions of 2021! By the way, 13.1% is also the current blended forecast for all of the S&P 500 companies and could improve further as the remaining 23% of the companies report Q3 results.

(3) Magnificent-7 margins at a record high. The Magnificent-7’s blended Q3 profit margin of 25.3% is a new record high and well exceeds the prior record of 23.7% during Q1. Margins rose q/q for all six Magnificent-7 reporters to date—Amazon’s to a record high—up from just two the prior quarter: Meta (38.6% quarterly profit margin, 15-quarter high), Microsoft (37.6, four-quarter high), Alphabet (29.8, 13-quarter high), Apple (26.3), Tesla (10.0, five-quarter high), and Amazon (9.7, record high).

Nvidia is expected to report a Q3 profit margin of 55.9%; but with a big positive surprise, the Magnificent-7’s collective profit margin could easily exceed 26%.

(4) S&P 493 profit margins rising too. With 377 of the S&P 493 reporting so far, the S&P 493’s Q3 profit margin of 11.6% (including Boeing’s loss) is the highest since Q3-2022 and compares to a forecasted 11.0% and 11.4% a year earlier. That’s still below the group’s record high of 12.9% during 2021.

(5) S&P 493 excluding Boeing and Energy. Looking at the S&P 493 excluding the noisy results from Boeing and Energy reveals a Q3 profit margin of 13.9%. That compares to a 13.1% forecast and 12.9% a year earlier. Boeing’s strike lowered the S&P 500’s Q3 earnings growth rate to 9.1% from 10.4%. Even with Boeing’s large loss in Q3, the Industrials sector’s 8.7% profit margin is down just 0.5ppt from a year ago. Among Q3’s lagging sectors, Energy’s Q3 margin of 7.9% is down materially from 9.6% a year earlier, and Materials’ 8.8% is down from 9.7%.

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A Negative Saving Rate?

November 5 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
US Economy I: Do Presidents Create Jobs? Today is Election Day. Please go vote and vote often. Just kidding, of course. Vote once. Among the worst-case scenarios is that the election will be contested for weeks. The contest between George W. Bush and Al Gore is one of the most famous. It lasted until December 12, 2000, when the US Supreme Court’s decision in Bush v. Gore effectively resolved the election in Bush’s favor over a month after Election Day. A bitterly contested election certainly could unnerve the financial markets and act as a speed bump for the economy.

I agree with the widely held view that today’s election is the most important election of our lifetime, as were all the previous elections of our lifetime. I don’t want to influence your vote. But in this Morning Briefing, Debbie, Eric, and I review the latest GDP data. They are great. Yesterday, we reviewed the latest employment data and concluded that excluding the effects of strikes and hurricanes, the labor market is in great shape too.

That’s not an endorsement of the policies of the current administration. It reflects our long-held view that the American economy has performed remarkably well over the years despite Washington’s policies. Real GDP has been rising for decades with a few recessions along the way no matter who sat in the Oval Office (Fig. 1). Recessions have occurred when either party held the White House. Both parties have contributed to the ballooning of the federal government’s debt.

Presidents often take credit for bull markets in stocks. That’s because bull markets last longer than the relatively infrequent bear markets. The S&P 500 has been trending higher for decades—again, despite the meddling of Washington (Fig. 2).

Also trending higher over time, no matter the party of the president, has been payroll employment (Fig. 3). Not surprisingly, presidents often take credit for creating jobs during their time in office to assert that their administration’s policies were good for the economy. Our view is that jobs are created by companies that manage to increase their profits over time—again, despite Washington’s meddling.

According to ADP, during October, small, medium sized, and large companies’ payrolls totaled 57.6 million, 51.1 million, and 24.1 million (Fig. 4). Among the companies that tend to hire the most over time are successful small and medium sized companies that grow into medium sized and large companies.

The US economy remains a very entrepreneurial one (again, despite Washington). We are particularly impressed that as of 2021 there were 29 million nonfarm sole proprietorships (Fig. 5). Proprietors’ income (which is included in personal income) rose to a record $2.0 trillion (saar) during September (Fig. 6). Also impressive is that over the 12 months through September, business applications totaled 426,000 (Fig. 7).

Our conclusion is that presidents don’t create jobs; employers do that when their companies are profitable and the economy is expanding.

US Economy II: Record Setting Economy. The last US economic recession lasted two months, during March and April 2020, when pandemic lockdowns depressed the economy. Real GDP fell 9.2% from Q4-2019 through Q2-2020 to $19.1 trillion (saar). Since then, it is up 22.7% to $23.4 trillion. That’s a record high. It has been rising to record highs since Q1-2021. There has been only one slightly negative quarter, i.e., Q1-2022 (Fig. 8).

That’s an impressive achievement given the pandemic and the tightening of monetary policy from 2022 through 2024. Indeed, both the goods and services components of real GDP have been growing since the lockdown recession and are at record highs (Fig. 9). On September 28, 2023, the latest annual benchmark revision of real GDP raised it by 1.3% during Q2-2024 (Fig. 10).

We expect that Q3’s productivity index will show a solid increase to another record high when it is reported on Thursday. Real nonfarm business output probably rose faster than Q3’s real GDP increase of 2.8% (saar). Payroll employment averaged monthly gains of 104,300 during Q3, down from Q2. Aggregate hours worked rose 0.8% (saar) during Q3, down from 1.2% during Q2.

Unit labor costs (ULC) likely rose to a new record high in Q3, but the ULC inflation rate probably remained close to zero; it was 0.3% through Q2. ULC determines the underlying inflation rate, which explains why the PCED headline inflation rate fell to 2.1% y/y during September, the lowest reading since February 2021. The broadest measure of inflation is the yearly percent change in the GDP price deflator. It was down from a peak of 7.8% during Q2-2022 to 2.2% during Q3-2024 (Fig. 11).

In other words, mission accomplished: Our “Immaculate Disinflation” outlook has been achieved—i.e., economic growth has remained resilient while inflation has subsided significantly. We first started to write about this scenario in our September 6, 2022 Morning Briefing:

“Of course, a return to the Old Normal requires that inflation shows more signs of moderating and does so without the economy falling into a significant recession. Is immaculate disinflation possible? History shows that inflation rarely falls on its own without a recession. … But we don’t think history necessarily has to repeat itself (despite how often it rhymes). … What seems to be different this time (so far) is that the credit system is less vulnerable to a credit crunch than it was in the past. The result is what we now have: a rolling recession hitting different sectors of the economy at different times; we expect it to bring inflation down without precipitating an economy-wide downturn.”
 
US Economy III: Baby Boomers Saving Less. Also at a record high during Q3-2024 were total real personal consumption expenditures (PCE) including both goods and services real PCE (Fig. 12). Real disposable personal income (DPI) per household rose to a pre-pandemic record high of $133,500 during Q3-2024 (saar). Real PCE per household rose to a record high of $121,400 (saar) last quarter (Fig. 13). This is our favorite measure of the standard of living in the United States. It is up five-fold since 1960. It has doubled since the early 1980s.

The “nattering nabobs of negativity” observed that real PCE rose 3.7% (saar) during Q3, while real DPI rose 1.6% during the quarter. As a result, the personal saving rate fell to 4.8% from 5.2% during the previous quarter (Fig. 14). That’s true, but the saving rate was also revised up (along with GDP) during the recent annual benchmark revision, from 3.3% to 5.2% during Q2 (Fig. 15).

At a September 30 conference, Fed Chair Jerome Powell responded to that news by saying that the revision “removes a downside risk to the economy.” He added: “These were very large, healthy revisions.”

In any event, we’ve been predicting that the personal saving rate might stay very low during the rest of the decade as the Baby Boomers continue to retire. Indeed, we now think it might turn slightly negative in coming years. That’s because retired Baby Boomers will no longer receive wages and salaries. They will have other sources of unearned income, but the personal saving rate is bound to decline for retired Boomers as they continue to consume while no longer receiving paychecks. They will do so by reducing their net worth, which has been bolstered by rising stock and home prices. Consider the following:

(1) From 1946-1964, 75 million Baby Boomers were born (Fig. 16). The latest Visa Business Economic Insights observes: “Baby Boomers … have always had an outsized presence compared with other generations. Four times larger than any previous birth wave, their sheer size created a massive bulge in an otherwise narrow age distribution that ensured every stage of their life was experienced by the entire country.” Furthermore, “the big bulge of the baby boomer generation is now a retirement wave.” Indeed, more than 11,000 Americans will turn 65 every day. That’s more than 4.1 million every year from 2024 to 2027.

(2) The oldest of the Baby Boomers turned 65 years old in 2011 and 75 in 2021 (Fig. 17). Since the start of 2011, the number of seniors (over 65 years old increased by about 10 million to 48 million.

(3) At the end of Q2-2024, the Baby Boomers had amassed a net worth of $79.8 trillion, or 49% of total household net worth (Fig. 18). They have lots of assets and few liabilities (Fig. 19). There current portfolio includes corporate equity and mutual funds ($23.0 trillion), owner’s equity in real estate ($17.3 trillion), pensions ($9.8 trillion), liquid assets ($8.4 trillion), noncorporate business equity ($7.8 trillion), home mortgages ($2.6 trillion), consumer credit ($1.1 trillion), and life insurance reserves $1.0 trillion).

(4) The Baby Boomers watched Star Trek starting in 1966. They often heard Spock’s benediction “Live long and prosper.” They certainly have done so. And now they are spending their wealth on their retirement. The personal saving rate could certainly fall closer to zero or even turn negative.

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Bond Vigilantes Are Fed Up

November 4 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: Don’t Fight the Bond Vigilantes. Nothing seems to be stopping US Treasury bond yields from rising. The Fed is widely expected to cut the federal funds rate (FFR) this week by 25bps after the 50bps cut on September 18. The price of oil has dropped sharply since Israel bombed Iran on October 26. September’s PCED headline inflation rate declined to 2.1% y/y. Last month’s payroll employment was weaker than expected, and so was the manufacturing PMI. Yet bond yields continue to rise.

After briefly dipping on the weak headline 12,000 rise in payroll employment, the 10-year US Treasury yield finished Friday 10bps higher. It’s now at 4.37%, roughly 75bps higher than where it was trading just before the Fed’s September rate cut (Fig. 1). The bond market appeared to look right through the impacts of strikes at Boeing and two hurricanes, focusing ahead on Tuesday’s US election and Thursday’s Federal Open Market Committee (FOMC) decision. Both are increasingly likely to deliver more stimulus to an economy that’s doing quite well already.

We aren’t (yet) calling for the 10-year Treasury yield to reach 5%, but the Bond Vigilantes seem to be threatening to take it there:

(1) Bond Vigilantes in the driver’s seat. As noted above, the FOMC is widely expected to cut the FFR by 25bps next week. Based on the prevailing economic strength, there’s little to suggest it needs to. We suspect the latest weak ISM manufacturing PMI report and October employment report may be used to justify another rate reduction. Fed Chair Powell may also point to the real FFR becoming increasingly “tighter” as inflation falls as justification.

Investors often hear “Don’t fight the Fed,” but perhaps it’s the Fed that shouldn’t be fighting the Bond Vigilantes. The bond market could easily nullify the impacts of another rate cut. That’s because the bond market believes the Fed is cutting rates by too much, too soon, and is therefore raising long-term inflation expectations (Fig. 2). These expectations are heightened by concerns about more fiscal excesses from the next administration.

So the Fed must weigh whether it’s better to leave rates unchanged or to cut the overnight FFR and risk even higher long-term bond yields. Indeed, mortgage rates have climbed back above 6.7% since the Fed’s September cut (Fig. 3). Tighter financing conditions aren’t the only risk facing the FOMC officials: If yields keep rising despite more rate cuts, they risk losing credibility now that they’ve gotten the Bond Vigilantes to saddle up.

(2) Note Vigilantes in the passenger’s seat. Some market commentators have opined that bond yields have risen since the Fed’s September rate cut because the risk of recession has fallen. We find a few flaws with that reasoning. First, there wasn’t material recession risk before the Fed cut rates. Second, were that the case, the yield curve would likely be much steeper than 16bps (Fig. 4). Instead, the entire yield curve has shifted upward as the 2-year Treasury yield has risen 62bps (Fig. 5). The kicker is that the spread of junk bond yields over Treasuries is historically low below 300bps (Fig. 6). It never signaled much concern about a recession.

(3) Bonds versus oil. It’s unsettling to see that yields have not responded to falling oil prices. Historically, breakeven inflation is highly correlated with the price of crude (Fig. 7). The PCED inflation rate was just 2.1% y/y in September. But breakeven inflation has climbed near cycle highs above 2.4%. That suggests the Fed is potentially making a policy mistake amid growing concerns about more fiscal excesses.

(4) MOVE to the side. Bond volatility has spiked in recent weeks, much more than currency or stock market volatility (Fig. 8). That corroborates the story that fiscal concerns are rising in the bond market.

We also note that swap spreads—the difference between yields on Treasuries and their accompanying derivatives—are trading deeply negative. That means bank balance sheets are getting bloated with Treasury bonds and investors would rather buy lower-yielding derivatives than own bonds.

Rising bond yields, inflation expectations, and volatility all appear to be correlated with policy concerns. The US economy is doing well, surpassing its global peers. We, and the bond market, see more risk in DC policymakers overheating the economy than underdoing stimulus. That’s why we incorporated the risk of a debt crisis into our geopolitical risk scenario, raising it from a subjective probability of 20% to 30% (see last Wednesday’s Morning Briefing).
 
US Economy II: Countering Negative Employment Spins. We didn’t see anything in the October employment report to make us change our upbeat economic outlook. Apparently, neither did the financial markets.

Both labor market indicators throughout October and the monthly employment report suggest that the jobs market is still in good shape. But as we discuss above, the FOMC is likely to cut the FFR by 25bps after the November 6-7 meeting of the committee, raising the risk of overheating the economy. It could also fuel a stock market meltup, though we did lower the odds of that last week from 30% to 20% because we raised the odds of a debt crisis (and a geopolitical crisis) from 20% to 30%.

Consider our takeaways from the latest labor market data:

(1) Unemployment rate. Due to the weather, 1.41 million workers had to work part time in October, and an additional 510,000 were not at work (Fig. 9). Notably, these workers were all counted as “employed” in the household survey, which includes the unemployment rate. The Bureau of Labor Statistics (BLS) said it found “no discernible effect on the national unemployment rate from the household survey.”

We’re skeptical of this claim considering the unemployment rate rose to a cycle high of 4.3% in July when Hurricane Beryl struck, before falling to 4.0% just two months later. It’s difficult to account for the downstream impacts on suppliers and permanent business closures. In any case, the unemployment rate remained essentially unchanged in October at 4.1%, rising less than a tenth of 1% (Fig. 10).

(2) Labor force. It is true that 220,000 workers dropped out of the labor force in October. The labor force participation rate for prime-age workers (25-54) fell from 83.8% to 83.5% (Fig. 11). But in the grand scheme of the labor market, neither is very significant, especially off record highs. The same is true for the employment-population ratio, which dipped from 80.9% to 80.6%. We wouldn’t be surprised to see each of those series bounce back next month.

Meanwhile, the number of employed workers losing their jobs and becoming unemployed remained less than 1% of the total labor force in October (Fig. 12). Hardly cause for concern.

(3) Payroll employment. The weather likely led to a one-off reduction in payroll employment. The BLS said: “[I]t is likely that payroll employment estimates in some industries were affected by the hurricanes; however, it is not possible to quantify the net effect on the over-the-month change in national employment, hours, or earnings estimates because the establishment survey is not designed to isolate effects from extreme weather events.” In other words, ignore Friday’s payrolls data!

The 49,000 fall in temporary employment industries could also have been weather related (Fig. 13). Furthermore, the BLS acknowledged that the 44,000 decline in transportation equipment manufacturing was largely due to strike activity. So perhaps payroll employment actually increased by more than 100,000 last month excluding these two developments. Who knows?

(4) Hours and earnings. Average hourly earnings (AHE) rose 0.4% m/m in October, beating expectations. Our Earned Income Proxy for private wages and salaries in personal income also rose 0.4%, as total hours worked was unchanged last month (Fig. 14).

We expect the headline PCED inflation rate declined 0.1% m/m in October led by falling gasoline prices; that suggests strong growth in real wages. The rising rate of wage growth also supports our upbeat outlook on the labor market, consumer spending, and the economy (Fig. 15).

Hours worked were likely affected by the hurricanes and strikes, yet they remained flat m/m in October rather than falling (Fig. 16). We expect a rebound in November.

(5) Collection rate. The BLS said that the payroll survey response rate was “well below average.” The collection period was also only 10 days (it can be up to 16 days). That led to the October response rate falling to 47.4%, the lowest for the month of October since 1985 (Fig. 17).

(6) Revisions. August payroll growth was revised down by 81,000 to 78,000, and September payrolls were revised lower by 31,000 to 254,000. At face value, these help drag the three-month average for payroll growth to 104,000 (Fig. 18).

However, these revisions can be taken with two grains of salt: First, they reflect the data from late responders, who might have been delayed by strikes and hurricanes. Second, as BLS commissioner Erika McEntarfer notes, August and September payrolls were actually revised up by 4,000 on a non-seasonally adjusted basis. The downward revisions on a seasonally adjusted basis were due to updated seasonal factors, which can “push back weakness/strength in current month data as the moving average of employment growth changes.”

That helps explain why positive (negative) surprises in payroll employment tend to be accompanied by positive (negative) revisions to prior months. All in all, there was little to worry about in this employment report. The bulk of indicators suggests the labor market remains in good shape. We expect that to continue through year-end and well into next year.

Movie. “Conclave” (- -) (link) was an interesting suspense drama until it went into a woke death dive near the end. Even the fine performance of Ralph Fiennes couldn’t save it. The movie is about the intrigue behind the selection of a new pope. Secrets that could shake the foundation of the Vatican are uncovered. There’s a schism between conservative and progressive Cardinals. The tensions between Christianity and radical Islam are briefly mentioned. If you leave the theater when the bomb goes off in the movie, you’ll undoubtedly come up with a better ending for the film than the one chosen by the director.

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More On Sweep Stakes

October 31 (Thursday)

Politics & Strategy I: Red Vs Blue Wave. Whether Donald Trump or Kamala Harris is the next US president, the outcome is likely to be four years of policies that widen an already wide federal deficit (Fig. 1). Harris would favor more spending, partially funded by raising taxes, while Trump would favor tax cuts, partially funded by tariffs. Both hope that stronger economic growth would help fill in the gaps and prevent the debt load from blowing out relative to GDP (Fig. 2).

The Committee for a Responsible Federal Budget estimates Harris' current proposed plans would increase the federal debt by $4 trillion through 2035—only about half of its estimate for President Trump’s proposed plans.

We are still rooting for gridlock, but a GOP sweep (controlling both houses of Congress and the White House) looks more likely than a Democratic sweep. The latest forecast from FiveThirtyEight has Trump (52%) beating Harris (48%). Furthermore, according to its model, the Republicans have an 88% chance of flipping the Senate. The odds for the House are currently 52%/48% Republicans versus Democrats, with the majority boiling down to “less than 30 key seats.”

As we all know, neither party looks the same as it did 20 years ago. Even if the GOP flips the Senate, our friend Jim Lucier of Capital Alpha Partners believes it may take 53 or 54 seats for Trump to have a comfortable majority that sides with him on key issues.

In our view, a Trump win would likely be accompanied by a red wave. These outcomes are not mutually exclusive—if Trump wins by any sizeable margin, it is likely that voters would have chosen Republican congressional candidates as well. A sweep by either party has long been the outcome we believed would widen the deficit the most.

We presented our case for shorting bonds in our August 19 Morning Briefing. The thesis was predicated on the Federal Reserve’s preparing at the time to cut interest rates despite the economy still running hot. The 10-year Treasury bond yield rode both of those from roughly 3.6% to 4.1% in just a few weeks. The bond market may have sniffed out the rising odds of a GOP sweep, as the 10-year yield climbed to near 4.3% this week (Fig. 3). Then again, the backup in yields coincided with better-than-expected economic indicators (as tracked by the Citigroup Economic Surprise Index) and a growing realization that the Fed’s 50bps cut in the federal funds rate on September 18 was too much too soon (Fig. 4).
 
Politics & Strategy II: Weighing the Election’s Impact. Presidential candidates Trump and Harris propose dramatically different policies, which would have dramatically different impacts on specific S&P 500 sectors and industries. The S&P 500 Technology, Health Care, and Consumer Discretionary sectors in particular would face very different futures under a Harris administration versus a Trump one. The Financials sector, however, may benefit under both candidates due to their spendthrift ways.

Let’s compare the ramifications of the two candidates’ proposals on specific sectors and industries in the S&P 500:

(1) Financials: Rates higher for longer. Polls favoring Trump have improved over the past month, leaving the two candidates in a statistical dead heat. Stock market activity seems to suggest that investors believe that Trump’s momentum will lead him into the Oval Office.

Shares of Trump Media & Technology Group have jumped more than 300% since bottoming on September 23. The yield on the 10-year Treasury bond has risen to 4.28% from 3.75% over the same period (Fig. 5). And the yield curve has an upward slope this month (Fig. 6). Improving prospects for the economy have certainly contributed to higher rates, but the slew of debt that will be sold to finance Trump's or Harris's plans is likely adding to the bond market's jitters.

A steeper yield curve has likely helped the S&P 500 Financials sector index rally this month, outperforming all other S&P 500 sectors except Information Technology. The Financials sector also has responded to stronger-than-expected Q3 earnings reports. On the other hand, loftier interest rates presumably weighed on the Utilities and Real Estate sectors.

Here’s the performance derby for the S&P 500 and its sectors since the start of October through Tuesday’s close: Information Technology (4.1%), Financials (3.4), Communication Services (2.5), S&P 500 (1.2), Consumer Discretionary (0.2), Energy (0.0), Industrials (-0.1), Utilities (-1.9), Real Estate (-2.1), Materials (-2.4), Consumer Staples (-2.6), and Health Care (-3.8) (Fig. 7).

Within the Financials sector, the Investment Banking & Brokerage industry stock price index has gained 10.7% in October through Tuesday’s close, followed by Diversified Banks (6.9%), Asset Management & Custody Banks (6.9), and Regional Banks (3.9) (Table 1).

Conversely, the S&P 500 Homebuilding and Automobile Manufactures industries, which are in the Consumer Discretionary sector, could face headwinds as higher interest rates make borrowing to buy a home or a car more expensive (Fig. 8). Harris plans to lend a hand by offering first-time homebuyers $25,000 toward their downpayment. After rallying for most of 2024, the Homebuilding industry’s stock price index fell 10.0% in October, while the S&P 500 Automobile Manufacturers industry gained 0.1% during the month thanks to GM’s strong Q3 earnings report (Fig. 9 and Fig. 10).

(2) Technology: Betting on Khan’s departure. Lina Khan was named head of the Federal Trade Commission (FTC) by the Biden administration and has been a thorn in the side of technology companies ever since. The agency tried unsuccessfully to block Microsoft’s $69 billion acquisition of Activision Blizzard last year. It was reviewing Amazon’s offer for iRobot when the two companies agreed to walk away from the deal after the European antitrust agency raised concerns about it.

The FTC is currently examining large technology companies’ investments into and partnerships with artificial intelligence companies. Companies under the microscope include Amazon, Alphabet, Microsoft, Anthropic and OpenAI, a January 25 CNBC article reported. The FTC also sued Amazon, alleging that it used its position as an e-commerce superstore and fulfillment center to prevent rivals from entering the industry.

A Trump administration would likely appoint its own head of the FTC and head of the Department of Justice’s antitrust division. Though Harris hails from California, home to many tech mavens, she is expected to reinstate Khan. Despite Khan’s tenure, the S&P 500 Technology sector has soared 34.9% ytd through Tuesday’s close, and the Communication Services sector has added 31.0% (Fig. 11).

(3) Health Care: Sickly under both candidates. The S&P 500 Health Care sector is the perpetual punching bag for political candidates. Harris has run on the promise to cap the price of insulin for all consumers, not just the seniors who benefit from the $35 price cap today. She’d also expand the $2,000 out-of-pocket cap on drug expenses that seniors enjoy to the masses. And she’s expected to expand the number of drugs for which Medicare and Medicaid Services are allowed to negotiate prices faster than a Trump administration might.

Former President Trump wasn’t exactly a friend of the pharma industry either. He signed an executive order that would have set Medicare reimbursements for 50 drugs at the lowest price paid for those drugs in other developed countries. A US District Judge blocked the rule because the administration hadn’t given the public a chance to comment on it, as is required by law. Trump proposed another executive order that banned drug makers from providing rebates to pharmacy benefit managers and insurers, but it never went forward. Nonetheless, both actions indicate that the former President is willing to try unorthodox ways of reducing drug prices.

Health Care is the worst performing sector in the S&P 500 this month through Tuesday’s close and the second worst performing sector ytd. Its returns this month are being dragged down by the Pharmaceuticals (-1.3%) and Biotechnology (-2.6%) industries (Fig. 12 and Fig. 13). More problematic have been the rising prices weighing on the profitability of health insurers in the Managed Health Care industry’s stock price index, which has fallen 6.5% in October through Tuesday’s close (Fig. 14).

By the way, Robert F. Kennedy Jr. said on Monday that former President Donald Trump has promised him “control” of HHS and the Department of Agriculture, according to a video obtained by POLITICO.

Speaking at a virtual event, the former presidential candidate said “[T]he key that President Trump has promised me is control of the public health agencies, which are HHS and its sub-agencies, CDC, FDA, NIH, and a few others … and then also the USDA.” Kennedy did not specify whether he was referring to the HHS secretary post. An appointment of Kennedy to a cabinet position like HHS secretary would require Senate confirmation, which could be a significant hurdle given his vaccine skepticism and other controversial positions.

(4) Consumer Discretionary: Tax cuts for everyone. The Trump and Harris campaigns are handing out tax cuts and tax credits like Tic Tacs. Both camps want to eliminate taxes on tips.

Harris has said she’d boost the child tax credit to $3,000 and give new parents a $6,000 tax credit. But Harris is expected to raise taxes on the wealthy by increasing the capital gains taxes from 20% to 28% for anyone making $1 million or more. She may also ensure that households with $100 million or more in assets face a tax rate of at least 25%.

Trump would end taxes on Social Security and overtime, while also extending all of the tax breaks under the Tax Cuts and Jobs Act. He also promises to reinstate the State and Local Tax deduction.

If their promises come to fruition, high-end end retailers could suffer under a Harris administration, while retailers catering to lower- and middle-class consumers could benefit. Under Trump, all retailers stand to benefit from increased consumer spending, but they also could be hurt if the many imported goods they sell get slapped with tariffs. Trump has proposed tariffs of 10%-20% on imported goods. II manufacturers pass the tariffs' cost on to retailers and retailers pass on the higher costs to consumers in the form of price increases, consumers may buy less; if retailers don’t do so, their costs will rise and margins will shrink. Neither are good options.

(5) Energy: Watch supply. The Trump camp has said it will be far friendlier to the Energy sector, lifting regulations imposed by the Biden administration and presumably continued under Harris. But in an odd twist, Harris may be better for the sector. If the Harris administration limits drilling and that reins in supply, the price of oil could perform better than it would if Trump increases drilling, putting additional pressure on an already oversupplied market.

Disruptive Technologies: Bitcoin for Trump. Former President Trump, the self-described “crypto-candidate,” has endeared himself to the crypto community. He believes the US should be the crypto capital of the world, and his campaign accepts donations in bitcoin and other crypto currencies. Trump has promised to create a national bitcoin reserve and introduced a new crypto company, World Liberty Financial, which some believe will be a crypto borrowing and lending platform. While Trump and the Trump organization don’t own the company, they may receive compensation from it.

Trump has gained crypto fans by promising to fire Securities & Exchange Commission (SEC) Chair Gary Gensler, whose term expires in January 2026. Gensler is unpopular among the crypto crowd because he considers most crypto coins unregistered securities, he has highlighted the fraud and scams in the crypto market, and he has enforced investor protection laws. The crypto bros accuse him of regulatory overreach.

Ironically, it was also under Gensler that a bitcoin ETF was approved. Since the ETF launched on January 11, bitcoin has soared more than 50% (Fig. 15). During October, the cryptocurrency has gained roughly 13.9%, pushed higher by the awareness of growing US deficits and rising Treasury bond interest rates in addition to Trump’s gains in the polls.

Harris has said much less about the crypto market, but she has promised to support digital currencies and has used Mark Cuban to court the crypto community. She has called for stronger regulatory oversight of the crypto markets, and she’s considered more likely to retain Gensler as SEC chair.

While bitcoin would likely fall if Harris wins the election, its response to a Trump presidency is harder to gauge. Bitcoin could continue to rally, or given its ytd gains, the currency could fall in a classic case of buy-the-rumor-sell-the-news.

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Trick Or Treat?

October 30 (Wednesday)

Strategy: The SNAFU Stock Market. Stocks are trading at record highs as though there is nothing to worry about. As far as stock investors are concerned, the situation is normal, all “fouled up.” The military acronym for this state of affairs is “SNAFU.” In other words, the situation is bad, but that’s normal.

We mostly agree, but we are becoming concerned about the outlook for the widening federal government deficit—partly as a result of soaring net interest outlays—and the mounting federal debt. We’ve often said that we will worry about these fiscal excesses when the bond market starts doing so. It is doing so now, as it did from August to October 2023, when the 10-year Treasury bond yield soared from a low of 4.00% to a high of 5.00% (Fig. 1).

We now must make room for this possible debt-crisis scenario in our three-scenarios framework and their subjective probabilities, which must add up to 100%. We are sticking with our 50% odds of a Roaring 2020s scenario. We are lowering the odds of a 1990s-style stock market meltup back to 20% from 30%. We are raising the odds of a crisis scenario, either a 1970s-style geopolitical crisis and/or a 2023-style government debt crisis, to 30%, up from 20%.

The bottom line is that we are still bearish on bonds, as we have been since our August 19 Morning Briefing titled “Get Ready To Short Bonds?” We are less bullish on stocks for now. So we feel comfortable with our decision to stay with our year-end target of 5800 for the S&P 500. We remain bullish longer term, with targets of 6300 by the end of next year and 8000 in 2029. We think that the odds of a recession remain low.

Meanwhile, “SNAFU” best describes current events:

(1) The economy is performing well, yet measures of consumer and business confidence are relatively depressed. The jobs data looked weak during the summer but has seemed fine since then. However, the Fed’s September 4 and October 23 Beige Books were relatively downbeat about the labor market. Barron’s posted an October 28 story titled “Why It’s So Hard to Find a Job in This Strong Labor Market.” The article suggests that perhaps the labor market isn’t that strong. There may still be plenty of job openings, but employers aren’t rushing to fill them (Fig. 2 and Fig. 3). We think the labor market remains in good shape. (See our latest QuickTakes titled “Help Still Wanted.”)

(2) The Fed cut the federal funds rate by 50bps on September 18 largely because labor market indicators were weakening. Fed officials expected that it would be the start of a monetary easing cycle. The Bond Vigilantes had a different idea, as the 10-year Treasury bond yield rose from 3.70% on September 18 to 4.30% currently. Even the 2-year Treasury yield is up over this period from 3.61% to 4.10%.

In their September 18 Summary of Economic Projections, Fed officials indicated that they expected to continue to cut the federal funds rate through 2025 and 2026 (Fig. 4). They might have to reconsider if their easing moves cause the Bond Vigilantes to tighten credit conditions.

(3) The Bond Vigilantes seem to believe that the economy and the labor market are stronger than Fed officials believed when they cut the federal funds rate last month. Recent data confirm this view, which has been our view. The Bond Vigilantes clearly believe that the so-called “neutral” interest rate is higher than Fed officials think, as do we.

Furthermore, Fed officials often state that they intend to “stay in their lane” by avoiding any discussion of fiscal policy. The Bond Vigilantes may be starting to freak out about ballooning federal deficits and mounting federal debt, just as they did last year from August through October. Unlike Fed officials, they are aware that Washington’s fiscal follies may only get worse no matter who is in the White House next year.

(4) Meanwhile, the geopolitical issues can also be described as a “SNAFU.” The Middle East conflict remains incendiary. However, because there might be a pause in the tit-for-tat retaliation between Israel and Iran, the price of oil fell sharply on Monday (Fig. 5). A loose alliance of emerging economies including the original BRICs is seeking to topple America’s supremacy in global finance. Many of their central banks are buying gold. So the price of gold has been soaring (Fig. 6). Yet the dollar has been relatively firm in recent weeks (Fig. 7).

(5) The US stock market, meanwhile, continues to rise (Fig. 8 and Fig. 9). Nevertheless, we still think that the S&P 500 will be around 5800 by the end of the year and resume climbing in 2025. Then again, the stock market isn’t fazed by all the SNAFUs, so maybe our expectations aren’t bullish enough.

Geopolitics: SNAFUs or Nightmares? Halloween is on Thursday. Financial and commodity markets haven’t been spooked by the latest unsettling geopolitical developments. US stocks are trading at record highs. The dollar remains firm. Oil prices have declined.

Let’s focus on the latest geopolitical frights:

(1) BRICS. From October 22-24, more than 30 countries convened in Kazan, Russia, where Russia’s President Vladimir Putin played host to member leaders from Brazil, India, China, South Africa, Iran, Egypt, Ethiopia, Saudia Arabia, the UAE, and other nations, including NATO member Turkey. Even the United Nations Secretary-General António Guterres attended.

The participants signed a 134-point “Kazan Declaration,” which outlines positions on everything from climate change and pandemic response to countering drug trafficking and terrorism. Yet its main focus is on expanding BRICS ranks and subverting Western dominance, conjuring a world less tethered to the dollar. That vision remains more shadow than substance. Far-reaching dollar-alternative global payment systems would be highly complex to implement. The BRICS’s New Development Bank, with $5 billion in annual funding, is small compared to the World Bank’s $72.8 billion.

Meanwhile, China’s economy remains shaky despite hefty government support. Russia’s economy is muddling along at best, supported by the government’s military spending. Despite playing the BRICS’s host, Russia fell short of the geopolitical backing it sought. The culminating declaration, in fact, urged peaceful negotiations aligned with UN policies to end the war in Ukraine. The next BRICS summit will be in Brazil in 2025.

(2) Russia & North Korea. North Korea's foreign minister arrived in Russia on Tuesday, Reuters reported, possibly to coordinate the 10,000 North Korean troops in Russia joining the front lines against Ukraine.

In June, Russia and North Korea inked a defense pact to support each other in case of an armed attack, signaling the tightest ties between them since the Cold War. The arrangement raises unsettling questions about what Putin may be providing North Korea in exchange for the troops.

South Korea’s response is likely to be limited to providing lethal aid to Ukraine. That’s a marked shift from its prior humanitarian stance.

(3) Israel & Iran. In retaliation for missiles fired at Israel by Iran on October 1, Israel conducted airstrikes on Iran early Saturday, which threatened to ignite a broader Middle Eastern conflict. For now, however, the exchanges appear intended to achieve mutual deterrence while avoiding a full escalation to war. Brent crude oil prices have fallen more than 6% since the start of the week as Iranian oil fields were left untouched.

Iran quickly downplayed the strikes, noting that Israel hadn’t disrupted energy supplies. Israel’s focus stayed on Tehran’s military and other facilities, steering clear of nuclear or oil infrastructure.

(4) Israel, Gaza & Lebanon. Tensions in Gaza and Lebanon persist as the Israel Defense Forces (IDF) carry out operations targeting Hamas and Hezbollah. Following the IDF’s October 17 assassination of Hamas leader Yahya Sinwar, Israel has yet to share what it intends next for Gaza’s leadership.

In Lebanon, the IDF is systemically forcing Hezbollah away from the northern Israeli border following the killing of Hezbollah leader Hassan Nasrallah. Hezbollah’s drone attacks on Israel continue to be effective.

In the background, trust between Israel and the US is haunted by recent surprises and differing strategies. Reportedly, the Biden administration was in the dark on the IDF’s assassinations of Sinwar and Nasrallah. While the US advocates for ceasefires and humanitarian aid, Israel remains focused on military solutions. With the US presidential election imminent, uncertainty about future policies seems to be making Israel hesitant to fully disclose its intentions.

(5) India & China. India and China struck a recent accord to dial back four years of heated tensions along their Himalayan border. This new pact, which aims to cool a military standoff that’s been simmering since 2020, could signal significant reset in Asia’s balance of power. Both sides reportedly disengaged from two points along their border temporarily to ease tensions, a positive signal but by no means a permanent solution.

The recent accord may prove insignificant if bilateral relations between the two nations fail to improve. Following the 2020 clash, India curbed Chinese imports, barred Chinese telecom companies from national projects, and banned several Chinese apps. While these policies remain in place, the accord could signal the first step toward lifting them.

The timing of the agreement on the eve of the BRICS meeting is likely unsettling for Washington. China’s strategic charm offensive with India sidesteps Western efforts to bind New Delhi closer. As Russia, India, and China continue to consolidate under BRICS, this accord signals an emergent front that complicates the West’s coalition-building ambitions in Asia and beyond.

Nevertheless, India and China are global competitors, which will likely override the ties that bind them.

(6) China & Taiwan. Daily reports of Chinese vessels near Taiwan’s coast serve as a constant reminder of the precariousness of peace in the South China Sea. Beijing labels these exercises a “warning” against Taiwan’s democratic separatism.

Last week, Beijing conducted a blockade “exercise” in the Taiwan Strait. Taiwan’s Defense Minister warned that a real Chinese blockade would be an act of war, with the potential to send global trade into a tailspin. Taiwan, backed by the US and other allies, argues that the Strait is free for global passage. Nevertheless, China declared no no-flight or no-sail zones in its latest war games.

This was just a drill.

Earnings: S&P 500 Q3 Earnings Season Update. The S&P 500 companies’ Q3 earnings reporting is nearly 42% complete through midday Tuesday, and the early results are encouraging. Aggregate Q3 earnings for the 209 companies that have reported so far are 6.7% above forecast, and revenues have beat by 1.6% (Fig. 10 and Fig. 11). That beats Q2’s beat measures. Earnings surprises continue to outpace revenue surprises on a percentage basis, continuing a 15-year trend.

Below, Joe dissects the results so far and weighs in with his thoughts:

(1) Financials earnings growth broadening. Due to their status as early reporting companies, the Financials sector tends to weigh heavily on the early results, as it does every quarter. Financials’ Q3 season is nearly two-thirds finished, while all other sectors are between 10% and 45% complete. The sector has reported a 9.7% earnings surprise and 9.7% y/y earnings growth so far. That’s the biggest surprise in nine quarters. More impressively, nearly 80% of the sector has reported positive y/y revenue and earnings growth. That’s the biggest percentage of Financials’ firms reporting earnings gains in three years.

(2) Autos driving Q3 surprise too. Also surprising were the big earnings beats and positive guidance coming out of General Motors and Tesla. Not surprising was Ford’s slip. The earnings beats by GM and Telsa easily rank in the top nine of the S&P 500’s biggest total dollar earnings surprises so far.

(3) Double-digit earnings growth, without Boeing. While Boeing’s strike-impacted Q3 results came close to its recently reduced forecasts, its $6.4 billion loss was more than triple a year earlier and the biggest in the S&P 500. Boeing’s loss reduced the S&P 500’s y/y growth rate for Q3-2024 by 2.3ppts to 7.7%.

Excluding Boeing, the S&P 500’s y/y earnings growth rate improves to 10.0%, which ranks among the strongest earnings growth quarters since Q1-2022, when the US economy was still recovering from the pandemic.

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On Economic Data & Theories

October 29 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

US Economy I: Less Useful Soft Data. Soft data, or data from surveys, can give investors a heads-up about emerging economic shifts before hard data record them. They can also be useful for confirming or questioning the latest economic indicators before revisions arrive.

However, soft data seem to be getting less reliable. Whether due to longstanding pandemic distortions, political polarization, or declining (or online) response rates, we find surveys are less accurate today than in years past.

That’s caused several head-fakes in this cycle and cemented many die-hard hard-landers to their narrative of impending doom and recession despite two years of a roaring bull market and above-trend economic growth.

Let’s discuss a few of the key surveys that we believe some observers have been placing too much weight on:

(1) Beige Book. The Fed publishes its Beige Book roughly eight times per year and is often cited by officials on the Federal Open Market Committee (FOMC) as their grassroots perspective on the economy. The Beige Book collects anecdotes on current economic conditions from the Fed’s 12 District Banks on key sectors.

In the October 1 Morning Briefing, we cited anecdotes from the Fed’s August 2024 Beige Book suggesting that the presidential election has weighed on economic activity across the country and myriad sectors. One of our competitors commented that the August Beige Book strongly supported a 50bps drop at the September FOMC meeting, which the bond market quickly assessed to be too much, too soon.

The Beige Book edition published last week held several bearish anecdotes, noting slowing bank lending volume (excluding credit cards) and a slowdown in hiring in several industries. The second point jibes with the slowdown in job openings and quits reported in the JOLTS survey (Fig. 1). But bank lending data show continued—and quicker—growth (Fig. 2).

Among the bullish comments, banks reported strong credit quality and low delinquency rates. That jibes with what Capital One’s CEO said last week on the company’s Q3 earnings call—i.e., that consumers generally are in good shape. But it flies in the face of some analysts’ concerns about consumers and delinquencies.

Rather than being used to find new or contrarian ideas, soft data seem to be more often used to confirm biases and narratives. That can cause trouble, particularly when soft data become less reliable.

(2) SLOOS. The Fed’s Senior Loan Officer Opinion Survey (SLOOS) is another survey that FOMC members like to cite. Credit conditions tightened rapidly as the Fed raised rates, per the SLOOS (Fig. 3). Yet bank lending continued to grow throughout the past two years. We expect the survey to start showing an outright loosening next quarter.

As Eric observed in the August 12 Morning Briefing, the SLOOS tends to tighten rapidly but ease slowly, because banks are hesitant to appear trigger happy with making loans to the Fed, knowing it may affect monetary policy. We believe the SLOOS reflected the same fears as the inverted yield curve—that monetary tightening would cause a credit crisis that morphed into a credit crunch and therefore recession, ultimately leading lenders to pull back from financing even for highly rated borrowers. What we call the “Credit Crisis Cycle” was put on pause by the Fed and Treasury’s efforts to quickly stem the mini regional banking crisis in March 2023.

(3) ISM M-PMI. The Institute for Supply Management’s (ISM) monthly manufacturing survey tends to lead the growth rate of real GDP goods. Indeed, new orders in the M-PMI is one of the 10 series within the Index of Leading Economic Indicators (LEI). While the ISM M-PMI has been one of the few soft data series that is accurately aligned with the slowdown in actual production, real GDP goods has continued to grow at around a 2.0% y/y pace (Fig. 4). Survey data seem to be more pessimistic than the economic reality.

The monthly regional M-PMI surveys conducted by some Fed district banks come out before the national ISM report is released. For October, the average of the key districts we track remains negative, suggesting the October ISM M-PMI will as well (Fig. 5).

(4) NFIB. The NFIB Small Businesses survey has similarly been depressed since the Fed began tightening monetary policy in 2022 (Fig. 6). The survey suggests that few small business owners believe it’s a good time to expand (Fig. 7). However, it’s unclear whether that’s because business is bad or because they cannot find enough qualified workers (Fig. 8). Inflation remains small business owners’ biggest issue, while poor sales and higher interest rates are the least cited “most important problem” (Fig. 9).

(5) Consumer sentiment. Consumer expectations for business conditions in the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI) are also in the LEI (Fig. 10). Yet the University of Michigan’s CSI has been extremely downbeat, most recently below 69. We believe that has to do with the survey’s focus on inflated prices compared to when the pandemic started, which remains top of mind for consumers.

Meanwhile, a recent study by former Council of Economic Advisers chief economist Ernie Tedeschi and Ryan Cummings found that the University of Michigan’s switch to online interviews has artificially depressed the data by 9 points. Participants also increasingly rate the economy as better when their party is in the White House.

The CCI has also recorded much lower readings for income cohorts below $50,000 per year (Fig. 11). Many of these respondents are either part-time or much younger, which isn’t a surprise. Earning $30,000 per year after the cost of essentials rose roughly 40% in a few years would certainly make anyone pessimistic (Fig. 12). However, a significant portion of young adults are receiving financial help from their parents, as Ed knows all too well.

Such misleading soft surveys are the reason we believe the LEI has inaccurately predicted a recession for the past two years despite brisk economic growth and new record highs in the Index of Coincident Economic Indicators (Fig. 13). Those who over-rely on soft data are likely to continue to be misled.
 
US Economy II: Ten Useless Macro Theories. It’s difficult to count the number of mainstream macro theories that we’ve debunked over the past few years. Many long-used relationships and correlations have been upended by record monetary and fiscal stimulus during the pandemic, a wave of early retirements by Baby Boomers, and interest-rate hikes off ultralow levels. We’ve been busy shooting them down since early 2022. Taking great pains to keep it short, below is a review of the 10 widely held macro theories that haven’t held water and the reasons that they’ve led many astray:

(1) Modern Monetary Theory. Melissa and I have said before that Modern Monetary Theory (MMT) isn’t modern, isn’t monetary, and isn’t a theory. MMT’s proposition that a government that borrows in its own currency can finance its spending at will with more debt lost credibility as inflation soared in 2022 and 2023. However, MMT seems to be working now that inflation has subsided. Even as the federal deficit remains very wide—and the consensus is that after the November elections, it will continue to widen—inflation has moderated to near 2.0% (Fig. 14 and Fig. 15).

MMT’s zealots within the current administration have been essentially using a blank check to load up on fiscal stimulus even though the economy is already growing faster than 3.0% y/y. The interest cost on the federal debt is increasing rapidly due to the record debt issuance and higher rates (Fig. 16).

It’s not the Fed’s job to lower rates to accommodate the government, as some have suggested, because that would lead to more inflation. The government instead needs to slow its pace of debt financing (Fig. 17). Without doing so, future generations will be saddled with a huge pile of debt that will hamper any stimulus efforts if and when there is a recession (Fig. 18).

(2) Inverted yield curve. According to our Credit Crisis Cycle theory, the inverted Treasury yield curve signals that bond investors are worried that higher short-term interest rates will cause a credit crisis and therefore a recession. Because the Fed and Treasury prevented a credit crunch from emerging as regional banks collapsed last March, the expansion was able to continue (Fig. 19).

(3) Disinverting yield curve. The Treasury yield curve has flipped positive in September, with the 10-year yield now roughly 15bps above the 2-year yield (Fig. 20). Historically, a recession has followed soon after such a disinversion—but only because the Fed was cutting interest rates rapidly to stem a crisis, which then morphed into a recession. This time around, the Fed is cutting rates as a preventative measure.

(4) Falling LEI. The 10 components of the LEI are heavily weighted toward the manufacturing sector and include things like the inverted yield curve. That’s led the LEI to inaccurately predict a recession for the past two years. Goods consumption has stagnated at record highs since the Fed raised financing costs and demand for goods decreased after surging during the pandemic (Fig. 21). The US economy depends on services versus goods at a roughly 2:1 ratio, rendering the LEI less effective at predicting the economy's performance (Fig. 22).

(5) Phillips Curve. The Phillips Curve model is based on the inverse correlation between wage and price inflation versus the unemployment rate (Fig. 23). However, it ignores the inverse relationship between the unemployment rate and productivity growth. So inflation was able to fall in this cycle without a recession, in part because the tight labor market promoted investments that improved productivity (Fig. 24).

(6) Neutral interest rate. Doves on the FOMC advocate for cutting the federal funds rate (FFR) in order to maintain a neutral real FFR. Their worry is that as inflation falls, the real FFR gets tighter and exerts unnecessary pressure on the economy (Fig. 25). We think that adjusting an overnight borrowing rate (which few consumers or businesses actually use) by the y/y change in inflation makes no sense. Empirically, the US economy has also done well despite a rising real rate.

We believe that productivity growth may be one of the most important factors in determining the neutral interest rate. Fiscal policy certainly matters as well. But the Fed commentators who oft-cite the neutral rate don’t seem to account for those two factors.

(7) Taylor Rule. The Taylor Rule is a mechanical formula for setting the FFR based on the unemployment rate (or economic growth) and inflation. As inflation has fallen, proponents of the rule suggest rates should, too. However, the rule depends on knowing how high the economy’s potential growth is, and what the neutral unemployment rate is (the rate that neither raises nor weighs on inflation). Of course, neither of these is measurable. If anything, we believe that higher productivity growth and immigration have raised the US economy’s potential, suggesting the model would advise a higher FFR.

Of course, anyone using the Taylor rule to set monetary policy would have ended easing and started raising rates much sooner than this Fed did (Fig. 26).

(8) Sahm Rule. The so-called Sahm Rule, a recession indicator based on the moving average of the headline unemployment rate, was triggered in July when the unemployment rate rose to 4.3% (Fig. 27). We dismissed this at the time as yet another false recession signal. That proved to be the right call, as the unemployment rate ticked down from 4.2% in August to 4.051% last month. Besides, soaring unemployment is associated with credit crunches and recessions, not with real GDP growing 3.0%!

(9) Excess saving. JP Morgan Chase CEO Jamie Dimon warned in December 2022 that the exhaustion of excess savings and inflation would “derail the economy and cause a mild or hard recession.” We said that rising real wages, increased income from higher rates, and a very positive wealth effect would allow consumers to keep spending. Baby Boomers in particular would “dissave” as they retired during the pandemic, and soaring home and stock values would embolden them to spend.

The latest revision from the Bureau of Economic Analysis found that nonlabor incomes were much higher in 2022 and 2023 than it had believed, which raised the personal saving rate from 3.3% to 5.2% as of Q2 (Fig. 28). It seems consumers haven’t exhausted their savings after all.
 
(10) Money matters. M2 money supply contracted from November 2022 through March 2024 (Fig. 29). Yet the stock market enjoyed a huge bull run and inflation moderated. That should have quieted the monetarist view that inflation is everywhere and always a monetary phenomenon.

Perhaps monetary policy is not the most important factor for economic growth. Productivity attributable to the efforts of the private sector may be more important, in our opinion. Furthermore, fiscal policy may quicken money velocity and encourage more consumer spending and business investment.

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Valuation In A Resilient Economy

October 28 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
Strategy: Evaluation of Goldman’s Valuation Model. We admire the economists and strategists at Goldman Sachs. They often agree with us, though we often scoop them. However, we don’t agree with their recent depressing long-term prediction for the S&P 500 returns over the next 10 years. We explained why in our Tuesday, October 22 QuickTakes titled “Lost Decade Ahead For Stocks With Only 3% Annual Returns?”

We did receive a few questions from our readers on the issue of valuation raised by Goldman’s analysts. According to the October 25 Briefings from Goldman Sachs (which is publicly available): “The most important variable in this forecast is starting valuation. ‘In theory, a high starting price, all else equal, implies a lower forward return,’ writes David Kostin, chief US equity strategist at Goldman Sachs Research.”

That suggests that starting valuations now are high relative to what they’ll be in the future—so it seems to assume that they’ll be lower 10 years from now. However, that’s clearly a “known unknown”: We know that 10 years from now, valuations will be higher, the same, or lower than now; but we don’t know which.

Granted that current valuation multiples are stretched by historical standards; but 10 years into the future, they might still be as high as they are now even with drops along the way. If so, then over the next 10 years the S&P 500 price index would rise along with its earnings—at a pace that should be at least twice as fast as Goldman’s 3% annual projection and closer to 11% including reinvested dividends. In our Roaring 2020s (and maybe Roaring 2030s), valuations might be higher than they are today.

Goldman acknowledges that the S&P 500’s annualized nominal total return over the past decade was 13%, a bit higher than the 11% long-term average. Our numbers agree with theirs (Fig. 1). We also note that the longer-term average gain of the S&P 500 stock price index (excluding dividends) has been around 6% per year. That has been the same as the longer-run average of the annual growth rate of S&P 500 reported earnings per share (Fig. 2). There’s no reason to expect earnings to grow less than 6% per year on average over the next 10 years. In our Roaring 2020s (and maybe Roaring 2030s), they might grow at a faster pace.

If the valuation multiple were to be halved over the next 10 years, then the S&P 500 stock price index indeed might rise by only 3% per year. But that still leaves an extra 4% annualized return given that the difference between the total return of the S&P 500 index and the return on just the index itself has been roughly 4% per year on average over the longer run. That differential represents the powerful effect on the S&P 500’s total return of compounding dividends (Fig. 3).

Goldman’s concern about the potential downside of the stock’s market’s valuation multiple over the next 10 years is heightened by the market’s concentration. According to the Briefings cited above: “At present, the 10 largest stocks in the S&P 500 account for more than a third of the total market cap. The current level of market concentration—at a multi-decade high—represents another drag on our analysts’ forecast. Without this variable, the baseline return forecast would be roughly 4 percentage points higher (7% rather than 3%) and the range would be 3% to 11% rather than -1% to 7%.”

Let’s further critique Goldman’s analysis by focusing on its valuation assumption and its issue with concentration:

(1) Valuation and returning to the mean. One of the most popular and simple models of valuation is reversion to the mean. The four-quarter trailing P/E of the S&P 500 has averaged 19.6 since the start of 1964. It was well above that during Q2-2024, at 26.8 (Fig. 4). The trailing P/E, using either reported or operating earnings, tends to exceed the forward operating P/E of the S&P 500 (Fig. 5).

The S&P 500 forward P/E averaged 15.7 since the start of 1985 and was 21.8 during the October 25 week (Fig. 6).

The reversion-to-the-mean model confirms that P/E valuations are stretched. They aren’t as high as they were during the tech bubble in 1999 and 2000, but they are getting close. The forward P/E hit a high of 25.0 during the April 13, 1999 week. If the current P/E revisits that level, such a meltup could set the stage for a meltdown, as occurred during the tech wreck of the early 2000s.

If so, that scenario would more likely play out over the next couple of years than over the next 10 years, when valuations might be as high or higher than they are today. The stock market certainly recovered from the tech wreck of the early 2000s and the valuation multiple today is fast approaching the one back then!

To be fair to Goldman, a lost decade for stocks isn’t unheard of: The S&P 500 was basically flat 10 years after it peaked at a record high during April 2000. However, that’s largely attributable to the Great Financial Crisis. By April 2013, it was back at a new high and nearly quadrupled since then. Over that so-called lost decade from Q2-2000 through Q2-2010, S&P 500 dividends rose 41%.

(2) Valuation and interest rates. Valuation is certainly influenced by both interest rates and inflation rates (Fig. 7 and Fig. 8). However, the Fed’s Stock Valuation Model (as Dr Ed dubbed it in 1996), showed that the correlation between the 10-year Treasury bond yield and the S&P 500’s forward earnings yield (i.e., the reciprocal of the forward P/E) was much higher from 1985 through 1999 than it has been since then (Fig. 9).

In any event, interest rates and inflation rates are hard enough to forecast on a short-term basis let alone over the next 10 years. Furthermore, despite the ups and downs of both over the past several decades, the S&P 500 stock price index has reliably delivered annual gains averaging between 5.0% and 6.0%, and dividends have been trending higher.

(3) Valuation and the Misery Index. We recently observed that the S&P 500 forward P/E has been inversely correlated with the Misery Index since 1985 (Fig. 10). Again, forecasting the Misery Index, which is the sum of the unemployment rate and the inflation rate, over the next 10 years is an undertaking accepted only by the Congressional Budget Office (CBO) to project the outlook for the federal deficit over that period. The CBO adjusts its forecasts on an annual basis and isn’t held accountable for being regularly wrong.

(4) Concentration. Goldman’s concern about the market’s lofty valuation is heightened by the concentration of the stock market. The Magnificent-7 stocks currently account for the following shares of the S&P 500: 29% of the market capitalization, 21% of forward earnings, and 11% of forward revenues (Fig. 11). Collectively, the group has a forward P/E of 29.0 (Fig. 12). The S&P 500 forward earnings with and without these seven companies is 21.9 and 19.6.

Here is how we addressed the market concentration issue in Tuesday’s QuickTakes: “One of the biggest ‘worries’ in Goldman’s analysis is that the stock market is highly concentrated. But while the Information Technology and Communication Services sectors together now make up about 40% of the overall S&P 500, around the same as at the peak of the dotcom bubble, their companies are much more fundamentally sound today than back then.

“These two sectors account for more than a third of the S&P 500’s forward earnings today versus less than a quarter in 2000 (Fig. 13). We also believe that these days all companies can be thought of as technology companies. Technology isn’t just a sector in the stock market but an increasingly important source of higher productivity growth, lower unit labor costs inflation, and higher profit margins for all companies.”

By the way, collectively, the forward P/E of the S&P 500 Information Technology and Communication Services sectors is currently 25.8, well below the record 41.0 peak in early 2000 (Fig. 14).

(5) Valuation and resilient economic growth. Often missing in discussions of valuation is the outlook for economic growth. The P/E multiple of the stock market is likely to be higher the more that investors believe that the economy will grow at a solid pace for a longer period of time. It will be lower if they are fretting about an imminent recession. When investors anticipate a recession, the P/E often falls because investors are uncertain about how long it will be before a recovery starts and how strong (or weak) the recovery will be (Fig. 15). Once a recession occurs, the P/E tends to rise when investors start anticipating a recovery.

This accounts for the inverse correlation between the stock market’s valuation multiple and inflation rates and interest rates. Rising inflation forces the Fed to raise interest rates, thus increasing the odds of a recession, which depresses the P/E. Low inflation and interest rates have the opposite effect on the P/E, raising it because the odds of a Fed-led recession are relatively low.

So not surprisingly, there’s a close correlation between the S&P 500’s forward P/E and analysts’ consensus expected long-term earnings growth (LTEG) over the next five years (Fig. 16). LTEG and S&P 500 forward earnings per share are available only since 1985. Nevertheless, the P/E tends to rise (fall) when LTEG is rising (falling).

Here's one more very important point regarding the relationship between valuation and expected economic growth: Valuation of an individual stock is more a function of how long investors expect it to take for earnings to catch up with valuation. That’s why rapidly growing companies have higher-than-average P/Es. Maturing companies have lower-than-average P/Es because they are expected to grow more slowly. The Magnificent-7 companies refuse to mature, continuing to deliver surprisingly strong earnings growth. So they get a higher P/E. Perhaps in the future, they will stay that way and perhaps there will be more such companies.

(6) Bottom line. The latest Briefings from Goldman Sachs concludes: “US stocks will face stiff competition from other assets at such low levels of return, according to our strategists. Their forecast suggests the S&P 500 has roughly a 72% probability of underperforming bonds and a 33% likelihood of lagging inflation through 2034.”

So what’s an investor to do? Open an account at Goldman and buy the firm’s alternative investments promoting higher returns for the next 10 years! Or else rely on our more optimistic outlook for the S&P 500, which should continue to rise by 6% per year on average and deliver an 11% annual total return over the next 10 years. If our Roaring 2020s scenario continues to play out, the return should be even greater as technology-led productivity gains boost economic growth and profit margins (Fig. 17).

Movie. “Monsters” (link) is a 2022 Netflix docudrama series about the Menendez brothers, who were convicted in 1996 of the brutal murders of their parents in their Beverly Hills mansion in 1989. It is especially relevant today because they might soon be resentenced, opening the possibility of parole instead of serving out their life sentences. The unanswered question is whether the monsters were the two brothers or their two parents. The dialogue about the abuse that the parents allegedly committed against their two sons is intensely graphic and unsettling. The actors portraying all four of the dysfunctional family members did a great job of portraying their characters as monsters. The directing and editing are superb too.

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Industrials, Housing & Smart Robots

October 24 (Thursday)

Industrials: Tough to Beat Lofty Expectations. The stock price index of the S&P 500 Industrials sector may not be soaring as high as those of the Information Technology or Communication Services sectors, but it’s still having one heck of a year, up 20.2% ytd through Tuesday’s close.

Here’s how the Industrials’ performance stacks up against the S&P 500 and its other sectors ytd: Information Technology (34.7%), Communication Services (28.7), Utilities (28.3), Financials (25.2), S&P 500 (22.7), Industrials (20.2), Consumer Staples (15.7), Materials (12.4), Consumer Discretionary (11.5), Health Care (10.7), Real Estate (9.4), and Energy (8.6) (Fig. 1).

Some of the industries within the Industrials sector have had even more impressive ytd performances than the sector, including: Industrial Conglomerates (34.5%), Passenger Airlines (31.9), Construction Machinery & Heavy Trucks (28.9), and Electrical Components & Equipment (21.0) (Fig. 2).

The sector’s ytd performance would have been higher had it not been dragged down by the likes of Boeing (-38.7% ytd), which weighed on the Aerospace & Defense industry index (18.6%). Also hurting the Industrials sector were Industrial Machinery (14.5%) and some transportation-related industries, such as Rail Transportation (0.5%), Cargo Ground Transportation (-3.7%), and Air Freight & Logistics (-6.7%) (Fig. 3).

This week, GE Aerospace, Lockheed Martin, RTX, and Boeing reported September-quarter earnings. Let’s take a look at what they had to say.

(1) High expectations. Many Industrials stocks sold off after reporting Q3 earnings, but they remain up sharply for the year. GE Aerospace shares fell 9.1% after reporting earnings on Tuesday, reducing the stock’s ytd gains to a still impressive 73.6%. Lockheed Martin shares dropped 6.1% on Tuesday, but its ytd gain remains a healthy 27.3%. 3M shares dipped 2.3% and RTX shares declined 0.29% on Tuesday, but both stocks remain up more than 40% ytd. The S&P 500 was essentially flat on Tuesday, down 0.05%.

Boeing, however, is a different story. Its shares fell roughly 1.5% after reporting earnings on Wednesday, bringing its ytd decline to almost 40%. The company has made an offer to union workers that it hopes ends their strike. It also faces operational issues that have led to two plane crashes, plane malfunctions, and the delayed rollout of new planes. The company reported a $6.2 billion Q3 loss.

Ironically, Boeing’s woes have benefited GE Aerospace. Older planes in the air need more repairs, and that’s good for GE’s aftermarket parts business. GE makes better margins on replacement parts than it does on the sale of engines that go into new planes.

GE Aerospace’s Q3 revenue of $9.8 billion rose 5.8% y/y and topped Wall Street’s estimate of $9.3 billion. Adjusted EPS of $1.15 topped analysts’ consensus estimate of $1.13. The company also upped its full-year EPS forecast to $4.35 from $4.20.

(2) Wars boosts defense spending. Lockheed Martin and RTX both benefitted from increased defense spending by countries around the world. Lockheed has had some difficulties updating its F-35 fighter jet, but investors seem to be hoping the issue will be resolved soon and are focusing instead the orders backlog for all Lockheed products, which has grown to $165 billion. The defense contractor also manufactures missiles, which are in high demand, with sales in that segment up 8% y/y.

Lockheed’s Q3 sales rose only 1.3% y/y, and adjusted EPS came in at $6.84, above the consensus of $6.50 and up from $6.77 a year ago. The company increased its 2024 earnings forecast to $26.65 a share, above the previous range of $26.10-$26.60.

RTX reported adjusted Q3 sales excluding divestitures of $20.1 billion, up 8% y/y, and adjusted EPS of $1.45, a 16% increase. The contractor also has a large backlog of $221 billion. Like its competitors, RTX benefitted from a strong aftermarket airplane parts market and solid spending on missiles and missile defense systems, among other defense products. It too boosted its 2024 forecast, with adjusted EPS now expected to come in at $5.50- $5.58 instead of $5.35-$5.45 previously.

(3) Multiples flying high. Despite being weighed down by the shares of Boeing, the S&P 500 Aerospace & Defense industry’s stock price index has risen 18.6% ytd through Tuesday’s close (Fig. 4). Analysts presumably are optimistic that Boeing will get its act together next year or at least benefit from the easier y/y comparisons it faces, because the overall industry’s sales are expected to flip from declining 4.5% this year to rising 9.5% in 2025 (Fig. 5). Likewise, the industry’s earnings, which declined slightly this year, by 0.6%, is expected to surge 52.0% next year (Fig. 6).

The only thing not to like about the S&P 500 Aerospace & Defense industry is its lofty forward P/E of 26.4 (Fig. 7). That’s well above even the highest valuations of the past three decades. Boeing’s return to profitability and the continuation of wars around the world may allow the industry to grow into its multiple, but it’s certainly something for investors to watch.
 
Housing: Higher Rates Spook Homebuilders. The S&P 500 Homebuilding stock price index is up 22.8% ytd through Tuesday’s close but has fallen 7.6% from its high on Friday as interest rates backed up over the past week (Fig. 8). The 10-year Treasury yield has popped back up to 4.20% from its recent September 16 low of 3.63% and mortgage rates followed suit, inching up to 6.44% from their recent low of 6.08% during the final week of September (Fig. 9).

That said, home mortgage rates remain almost a percentage point below where they stood a year ago. The unadjusted mortgage purchase index decreased 5% w/w, but rose 3% y/y for the survey week ended October 18, the Mortgage Bankers Association reported on Wednesday.

We’ve been keeping an eye on the inventory of new and existing homes for sale. The number of existing homes for sale has been creeping up but remains near record-low levels. Existing home sales in September fell 3.5% y/y and 1.0% m/m, and the inventory of unsold existing homes rose 1.5% m/m and 23.0% y/y, the National Association of Realtors reported yesterday.

The number of new homes for sale has jumped more sharply and bears watching. The inventory of new homes on the market rose to 467,000 units (saar) in August, up from a recent low of 426,000 units in May 2023 (Fig. 10).

Most home prices are up y/y, with the median existing-home sales price up 3.0%y/y in September. There are a handful of exceptions, however, including small percentage declines in the once-hot markets of Austin, Dallas, and San Antonio, Texas as well as Tampa and Jacksonville, Florida, an October 21 Fast Company article reported.

More surprising are the price declines in 20 of the 50 largest metro areas since the 2022 peak in housing prices. Some drops were modest, in the low single-digit percentages. But other price declines were nothing to sneeze at, such as in Austin (-20.4%), Phoenix (-8.0), San Antonio (-6.8), Denver (-6.4), and Salt Lake City (-5.7). While it’s hard to imagine a broad-based housing decline during a time of low unemployment, inventory levels and prices deserve watching.
 
Disruptive Technologies: Spatially Intelligent Robots. Robots traditionally have been used for repetitive tasks, like welding or painting a particular object on an assembly line. But the most advanced humanoid robots can react to unexpected events thanks to artificial intelligence (AI). They can be trained to respond appropriately to events they’ve never encountered by watching videos or human trainers. They possess “spatial intelligence.”

“The next generation of robotics will be able to sense, see, make decisions, and take action based on their objectives and surroundings,” explained an excellent Business Insider article. And companies creating these futuristic, intelligent robots are out raising oodles of money. Let’s take a look at how these robots are being trained and who’s attracting some of the big bucks:

(1) Training robots. Large language models are trained by “reading” everything available on the web. But there isn’t as much video available to train robots. So folks like Fei-Fei Li, the “Godmother of AI,” are working to digitize the 3D world so that robots can be trained to implement what they learn in the real world under circumstances they recognize.

Li began down this road by identifying and labeling objects in pictures for computers. Her company ImageNet was launched in 2007, and two years later it had labeled 15 million images in 22,000 categories using everyday English words. Li gave a sense of the project’s massive size in a 2015 TedTalk. She explained the project labeled the pictures of 62,000 cats in all kinds of poses and species so that the computer would be able to recognize a kitten poking out from behind a chair as well as a large cat laying on its back. And then it did the same for dogs and cows, etc.

Once pictures were labeled, computers could use a neural network to recognize pictures and then computers were “taught” to apply language to the visual picture so that they could describe it. That was the start of giving “sight” to the machines.

Now Li and other researchers have formed World Labs, a spatial intelligence AI company, which plans to build large world models to perceive, generate, and interact with the 3D world. The company plans to release products next year for applications in robotics, gaming, and other areas.

Li envisions a future where humans digitize the world into 3D environments and create a wide variety of simulations with which to train robots, she explained in a April TedTalk. Beyond just identifying an object, trained robots will be able to react appropriately in “real world” situations. They’ll not only know that an object is a glass of milk; they’ll know when to support it to prevent a spill (and won’t cry if they’re not fast enough!).

(2) Companies raising lots of cash. Companies involved with AI and robots are out pounding the pavement raising cash, while investors are extremely enthusiastic about this intersection of AI and robotics.

Figure, which is building general use robots, raised $675 million this spring from investors that include Microsoft, Nvidia, Jeff Bezos, OpenAI Startup Fund, Amazon Industrial Innovation Fund, Parkway Venture Capital, Intel Capital, Align Ventures, and ARK Invest. The deal placed a $2.6 billion valuation on the company, a February 29 Reuters article reported. The company will use the funds to train its robots, build manufacturing facilities, and hire more people.

Physical Intelligence raised $70 million in seed funding to help it “develop foundation models and learning algorithms that can power a wide range of robots and physically-actuated devices,” a March 12 article in Maginative reported. More simply, the company aims to bring AI to the physical world and allow robots to operate in any environment. Investors included Thrive Capital, Khosla Vetures, Lux Capital, OpenAI, and Sequoia Capital.

Skild AI aims to build a “scalable AI foundation model for robotics,” which would basically lead to a generalist robot that isn’t pretrained on any one task. The company raised $300 million, which values the company at $1.5 billion. Funding was led by Lightspeed Venture Partners, Coatue, SoftBank Group, and Jeff Bezos.

And Carbon Robotics raised an undisclosed amount of new funding in May to further its efforts to create a robot that uses AI and lasers to kill weeds on farms. “Carbon Robotics said the LaserWeeder processes 4.7 million high-resolution images per hour and can eradicate 5,000 weeds per minute with sub-millimeter precision. The company also said its agricultural image dataset consists of 25 million labeled plants and more than 30,000 crop and weed models,” a May 7 article in The Robot Report reported. The LaserWeeder should reduce the amount of herbicide farmers need to apply either preventatively or after the weeds appear.

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Still Staying Home

October 23 (Wednesday)

Global Strategy I: Paying for Profits. One reason US stocks command higher valuations than those of other developed markets is that US companies tend to have better profit margins (Fig. 1 and Fig. 2). Wider margins result from both stronger productivity in the US and a heavier weighting toward technology companies at the index level (Fig. 3). If you think about it, these go hand in hand. America’s latest productivity boom is driven by surging investment in technology like software and R&D, while the companies producing those at scale also tend to have wider margins (Fig. 4).

Consider the divergence between how well American companies keep their revenues versus companies in foreign markets:

(1) Developed economies. Few countries’ stock markets compete with America’s when it comes to forward profit margins (we derive forward margins from the time-weighted average of analysts’ consensus revenues and earnings estimates for the current and following year, measured weekly). Among advanced economies, only MSCI Canada (14.1%) and MSCI Australia (13.4%) exceed the MSCI US’s 13.1% forward profit margin (Fig. 5 and Fig. 6).

Of course, both Canada and Australia are large commodities producers with a heavy weighting toward banks. Financials stocks tend to command better margins—the S&P 500 Financials sector has a 19.4% forward profit margin, for instance (Fig. 7).

(2) Emerging economies. Not many emerging market (EM) economies can compete with the US in terms of profit margins either. India’s 12.3% forward margin is close and showing a strong uptrend (Fig. 8). But at 23.6 times forward earnings, India’s MSCI index is even more expensive than American stocks. South Africa, another commodities-heavy economy, has 16.2% forward margins (Fig. 9). That makes more sense when considering that nearly half of its MSCI index is the global internet company Naspers.

(3) US presidential election. The outcome of the US November elections could change the dynamic, hurting US margins (Fig. 10). Should Vice President Kamala Harris win and the Democrats sweep both houses of Congress, higher corporate tax rates would depress margins. Of course, a sweep by either party is likely to put upward pressure on long-term bond yields and financing costs as they widen the deficit (through spending by the Democrats or tax cuts by the Republicans).

In our opinion, productivity growth will continue powering the US economy, expanding profit margins, tempering inflation, and keeping the debt levels in check relative to GDP. But a sweep by either party in November raises the risk of the US's post-pandemic stock market excellence dimming a bit.

Global Strategy II: Vote of Confidence for the US. Since 2010, we’ve maintained a Stay Home investment strategy versus Going Global. We expect that theme to continue to outperform.

Risks for both EMs and the US may emerge as the Federal Reserve balances its dual mandate, however. Let’s look at the global indicators pointing to continued US strength, starting with forward revenues:

(1) US forward revenues consistently outperform. The US MSCI’s forward revenues per share has surged 47.0% since the week of June 4, 2020. Compare that to the forward revenues per share of the All Country World (ACW) Ex-US MSCI (in local currency), which has increased by 10.2%. US companies' revenue growth prospects are a clear sign of economic resilience and strong consumer demand (Fig. 11).

Emerging markets have paled in comparison. Revenues of the ACW Ex-US index has grown just 8.3% since June 4, 2020. The Developed World MSCI’s forward revenues has also failed to keep up, up 21.9% since June 4, 2020 (Fig. 12).

(2) Global growth’s a drag. Global economic growth remains lackluster, dragged down by China and Europe. Our YRI Global Growth Barometer has been trending weak since the start of 2023, alongside falling commodity prices (Fig. 13).

(3) Global industrial production’s a drag. Global industrial production rose a mere 1.8% y/y through July—well below the long-term average of 2.5%. Despite stagnating over the past couple years, industrial production has been much stronger in the US than the rest of the G7.

(4) EMs at risk of US protectionism. The outlook for China and other exporting EMs could get bleaker if Trump 2.0 results revived US protectionism and tariffs.

(5) Fed’s coin toss could hurt EMs. If the Federal Reserve holds US interest rates at current levels for an extended period, EMs could face the familiar double-edged threat of capital outflows and currency depreciation.

On the other hand, if the Fed opts to further cut rates, the risk shifts to overstimulating the US economy. Such a scenario could ignite a fresh rally in equity markets, potentially leading to a meltup, as we discussed in Monday’s Morning Briefing.

Global Strategy III: World Growth Tour. Our latest global expedition reinforces the idea that there’s no place like home.

Here’s a roundup of selected countries’ forward revenues per share and growth outlook:

(1) The soft ABCs of global commodities. The export-heavy economies of Australia and Brazil are reeling from China’s economic slowdown. China’s reduced demand for Australia’s iron ore has sharply reduced Australian exports. Coal and natural gas demand is also down, though gold exports have offered some relief.

After a slight recovery post-pandemic, Australia’s revenues and GDP growth have slowed, with GDP growth at just 1.0% y/y, below the pre-pandemic range of 2.0%-3.0% (Fig. 14).

Brazil's iron ore exports similarly suffered from China’s weaker demand (Fig. 15). Flooding this year hurt soybean exports, and recent dips in oil exports reflect an oversupplied global market and slowing demand.
 
(2) Mexico, a deceptively bright spot. Mexico defies the exporter slowdown, with forward revenues per share up 8.8% since January 3, thanks largely to US nearshoring (Fig. 16). Whereas China used to represent the majority share of total US imports, Mexico has held that honor since early 2023. Of course, some of that increase in volume has resulted from Chinese companies shifting supply chains to avoid tariffs.

Mexico is no investing Eden, however. Cartel violence, political corruption, and China’s potential backdoor influence keep us cautious on Mexican assets. In addition, a Trump 2.0 administration could upend the trade agreement negotiated during his first term.
 
(3) Eurozone drags as Germany stumbles. Eurozone GDP edged up by just 0.6% y/y in Q2 (Fig. 17). Forward revenues per share rose 3.9% from January 3 through October 21, trailing the US’s 4.8% jump.

The region faces a tough combination of high interest rates, weakened demand at home and abroad, scaled back fiscal support, and significant drag from Germany's struggling industrial sector. The forward revenues of the economy we call “the sick man of Europe” have stayed flat since mid-2022, and real GDP growth was zero y/y in Q2. Joe is looking into whether the October spike in revenues was due to an index composition change. Stay tuned.

(4) The sun rises and sets in Japan. Japan’s forward revenues per share (in yen) surged by 34.2% from June 4, 2020 through the latest week (Fig. 18). However, this increase has had a muted impact on annual real GDP output compared to other countries. This is likely due to Japan’s private consumption constituting a smaller share of GDP than in other nations. Conversely, Japan’s public debt remains significantly high as a percentage of GDP.
 
(5) China’s misses the mark. China’s economy continues to struggle; recent data releases haven’t inspired optimism. Real GDP growth fell short of the government’s 5.0% target in Q2 for the second consecutive quarter; it was the weakest performance since early 2023 (Fig. 19). Industrial production was also down y/y in Q2.
 
The Chinese government’s stimulus efforts to revive the struggling real estate market and boost domestic demand are unlikely to yield results anytime soon, as Eric discussed in yesterday’s Morning Briefing. And President Xi shows little inclination to send “helicopter money” directly to consumers, which could improve consumer spending sooner.

(6) Don’t forget about the Golden Elephant. India’s economy is projected to grow by nearly 7.0% this year, fueled by robust public investment and resilient private domestic consumption. Forward revenues momentum, too, looks strong (Fig. 20). The outlook remains positive despite global challenges, with easing inflation and favorable monsoon conditions bolstering growth. Investors are paying up for these conditions, however, and we're hesitant to buy stocks in EM indexes that are more expensive than American stocks.

Strategy: Don’t Fear S&P 500’s Q3 Earnings Growth Jitters. Analysts’ consensus forecast for what S&P 500 companies collectively earned during Q3-2024 on a per-share basis unexpectedly fell 0.6% last week to $60.13 from $60.47 a week earlier (Fig. 21). The surprising decline occurred even though strong results reported early by the big banks were already baked into the earnings pie. The sudden dip in S&P 500 Q3 EPS caused the S&P 500’s y/y proforma Q3 earnings growth rate also to fall unexpectedly, to 4.0% from 4.9%. A week earlier, the growth forecast had been down only 0.1ppt from 5.0% at the beginning of the month before earnings season started.

Joe carved the S&P 500’s Q3 earnings down to the sector level to uncover what’s happening. He found that the unexpected drop does not foretell a broader slowdown but occurred for company- and industry-specific reasons:
 
(1) Energy & Boeing strike again. Analysts following Energy industry companies and strike-affected Boeing have been making heavy last-minute estimate cuts ahead of the quarterly earnings releases. More typically, analysts are confident of their estimates during the third week following a quarter’s end and stand pat as they await the earnings reports.
 
(2) Energy’s y/y growth earnings has been on a roller-coaster ride. The sector had recorded slightly positive y/y earnings growth of 1.3% in Q2-2024 following double-digit percentage declines for four straight quarters. It’s now expected to backslide into an earnings decline of 27.3% in Q3-2024. That’s down from a forecasted 21.7% decline at the start of the month as the sector’s total expected earnings has tumbled another 5.6% since then. The sector isn’t expected to record positive y/y earnings growth until Q2-2025 and will become less of a drag on S&P 500 growth after Q4-2024.
 
(3) Boeing analysts assess strike’s impact (again). Analysts following Boeing have been hard at work lately while Boeing’s workers haven’t. The strike, now over, deeply impacted Q3 forecasts. The consensus loss of around $1 per share at the start of the month has tumbled to a loss of over $10 now. As a result, the Industrials sector’s total expected Q3 earnings fell by 9.5%, which dropped its Q3 y/y growth rate to -7.6% from 2.1% when October began.
 
(4) Unwinding the growth jitters. The S&P 500’s earnings metrics look considerably better when the bad news from Energy and Boeing are filtered out of the index. While analysts currently expect just 4.0% growth for the S&P 500 in Q3-2024, the growth rate improves to 6.5% excluding the Energy sector and to 7.8% excluding Industrials too.

Removing the impacts of Energy and Industrials also improves the S&P 500’s earnings momentum. The total expected Q3 earnings for the S&P 500 ex-Boeing and Energy has risen 0.2% since October 1 versus dropping 0.9% with them. That 0.2% improvement is paced by a 4.7% pickup in Financials’ total earnings so far and should spread, as is typical, when other sectors’ firms begin releasing results.

Here’s how much total Q3 earnings forecasts have changed since October 1 for the sectors and for the S&P 500 with Energy and Industrials removed: Financials (4.7%), Real Estate (0.5), Communication Services (0.3), S&P 500 ex-Energy & Industrials (0.2), Consumer Staples (0.0), Consumer Discretionary (0.0), S&P 500 ex-Industrials (-0.2), Information Technology (-0.3), Utilities (-0.4), S&P 500 ex-Energy (-0.6), S&P 500 (-0.9), Materials (-1.4), Energy (-7.1), and Industrials (-9.5).

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On China & The Dollar

October 22 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
China: Any More Stimulus? The Chinese government has spent the past month scraping together measures to stimulate its economy. The rapid rally in Chinese stocks that kicked off on September 24 has stalled. The Shanghai Composite is up 21% from its September lows as of Tuesday, but off 6.4% from its highs two weeks ago. The Chinese benchmark index is up just 10% this year; that’s about how much it’s risen over the past five years as well (Fig. 1).

Investors want the Chinese Communist Party (CCP) to provide direct fiscal stimulus to households to combat headwinds such as deflation, the negative wealth effect, an aging labor force, and weak consumer spending. That type of stimulus might be too socialist even for the CCP, despite its effectiveness here in the US.

Let’s discuss the latest developments in China and why investors who went “all in” on Chinese stocks a few weeks ago have been disappointed thus far:

(1) Helicopter money still MIA. Consumer confidence has plummeted in China (Fig. 2). Consumer spending is falling as a result (Fig. 3). But the Chinese government’s response has attempted to refuel consumer optimism via boosting asset prices rather than handing consumers cash. It will take time for the property market to clear, and likely too long for asset values to recover enough for consumers to start shopping again soon.

Kickstarting consumer spending with helicopter money seems to make more sense, but President Xi Jinping apparently lacks the will to provide direct fiscal stimulus. The easing measures employed instead target financial markets and assets, such as reducing interest rates and lowering bank reserve requirements. On Monday, the People’s Bank of China (PBOC) cut its benchmark one-year loan prime rate (LPR) and five-year LPR by 25bps, to 3.1% and 3.6%, respectively (Fig. 4). The Chinese government also has offered $71 billion of leverage to brokers and insurers to buy stocks.

Fiscal measures, on the other hand, have mostly tried to stoke demand in the property market. The Chinese government has lowered mortgage rates as well as down payments on second homes and is providing financing for local governments to purchase homes from developers. That sounds like stemming the bleeding rather than instigating a recovery. Even those measures aren’t receiving much of a hurrah: A $562 billion loan quota for residential real estate projects spooked property stocks late last week after falling short of expectations, Bloomberg reported (Fig. 5).

It appears that the CCP is not pivoting its economic development model but rather trying to avert a deflationary crisis. The WSJ’s Chief China Correspondent wrote on October 15, “For Xi, the officials and advisers say, the near-term goal isn’t to massively stimulate demand but to fend off a brewing financial crisis—or ‘derisking,’ in official lingo—thereby helping to stabilize the overall economy and achieve the 5%-or-so growth target for this year.”

(2) The cure for too much debt is more debt? Xi prefers to shore up the balance sheets of local government financing vehicles (LGFV) so they can continue to fund projects across the country using debt. The issue is that these LGFVs are already highly indebted.

Bank loans in China total roughly $36 trillion, roughly double China’s 2023 GDP (Fig. 6). However, an additional $7 trillion to $11 trillion in loans are estimated to be off the books, according to the WSJ, residing in places like LGFVs. Many municipalities overleveraged themselves by lending to dead-end projects just to meet China’s growth targets. Now they are stuck with low to no returns and debt overhangs that prevent continued lending. Total social financing has fallen from a peak of $3.4 trillion in the 12 months ended April 2023 to $2.5 trillion in the year ended September (Fig. 7).

(3) The vote from the commodity pits. Commodity traders in London, Chicago, and across the globe are giving a vote of no-confidence to the CCP’s efforts to shore up domestic growth. The price of copper, which is very sensitive to manufacturing and construction activity in China, is still trading below $4.50 a pound (Fig. 8). The price of oil has remained unperturbed, and that’s including the growing geopolitical risks in the Middle East (Fig. 9).

(4) Yuan matters. The Chinese government announced its first flurry of stimulus on September 24, less than a week after the Federal Reserve’s 50bps rate cut. That’s because if China eased monetary policy too much while the Fed stayed tight, it would risk devaluing the yuan too far (Fig. 10). A cheaper yuan fuels exports, sure. But foreign capital could flee the country as Chinese rates aren’t attractive relative to other countries. That’s what happened as global central banks raised interest rates in 2022 and 2023 (Fig. 11). Only this year did investors start to bring cash back.

China likely has not been able to provide a “bazooka” of stimulus over the past month, as expectations for Fed rate cuts have shifted. Economic data in the US have been stronger than the consensus expected, and now futures markets see just five Fed rate cuts within the next 12 months, down from nearly 10 in September (Fig. 12).

If the Fed becomes more hawkish, China’s ability to ease may be limited.

(5) China buying gold. China has increased its gold purchases since Russia invaded Ukraine, likely looking to safeguard its reserve from potential sanctions (Fig. 13). The price of gold has climbed 33% ytd to a new record high of $2,750. Global central banks, particularly those of countries unfriendly to the US, have been buying gold for their reserves since the US enacted heavy financial sanctions on Russia in 2022 (Fig. 14).

Currencies: Is the Dollar’s Rebound Sustainable? The US Dollar Index (DXY) has risen 2.9% over the past month. The greenback has been aided by strong economic data that have boosted Treasury bond yields and reduced expectations for Fed easing. How long the dollar remains strong may depend as much on the US as other countries. Broadly speaking, we expect the greenback to remain strong.

Consider the following:

(1) Global central banks. Last week, the European Central Bank cut rates by 25bps to 3.5%, its third such cut this year (Fig. 15). Meanwhile, the Bank of Japan has shed its temporary hawkish stance and looks primed to keep rates ultralow for the foreseeable future. With two major central banks easing policy (or maintaining easy policy), even a couple more 25bps cuts by the Fed would preserve a sizable gap between domestic interest rates and those in advanced foreign economies (AFEs).

(2) Petrodollar. The DXY has been tightly correlated with the price of crude oil since the pandemic (Fig. 16). That makes sense, as the US is now a net exporter of oil and brisk US spending on imports has aided global growth (Fig. 17 and Fig. 18).

While the price of oil and the value of the dollar benefit from strong growth, they also benefit from geopolitical instability. Should the war in the Middle East bring Iran and Israel into direct conflict, then fears of lower oil supply would raise oil prices, while investors would rush into the dollar for safety. The BRICS (Brazil, Russia, India, China, and South Africa) and OPEC+ could also find ways to cap energy supply, similar to what occurred in the 1970s.

Our Roaring 2020s economic scenario (50% subjective odds) sees the US outperforming thanks to strong productivity growth. That should benefit the dollar. Our meltup scenario (30%) sees profligate fiscal spending and over-easy Fed policy driving inflation expectations higher. That boosts the dollar. Our geopolitical shock scenario (20%) sees a rush into dollars as a hedge.

Major risks to the dollar include a black swan event affecting the US economy more than the rest of the world and, more likely, the presidential election not settling smoothly. While we are mindful of those risks, we are far from turning bearish on the US economic outlook because of them. Our outlook suggests the dollar's value should hold up relatively well.

(3) BRICS. The emerging markets’ version of the G-7 convenes in Russia on Tuesday. The BRICS will also be joined by the UAE, Iran, Ethiopia, and Egypt. Ideally, the BRICS would like to create a payments and financial system away from the dollar and independent of potential sanctions from the West. We don’t see that idea supplanting the dollar anytime soon.

Since the US booted Russia from the international payments system known as “SWIFT” in 2022, trade among Russia, China, and other developing countries has surged. But that’s unlikely to uproot the dollar’s de facto reserve role. More than 58% of global foreign exchange reserves are held in dollars (Fig. 19). While that is down from 72% at the start of the century, that’s mostly because the emergence of the euro has allowed reserve managers to diversify. We do not expect the dollar's share to fall meaningfully further.

Even the euro has fallen from roughly a quarter of global foreign exchange reserves a decade ago to just a fifth today. The yen and other AFE currencies have filled the gap. The Chinese renminbi is just 2% of global reserves despite China's major role in global trade.

While gold reserve purchases are in vogue, the bigger challenge for the BRICS is the dollar's role in trade. According to the Atlantic Council, roughly 54% of global trade is denominated in dollars, and 88% of foreign exchange transactions involve dollars.

Fed research shows that in the two decades ended 2019, the dollar accounted for 96% of trade invoicing in the Americas, 74% in Asia-Pacific, and 79% in the rest of the world excluding Europe (where the euro naturally is used more often).

Moreover, supplanting the dollar's role with Chinese renminbi would be nearly impossible, as the renminbi is pegged by the state, has two competing markets (onshore and offshore), and is not joined by a highly liquid sovereign debt market like US Treasuries.

In short, the features of the US monetary system that make the dollar so desirable are likely to remain in place.

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Life In The Fast Lane

October 21 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
The Fed I: Depending on Misleading Data. The party line among Fed officials is that their monetary policy decisions are data dependent. The challenge for them is that the data aren’t always dependable, are often revised, and can sometimes be ambiguous and even contradictory. Indicators that raise concerns about a recession might simply reflect a temporary soft patch in the economy, which might be revised away by the next batch of economic reports.

When the Federal Open Market Committee (FOMC) met on September 17 and 18, there was a case to be made for a cut in the federal funds rate. Indeed, the minutes of that meeting observed: “In the Open Market Desk’s Survey of Primary Dealers and Survey of Market Participants, most respondents had a modal expectation of a 25 basis point cut at this meeting, though the manager also noted that, since the time of the surveys—about a week earlier—the probability of a 50 basis point cut at the September meeting implied by futures prices had increased and exceeded the implied probability of a 25 basis point cut.”

The minutes strongly suggested that several participants favored a 25bps cut. Apparently, Fed Chair Jerome Powell, who pivoted toward a very dovish monetary stance in his Jackson Hole speech on August 23, 2024, must have persuaded all but one dissenter on the committee to opt for a 50bps cut. Powell turned increasingly concerned about an apparent weakening of the labor market, as evidenced by the increase in the unemployment rate from below 4.0% during the 27 months through April to 4.3% in July (as reported in early August) (Fig. 1).

The data since the last meeting of the FOMC suggest that the 50bps cut that occurred was probably too much, too soon. If so, that raises the risks that price inflation might stop moderating and that stock prices might continue to melt up. Let’s review what the data showed before and after the last FOMC meeting:

(1) Labor market. Before the September 18 meeting, the perception was one of more weakness in the economy in general and the labor market in particular. The September 6 employment report was weaker than expected in August with payrolls up just 142,000, and July and June were revised downward by 86,000. So the three-month average gain was just 116,000.

A couple of weeks after the September 18 FOMC meeting, on October 4, September’s employment report was stronger than expected and there were upward revisions to the prior two months! Payroll employment jumped 254,000, and the previous two months were revised higher by 72,000. The three-month average gain was 186,000. That was consistent with the gains prior to the pandemic (Fig. 2).

Furthermore, the unemployment rate dropped from 4.3% in July to 4.2% in August, and 4.1% in September.

(By the way, our September 9 Morning Briefing was titled “Another Growth Scare.” Our October 7 report was titled “A Dozen Reasons For None-And-Done.”)

(2) Economic surprises. This year, the Citigroup Economic Surprise Index was consistently in negative territory from May 3 through September 30 (Fig. 3). It has been positive since the beginning of the month.

(3) Real GDP. The growth rate in real GDP certainly didn’t call for any rate cut, let alone a 50bps cut. The second revision of Q2’s real GDP was released on August 29. It showed a gain of 3.0% (saar), up from the 2.8% advance estimate. The third revision was released on September 26, after the September 18 meeting. It was unchanged at 3.0%. The y/y growth rate was 3.0% almost exactly matching the 3.1% average annual growth rate since 1950 (Fig. 4).

Meanwhile, the Atlanta Fed’s GDPNow model showed that Q3’s real GDP was tracking at 2.6% on September 16 (Fig. 5). It has been tracking at over 3.0% since October 3. The latest reading on Friday was a whopping 3.4%. Real personal consumption expenditures was raised from 3.1% to 3.6% (Fig. 6).

As an extra bonus, the levels of real GDP and real GDI (i.e., gross domestic income) both were revised higher on September 27 when the third revision of Q2’s numbers were released (Fig 7).

(4) Inflation. Powell & Co. based their decision to cut by 50bps on data suggesting that inflation was on track to fall to their 2.0% target. On September 11, August’s CPI report showed headline and core CPI up 2.5% and 3.2%. After the meeting, on September 27, the headline and core PCED inflation rates were 2.2% and 2.7%. On October 10, September’s CPI headline and core inflation rates were 2.4% and 3.3%.

So the Fed’s 50bps rate cut on September 18 was an implicit mission-almost-accomplished message. The problem is that inflation has lots of moving parts; some of them remain relatively high, and some might start putting upward pressure on inflation.

Supercore inflation (core services inflation, excluding housing) was previously referred to as “possibly the most important category for understanding the future evolution of core inflation” by Fed Chair Jerome Powell. September’s supercore CPI inflation ticked up from 4.3% to 4.4% y/y (Fig. 8). The comparable readings for the September PPI were 3.7% and 3.3% for August’s PCED.

CPI used car and truck inflation peaked at a record-high 45.2% y/y during June 2021. This index then fell 7.5% through September of this year (Fig. 9). The Manheim Used Vehicle Value Index has been on an uptrend since June. Higher used car prices might also put upward pressure on new car prices.

The Fed II: The Case for a Higher R-Star. Fed officials indicated that the September 18 rate cut was likely to be followed by more cuts. They deemed that 5.25%-5.50% was too restrictive, which is why they cut it by 50bps to 4.75%-5.00%. That’s still restrictive, in their opinion. According to their September 18 Summary of Economic Projections, collectively they seem to be aiming to lower the federal funds rate to 2.9% over the next couple of years. That’s their estimate of the “longer-run” inflation rate (Fig. 10).

The SEP defines it as follows: “Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run.”

In other words, it is the Fed’s assessment of the so-called “neutral” federal funds rate. We’ve often referred to it as a theoretical concept with no realistic usefulness. Everyone agrees that it can’t be measured and that it probably isn’t constant.

Sure enough, the latest SEP shows little agreement among even the 19 FOMC meeting participants, whose estimates of this long-run rate varied from 2.37% to 3.75%. Based on the performance of the economy, we think the rate is currently 4.00% and probably higher. Here’s why:

(1) First and foremost, the economy has continued to grow in the face of monetary tightening. The economy is at full employment. Inflation has subsided without a recession. The labor-market part of the Fed’s dual mandate certainly has been accomplished and inflation is fast approaching the Fed’s 2.0% target. In other words, the resilient economy is demonstrating that if there is such a thing as the neutral federal funds rate, we are there.

(2) Productivity growth seems to be making a comeback, as we’ve been expecting. It is up 2.7% y/y through Q2-2024, exceeding the average of 2.1% since the late 1940s (Fig. 11). As a result, unit labor costs inflation was down to only 0.3% during Q2-2024, contributing significantly to lowering consumer price inflation (Fig. 12).

(3) Better-than-expected productivity growth also boosts real economic growth at the same time that it’s keeping inflation contained (Fig. 13). So the faster productivity growth is, the higher both the nominal and real federal funds rates must be.

(4) Productivity growth may be one of the most important factors in determining the neutral interest rate. There are lots of other moving parts undoubtedly, including the federal budget deficit. Over the past three years, it has been at a record high during a period of solid economic growth. Yet inflation has moderated. Large fiscal deficits have boosted economic growth and offset the recessionary impact of the tightening of monetary policy. Again, the conclusion must be that the neutral interest rate has been increased by the current administration’s fiscal policy. Fed officials may be in denial about this because they are so committed to being nonpolitical that they avoid discussing fiscal policy.

(5) Our conclusion is that if the Fed continues to lower the federal funds rate, monetary policy will most likely stimulate an economy that doesn’t need to be stimulated. The result could be rebounds in both price and asset inflation rates. The latter is certainly underway in the stock market.

Movie. “Lee” (+ +) (link) is a docudrama about Lee Miller. She was a fashion model in New York City during the 1920s and a photojournalist during World War II. She was a war correspondent for Vogue and covered the London Blitz and the liberation of Paris. Her most remarkable photos were taken immediately after the war, documenting the horrors of the Nazi concentration camps at Buchenwald and Dachau. One of the best known photos of Lee shows her taking a bath in Hitler’s bathtub on the same day that he committed suicide. Kate Winslet gives an admirable performance as Lee.

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Mixed Emotions

October 17 (Thursday)

US Economy I: Misery Loves Company. A horse walks into a bar. The bartender says, “Why the long face?”

The bartender can ask both US consumers and small business owners the same question. They should be happier than they are. Why aren’t they? It’s an important question because unhappy consumers might reduce their spending, and unhappy small business owners might curtail their hiring. If both groups act on their current downbeat emotions, they collectively could cause a recession.

Of course, that’s not our current economic outlook. We’ve based our no-hard-landing scenario for the past couple of years on our observation that recessions tend to be caused by tightening monetary policy causing a financial crisis, which turns into a credit crunch and a recession. We don’t see that scenario playing out anytime soon. Indeed, the Fed started lowering the federal funds rate on September 18 in a move taking it from 5.25%-5.50% to 4.75%-5.00%. The Fed has plenty of room to lower interest rates further if necessary to avert a recession (Fig. 1).

Unhappiness isn’t usually a cause of recessions even though a measure of consumer expectations is one of the 10 components of the Index of Leading Indicators, which has been misleadingly predicting a recession since late 2021 (Fig. 2). On the other hand, recessions invariably depress consumer confidence as unemployment increases. Again, the Fed can always continue to lower interest rates if consumers and business owners start to retrench their spending and hiring because they are unhappy.

Debbie and I often have observed that Americans are born to shop. When we are happy, we shop. When we are depressed, we shop even more because it makes us feel better by releasing dopamine in our brains. Of course, to do so we must have purchasing power, which is eroded by unemployment during recessions.

Currently, however, that’s far from happening: The unemployment rate was only 4.0% in September. The latest initial unemployment claims suggest that October’s unemployment rate rose because of the month’s hurricanes and strikes (Fig. 3). Indeed, in an October 14 speech, Fed Governor Christopher Waller observed that October’s employment report “will most likely show a significant but temporary loss of jobs from the two recent hurricanes and the strike at Boeing. I expect these factors may reduce employment growth by more than 100,000 this month.”

Let’s have a closer look at the latest relevant data for US consumers and small business owners in the next two sections.

US Economy II: Should Consumers Be Happier? The Misery Index is the sum of the unemployment rate and the inflation rate (measured as the yearly percent change in the CPI) (Fig. 4). It was 6.5% during September, well below its average since 1947 of 9.1% (Fig. 5). So misery is relatively low. On the other hand, the Consumer Sentiment Index (CSI), which is inversely correlated with the Misery Index, was 68.9 during October, below its 82.5 average since 1978.

Debbie and I have found over the years that the CSI is more sensitive to inflation than is the Consumer Confidence Index (CCI), which also is inversely correlated with the Misery Index but tends to be more sensitive to labor market conditions. The CCI is showing a happier reading of 98.7 during September, solidly above its 92.7 average since 1978 (Fig. 6).

Inflation over the past two years remains a sore point with consumers even though it has been moderating since last summer and even though wage gains have mostly kept pace with price increases. Consider the following:

(1) Since the start of the pandemic during March 2020 through September of this year, the CPI is up 21.9%, with CPI goods and CPI services up 20.3% and 22.8%, respectively (Fig. 7 and Fig. 8). Interestingly, the CPI goods price level has been flat since June 2022. However, the CPI services price level has continued to rise since then, led by its shelter component.

The post-lockdown consumer buying binge on goods peaked during the spring of 2021 as consumers pivoted to spending more on services (Fig. 9). Roughly one year later, supply-chain disruptions dissipated, and consumer goods prices flattened, albeit at record highs.

(2) Wages stagnated relative to prices during the pandemic years of 2020-22 but started to slightly outpace prices during 2023 (Fig. 10). In fact, average hourly earnings for all workers rose 22.9% since the start of the pandemic during March 2020 through September of this year. That’s slightly ahead of the CPI inflation rate.

(4) So why is the Consumer Sentiment Index still relatively depressed? Inflation remains a problem for lots of consumers. According to a September 11-16, 2024 Bankrate survey, 41% of Americans say inflation is their No. 1 economic issue. Economists (including most policymakers) measure inflation on a year-over-year basis and are pleased to see that it has subsided significantly since it peaked during the summer of 2022. They note that the headline CPI inflation rate peaked at 9.1% y/y during June 2022 and fell to 2.4% in 2024 (Fig. 11).

However, many consumers compare today’s prices to what they were at the start of the pandemic. The CPI is up 21.9% since then (Fig. 12). That’s actually slightly below the 22.9% increase in hourly wages for all workers over the same period. However, the prices of essentials have increased by more since the pandemic. The CPI components for energy and food are up 34.3% and 26.3% since March 2020. Here are the CPI price increases in various essentials since the pandemic: gasoline (36.1%), motor vehicle maintenance & repairs (35.2%), rent of primary residence (24.9%), furnishings (19%), and auto insurance (18.8%) (Fig. 13).

(5) In his March 15 Barron’s column, Randy Forsyth also examined why consumers seem to be unhappy. He concluded: “The free lunch of historically low interest is over. Even as unemployment remains low and the CPI has receded from its four-decade pandemic peak, normalized interest costs weigh on Americans’ budgets. And they’re not happy about it, even with stock prices at records.”

(6) Another concern about the outlook for consumer spending expressed by many economists is that consumer credit is at a record high of $5.1 trillion. That’s true, but it isn’t at a record high relative to disposable personal income (Fig. 14). Besides, the level of consumer debt has never caused a recession, though it did exacerbate several recessions that occurred for other reasons.

(7) We note that the net worth of all US households rose to a record $163.8 trillion in Q2-2024 (Fig. 15). Almost half of that sum ($79.8 trillion) was held by the Baby Boom generation in Q2-2024 (Fig. 16). During Q2-2024, the Baby Boomers held a record $23.0 trillion in corporate equities and mutual fund shares, up a whopping $6.9 trillion since just before the start of the pandemic (Fig. 17)!

(8) Many of the Baby Boomers are retiring and spending their retirement savings on goods and services as well as supporting their young adult children, who are also spending money. Indeed, Census data show that in 2024, 30.2% of people between the ages of 25 and 34 years old are living in their parent’s home (Fig. 18). The third annual review of parental patronage by savings.com (dated May 21, 2024) found that:

(i) 47% of parents with grown children provide them with some form of financial support (not including adult children with disabilities). This is a rate similar to that in last year’s report.

(ii) On average, parents providing financial support give $1,384 to their children monthly. That’s more than twice what the average working parent in the study contributed to his/her own retirement savings monthly ($609 on average).

(iii) Among parents who financially support adult children, 46% give them money for vacations and discretionary spending and 18% help their adult kids pay off credit cards.

(9) Consumers are unhappy for various reasons. The cost of living has increased significantly since the start of the pandemic. However, so have wages, especially for lower-wage workers. In any event, real consumption per household rose to a record high during Q2-2024 (Fig. 19).

The Baby Boomers have followed the advice of Star Trek’s Spock: They have lived long and prospered. They are mostly happy now that they have paid off their mortgages, finished with college tuition, and seen their asset values soar.

Many younger people, on the other hand, can’t afford to buy a house, so they are living at home or sharing an apartment with roommates. Many probably can barely afford auto insurance. I just took my two recently employed college graduates off my auto policy. That raised the cost of their auto insurance close to $5,000 per year each! I’m helping them with that outlay.

(10) Elevated mortgage rates and home prices have crushed housing affordability. The National Association of Realtors index of affordability is currently worse than it was during the lead up to the Great Financial Crisis and lower than at any time since the early 1980s. Getting priced out of the American Dream—or watching your kids struggle to achieve it—is depressing.

Home insurance premiums also are surging alongside other housing costs and more frequent extreme weather events. Home insurance rates have increased by more than 20% across most of the country since the start of last year, per WSJ reporting. Yet those increases do not make their way into CPI. Along with the wonky owner’s equivalent rent measure, only renters’ insurance is gauged by the Bureau of Labor Statistics. Renters’ insurance is a fraction of the cost of true homeowners’ insurance, hence why it represents less than half-a-percent of the overall CPI.

US Economy III: Should Small Business Owners Be More Optimistic? Small business owners have been depressed for a long time. The National Federation of Independent Business (NFIB) surveys its membership once a month. Its Small Business Optimism Index has been hovering between roughly 88 and 94 since mid-2022 (Fig. 20). That’s more depressed than they were during the pandemic lockdown. Consider the following:

(1) Business can’t be all that bad for small business owners given that they’ve reported relatively high job openings and hiring intentions since the second half of 2021 (Fig. 21). Perhaps they’ve been depressed about the quits rate and the shortage of qualified workers. But now that quits have declined and job openings are down (but remain as high as just before the pandemic), small business owners are still depressed. A persistent problem for small business owners is that there are no qualified applicants for their job openings. In September, 52% of those with positions to fill said so.

(2) In recent months, there has been significant weakness in the NFIB survey’s series tracking the net percent of small business owners expecting higher real sales over the next six months and the net percent reporting higher earnings over the past three months (Fig. 22 and Fig. 23). The forward revenues per share and earnings per share of the S&P 600 SmallCaps have been essentially flat around their respective record highs since mid-2022 (Fig. 24).

(3) Small business owners don’t seem to be fazed by credit conditions. Only 8% said credit was harder to get than last time (Fig. 25). Only 26% said that they are borrowing at least once a quarter.

(4) When asked about the most important problem they faced, the percentage of small business owners split up as follows in September: inflation (24%), quality of labor (19%), taxes (14%), cost of labor (9%), poor sales (8%), and interest rates (4%) (Fig. 26).

(5) Finally, we should note that small business owners include lots of proprietors and landlords. Collectively, they earned a record $3.1 trillion (saar) during August, with the former at a record $2.0 trillion and the latter at a record $1.1 trillion (Fig. 27). These sums are included in personal income, not in corporate profits. So their downbeat assessment of their earnings might be because they are taking their profits as income!

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On China, Global Wages & The S&P 493

October 16 (Wednesday)

China: The Year of the State Planner. The quick knee-jerk rally in Chinese equities already looks like it’s getting a leg cramp.

After the Communist Party of China (CCP) announced its first round of stimulus measures on September 24, several commentators suggested that the time to invest in China is now. We issued caution, writing on September 26 that the resulting economic stimulus “may be offset by Chinese government actions that chill the willingness of consumers and companies to spend and invest in the country.”

The Shanghai Composite stock index is now down 8.3% from its recent high on October 8 (Fig. 1). It has climbed 8.1% this year and 9.0% over the past five years. It was recently reported by Reuters that China may raise $850 billion (roughly 6 trillion yuan) in special government bond over three years. Regardless, it would require much more than interest-rate cuts, looser financing terms, and fiscal stimulus to convince us to invest in China over the US or even India.

With that said, here’s more on China’s policy predicament and stock market:

(1) Dire straits. It will be a heavy lift for the CCP to stimulate an economy that is broadly deleveraging. Growth in Chinese bank loans fell to the lowest level in more than two decades in September, at 8.1% y/y (Fig. 2). Lending peaked in early 2023 and has fallen off since. And growth in M1 money supply—the narrower measure of money supply that represents cash in deposit accounts that Chinese consumers usually use to invest—declined by a record 7.4% y/y last month (Fig. 3).

(2) Fighting the last war. The Chinese government is attempting to spur consumer spending by boosting the wealth effect and increasing financial market liquidity. We doubt that’s the most effective remedy for China’s ailments.

Stimulating a highly indebted country out of a collapsed property bubble with easier financing conditions may not be the best solution, as Uncle Sam learned following the Great Financial Crisis (GFC). It takes time for consumers and businesses to rebuild their balance sheets and grow comfortable with borrowing after a massive leveraging comes undone. And China has much more work to do than the US did. China’s nearly $36 trillion in outstanding bank loans is roughly three times the amount outstanding in the US today (Fig. 4).

Just as the US struggled to stimulate growth and inflation after the GFC using quantitative easing, China will struggle unless it unleashes a fiscal bazooka such as helicopter money comparable to the three rounds of free money dropped by the US government during the pandemic. China’s producer prices deflated further in September, down 2.8% y/y, while consumer prices rose just 0.4% (Fig. 5).

Consumer confidence has also collapsed in China and will need more than higher stock prices to encourage spending. But China’s options may be limited.

(3) US privilege is China’s disadvantage. The Chinese government announced its first flurry of stimulus on September 24.

The Fed’s interest-rate cutting and dovish forward guidance likely emboldened China to ease policy. It is no surprise that China announced its stimulus package less than a week after the Fed’s 50bps rate cut. Since the Fed’s September meeting, futures contracted tied to the federal funds rate (FFR) have priced out some 60bps of rate cuts over the next year (Fig. 6). But if US inflation gets stuck high enough above 2.0% to prevent the Fed from easing further, the CCP’s options may be limited.

If China eases more than the Fed, it risks foreign capital fleeing the country. Foreign investors pulled cash from China as the Fed and other developed economy central banks hiked interest rates in 2022 and 2023 (Fig. 7). Only this year did investors start to bring cash back. But with foreign direct investment flows still negative and with more investors growing skittish on China’s prospects, capital could flee again.

(4) Valuation is not a catalyst. Just because something is cheap does not mean it’s on sale. The China MSCI index is trading at 10.5 times forward earnings (Fig. 8). That’s roughly half the valuation of large-cap US stocks and cheaper than most other emerging markets. Many money managers thought it wouldn’t hurt to take a flyer on the world’s second biggest economy at these prices.

Putting aside the numerous risks of doing business in China, forward earnings has been relatively flat for the past 15 years (Fig. 9). Earnings have persistently disappointed since 2022 as well (Fig. 10). It’s easier to fudge national growth numbers with local government projects; it’s harder to fudge corporate earnings.

(5) The 800lb panda in the room. China’s demographics are rapidly Japanifying. Its working age population is faltering after the one-child policy backfired and today’s citizens are averse to having kids for financial reasons (Fig. 11). The CCP will either have to encourage immigration despite preferring homogeny and restrictiveness or transfer wealth to the lower classes. Perhaps some “socialist” fiscal policy might actually be useful for China’s state planners.

Global Wage Growth I: In a Sweet Spot. Finding a high-paying job in the US is easier these days. There are more of them thanks to inflation. For example, in 2024 Walmart store managers earn about $128,000 a year on average, up from $117,000 in 2023 and about $92,000 in 2014.

Wage growth across the US has surged over the past decade, but its pace has slowed in recent years (Fig. 12). The Fed has no official wage growth target, but it prefers wage gains around 3.5% y/y, aligning with its 2.0% y/y consumer price inflation target plus productivity growth of around 1.5%.

Here’s a snapshot of key y/y wage developments:

(1) Average hourly earnings (AHE). The Bureau of Labor Statistics (BLS) reported a 4.0% y/y rise in average hourly earnings through September 2024 for all workers, with production and non-supervisory workers seeing a 3.9% increase. The latter account for about 80% of payrolls and have lower wages than the remainder of employed workers. The higher-wage workers AHE rose 4.2% in September. These wage gains have eased from their 2022 recent peaks of 5.9% for all workers and 7.0% and 5.9% for lower- and higher-wage workers during the pandemic inflation crisis. It’s worth noting that AHE can vary due to shifts in workforce composition as well as changes in actual earnings. That helps to explain some of the volatility in AHE inflation during the pandemic.

(2) AHE lower- vs higher-wage workers. A shortage of lower-wage workers during the pandemic pushed their wages up 7.8% y/y during April 2020, while higher-wage earners saw a more modest 3.2% increase (Fig. 13). A significant spread reappeared in March 2022, with lower-wage workers’ wages rising 7.0% versus 3.8% for higher earners.

Lower-wage workers represent a larger share of payrolls and tend to grow their wages quicker than higher earners (Fig. 14). But because higher-wage earners punch above their weight in terms of their representation in aggregate earnings, their often-slower wage growth distorts overall AHE growth.

(3) Real AHE. Adjusted for inflation, real AHE rose 1.6% y/y through September (Fig. 15). Real AHE for lower-wage workers rose 3.2% from August 2022 to August 2024 compared to an increase of just 1.9% for higher-wage workers. These figures exclude benefits and bonuses, which tend to bolster the pay of higher earners more.

(4) Employment Cost Index (ECI). The BLS’s ECI—which encompasses wages, benefits, and bonuses—recorded a 3.9% increase in total compensation for all civilian workers in Q2, a decline from the 5.5% peak in 2023. Wages and salaries rose by 4.0%, while benefits increased by 3.5%.

(5) Atlanta Fed’s Wage Growth Tracker (WGT). The WGT, which factors in worker composition changes, rose 4.7% through September—surpassing AHE but down from its 6.7% peak in August 2022 (Fig. 16). The largest wage gains in the WGT tend to be and have been for 16-24 year olds, who tend to earn less than more experienced workers. Job switchers also tend to experience larger wage gains than job stayers. However, switchers’ wage growth premium has come down since peaking in 2022, indicating a normalized balance of supply and demand for workers.

(6) AHE vs WGT. AHE growth has tended to skew lower because it gives more weight to high earners based on their share of total earnings. This disparity helps explain why AHE has lagged WGT in recent years. Since March 2020, the post-pandemic labor shortage has highlighted a significant divergence in wage growth, with lower-wage workers experiencing cumulative increases of 27.1%, notably exceeding the 14.1% rise for higher-wage earners (Fig. 17). On a y/y basis, the AHE (wages only) correlates well with the ECI (total compensation), though AHE tends to exceed ECI because benefits and bonuses typically grow slower than wages.

Global Wage Growth II: Global Wage Highlights. Emerging markets have been seeing a sharp rise in wage growth, driven by economic expansion and demand for skilled workers. Wage increases in developed nations have been more restrained, as these countries have been focused on stabilizing their economies and curbing inflation. In other words, central bankers in emerging markets have more work to do to balance growth and price stability.

Here’s a closer look at y/y wage trends outside the United States:

(1) Japan’s aging problem. In Japan, wage growth hit 5.4% y/y during August 2024, driven higher by labor shortages from an aging population and government efforts to stimulate economic activity (Fig. 18). After a prolonged period of wage stagnation, workers are finally seeing gains, with real wages rising 2.6% as inflation settles at 2.8%.

(2) Europe’s mixed picture. In the UK, wages have grown 5.0% y/y through August, supported by labor shortages and inflationary pressures. Real earnings rose 1.4% after adjusting for the Retail Price Index (Fig. 19). Germany is seeing a moderate recovery, with wage growth of 4.9% comfortably outpacing CPI inflation at 2.6% (Fig. 20).

(3) Emerging markets’ surge. Emerging markets are seeing the most substantial wage growth. India’s wages increased by 9.7% in 2023 and are projected to rise 9.5% in 2024. With inflation slowing, real wage growth is expected to accelerate. In Brazil, wage growth exceeded 8.5% for several months earlier this year, as strong domestic demand and stable inflation around 5.0% supported higher earnings.

Strategy: S&P 493 Hitches Ride on Magnificent-7’s Bull. Happy second birthday to the bull market! It turned two years old on Friday. There’s always one group of stocks in every bull market that greatly outperforms the rest of the index from the start. This time, that group is the Magnificent-7 stocks, which have soared due to substantially improved fundamentals, including profit margins. As the bull ages, other groups hitch a ride when their prospects improve and/or when the market leaders become too expensive. With interest rates now heading lower, the entire rest of the market—i.e., the S&P 493--should enjoy improving fundamentals and stock price gains.

Indeed, the recent improvement in the S&P 493’s returns suggests investors are looking there for growth at a reasonable price. For now, however, the Magnificent-7 continues to lead the way, as Joe shows below:

(1) Bull market performance to date. Since the bull left the gate on October 12, 2022, the MegaCap-7 has risen 102.5% through Monday’s close (Fig. 21). That’s still well ahead of the 56.1% gain for the S&P 500 and the 42.2% rise for the S&P 493. However, the Fed’s pivot to a rate-cut cycle should help to improve the S&P 493’s fundamentals too. Their share price performances suggest investors believe so.

(2) Rolling one-year performance improving for S&P 493. While MegaCap-7 is still ahead in terms of rolling one-year performance, it has lost ground to the S&P 493 and the S&P 500 (Fig. 22). The Magnificent-7’s y/y gain has dropped to 44.8% from nearly 75.0% at the start of the year. Over the same period, the 493’s rolling one-year performance has doubled from 15.0% y/y at the start of 2024 to 31.2% now.

(3) Will S&P 493 beat the Magnificent-7? That’s a tough call considering how well the Magnificent-7 companies historically have expanded their revenues, earnings and profitability.

However, the Magnificent-7 stocks have been volatile and susceptible to bouts of price weakness primarily due to concerns about their valuations and slowing rates of growth. Their rolling one-year performance has nearly matched or fallen below those of the S&P 500 and S&P 493 more than a few times in the past, when investors lightened their positions and rotated into the S&P 493—specifically during late 2016, 2018-19, and 2021-23.

While the Magnificent-7 has led the way since mid-2023, the S&P 493 is now beginning to catch up.

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Will Fed Get Stuck With Sticky Inflation?

October 15 (Tuesday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

US Economy I: Why Sticky Inflation Matters for the Real Economy. Immediately following the Fed’s supersized 50bps cut to the federal funds rate (FFR) on September 18, we raised our subjectivity probability of a 1990s-style stock market meltup from a 20% to 30%.

Since then, the Bureau of Economic Analysis revised Gross Domestic Product (GDP) and Gross Domestic Income (GDI) higher. Personal savings was revised higher also thanks to better-than-expected personal income. Furthermore, the Bureau of Labor Statistics (BLS) reported a better-than-expected payroll employment gain for September and revised July and August increases higher too. September’s unemployment rate fell to nearly 4.0% from 4.3% in July. Not surprisingly, the Citigroup Economic Surprise Index has climbed into positive territory in recent weeks (Fig. 1).

Now, Fed officials must choose. They can either leave the FFR unchanged because the economy is doing so well, or they can persist with their newly revived dovishness. If the Fed continues to cut the FFR despite the economy growing at a stronger-than-expected pace, inflation could very well remain sticky above the Fed’s 2.0% target. That would put the Fed in a very tricky (and sticky) spot in terms of both signaling and communications. To ascertain how much room the Fed has to ease from current levels, let’s assess the inflation outlook:

(1) Sticky services. Supercore inflation (core services inflation, excluding housing) was previously referred to as “possibly the most important category for understanding the future evolution of core inflation” by Fed Chair Jerome Powell. Last week, September’s supercore CPI inflation ticked up from 4.3% to 4.4% y/y (Fig.2 ).

A somewhat less comparable version of supercore inflation in the PPI—PPI finished services less trade services (which represent wholesaler and retailer margins)—fell from 3.9% to 3.7% last month. Despite some progress on the producer front, both indexes point to core services inflation in the PCED remaining sticky at levels inconsistent with inflation remaining sustainably at-or-around 2.0%. The supercore PCED was up 3.3% y/y in August.

The Atlanta Fed’s version of “sticky” prices, which is based on the least volatile categories of CPI, suggests the same. The sticky core CPI ex-shelter prices increased 2.9% y/y in September, while the headline sticky CPI was up 4.0%. Furthermore, the Atlanta Fed’s Wage Growth Tracker increased to 4.9% y/y  (Fig.3). Perhaps that’s why Atlanta Fed President Raphael Bostic said on Thursday that he was open to skipping a rate cut at the Fed’s November 6-7 meeting. Maybe he is more data dependent on the useful statistics that his research staff generates than are other Fed bank presidents.

(2) Calculation quirks. We don’t think September’s PCED services inflation rate will decline much from August’s 3.7% y/y increase. However, it will benefit from some calculation choices by the BLS. For instance, during September, the 2.9% m/m (nsa) increase in CPI airline fares and 1.1% increase in CPI auto insurance won’t be reflected in the month’s PCED. Those components are derived from the PPI report, where airfare inflation fell 1.7% and auto insurance inflation rose just 0.2% m/m during September (Fig. 4 and Fig. 5).

(3) Revisions. Revisions of key economic and inflation indicators continue to suggest that the Fed pivoted to easing too soon and by too much. On the inflation front, the PPI was revised higher for several months from May through August (Fig. 6). So Fed officials had even less PPI disinflation than they believed when they cut the FFR by 50bps in September.

(4) Durable goods. One of the biggest factors supporting overall disinflation has been deflating goods prices. CPI durable goods fell 3.7% y/y in September, thanks partly to falling import prices for Chinese goods (Fig.7). Consumer spending on durable goods has also been relatively weaker for the past couple years, after the buying binge during the pandemic depressed future demand. However, deflation may be entering the rearview mirror as base effects and rising demand begin to put upward pressure on durables prices (Fig.8).

(5) Summary of economy projections. Our near-term outlook for inflation remains optimistic, as it has been since mid-2022 (Fig. 9). That said, we disagree with the Federal Open Market Committee’s (FOMC) assumption of the FFR level that is consistent with an “acceptable” headline inflation rate. In the latest Summary of Economic Projections (SEP), the FOMC projected a 3.4% FFR and 2.2% core PCED rate by the end of next year (Fig. 10 and Fig.11). In our opinion, cutting interest rates by 150bps might be inconsistent with inflation falling by 50bps from its current level.

(6) Transitory redux. A few economists have said that increases in various components of the September CPI are irrelevant, because either they will not filter into the PCED or they will prove transitory. Among these were airfares and insurance, as noted above, as well as the 1.2% m/m increase in the apparel category (Fig.12). They might be right. In our opinion, the nitty gritty details can be useful for forecasting but ultimately may be less helpful for investors with medium- to long-term time horizons. The overarching story is that if the Fed stimulates already-strong aggregate demand, inflation will likely remain sticky, if not rise. The inflation devil may not be in the details, but in the inflation picture nonetheless.

US Economy II: Why Sticky Inflation Matters for Investors. Again, in our opinion, there is now an increased risk that the Fed in effect declared mission accomplished a wee bit prematurely in the inflation fight. To understand why this matters for investors, look no further than those who wrongly believed that inflation was a blip and that the Fed would maintain ultra easy monetary policy forever (such as the asset-liability managers at Silicon Valley Bank and others). While the level changes in interest rates and bond yields will not be as drastic as they were during the latest hiking cycle, there is some risk in being wrong sided by inflation. While stocks have climbed to new records alongside rising bond yields, that relationship is less likely to continue. Let’s discuss why:

(1) Premature pivot. The bond market has started to judge the Fed’s pivot to be premature, as the 10-year Treasury yield has risen from 3.63% to 4.10% in less than a month. However, stocks haven’t skipped a beat.

Since September 2022, the six-month rolling correlation between stocks and bonds has become the most positive since 1998 several times (Fig. 13). This correlation fell dramatically as the 10-year Treasury yield rose over the past month, largely because the Fed’s rate cut and dovish guidance reduced the likelihood that economic growth slows. In other words, the Fed raised the strike price on their put and boosted stocks. The 10-year yield mostly rose as concerns of a recession waned, yet remains well below its 5.0% peak reached last fall.

Since September 2022, the six-month rolling correlation between stocks and bonds has become the most positive since 1998 several times. This correlation fell dramatically as the 10-year Treasury yield rose over the past month, largely because the Fed’s rate cut and dovish guidance reduced the likelihood that economic growth slows and increased the risk that inflation might stop slowing. In other words, the Fed raised the strike price on the Fed Put and thus boosted stock prices. The 10-year yield mostly rose as concerns of a recession waned, yet remains well below its 5.0% peak reached last fall. Furthermore, market-based inflation expectations are now rising, according to breakeven rates and inflation swaps (Fig.14). Rising bond yields could cause the recent gains by rate-sensitive sectors and cyclicals to stall if not reverse.

(2) Bonds don’t like volatility. Bond returns and bond volatility tend to be very negatively correlated (Fig.15). Higher bond volatility can be driven by varying expectations for long-term interest rates and inflation, or increased Treasury supply.

(3) Fiscal stimulus. Expanding supply-side capacity has helped reduce inflationary pressures. Investments in technology and infrastructure are growing rapidly and powering broader productivity-driven growth. But the economy may now have both monetary and fiscal tailwinds at its back. If the Fed cuts rates and stimulates, demand is likely to increase quicker than supply.

If the next presidential administration also stimulates aggregate demand with fiscal policy faster than supply can keep up, there could be another inflationary shock as there was during the pandemic.

(4) Inflation hedging. Higher nominal growth is not bad for stocks. That said, an economy where 2.5%-3.0% inflation is tolerated after two decades of sub-2.0% inflation will create different outcomes—particularly if there is no Fed quantitative easing (QE) supporting asset prices. Quality stocks (including tech), equities linked to real assets, and gold are likely to outperform. Assets with fixed cash flow streams, such as utilities, REITS, and bonds, are likely to underperform.

The bottom line is that it is difficult to expect tame inflation when adding interest-rate cuts to fiscal deficits running hotter than 6.0% of GDP and real GDP growing at roughly 3.0% y/y (Fig.16). The private sector is not embarking on mass deleveraging as it was immediately following the Great Financial Crisis, having put the finishing touches on its balance sheet during the pandemic. Better yet, consumers seem to be marginally re-leveraging (Fig.17).

All that said, we are relatively optimistic about the outlook for inflation given the strong productivity growth that we expect to continue (Fig. 18). But we’re mindful of the growing risk of higher inflation, or at least occasional surprises to the upside.

US Economy III: Are Fed Officials Ignoring Sticky Inflation? While a few Fed officials have noted that they’re still worried about inflation, doves like New York Fed president John Williams and Chicago Fed President Austan Goolsbee are cooing the loudest. In our opinion, they are focusing on a faulty concept of the neutral and real FFRs. Let’s discuss:

(1) The Fed’s biggest star. Williams has a permanent vote on the FOMC as the head of the Fed's most important regional bank. So his view carries extra weight. He is particularly concerned with the neutral FFR—the one that does not stimulate or dampen aggregate demand. In September, the median view of Fed officials was that this neutral FFR is 2.9% over the long run, or 0.9% when adjusted for their 2.0% inflation target, which they presume will soon be achieved (Fig. 19). We should note that there’s a wide range of long-run FFR estimates among Fed officials, anywhere from a 2.4% to 3.8% nominal rate!

As inflation has fallen, the real FFR has climbed. Adjusting the nominal FFR for the y/y percent change in the CPI, the real FFR is now around 2.9% (Fig.20). Officials like Williams and Goolsbee deem this rate to be excessively restrictive. So as the inflation fight is nearly won, by their judgement it is time to reduce restrictiveness by lowering the nominal FFR.

(2) Powell Paradox. The bond market has a different opinion thus far, agreeing with us that the Fed’s 50bps cut was too much too soon. In any event, adjusting an overnight borrowing rate by the annual percentage change in inflation doesn’t really make sense to us in the first place. Perhaps adjusting actual borrowing rates for households and businesses by long-term inflation expectations better reflects how households and businesses make financing decisions.

However, unlike actual inflation falling, the market’s daily measure of long-term inflation expectations has risen since the Fed cut rates. Adjusting the FFR by this measure of inflation shows the real FFR has fallen from 3.3% to 2.5% in a matter of weeks (Fig.21). So the Fed is unintentionally raising inflation expectations by cutting the nominal FFR. That’s quite a paradox for those officials who believed interest rates were too restrictive.

(3) Loosening financial conditions, or tightening? The Fed’s dovishness has increased expected inflation, and therefore raised benchmark Treasury yields. So households and businesses are seeing their borrowing rates rising as the Fed started easing.

We’ve seen plenty of commentators say that the Fed must cut rates to reduce the interest expense of the US Treasury or mortgage rates. But as the 10-year yield rises, so do the financing costs of government bond issuance and mortgage borrowing (Fig.22 and Fig.23). Ultimately, both burdens fall on taxpayers.

In January, Senator Elizabeth Warren and several other senators sent a letter to Fed Chairman Jerome Powell arguing that high interest rates are worsening the housing unaffordability crisis. They must have forgotten that the average consumer does not borrow overnight money. In fact, very few participants in the real economy do.

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Happy Second Birthday!

October 14 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.

Strategy I: Anatomy of a Bull Market. The current bull market started two years ago. We’ve loved it from the start even though it was among the most widely hated bull markets in history. Its many detractors all were in the hard-landing camp. They were sure that the tightening of monetary policy from March 2022 through August 2024 would cause a recession and a bear market. Consider the following:

(1) S&P 500 and LEI. The bears were right for a while when the S&P 500 fell 25.4% from January 3, 2022 through October 12, 2022 (Fig. 1). That jibed with the Index of Leading Economic Indicators (LEI), which includes the S&P 500 as one of its 10 components. However, the S&P 500 started to diverge from the LEI during the final through months of 2022 through today, as the latter has continued to fall through August of this year.

The LEI is down 15.5% from its record high on December 2021. The S&P 500 is 21.2% above its previous record high on January 3, 2022.

(2) S&P 500 and CEI. The S&P 500 recovered from its relatively short bear market because the economy did not fall into a recession as was widely feared. Indeed, the Index of Coincident Economic Indicators (CEI) continued rising into record-high territory during the period of monetary tightening (Fig. 2). That’s what it typically did in the past until the tightening triggered a financial crisis that turned into a credit crunch and a recession.

This time has been different because the Fed averted this chain of events during March 2023, when a banking crisis emerged, by providing an emergency liquidity facility. It worked like a charm, so much so that the Fed raised the federal funds rate by 25bps on March 22, right after the crisis, did so again two more times in May and July of 2023, and didn’t start cutting the rate until September of this year.

(3) S&P 500 forward earnings. While we didn’t flinch in our commitment to the no-landing economic scenario, industry analysts did so from June 2022 through February 2023. S&P 500 forward earnings per share (which is the time-weighted average of their operating EPS estimates for the current year and coming year) dipped back then (Fig. 3).

We are big fans of this series, which closely tracks the CEI. However, we sided with the CEI, which continued making new record highs while forward earnings was dipping. Now both series are at record highs.

(4) S&P 500 actual earnings. There was no recession in actual S&P 500 EPS, which rose from $208.1 in 2021 to $218.1 in 2022 to $221.4 in 2023 (Fig. 4). EPS is on track to hit $242.11 this year, $276.10 next year, and $312.17 in 2026 according to the latest analysts’ consensus estimates. We are still forecasting $250 this year, $275 next year, and $300 in 2026.

On a quarterly basis, there have been only three modest negative y/y readings in earnings growth since the start of 2021: Q4-2022 (-1.5%), Q1-2023 (-3.1%), and Q2-2023 (-5.8%). The S&P 500’s latest bull market started before those negative readings were available.

(5) S&P 500 forward P/E. On October 12, 2022, the forward P/E of the S&P 500 bottomed at 15.3 (Fig. 5). The bears couldn’t believe that their bear market could have ended with the valuation multiple that high. But that’s what it did. We had no problem believing it, as noted below.

(6) Just another bull market. In any event, the S&P 500 bottomed on October 12, 2022 and is up 62.6% since then (Fig. 6). That’s about on par with the previous eight bull markets.

Strategy II: Not Bullish Enough. After the S&P 500 closed at 4769.83 on the last trading day of 2023, our 2024 year-end target for the S&P 500 was 5400, which was among the most bullish forecasts among Wall Street’s investment strategists. It was exceeded on June 12. So we raised it to 5800. That level was exceeded on Friday last week.

It was a similar story in 2023: At the end of 2022, when the S&P 500 was 3839.50, we forecast that the S&P 500 would end 2023 at 4600. That was also among the most bullish forecasts out there. It came close to exceeding our year-end target five months ahead of schedule on July 31. We kept it there and predicted a 10% correction, which occurred as we expected. The S&P 500 ended 2023 at 4769.83, slightly above our target.

So what do we do now? We are sticking with our forecast of 5800 by year-end, 6300 in 2025, 6800 in 2026, and 8000 by the end of the decade in 2029. Our targets are based on our bullish outlook for S&P 500 forward earnings at the ends of 2024, 2025, 2026, and skipping ahead to 2029 of $275, $300, $325, and $400. We are using a forward P/E of 21.0 for each year to derive our S&P 500 year-end targets (Fig. 7, Fig. 8, and Fig. 9).

And by the way, our bullish outlook for earnings assumes that the S&P 500 profit margin will increase to record highs of 14.0% and 14.6% over the next two years, consistent with our productivity-led Roaring 2020s scenario (Fig. 10).

For the past three years, Joe, Eric, and I have been among the most bullish investment strategists on the Street. Yet we’ve been trampled by the stampeding bull this year. We have hoof marks on our backs.

We could choose to run ahead of the bull market and forecast 6000 or higher for the S&P 500 by the end of this year, as have other investment strategists recently. We aren’t joining them, for now. Our underlying forecasts for S&P 500 revenues, the profit margin, earnings, and the valuation multiple are all bullish enough, in our opinion.

We think that the year-end Santa Claus rally got a head start in September this year thanks to “Santa Jay,” better known as Fed Chair Jerome Powell. So far, there hasn’t even been a year-end tax-loss selling season, as often sets the stage for a Santa Claus rally at year-end.

If the stock market continues to fly to new highs, we will probably raise our 30% subjective probability of a 1990s-style meltup scenario. We are currently also assigning 50% to our Roaring 2020s scenario that lifts both the economy and the stock market, and 20% to a 1970s-style stagflationary outlook, the worst case for stocks.
 
Strategy III: A Bull Market for All Seasons. Birthdays and anniversaries are usually times for nostalgic reflection. So we went back in time to see what we wrote when the young bull was born two years ago:

(1) Our October 12, 2022 commentary was titled “The Most Widely Anticipated Recession In History.” We were bullish on the economy during 2022 when the consensus became increasingly convinced that the economy was heading into a recession. We wrote that the “US economy is actually doing well even though we think it has been in a ‘rolling recession,’ hitting different industries at different times, since the start of this year. So rather than a hard landing, we think we are already experiencing a soft landing, a.k.a. a ‘growth recession.’”

Indeed, as first reported in 2022, real GDP fell 1.4% (saar) during Q1 and 0.9% during Q2, but then rose 2.6% and 2.9% during Q3 and Q4. However, on September 26, 2024, the Bureau of Economic Analysis revised these numbers higher to -1.0%, 0.3%, 2.7%, and 3.4%, respectively. So even the technical recession during H1-2022 was revised away. In addition, the level of real GDP during Q2-2024 was revised up by 1.3% (Fig. 11). It had been widely expected that real GDP would be revised down to close its widening gap with real Gross Domestic Income (GDI). Instead, the level of real GDI was revised higher by 3.6% (Fig. 12, Fig. 13, and Fig. 14).

(2) Our October 18, 2022 commentary was titled “Going Fishing.” We were fishing for bottoms in stock and bond prices. We saw a double bottom in the S&P 500: “We are thinking that instead of a V-shaped capitulation bottom, the S&P 500 may very well remain in a volatile trading range around the June 16 low of 3666 for a while longer before moving back toward the August 16 high of 4305 over the rest of this year.” The S&P 500 rose as high as 4080.11 by the end of November before ending the year at 3839.50.

(3) Our October 31, 2022 commentary was titled “Bear Bottoms.” We wrote: “The bear market has clawed 30% out of stock valuations, returning the S&P 500’s forward P/E to its historical average of 15. But October 12 may have marked the bear’s bottom. If GDP and inflation perform as we expect and the Fed does what everyone expects, that bottom should hold.”

(4) Our March 16, 2022 commentary was the first in which we nailed the economy and the stock market outlooks. That was because we nailed the outlook for inflation. We thought it would moderate without an economy-wide recession. We wrote the following on March 16, 2022: “At the beginning of last week, Debbie and I raised our inflation forecast as a result of the Ukraine crisis. We now expect that the core PCED inflation rate will peak at 6.0%-7.0% around mid-year and fall to 4.0%-5.0% by the end of the year. Then it might decline to 3%-4% in 2023, maybe.” During H2-2023, we projected that it would fall to 2.0%-3.0%.

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The Shifting Sands Of Global Manufacturing

October 10 (Thursday)

Global Manufacturing I: Shifting Power Dynamics. Global manufacturing is undergoing seismic upheaval. Among the forces shifting the trade winds are geopolitical tensions, fractured supply chains, scarce skilled labor, and rising labor costs.

Local sourcing and reshoring are now highly touted as corporations and governments seek to safeguard domestic industries and jobs. US-China trade disputes, the Covid-19 pandemic, and the Russia-Ukraine conflict have bolstered the global impetus to enact change, increasingly on national security grounds.

Established manufacturing hubs like China and Germany are losing their competitive edge, while emerging markets such as Mexico and Vietnam are stepping in to fill the void. The US government is incentivizing the revitalization of its domestic manufacturing base with tax breaks and other subsidies.

Global industrial production continues to rise—its geographic composition is what is shifting (Fig. 1 and Fig. 2). In our Roaring 2020s scenario, companies are likely to invest in technology to offset some of these challenges. Burgeoning productivity growth suggests this is already happening (Fig. 3). Indeed, these investments and supply-chain reordering are likely to prove inflationary, and therefore may result in higher global interest rates.

Here’s more on how historical hubs of global manufacturing and relative newcomers are faring:

(1) The fading dragon. China continues to lead global manufacturing, particularly in electronics and machinery. Over 6 million Chinese firms contribute more than $4 trillion in net value-added to the Chinese economy.

However, China’s dominance is being eroded by escalating labor costs, decoupling from trading partners, and an aging population. We believe China’s demographic issue is among its foremost challenges in the coming years and decades (Fig. 4). The Chinese Communist Party (CCP) can no longer rely on mass urbanization and a booming working-age population to power its growth (Fig. 5). To begin transitioning from a developing to a developed economy, the CCP’s “Made in China 2025” initiative aims to pivot manufacturing from a concentration on mass production of consumer goods to high-tech innovation in artificial intelligence (AI), semiconductors, and electric vehicles (EVs).

Additionally, US-China trade tensions are pushing manufacturers with operations mostly in China to diversify their production geographically. But the demographic challenges are still likely to inflate labor costs and stifle innovation in the long run.

(2) The weakening strong man. Germany’s manufacturing sector, primarily renowned for precision engineering in automobiles and machinery, contributes nearly $900 billion to its $4.5 trillion economy.

However, Europe’s industrial powerhouse is increasingly vulnerable to rising energy costs. It is very slowly transitioning toward green manufacturing and renewable energy sources. Recall, Germany shut down its last three nuclear power plants in April 2023. The sick man of Europe shot himself in the foot.

The 2022 energy crisis prompted German firms to rely more heavily on liquefied natural gas. Boston Consulting Group anticipates that German firms are underestimating the impact of a potential increase of 50%-100% in natural gas prices by 2030.

German automakers are racing to innovate and ramp up their EV offerings to stay competitive. China’s EV market dominance is intensifying competition and squeezing market share for brands like Volkswagen and BMW. Nevertheless, Germany recently voted against the European Union’s recently approved tariff on China-made EVs, fearing retaliation in Chinese markets for German autos.

Additionally, global reliance on China’s battery supply chain is a strategic challenge for German EV makers.

(3) The nationalist revivalist. The US is experiencing a manufacturing renaissance driven by reshoring initiatives, technological advancements, and supportive legislation. The nation’s manufacturing firms collectively produce about $2.5 trillion, with a focus on aerospace, autos, electronics, and high-tech products.

Legislative measures signed into law in 2021 and 2022—specifically, the Infrastructure Investment and Jobs Act, the CHIPS Act, and the Inflation Reduction Act—incentivize companies to bring production back home to enhance national security and address supply-chain vulnerabilities. These measures have helped stimulate a doubling of private investment in manufacturing structures construction within real GDP (Fig. 6).

In recent years, US industrial production has plateaued amid an ongoing shortage of skilled labor, supply-chain disruptions, climate-related challenges, and competition from lower-cost and emerging markets with larger, younger workforces (Fig. 7).

(4) The backdoor to China. Mexico is positioning itself as a critical player in nearshoring, particularly for US companies seeking alternatives to producing goods in China. Mexico’s manufacturers contribute about $360 billion to its economy, predominantly driven by automotive goods. Competitive labor rates and favorable trade agreements further enhance Mexico’s competitive advantage as an exporter.

As Western firms withdraw from China, many Chinese manufacturers are relocating operations to Mexico to capitalize on these advantages. The United States-Mexico-Canada Agreement encourages global firms to invest in Mexican manufacturing, supported by significant investments in logistics and infrastructure. However, challenges such as political instability, domestic corruption, and cartel violence continue to undermine the investment landscape.

(5) The emerging frontier. Vietnam’s manufacturing sector is rapidly rising as a favored low-cost producer. Global companies seeking to diversify their supply chains are attracted to Vietnam’s competitive workforce, strategic location to trade routes, robust export infrastructure, and pro-business policies. It’s a beneficiary of the “China+1” strategy and boasts production output of about $100 billion, particularly in electronics and textiles.

Foreign direct investment in Vietnam increased 7.1% last year to $4.6 billion.

Vietnam’s pro-business policies include tax incentives for manufacturers, favorable trade agreements like the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, and a focus on the expansion of industrial parks.

Vietnam’s manufacturing sector still lacks the competitiveness and robustness of China’s, however. Weaker productivity, skilled labor shortages, import dependence, and lack of energy security weigh on its output.
 
Global Manufacturing II: US Holds Amid Global Contraction. Global manufacturing remains weak, with Manufacturing Purchasing Managers’ Indexes (M-PMIs) pointing to contraction across major economies. China’s decision to dump cheap exports onto global markets has crushed Germany’s manufacturing sector, for instance, and weighed on many others.

Here’s a brief summary of the latest M-PMIs globally and by major country:

(1) Worldwide. The S&P Global Manufacturing PMI (M-PMI) fell to 48.8 in September 2024, marking a sustained contraction (Fig. 8).

(2) China. China’s national M-PMI dropped to 49.3 in September from 50.4 in August, led by a renewed downturn in new orders and the lowest reading since July 2023. This decline stems mostly from a sluggish domestic market (Fig. 9).

(3) Germany. Germany’s M-PMI plummeted to 40.6 in September, down from 42.4 in August (Fig. 10). Additionally, the volume of German manufacturing orders decreased in August (Fig. 11).

(4) United States. The US M-PMI held relatively steady at 47.3 in September versus last month’s 47.9 (Fig. 12). New orders rose slightly to 46.1 (Fig. 13).

However, US M-PMIs have decoupled from their historical correlation with real GDP goods. The former has been in contraction for much of the past two years, while the latter rose 2.7% y/y in Q2 (Fig. 14).

(5) Mexico. Despite numerous tailwinds at its back, even Mexico’s manufacturing sector is suffering from weaker global demand and increased supply. Mexico’s M-PMI suddenly deteriorated in September, to 47.3 from 48.5 in August (Fig. 15). Companies have reported sharper declines in new orders, production, and employment.

(6) Vietnam. Vietnam’s M-PMI plummeted to 47.3 in September from 52.4 in August, entering contraction territory for the first time since March (Fig. 16). Typhoon Yagi caused temporary, though significant, disruptions last month, including business closures and production delays; but the future outlook is brighter.
 
Global Manufacturing III: In Its Green Automation Era. The global manufacturing sector is undergoing a profound transformation driven by automation and green technology. Innovations in these areas can enhance operational efficiency and address environmental challenges. As manufacturers embrace AI, robotics, and renewable energy solutions, they are poised to redefine productivity and sustainability for the future.

Here’s more:

(1) Automation. Staffing firm Hamlyn Williams explores how automation technologies are reshaping manufacturing and the industry’s hiring needs through breakthroughs in AI, robotics, and the Industrial Internet of Things (IIoT). AI optimizes production and enhances uptime via predictive maintenance, while collaborative robots (a.k.a. cobots) boost productivity alongside human workers. IIoT integration facilitates real-time monitoring, enabling data-driven decisions that streamline operations.

As these technologies become increasingly affordable, their adoption will accelerate, promising significant gains in efficiency and output.

(2) Sustainability. In response to environmental regulations and consumer preference trends, manufacturers are racing to adopt green practices to drive sustainability forward, enhancing both brand reputation and resilience. From cutting waste to improving energy efficiency, the focus is on eco-friendly methods across all stages of production, Hamlyn Williams observes. Many are turning to renewable energy sources like solar and wind to reduce dependence on fossil fuels and curb carbon emissions.

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The Fed’s Mission Hasn’t Been Accomplished

October 09 (Wednesday)

US Inflation: Mission Accomplished? We’re expecting to see September’s headline CPI inflation rate fall closer to 2.0% y/y when it is released on Thursday. Since mid-2022, Debbie, Eric, and I have predicted that inflation was likely to fall to the Fed’s 2.0% target for the PCED inflation rate by 2024-25 (Fig. 1). We still believe this to be the case now that it is down to 2.2%. But the Fed’s 50bps interest-rate cut on September 18 raises the risk that this putative “mission accomplished” declaration on inflation will prove premature.

To be clear: Our base-case Roaring 2020s scenario projects that strong productivity growth will subdue inflationary pressures. But we believe investors should be mindful of the potential risks for higher-than-expected inflation if the Fed overheats our hot economy. Consider the following:

(1) Powell pivot. Fed Chair Jerome Powell signaled his pivot from monetary policy hawk to dove on August 23 at Jackson Hole. What changed? In our August 27 Morning Briefing, we wrote that Powell was likely trying to earn another renomination as Fed chair. That’s the same playbook that led him to maintain the federal funds rate (FFR) at zero and continue buying bonds in 2021, even though inflation was heating up during the second half of that year (Fig. 2). He was reappointed at the end of 2021. Even so, he didn’t pivot from that dovish position until March 2022, when the Fed started its latest and belated monetary policy tightening.

Powell then stayed hawkish on inflation until his latest Jackson Hole speech this year. In late 2022, Powell pointed to so-called supercore inflation (core services inflation excluding housing) as possibly “the most important category for understanding the future evolution of core inflation. Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.” The supercore components represent more than half of the Fed’s preferred measure of inflation, the core PCED rate.

(2) Supercore still sticky and stuck. Supercore PCED inflation was up 5.1% y/y in November 2022, when Powell first referenced it. Supercore CPI was up 7.3% at the time. Those measures have declined to 3.3% and 4.3% y/y, respectively, as of August (Fig. 3). That’s progress, but neither is anywhere near 2.0%.

One of the stickiest parts of supercore inflation is transportation services, which rose 7.9% y/y in August (Fig. 4). This index captures car leases and rentals, auto maintenance and repairs, auto insurance, and public transit.

Auto insurance has risen substantially, up 16.5% in the CPI and 6.1% y/y in the PCED as of August (Fig. 5). Following the jump in car prices during the pandemic, inflation across auto-related categories has surged in kind (Fig. 6). Also, consumers have opted for more expensive vehicles. Light trucks have skyrocketed from roughly half of US auto sales a decade ago to more than 80% today (Fig. 7).

(3) Distribution of disinflation. Why has headline inflation fallen so much if supercore inflation has remained sticky at elevated levels? Because disinflation hasn’t been evenly distributed. Consumer durable goods prices have deflated meaningfully in recent quarters (Fig. 8). Even nondurables inflation has fallen below well 2.0% (Fig. 9).

There have been plenty of tailwinds supporting goods disinflation. The US import price index for goods made in China declined substantially as cheap Chinese goods flooded global markets (Fig. 10). Consumer goods demand has also been relatively weak after the spending surge during the pandemic lockdowns. Now several factors are threatening to raise import prices, including higher wages for longshoremen, geopolitical tensions, supply-chain chokepoints, Chinese economic stimulus, and rebounding global goods demand. In addition, the next president of the United States might raise tariffs on Chinese goods.

China’s stimulus plans and flareups between Israel and Iran have put upward pressure on crude oil prices. Brent crude rose from below $70 a barrel a month ago to above $80 on Monday (it slipped to $77.50 after China's latest policy announcement fell flat). Rising oil prices will flow through to input prices in the PPI as well as gasoline prices (Fig. 11). Rebuilding from Hurricane Helene, Hurricane Milton, and other extreme weather events will likely prove inflationary, too.

(4) Shelter. Rent represents roughly one-third of CPI inflation and 16% of PCED inflation. Shelter inflation has moderated as new market-based rents have slowly filtered into the lagging measure used by the Bureau of Labor Statistics (BLS), but it ticked up to 5.2% in August. The three-month percent change in the two major categories of rent—owner’s equivalent rent and rent of primary residence—are above 4.0% and rising (Fig. 12).

In some respects, we are all playing a waiting game with shelter inflation. Indeed, excluding rent, August’s CPI and core CPI were down to 1.2% and 1.6% y/y, respectively (Fig. 13). Notably, CPI includes renter’s insurance rather than homeowner’s insurance, which has increased substantially.

(5) Unit labor costs. Unit labor costs (ULC) is the best measure of underlying inflationary pressures in the labor market. It rose at a decade-low rate of 0.3% y/y last quarter (Fig. 14). We expect that ULC inflation may even be revised into negative territory thanks to the BLS’s latest upward revision to economic growth and downward benchmark revision to payroll employment!

The Fed deserves some (but not all) of the credit for taming inflation, especially considering that US economic growth has remained so strong. But if the Fed declares victory prematurely and lowers rates too much too soon, it risks causing goods and energy prices to rebound, boosting headline inflation unless supercore inflation gets unstuck. That’s the scenario that the bond market and your humble prognosticators at YRI have been discounting ever since the Fed’s 50bps rate cut on September 18.
 
US Inflation: Expect the Unexpected. Fed officials frequently brag that inflation expectations remain “well anchored,” which means around 2.50% plus/minus 50bps. Should inflation expectations ever become “unanchored” and rise well above the Fed’s target, consumer sentiment would deteriorate, a wage-price spiral would occur, and financial market volatility would increase as bond and stock prices fall.

Now that the Fed is less concerned about inflation, we think it is important to be more vigilant. Arguably, our friends the Bond Vigilantes seem to have woken up recently. Consider the following:

(1) Breakeven inflation. The difference between the 10-year nominal and inflation-protected Treasury yields—otherwise known as “breakeven inflation”—is currently 2.28% (Fig. 15). It was 2.04% a month ago. Swap contracts linked to the average inflation rate over the period five to ten years in the future are trading at 2.50%, up from 2.34% immediately after the Fed’s September meeting.

Why the increase? The Fed is easing despite a strong economic growth backdrop. As the economic data have surprised to the upside, both the growth and inflation expectations baked into bond yields have risen (Fig. 16).

(2) Oil. Rising crude oil prices have also put upward pressure on inflation expectations (Fig. 17). Should Iran and Israel engage in a full-on war, Iran’s production facilities may be bombed by Israel. Iran may also cut off shipments in the Strait of Hormuz. And if other Arab nations are pulled into the conflict, oil supply could be restricted further. In Europe, Ukraine could also put pressure on Russian production by attacking their oil fields.

These scenarios weighing on global growth and boosting inflation remain a roughly 20% risk, in our opinion. But they are a distinct possibility.

(3) Election. The elephant in the room at the Fed’s Eccles Building in DC is fiscal policy. The US government ran a $2.1 trillion budget deficit over the past 12 months (Fig. 18). To us, the biggest inflationary risk in 2025 is an election sweep. Should the Democrats or Republicans control both chambers of Congress and the White House, there’s no doubt the federal deficit will widen even further. Should increased spending or tax cuts boost demand faster than the private sector can respond by increasing supply, it’s unlikely that inflation will remain at 2.0% y/y for very long.

The Fed is apolitical and largely shuns commenting on fiscal policy, aside from Powell sometimes commenting that it is on an unsustainable path. There’s no doubt that Fed officials are thinking about the impact that wider federal budget deficits would have on the economy. Depending on the outcome of the November elections, perhaps they will express their concerns that fiscal policy is on an unsustainable path more often. They might even pivot again, this time toward a less dovish monetary policy stance, thus implicitly acknowledging that combining inflationary fiscal policies with easy monetary policies is a sure way to bring inflation back.

(4) Bottom line. The Fed’s mission has not been accomplished with regards to inflation. That’s our message. More importantly: That’s the message from the bond market.

Strategy: NERI Confirms Economic Strength. Last week, LSEG released its October snapshot of the industry analysts’ consensus estimate revisions activity over the past month for revenues and earnings forecasts. With these data, we create our Net Revenues Revisions Index (NRRI) and Net Earnings Revisions Index (NERI), which are automatically updated in our S&P 500 NRRI & NERI report. There, a zero reading indicates that an equal percentage of estimates were raised as were lowered over the past three months, which encompasses an entire quarterly reporting cycle. Since analysts tend to revise their estimates to different degrees at different points in the three-month cycle, the three-month data are less volatile than a monthly series.

Joe found that October’s NERI readings were only slightly negative, which is markedly better than the historical average. That confirms our strong outlook on the economy. Below, Joe highlights what’s most notable about October’s NERI readings:

(1) S&P 500 NERI now negative. The S&P 500’s NERI index was negative in October for the first time in five months and weakened for a third straight month to -0.4% from a 27-month high of 2.2% in July (Fig. 19). We’re not worried since October’s reading remains above the average of -1.9% since April 1985. Furthermore, negative NERIs are the norm, occurring during nearly 60% of the months since the data were first calculated in April 1985.

(2) Most sectors still have positive NERIs, but fewer improved m/m. Six of the 11 S&P 500’s sectors had a positive NERI in October. That count is unchanged from a month earlier but is down from nine sectors with a positive reading in June and July, which was the highest in 30 months dating back to March 2022.

Looking at October NERI data by sector, just four of the 11 sectors’ NERIs improved m/m, down from five improving m/m in September and 10 in June. The four sectors with improving NERIs m/m: Communication Services, Financials, Health Care, and Industrials. The longest positive NERI streak of nine months belongs to Information Technology, followed by Financials (eight months), Health Care (seven), Communication Services (six), Utilities (five), and Real Estate (three). Consumer Staples has the longest negative NERI streak, of four months, with the remaining sectors at two to three months.
 
Here’s how NERIs ranked for the S&P 500 and its 11 sectors in October: Financials (4.6%, 27-month high), Information Technology (3.1, four-month low), Health Care (0.9), Consumer Discretionary (-6.5, 21-month low), Utilities (2.2), Industrials (-0.1), S&P 500 (-0.4, five-month low), Real Estate (0.3), Communication Services (3.2, 11-month high), Materials (-6.0, five-month low), Energy (-8.0, six-month low), and Consumer Staples (-4.9, 10-month low).

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On Jobs, Bonds & Liquidity

October 08 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Economy: Long Live the Labor Market. After two years of higher interest rates and Fed balance-sheet tightening, the lack of cracks in the labor market has caught nearly everyone off guard. In disbelief that their economic models could be wrong, some claimed that this could not be true! The diehard hard-landers vocally grasped onto any sign that suggested that the “long and variable lags” sown by tightened monetary policy had come to roost in the labor market.

Among those signposts: The Bureau of Labor Statistics’ (BLS) downward revision to annual payroll employment by 818,000. The summer slowdown in hiring. The rise in weather-related unemployment during July. These were heralded as inescapable facts that the long-awaited recession had arrived. Champagne glasses were clinked.

September’s gangbusters payroll employment data allayed fears (or perversely, hopes) that the labor market was coming unhinged. We have been saying all along that those concerns were misplaced. There is no endogenous force that causes unemployment to spike once it starts rising, as some Fed officials and pundits have speculated. Financial crises cause the massive increase in unemployment associated with a recession, per our Credit Crisis Cycle theory (Fig. 1).

It was highly unlikely that the unemployment rate would remain at a historical low forever. That wouldn’t be consistent with moderating inflation... or reality.

While the hiring environment has cooled, we continue to believe that the labor market is simply normalizing after a period of record tightness. That’s partly why we think there wasn’t much need for the Fed’s 50bps rate cut in September—and certainly no need for an emergency 75bps rate cut in July, as some CNBC guests at the time asserted was necessary.

Here are our additional takes on the latest labor market data:

(1) Sahm Rule reversal. The so-called Sahm Rule, a recession indicator based on the moving average of the headline unemployment rate, was triggered in July when the unemployment rate rose to 4.3% (Fig. 2). Then, we dismissed this as yet another false recession signal. The creator of the eponymous rule did so too in the weeks following. That proved to be the right call.

The unemployment rate ticked down from 4.2% in August to 4.1% in September. Unrounded, the unemployment rate actually fell to 4.051%. The thinnest margin prevented the headline unemployment rate from declining 0.3ppts in just two months. That would have put the unemployment rate 0.2ppts below Fed officials’ latest projection of the long-term rate.

(2) Hiring head fake. Job vacancies typically fall when confidence in the economic outlook deteriorates. Feeling less optimistic about external job opportunities, fewer workers quit their jobs. As businesses are less confident about future profits, they are less likely to expand operations and therefore hire less workers.

The numbers of hires and quits measured by JOLTS have fallen recently (Fig. 3). Rather than fewer workers quitting their jobs because they aren’t confident about their job market prospects, staff retention may be improving, as wages and benefits now match what workers feel they are worth. As consumer inflation falls, there’s less pressure to job-hop in search of higher wages.

One curiosity is that the number of job openings relative to both the number of hires and the number of quits has stabilized above pre-pandemic levels (Fig. 4). That suggests employers still have an unmet demand for labor.

(3) Skills mismatch. As job openings fall, unemployment tends to rise. And vice-versa. That’s the foundation of the Beveridge curve model (Fig. 5). However, labor demand is retaining its post-pandemic surge and even turned higher last month (Fig. 6). Perhaps businesses are eager to hire, but the current (growing) labor pool does not possess the skills employers are looking for.

According to the NFIB survey of small businesses, 52% of small business owners said there were no qualified applicants to fill their openings in September (Fig. 7).

(4) Employment gains. We’ve highlighted that much of the upward pressure on the unemployment rate has come from workers entering the labor force. This is obviously preferable to layoffs causing a rise. Employed workers transitioning into unemployment fell from 1.06% of the labor force to 0.93% in September (Fig. 8). Even as more Americans previously out of the labor force started searching for jobs and became newly unemployed, the unemployment rate fell.

(5) Unions. Strikes have made headlines, and clearly workers have a lot of bargaining power. The longshoremen’s 62% raise over six years equates to roughly 8.4% annualized increases—better than expected equity returns! More than 30,000 Boeing employees continue to strike after refusing a 30% raise, plus additional bonuses and benefits. These pay raises are representative of a broader trend. Lower-wage workers (production and nonsupervisory workers account for roughly 80% of US employment) have seen their real wages rise for the past several years (Fig. 9). Union wages simply lag non-union wage gains because contracts lock in a set path of wage increases for several years (Fig. 10). It can take quite a while to negotiate new contracts.

Unions also represent a shrinking percent of total private sector employment, now just 6%, nearly half the representation in 1992 (Fig. 11). Union membership fell to less than one-third of government employees in 2023 for the first time on record. So while union members are seeing big wage increases, these figures may not make a big impact on national figures.

(6) Goods versus services. Union membership in the private sector has shrunk in part because the US economy is now driven much more by services providers than goods producers. Economic output and consumption favor services to goods at a roughly 2:1 ratio.

For instance, manufacturing jobs fell 7,000 last month (Fig. 12). But goods-producing jobs (i.e., manufacturing, construction, and mining) now represent just 10% of total nonfarm employment (Fig. 13). Employment in the leisure and hospitality industry, meanwhile, rose 78,000, boosted by consumer spending on services. Across services industries, the three-month moving average of job openings is increasing (Fig. 14).

Some hard-landers say there’s no way that September’s payroll gains make sense given that the employment series in ISM’s national Purchasing Manager Indexes (PMIs) has been depressed. While M-PMI employment is somewhat correlated with the monthly change in manufacturing payrolls, the relationship between the NM-PMI series and services employment broke down several years ago (Fig. 15 and Fig. 16). We’ll stick with the hard data.

Bonds: Re-Inversion? Fed officials’ decision to cut the federal funds rate (FFR) by 50bps was predicated on the fact that they were behind the curve on fighting rising unemployment. We note that many who continue to beat that drum were also calling for rate cuts back in July. In any case, the market has pared its expectations for future FFR cuts, as the most recent economic data have been much stronger than expected.

Here’s more:

(1) FFR futures. After the Fed’s rate cut on September 18, futures tied to the FFR priced in the Fed cutting all the way to the terminal rate (the ultimate endpoint of an easing cycle) of 2.8% over the next 12 months (Fig. 17). Now, the market expects the Fed to take the FFR to 3.5% in that period, a dramatic shift in expectations. The number of FFR cuts priced in over the next year has fallen from nearly 10 to about 5.5 (Fig. 18).

We aren’t worried about the Fed not “meeting” the market expectations for cuts. Recall, the market priced in seven cuts coming into this year, and the stock market did just fine without any until September. Leading up to the September Fed meeting, a number of pundits said that if the Fed didn’t cut as much as the market had priced in, the Fed effectively would tighten financial conditions. This was a big risk, according to them. No word from this group whenever financial conditions are loose and could risk higher inflation, of course. Nonetheless, long-term bond yields have risen meaningfully since the Fed’s too-big rate cut, putting a damper on their suggestion.

It makes sense that short-term-rates markets price in a slew of cuts at any sign of potential weakness in the economy. Investors who are long the Magnificent-7 and broader S&P 500—particularly with leveraged positions—know that the Fed’s reaction function is to cut first, ask questions later. Even if it is “expensive” to hedge recession risk in rates markets, why not do so to protect your downside? That’s likely why investors are so quick to pile in, especially considering that stock valuations are relatively stretched. Those recession hedges do provide a fade-able opportunity to those who trade rates futures and agree with our Roaring 2020s outlook, however.

(2) Yield curve. The US Treasury yield-curve spread (i.e., between the 2-year and the 10-year Treasury bond yields) has reverted from a local high of +23bps to now just +1bps, flirting with re-inversion (Fig. 19). Perhaps the bond market thinks the Fed will hold the FFR too high for too long and cause a credit crisis. Or rather, the bond market thinks the FFR will end up around 4.0% over the long run. That sounds about right to us.

The yield curve has bear flattened meaningfully since the payroll employment data on Friday, as both the 2-year and 10-year Treasury yields have risen. The 10-year has now breached 4.00% and is nearly 40bps higher than its recent low of 3.63% (Fig. 20). In the weeks following the Fed meeting, the curve had steepened, with the 2-year yield falling as the 10-year yield rose (pricing in over-easy monetary policy causing higher long-term growth and inflation). Such a reversal is rare, reflecting the fact that the strength of the employment report caught the consensus off guard.

(3) Credit spreads. The spread between high-yield corporate bond yields and comparable US Treasury yields has compressed further to just above 300bps (Fig. 21). The bond market continues to doubt the likelihood of a recession and defaults from the junk bond universe.

Rates & Repo: Liquidity Shortage? The Fed’s standing repo facility (SRF) was tapped for $2.35 billion on Monday, September 30. This facility was put up five years ago to alleviate pressures in the financial plumbing during the Fed’s previous go at quantitative tightening (QT). There were several causes for the increase in usage, but it’s not likely to ruffle too many feathers at the Fed. We expect QT to continue its tempered pace for several months. However, further pressure in repo markets could lead to a quicker ending.

Here’s more:

(1) Quarter-end. Funding markets always see pressure on quarter-end dates. This is when foreign banks pull back from these markets to window-dress their balance sheets for quarterly reporting. The SRF was designed to absorb these pressures, and $2 billion is chump change relative to past usage of the facility (Fig. 22). As a reminder, banks pledge Treasuries (or other high-quality collateral) to the SRF in exchange for overnight cash.

(2) Quantitative tightening. By reducing the amount of liquidity in the financial system, QT reduces the supply of cash to financing collateral (i.e., new Treasury supply). This can put upward pressure on repo rates and force banks to hit the Fed for financing. As the Treasury issues more and more debt, that also increases the amount of Treasuries that Wall Street needs to finance (Fig. 23).

(3) Should you worry? No. Bank reserves are still very high, above $3.0 trillion (Fig. 24). There are few signs of worry in funding markets. The rising Treasury supply and asset managers’ preference for Treasury futures have led to more trading activity at higher repo rates, but that’s not an immediate cause for concern. The bigger story is that M2 money supply is now increasing again on a y/y basis (Fig. 25). The Fed has plenty of shock absorbers, and they are more likely to end QT too soon than too late.

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A Dozen Reasons For None-And-Done

October 07 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy: The Widely Feared Phantom Recession Is Over. Pagliacci (Clowns, 1892) is an opera in a prologue and two acts with music and libretto by Ruggero Leoncavallo. The play tells the tragedy of a jealous husband and his wife in a commedia dell'arte theatre company. At the end, the husband kills his wife and her lover. In tears, he declares the chilling words “La commedia è finita!,” which in Italian mean “The comedy is over!”

Rudi Dornbusch, a renowned German macroeconomist, once said, “Expansions don’t die of old age. I like to say they get murdered.” Eric and I have observed that economic expansions usually are murdered by the Fed when monetary policy is tightened to fight inflation, triggering a credit crisis that quickly turns into an economy-wide credit crunch and a recession. We’ve referred to this repetitive pattern as the “Credit Crisis Cycle.”

Ever since the Fed started to raise the federal funds rate (FFR) in March 2022 (when the latest monetary policy tightening cycle began), most economists predicted that it would cause a recession. This consensus forecast was supported by the inversion of the yield curve and the decline in the Index of Leading Economic Indicators. We dissented from this consensus view for numerous reasons that we discussed numerous times since early 2022.

The Fed stopped raising the FFR in July 2023, and fears of a recession began to subside. Nevertheless, at the start of 2024 the financial markets along with most economists believed that the Fed would have to significantly lower the FFR five or six times by 25bps each to avert a recession in 2024 caused by the so-called “long and variable lags” of monetary policy (Fig. 1). That made no sense to us, so we predicted two cuts, three at most. There were no cuts until September 18, when the FFR was cut by 50bps.

Even so, the next day the FFR futures market indicated another seven cuts of 25bps in the FFR over the next 12 months, including another 50bps of rate cuts by the end of the year (Fig. 2). Again, that made no sense to us since we believed that the summer’s economic weakness was just a soft patch, and didn’t require an aggressive Fed easing response.

Following Friday’s strong September employment report, the FFR futures market predicted five or six rate cuts over the next 12 months, including one over the rest of this year. We are predicting none-and-done for the rest of this year for the 12 reasons we discuss below.

Meanwhile, since the beginning of this year a few vocal diehard hard-landers have remained convinced that a recession still was imminent. Indeed, a couple of them claimed that the economy was already in a recession.

On Friday, their operatic cri de coeur ended abruptly. September’s strong employment report and upward revisions in July and August murdered the hard-landing scenario. Tragically, it was a very hard landing for the diehard hard-landers. May they rest in peace.

The few remaining hard-landers immediately went on social media and raised doubts about the accuracy of the employment data. It is a time-honored tradition among economists to claim at times when the data don’t support their forecasts that something must be wrong with the data. Indeed, we made this argument during the summer when the economy was weaker than we expected: We blamed it on the weather. So now we are saying that the latest batch of strong data is good because it supports our resilient economy thesis.

Before we get too cocky, we should note that we aren’t completely ruling out the possibility of a recession. We are still assigning a 20% subjective probability to a 1970s-style geopolitically triggered hard landing (Fig. 3). If the Israelis hit Iran’s oil, military, and nuclear facilities with all they’ve got within the next few days, the result could be a dramatic increase in the price of oil as well as a shortage of the vital commodity should the Strait of Hormuz be blocked by the Iranians (Fig. 4). Israel’s retaliation could happen at any time, even today, which is the anniversary of the Hamas attack on Israel. That could lead to a global recession.

In any event, the notion that the lagged effects of the tightening of monetary policy will cause a consumer-led recession is dead, in our opinion. The no-show Fed-triggered recession will remain a no-show, especially now that the Fed has started to lower the FFR even though it isn’t warranted by the performance of the economy.

For the hard-landers: La commedia è finita!

US Labor Market: Help Still Wanted & Workers Still Available. The hard luck for the hard-landers has been good luck for employees and employers. During September, the demand for labor increased by 759,000 to 169.9 million workers, while the supply increased by 150,000 to a record 168.7 million workers (Fig. 5). That’s an almost perfect balance.

Consider the implications of the most recent indicators of labor market conditions:

(1) Demand for workers. The data belie the popular notion that while companies aren’t firing workers, they aren’t hiring them either. Layoffs do remain subdued, but nonfarm payroll employment rose 254,000 to a record 159.1 million during September with upward revisions totaling 72,000 during July and August. Job openings totaled 8.0 during August, about the same as the number of unemployed workers (Fig. 6).

(2) Supply of workers. The labor force rose 150,000 to a record 168.7 million during September (Fig. 7). Over the past 24 months, the labor force increased 4.1 million, led by a 2.6 million increase in foreign-born workers. The labor force participation rate remained flat at 62.7% in September. The civilian noninstitutional working-age population rose 224,000 during September (Fig. 8). Over the past 24 months, this measure of the population rose 4.7 million, led by a 3.4 million increase in the foreign-born population.

(3) Aggregate hours worked. Average weekly hours declined 0.3% m/m to 34.2 hours (Fig. 9). This is a very volatile series that tends to zig and zag. It did offset the 0.2% m/m increase in last month’s private industries payrolls. So aggregate weekly hours edged down 0.1% m/m during September from its record high of 4.6 billion hours during August (Fig. 10). We expect it will be back at a new record high this month.

(4) Hourly wages & Earned Income Proxy. The good news for workers was that average hourly earnings rose 0.4% m/m. So our Earned Income Proxy for private industry wages and salaries increased 0.3% m/m to yet another record high (Fig. 11). That sign of consumer health suggests that retail sales probably rose to another record high last month (Fig. 12).
 
The Fed: 12 Reasons To Do Nothing. Before the Fed cut the FFR by 50bps last month, we thought that 25bps made more sense given the resilience of the economy and that would be it for the year. Now we think the Fed might not cut again in either November or December; here are 12 reasons why:

(1) The economy didn’t need September’s 50bps cut in the FFR, as evidenced by Friday’s employment report as well as Thursday’s NM-PMI report for September (Fig. 13). The NM-PMI composite index rose to 54.9 led by big jumps in new orders (59.4) and production (59.9). The Citigroup Economic Surprise Index, which was negative from May 3 through September 30, rose to 14.1 on Friday (Fig. 14). That confirms our view that the recent economic soft patch is over.

(2) Fed officials now should be having some regrets about cutting by 50bps rather than 25bps on September 18. They should conclude that they’ve eased enough for the rest of the year while waiting for more data to assess what they should or shouldn’t do next.

At the September meeting of the FOMC, we sided with the one dissenter, Governor Michelle Bowman, who preferred to lower the FFR by 25bps. In a subsequent statement, on September 20, she explained that with the Fed not yet having achieved its inflation goal, easing could be premature and noted the risks that easing then could pose:

“Although it is important to recognize that there has been meaningful progress on lowering inflation, while core inflation remains around or above 2.5 percent, I see the risk that the Committee's larger policy action could be interpreted as a premature declaration of victory on our price stability mandate.

“We have not yet achieved our inflation goal. I believe that moving at a measured pace toward a more neutral policy stance will ensure further progress in bringing inflation down to our 2 percent target. This approach would also avoid unnecessarily stoking demand.”

(3) The backup in bond yields since the Fed started easing on September 18 is signaling that the easing wasn’t necessary and increased the possibility of stronger economic growth and/or higher inflation. Our August 19 Morning Briefing was titled “Get Ready To Short Bonds?” We warned that bond investors may be expecting too many Fed rate cuts too soon. The 10-year US Treasury yield bottomed at 3.63% on September 16 and rose to 3.98% on Friday (Fig. 15). The 2-year yield bottomed at 3.49% on September 24 and closed at 3.93% on Friday.

(4) Further rate cuts would raise the odds of a 1990s-style stock market meltup. Indeed, we reacted to the 50bps cut by raising our subjective odds of a stock market meltup from 20% to 30%. Valuation multiples already are comparable to the levels of the late 1990s. The S&P 500 forward price-to-sales ratio rose to a record 2.87 on Friday (Fig. 16). The forward P/E was 21.6.

(5) Oil prices are rising because of mounting geopolitical risks in the Middle East. That’s reminiscent of the 1970s-style stagflationary scenario, as we discussed above.

(6) Cleaning up and rebuilding following Hurricane Helene will be stimulative and possibly inflationary.

(7) The dockworkers’ recent huge pay settlement could raise import prices and put upward pressure on other wages.

(8) Both presidential candidates are proposing fiscal programs that would further widen the federal budget deficit and might be inflationary.

(9) The Chinese government is stimulating its economy, putting upward pressure on commodity prices.

(10) Further cuts in the FFR might weaken the dollar, with inflationary consequences.

(11) As Governor Bowman said, the Fed hasn’t fully accomplished its mission. The headline and core PCED inflation rates were 2.2% and 2.7% y/y in August—close to the Fed’s 2.0% inflation target but no cigar. The “supercore” PCED inflation rate has been stuck just above 3.0% recently.

(12) The real neutral FFR rate might be much higher than reflected in the FOMC’s September Summary of Economic Projections. It shows the FOMC’s median estimates of the “long run” FFR and PCED inflation rates are 2.9% and 2.0%, implying a real neutral FFR of 0.9%. Our opinion is that it is more like 2.0%, putting the neutral nominal FFR at 4.0%.

Movie. “Wild Rose” (+) (link) is an entertaining movie about a single mom who has a criminal record and aspires to be a country singer in Nashville. She lives in Glasgow with her two kids. She’s a good singer but not a very good mom. Along the way, reality bites, and she learns to be a better mom while still pursuing her aspirations. Jessie Buckley does a good job with the lead role and has a nice voice.

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Oil, Investment Banks & Flying Cars

October 03 (Thursday)

Energy: Fighting Boosts Oil Price. Hostilities between Israel and Iran have pushed up the price of oil, something that rounds of production cuts by OPEC+ have failed to achieve.

Iran fired about 180 ballistic missiles into Israel on Tuesday, but they were mostly intercepted by Israel and its allies, causing minimal damage. The attacks came in response to Israel’s recent strikes targeting Hezbollah leaders and their weapons in Lebanon. Now the world awaits Israel’s response, if any. As of Wednesday, Israel was continuing its air strikes in Beirut and its ground offensive in southern Lebanon.

After Iran’s April strike, Israel launched only a limited response that did not provoke Iran to retaliate. The oil market may be betting that that history will repeat. The Brent crude oil price has risen only modestly in recent days. At $74.55 per barrel, it’s up 3.6% from Friday’s close. It’s still well off of this year’s high price of $91.17 on April 5 and 2022’s peak level of $127.98 (Fig. 1).

Since November 2022, OPEC+ has been trying in vain to lift the price of crude by cutting back on production. Here’s a look at some of the reasons why OPEC’s cuts haven’t worked:

(1) Production cuts by OPEC+. Three different rounds of cuts have reduced OPEC+’s production by roughly six million barrels a day (mbd), or roughly 6% of global production. The organization was expected to bring 180,000 barrels per day (bpd) of that production back onto the market in October and then bring another 540,000bpd back on the market by the end of the year. The increases were part of OPEC+’s plan to eventually reintroduce 2.2mbd of production back onto the market. But in early September, the organization decided to postpone any increase in production by at least two months.

(2) OPEC+ foiled by soft demand. World oil demand is expected to grow by 900,000 barrels per day this year and 950,000 next year, down from the 2.1mbd increase in demand experienced in 2023. Much of that slowdown can be attributed to China.

China’s weaker-than-expected economy, its growing use of electric vehicles, and its national high-speed rail network—which has replaced some flying—have reduced the country’s demand for oil. Chinese demand fell by 1.7%, or 280,000bpd y/y in July, which is vastly different from the country’s 9.6% average consumption increase in 2023, according to IEA data. For 2024, the agency believes China’s demand for oil will only grow by 1.1% or 180,000 barrels per day.

(3) OPEC+ foiled by strong production. Excess supply has also hurt the price of oil. US production has climbed 53% over the past decade to 13.2 mbd, which is near a record high hit at the start of this year (Fig. 2). Canadian production likewise has climbed sharply over the past 10 years, while production out of Russia and Saudi Arabia has been roughly flat (Fig. 3).

Libya is expected to add to global oil supplies soon when it restarts oil production that was shut down since late August for political reasons, an October 1 Reuters article reported. Roughly half of the nation’s roughly 1.1mbd of production was halted.

And of course, there are the quota cheaters. Iraq and Kazakhstan failed to adhere to the cuts and pumped more oil than they had agreed to pump. “Both countries reaffirmed their commitment to now produce less than their agreed quotas to compensate,” a September 5 FT article reported. Brazil, Buyana, Argentina and Venezuela all have increased production.

Saudi Arabia’s oil minister said that the price of oil could drop to $50 a barrel if OPEC+s cheaters don’t start adhering to the organization’s agreed upon cuts, an October 2 WSJ article reported. The statement was interpreted as a threat that the Saudis would also stop adhering to the cuts if others didn’t start towing the line.

(4) EIA peers into its glass ball. The US Energy Information Administration (EIA) estimates that global inventories will decrease by 1.0mbd through Q1-2025. As a result, the agency expects the price of Brent crude to rise from $74 per barrel at the beginning of September to an average of $83 in Q1-2025.

By mid-2025, the EIA sees a return to moderate inventory builds, followed by inventory rises averaging 0.5 million b/d in H2-2025, as production increases from OPEC+ members and other countries outweigh global oil demand growth. It sees the Brent price averaging $84 per barrel in 2025.

Of course, that forecast depends on the Israel/Iran skirmishes not escalating into war. While we’ve acknowledged the oversupplied oil market in the past, we’ve suggested using investments in oil as a hedge against the risk of war in the Middle East.

Financials: Time for a Breather? Jefferies Financial Group is always the first of the S&P 500 Financials sector companies to report quarterly earnings, making it a great bellwether, particularly for how other investment banks have been faring.

This time around, Q3 EPS missed analysts’ consensus estimate by just a fraction, but Jeffries’ stock price dipped about 1% in the wake of the September 25 press release. The lackluster response might partly reflect the stock’s strong 53.1% ytd run-up through Tuesday’s close. The shares subsequently recouped the decline.

Here’s a deeper look at financials and at Jefferies’ results:

(1) Financials have come a long way. Outside of tech-related sectors, the S&P 500 Financials sector has been among the top performers ytd through Tuesday’s close: Utilities (28.5%), Communication Services (28.4), Information Technology (26.2), S&P 500 (19.7), Financials (19.7), Industrials (18.9), Consumer Staples (16.1), Consumer Discretionary (12.6), Health Care (12.4), Materials (12.3), Real Estate (10.7), and Energy (8.1) (Fig. 4).

The sector’s best performing industry index ytd is Consumer Finance, up 31.3%, led by American Express’ 43.4% gain. The Bank and Brokerage industry’s ytd performance has been far more sluggish: Consumer Finance (31.3%), Insurance Brokers (23.0), Diversified Banks (17.5), Regional Banks (16.3), Asset Management & Custody Banks (16.0), Financial Exchanges & Data (14.4), Reinsurance (12.1). and Investment Banking & Brokerage (11.7) (Fig. 5).

The shares of Jefferies, up 53.1% ytd, are actually not in the S&P 500 Investment Banking & Brokerage industry, which counts the stocks of Goldman Sachs (up 27.1% ytd), Morgan Stanley (12.0), Raymond James Financial (10.3), and Schwab (-7.1) as members.

(2) Jefferies brings good news. Jefferies’ Q3 (ended August) results were much better than a year earlier. Revenues jumped 42.4% y/y to $1.7 billion, and net income climbed 225.0% to $167.1 million. While EPS surged to 75 cents from 22 cents a year earlier, the result missed analysts’ consensus forecast of 78 cents.

The company’s results benefitted from a resurgence in investment banking, the revenues from which rose 47.3% y/y, pushed up by a 76.7% gain in the advisory business due to increased merger and acquisitions (M&A) activity. The firm also booked a 65.4% jump in debt underwriting revenues, offset by a small decline in equity underwriting revenues.

Revenues in the capital markets business grew 28.1%, with gains in both equities and fixed-income trading. Elevated expenses concerned some analysts, however.

The company’s aggressive hiring during the market’s downturn seems to be paying off. Jefferies executives said the firm benefitted from market-share gains. Analysts are forecasting fiscal (November) 2025 EPS of $4.46, up from a projected $2.95 this year and $1.10 last year. A joint statement by top brass mentions a strong investment banking pipeline, good momentum across business lines, and an expanded global team that’s well positioned for the release of pent-up deal flow expected in a lower-interest-rate environment.

(3) The big dogs are up next. Jefferies’ results bode well for other firms with large investment banking and underwriting operations. M&A volume rose during Q3 by 32.2% y/y globally and 14.9% y/y in the US (Fig. 6 and Fig. 7).

Analysts are expecting the S&P 500 Investment Banking & Brokerage industry to grow revenues 8.7% this year and 6.3% in 2025 (Fig. 8). The industry’s earnings are forecast to grow even faster, by 32.4% this year and 14.3% in 2025 (Fig. 9). At a recent 13.7, the industry’s forward P/E is near the upper end of the range it has been in over the past decade (Fig. 10).

The S&P 500 Diversified Banks industry—home to Bank of America, Citigroup, JPMorgan, US Bancorp, and Wells Fargo—also has exposure to investment banking and markets, but expectations for the industry’s earnings are much lower. It’s forecast to increase revenues by 3.5% this year and 0.8% in 2025, and earnings are expected only to inch up 2.0% this year, then 4.1% in 2025, after posting extremely strong 18.9% earnings growth last year (Fig. 11 and Fig. 12). The industry’s forward P/E is a more reasonable 11.2, only slightly higher than the midpoint of its 20-year range (Fig. 13).

Disruptive Technologies: Flying Cars Still a Work in Progress. Flying cars are off the drawing board and still attracting lots of funding, but they aren’t going to be in the ordinary Joe’s garage anytime soon.

Here are some of the companies raising big bucks as they try to get flying cars off the ground:

(1) Joby partners with Toyota. Toyota Motor is investing another $500 million in Joby Aviation in addition to the $394 million it previously provided. The latest round is expected to fund the certification and commercial production of Joby’s electric vertical takeoff and landing aircraft (eVTOL), an October 2 CNBC article reported. Toyota is Joby’s largest investor and supplies the company with powertrain and other components for the eVTOL. News of the Toyota investment on Wednesday sent Joby shares up 27.9% to $6.14.

(2) Stellantis bets on Archer. Stellantis announced in July plans to invest an additional $55 million in Archer Aviation following another $175 million from Stellantis and United Airlines. Archer is developing a five-seater eVTOL that can operate for 20-50 miles at speeds of 150 miles per hour. With orders for 116 units valued at $580 million, the company has plans to develop an “air taxi network” around the Los Angeles region ahead of the area’s plan to host the World Cup in 2026, the Super Bowl in 2027, and the Summer Olympics in 2028. Archer shares, which spiked briefly in 2021 to $17, now trade hands at $3.15.

(3) Alef takes preorders. Alef Aeronautics announced in September that it has preorders for 3,200 of its eVTOLS, which each sell for $300,000. Production of this pricey toy, which can drive for up to 200 miles and fly for 110 miles, is targeted for Q4-2025. The company anticipates the price will fall as production increases, and ultimately it shouldn’t cost more than a Toyota Corolla, noted its CEO Jim Dukhovny recently.

(4) Chinese companies in the mix. Chinese companies are in the race to develop a flying car as well. Vertaxi raised $29 million in financing that brings its total funding to more than $57 million. The company says its eVTOL has a 150-mile range and expects to get a manned airworthiness certificate in 2027. Vertaxi says it has a $28 million order that could include 15 eVTOLS, maintenance, equipment, and training services, an October 2 IOT World Today article reported. In addition, Xpeng Aeroht is developing the X2, a two-seater eVTOL. It can be seen zipping around in this video.

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The Economy That Roared

October 02 (Wednesday)

US Economy: An Even Louder Roar. The latest revisions to Gross Domestic Product (GDP) and Gross Domestic Income (GDI) suggest that the recent surge in productivity growth actually has been understated. Previously, the Bureau of Labor Statistics’ (BLS) downward revision to payroll growth led the die-hard hard-landers to rejoice that surely economic growth couldn’t be as strong as initially reported. They were wrong, again, as they have been since 2022.

In fact, higher productivity growth drove an even better economic outcome than first reported, underscoring our Roaring 2020s thesis. Actual and potential productivity growth continues to be widely underestimated by most mainstream economic models. Let’s dig into the details:

(1) Stronger growth means more output. Q2 real GDP growth was revised 1.3% higher, from $22.9 trillion to $23.2 trillion (saar) at the end of last week. Real GDI was upped by 3.8%, from $22.3 trillion to $23.1 trillion (Fig. 1). Given the very close relationship between nonfarm business (NFB) output and real GDP, it is highly likely that output will be revised higher (Fig. 2).

From the BLS: “To measure labor productivity for the business and nonfarm business sectors, BLS uses value-added measures of output published by the Bureau of Economic Analysis (BEA); they are closely related to real gross domestic product (GDP).”

(2) More output means higher productivity and cheaper labor. More output for the same, or fewer, hours worked means worker productivity has likely been growing faster than 2.7% y/y (Fig. 3).

Meanwhile, the large upward revision to GDI stemmed from an increase in personal income. At first glance, one might assume that suggests that hourly compensation rose even more than expected, offsetting better productivity growth. Therefore, unit labor costs (ULC) at decade lows of 0.3% y/y isn’t likely to be revised down (Fig. 4).

However, the increase to GDI personal income component was due to revisions in interest income, dividends, government transfers, and proprietors’ income. Compensation (i.e., wages and salaries) was actually revised lower in 2023, aligned with the BLS’ downward revision by 818,000 in payroll employment over the 12 months ended March 2024. Net interest income was also raised much higher for corporations.

In our September 4 Morning Briefing—just after the second estimate of GDI revised it lower to 1.3%—we wrote: “Net interest income has been a huge benefit to corporations and households alike. Personal net interest income ex-mortgage payments has risen to $1.3 trillion. Net interest payments for US nonfinancial corporations have fallen below 9% of profits, lows not seen since the 1960s. Interest paid on reserve balances has been a huge boon for money-market fund (MMF) investors: More than $6.2 trillion of cash earns over 5.0% in MMFs. More than $2.5 trillion of those assets are owned by retail investors.”

(3) More income means more savings. Let’s take stock: So far, output, productivity growth, and ULC all are likely better than first thought. Furthermore, higher personal incomes for the same level of consumer spending means that consumers have been saving more. Indeed, the personal saving rate in Q2 was revised up to 5.2% from the initial 3.3%, as we wrote in yesterday’s Morning Briefing. That provides more runway for consumer spending, as Fed Chair Jerome Powell suggested in his Monday comments at the National Association for Business Economics conference: That GDI wasn't as low as once thought “removes a downside risk to the economy,” and the upward revision to the savings rate “suggests spending can continue at a healthy level.”

All told, the consumer is doing well and the economy is growing at a robust pace thanks to investment in technological innovation. Concerns over the labor market are understandable given that the pandemic and Great Financial Crisis are fresh in many minds (or more likely, fresh in many charts). Yet where some see risk of deterioration, we see an economy that’s adapting to a shortage of skilled labor by rapidly improving worker capabilities. Considering the concerning trend of aging demographics and rising dependency ratios in developed economies, this should be welcomed, not feared (Fig. 5).

Global Commodities: Rally on, China. China’s latest round of economic stimulus has sent several global commodities markets flying.

Last week, the People’s Bank of China lowered bank’s reserve requirement ratio and key interest rates to boost liquidity and borrowing. The bank also recently announced measures intended to boost homebuying, including lower minimum downpayment requirements on purchases, allowing mortgage refinancing, and lowering mortgage rates.

As Jackie noted last week, we remain cautious about the potential for consumer-led growth and a revival of the property markets in China. To offset structural weaknesses, the government under the leadership of Xi Jinping is likely to continue shooting bazookas to bolster China’s stock market and exports and to fund its frontier technology development efforts. Stronger export demand—for example, for Chinese made electric vehicles (EVs)—could continue to boost global raw material markets, counterbalancing the shortfall from chronic property market weakness. Global commodities prices are already confirming this scenario:

(1) China’s MSCI stock price index is highly correlated with the price of copper (Fig. 6). Copper’s nearby futures price, a bellwether for industrial growth, surged 6.1% from September 20 to September 27 to $4.54 per pound (Fig. 7).

(2) The iron ore price rose $9.44 per metric ton to $93.42 from September 20 to September 27, signaling investor confidence in the China stimulus (Fig. 8). While still below the January 3 high of $130.49, the price has rebounded from the recent low of $81.91 on September 23.

(3) China’s bazookas of monetary and fiscal policy coupled with mounting hostilities in the Middle East have been supporting the Brent crude oil price. Last week, it ended at $71.98 per barrel, up from $69.19 on September 10—which was the lowest since December 2021 (Fig. 9).

Earlier this month, OPEC+ downgraded its demand forecast for both this year and 2025. The group is set to meet on October 2, with a planned production hike on December 1 looming. So the oil price may not get as much of a boost from China’s stimulus as the prices of other commodities.

(4) The prices of agricultural commodities such as soybeans and corn rose last week on the China news as well (Fig. 10 and Fig. 11). Chinese consumers might not go on a buying binge after they refinance their mortgages, but they might eat better.

Global Economy: Inflation Roundup. Global inflation is cooling, but regional differences persist. Advanced economies like the US and Europe are stabilizing at low inflation rates, while central bankers in emerging markets are still battling persistent price pressures. Japan, after years of deflation, is coping with an inflationary uptick, and China’s exceptionally low inflation may quickly shift as government stimulus measures take hold.

As global inflation generally has cooled off, most central banks have pivoted toward interest-rate cutting. In September 2024, 21 central banks reduced rates, the most since the onset of the pandemic. This suggests that central banks are prioritizing fueling economic growth over preventing a potential resurgence of inflation.

Despite slower inflation, global prices remain much higher than before the pandemic and the European energy crisis of winter 2022-23, posing challenges for central bankers and disgruntling consumers. Let’s take a closer look at inflation trends across key regions:

(1) Globally, the Great Inflation Moderation. Headline CPI inflation on a global scale has continued to drop, falling from 10.7% y/y during October 2022 to 4.7% by August 2024 (Fig. 12). Core inflation topped out at 7.7% during October 2022 and fell to 5.5% through July, nearly matching the headline rate as food and energy prices moderated (Fig. 13).

(2) US, easing but elevated core. In the US, the headline CPI dropped from a peak of 9.1% y/y in June 2022 to 2.5% in August, nearing the Federal Reserve’s 2.0% target (Fig. 14). The core rate moderated from 6.6% during September 2022 to 3.2% in August, sticking above the Fed’s preferred rate.

(3) Eurozone, not just energy relief. For the first time in three years, yesterday’s Eurozone data release showed that headline CPI inflation fell below the ECB’s 2.0% target to 1.8% y/y in September. The European Central Bank (ECB) successfully reined in inflation from its peak of over 10.0% y/y in late 2022 to 1.8% through September (Fig. 15). The decline in services inflation has uncoupled from trends in US inflation due to the economic slowdown in Eurozone economies, predominantly in the north (i.e., Germany) (Fig. 16).

The ECB held its deposit facility rate at 4.0% for about nine months until lowering it to 3.75% in June. It has not cut further through September but prior to the below target inflation data release, the bank indicated more cuts are likely at the October 17 meeting.

(4) Brazil, warm but cooling. Brazil’s CPI peaked at 5.2% y/y in September 2023 before falling to 4.2% by August, remaining above the central bank’s 4.0% target (Fig. 17). The central bank lowered its key interest rate from 13.75% during August 2023 to 10.50% by May 2024. However, in September, it reversed course and raised the rate to 10.75%.

(5) India, peaks and valleys. India’s headline CPI inflation climbed slightly in August to 3.7% from July’s five-year low of 3.5%, driven by lower prices for food and fuel (Fig. 18). Persistent food inflation concerns India’s central bankers. The Reserve Bank of India targets a 4.0% headline inflation rate, plus or minus 2.0%, and has held the main policy rate at 6.5% for the nine months through August.

(6) Mexico, stubbornly high. Mexico’s inflation rose from 4.3% in September 2023 to 5.0% in August but remains below the recent peak of 5.6% y/y in July (Fig. 19).

(7) China, subdued for now. China’s inflation remains remarkably low, with the headline CPI at just 0.6% y/y in July (Fig. 20). Weak domestic demand is suppressing inflation, but the recent stimulus could soon push prices higher.

(8) Japan, deflation no more. Japan, after decades of deflation, has seen inflation rise to a 10-month high of 3.0% in July 2024, but August’s rate declined to 2.8% (Fig. 21). Data released on Monday showed that Japan’s industrial output dropped in August, signaling lower price pressures ahead.

Japan: New PM Shakes Markets. Shigeru Ishiba is poised to become Japan’s new prime minister after winning the Liberal Democratic Party’s leadership contest on September 27, succeeding outgoing leader Fumio Kishida.

Ishiba, a former defense minister, has called for a snap general election on October 27 to unify the party. His leadership comes at a pivotal moment for Japan, as the country grapples with economic challenges such as slow growth and evolving monetary policy.

The financial markets reacted swiftly, with the Japan MSCI stock price index falling below its 200-day moving average following Ishiba’s victory (Fig. 22). Investors are concerned about his support for the Bank of Japan’s tighter monetary policies and potential corporate tax hikes.

Strategy: September Shuffle. Before the third week of September, the analysts’ consensus for the S&P 500 companies’ Q3-2024 earnings growth forecast implied a 4.9% y/y gain; it’s now down to a 4.4% gain as of the end of last week (Fig. 23). Also last week, the consensus annual forecasts of S&P 500 EPS for 2024-26 dropped at a faster w/w rate of 0.5%. That caused LargeCap’s forward earnings forecast to fall for a second straight week for the first time since December. It’s now 0.3% below its record high during the September 13 week.

What’s going on? At face value, it might appear that consensus estimates are declining faster than usual, raising concerns about too-high estimates in the first place or an inadequate pace of Fed easing. However, that’s not the case. S&P’s quarterly rebalancing of indexes is the disruptive force, as Joe discusses below:

(1) S&P’s quarterly rebalancing. Prior to the opening of trading on September 23, S&P Dow Jones Indices instituted a number of index changes associated with its regularly scheduled quarterly rebalancing. Three S&P 500 membership changes were made: The Information Technology sector gained Dell and Palantir, and the Financials sector picked up Erie Indemnity. Moving out of the S&P 500 were American Airlines (Industrials), Etsy (Consumer Discretionary), and Bio-Rad Laboratories (Health Care).

(2) Yet another “seasonal” blip in consensus forecasts. S&P’s index changes typically cause a blip in the w/w percent change of the forecasts (Fig. 24). That’s because the comparisons with the prior week’s data is apples-to-oranges: the index’s company roster as reconfigured on September 23 versus the old list of companies the week before that.

S&P also rebalances the S&P 400 MidCap and S&P 600 SmallCap indexes. The impact on those indexes tends to be greater, as evidenced by SmallCap’s 1.6% w/w decline, which was its biggest w/w drop in nearly a year.

(3) Getting growthier and more expensive. The latest index changes seem to have followed S&P’s usual m.o.: Companies on the decline (with generally lower forward P/Es) are replaced by those with better growth prospects (and higher forward P/Es). Assuming that forecasts for the rest of the index are unchanged w/w, replacing low-P/E companies with high-P/E companies reduces the aggregate earnings forecast.

Replacing the index’s underperformers with higher achievers results in a stronger portfolio of growth, which should improve consensus expectations in the future. We’re not concerned about the latest week’s change in consensus forecasts. Blips are typical following S&P’s quarterly rebalancings, but they tend to be more extreme for the SmallCaps and MidCaps than LargeCaps.

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On Labor, AI & Election Uncertainty

October 01 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

US Economy I: Labor & AI. In our base-case Roaring 2020s economic scenario, technological investment drives innovation and increased productivity growth. The results include wage growth that beats the rate of inflation, expanding corporate profit margins, and a briskly growing economy.

But what sparks investment in innovation? And if AI proves to be all that the forward earnings per share of AI enabling companies suggest it will, are widescale job losses likely?

Let’s answer those questions by examining the drivers of the technological boom, and how it may manifest as tech and non-tech companies alike adopt it:

(1) Fewer workers, more tech. Tight labor markets are correlated with higher productivity growth ( 1). When available workers do not match the skills that a company needs, they shell out cash for technologies that augment their current employees' productivity. This investment is often in the form of spending on software as a service (SaaS) or capex. Plenty of US companies—large and small—rely on renting cloud computing or AI from large tech companies. Others invest in data centers, software, and R&D.

These aren't your grandfather's capital spending plans. SaaS is akin to a monthly or annual rental. Software and R&D often require less manpower and borrowing upfront than traditional capex such as building a new manufacturing plant. So the technological investment used to enhance worker productivity in today’s labor market is less reliant on financing and therefore not hampered by higher interest rates. It makes sense that high-tech investment continued to thrive even as rates were ratcheted up and labor was scarce (Fig. 2). It’s also notable that intellectual property now represents a larger share of GDP (5.5%) than nonresidential equipment investment (5.2%) or residential investment (4.1%) as of Q2 (Fig. 3).

For non-tech companies, SaaS is easily accessible and upgrades happen instantaneously. That creates hyperscalability for the companies providing those technological services. The upshot is productivity growth can happen much quicker (Fig. 4).

(2) Demographics. A record 48% of Americans aged 65 and older are not in the labor force (Fig. 5). That’s up from less than 40% a decade ago. The wave of early retirements during the pandemic reduced the supply of workers, leading to a yawning gap between the demand and supply of labor (Fig. 6). Of course, unemployment remained relatively high despite proliferous job openings, creating a kink in the downward sloping Beveridge Curve (Fig. 7). We suspect that job openings’ descent “down and to the right” of the Beveridge Curve will be prevented by forces similar to those that rendered the model inadequate during the pandemic. In other words, we do not see a risk of surging unemployment without a crisis first materializing.

Workers continue to beat inflation with higher wages, suggesting that they still hold bargaining power over their employers and that their productivity is growing. In our opinion, most workers facing persistent unemployment (i.e., teens, those with less than a high school degree, new labor market entrants, etc.) largely lack the skills needed in today’s job markets. Thus, job openings may not fall much relative to the number of unemployed workers (Fig. 8). Rapidly declining immigration across the US’s southwest border, if it continues, may remove pressure on some of the groups struggling to find a job right now.

(3) Fiscal. Fiscal stimulus, of course, can jumpstart technological advancement. The Infrastructure Investment and Jobs Act (IIJA), Inflation Reduction Act (IRA), and CHIPS Act provided both funding and tax incentives for public and private manufacturing construction. Manufacturing structures have surged more than twofold to nearly $150 billion (saar) in real GDP (Fig. 9). These largely represent the construction of semiconductor chip fabrication plants, or “fabs.” Other forms of private nonresidential construction have also increased since the IIJA was signed into law in November 2021.

The more than $2 trillion pace of deficit spending over the past 12 months no doubt has driven some of the economic boom (Fig. 10). With government outlays stabilizing at a historically high 24% of GDP and few plans from either US presidential candidate to shrink the deficit, we expect the government's vault to remain open for business (Fig. 11).

(4) Nvidia. Nvidia is expected to generate nearly $161 billion in revenues over the next year (Fig. 12). The chipmakers’ forward profit margin has stabilized around 56%, supporting short- and long-term expected earnings growth rates of greater than 50% per year (Fig. 13 and Fig. 14). Is this reminiscent of the dotcom bubble? A repeat of that scenario would depend on those earnings not being realized because demand for chips substantially weakens in the coming year.

This Fortune magazine article describing a recent sushi dinner among the CEOs of Nvidia, Oracle, and Tesla casts doubt on the likelihood of that outcome: “‘I would describe the dinner as Oracle—me—and Elon begging Jensen for GPUs,’ [Larry] Ellison recalled. ‘Please take our money. Please take our money. By the way, I got dinner. No, no, take more of it. We need you to take more of our money please.’”

(5) Retraining workers. Researchers from the New York Fed collected data from its August regional business survey on how firms planned to use AI. Overall, they found roughly a quarter of services-providing firms and 16% of manufacturers use AI today. But much larger shares of both types of firms are training or retraining workers to use AI or planning to do so within the coming months. Here’s are some quick highlights of their findings:

• Five percent of services firms’ AI users have hired new workers to accommodate AI, while 10% have laid off workers. Most of those who were laid off had at most a high school diploma.
• Of firms planning to use AI in the future, 19% of services firms and 7% of manufacturers expect to hire new workers within the next six months because of AI. Only 12% of services firms planning to use AI and none of the manufacturers doing so plan to lay off workers within the next six months as a result of using AI.
• The large majority of workers being retrained for AI use had either some college, technical training, an associate’s degree, or a bachelor’s degree or higher. In over three-quarters of responses, businesses expected no change in wages over the next six months due to the use of AI. Among those expecting changes, more expected increases than decreases.

AI adoption is in its early stages, particularly for small businesses. However, it seems that most workers aren’t at risk of losing their jobs or their power to bargain for higher wages.

US Economy II: Removing Uncertainty. We expect interest-rate cuts to ease the debt-servicing burden on overleveraged companies among small-cap public companies, private middle-market firms with floating-rate debt, and small businesses that borrow directly from banks (Fig. 15). This should reaccelerate economic growth.

The Fed’s easing cycle was the first step to improving businesses certainty. The presidential election will improve it even further:

(1) Banks. With fewer underwater commercial real-estate loans, banks will seek to grow their loan books. The latest Senior Loan Officer Opinion Survey (SLOOS) showed that few, if any, lenders tightened credit conditions this quarter (Fig. 16). Banks were still lending over the past couple years despite higher rates and a highly uncertain environment with respect to the business cycle (Fig. 17). In our outlook, loan growth will accelerate in Q4 and into next year.

Not only will manufacturers and builders have more flexibility to start new projects, but they should see more demand from customers using financing. That should buoy the ISM M-PMI after a long stretch of downbeat readings (Fig. 18).

(2) Presidential election. Anecdotes from the Fed’s August 2024 Beige Book suggest that the presidential election has weighed on economic activity across the country and myriad sectors. Here’s a rundown of what regional contacts told the Fed:

• New York: “With uncertainty pertaining to the presidential election ahead, many firms have put hiring plans on hold.”
• Richmond: Ports & transportation contacts “cited high interest rates and the upcoming election as causes of uncertainty contributing to the suppressed demand.” Nonfinancial services firms also said they were delaying investments in part due to election uncertainty.
• St Louis: “District contacts reported that slowing demand and election uncertainty are negatively impacting their business.”
• Dallas: “The manufacturing outlook was weak with firms citing economic uncertainty, upcoming elections, high interest rates, and anemic global demand as the main strains.”

(3) CEO confidence. In the Q3 CEO economic outlook data series, produced by The Conference Board, fewer business leaders said they were likely to expand operations within the next six months. This data series is correlated with the y/y change in capital spending on equipment within GDP (Fig. 19). We suspect that improved confidence will help boost fixed investment in particular.

Moreover, a greater share of CEOs already expect to hire additional workers than reduce headcounts in the next six months. We expect this series to rebound toward even more hiring in the coming quarters (Fig. 20).

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No Hard Feelings

September 30 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: Permabears vs Permabulls. Some of our best friends are permabears. They are smart economists and strategists who tend to be bearish. We look to them for a thorough analysis of what could go wrong for the economy and the stock market. They are very vocal and fuel lots of pessimism about the future among the financial press and the public.

In response, to provide some balance, we examine what could go right. Often, we find that the permabears have missed something in their analyses. Since they accentuate the negatives, they often fail to see the positives, or they put negative spins on what’s essentially positive. We rarely have anything to add to the bearish case because the bears’ analyses tend to be so comprehensive. So our attempts to provide balance often cause us to accentuate the positives while still acknowledging the negatives. Not surprisingly, we get criticized for being too positive when it comes to the outlook for the US economy and stock market and get called “permabulls.”

That’s alright with us, since the US economy often grows at a solid pace, and the stock market has been on a bullish long-term uptrend as a result. Consider the following:

(1) Recessions are infrequent and don’t last very long (Fig. 1). In the US, the National Bureau of Economic Research (NBER) is the authority that defines the starting and ending dates of recessions. According to the NBER, the average US recession over the period from 1854 to 2020 lasted about 17 months. In the post-World War II period, from 1945 to 2023, the average recession lasted about 10 months.  Since 1945, there have been 12 recessions that occurred during just 13% of that time span.

(2) The stock market has been in a secular bull market since the Great Crash of the early 1930s. Bear markets are also infrequent and don’t last very long since they tend to be caused by recessions (Fig. 2). According to Seeking Alpha, there have been 28 bear markets in the S&P 500 since 1928, with an average decline of 35.6%. The average length of time was 289 days, or roughly 9.5 months. ABC News reported that since World War II, bear markets on average have taken 13 months to go from peak to trough and 27 months for the stock price index to recoup lost ground. The S&P 500 index has fallen an average of 33% during bear markets over that time frame.

US Economy II: Significant Upward Revisions Show No Landing. Among the recent pessimistic scenarios of the permabears is that real Gross Domestic Production (GDP) has been growing faster than real Gross Domestic Income (GDI). The two alternative measures of the US economy have increasingly diverged, suggesting that something is wrong with the real GDP data and that it is bound to be revised downward, consistent with the naysayers’ pessimism. They haven’t explained why they deem the GDI data to be a more accurate measure of economic activity than the GDP data.

Indeed, the Bureau of Economic Analysis (BEA), which compiles both series, favors GDP over GDI: “GDI is an alternative way of measuring the nation’s economy, by counting the incomes earned and costs incurred in production. In theory, GDI should equal gross domestic product, but the different source data yield different results. The difference between the two measures is known as the ‘statistical discrepancy.’ BEA considers GDP more reliable because it’s based on timelier, more expansive data.”

Meanwhile, the permabears have also been ringing the alarm bell about the personal saving rate lately. It had dropped to 3.3% during Q2-2024, according to the previous estimate, the lowest since Q3-2022. One permabear wrote on September 25 that “history suggests when the SR sinks this low, it usually proves unsustainable with a subsequent rise triggering a recession. The slide in the SR from 4% at the start of this year was not due to households dipping into to their pandemic-era excess savings, which have been long since spent. But it seems that households have become used to running down their savings and can’t break the habit.” His conclusion was that “the super-low US saving ratio a ticking economic timebomb.”

The very next day, on September 26, the BEA released its latest revisions of Q2-2024 GDP and GDI. Much to the chagrin of the permabears, real GDI was revised significantly higher, led by an upward revision in wages and salaries—which also caused a significant upward revision in the personal saving rate!

Here is the happy news from the BEA:

(1) GDP & GDI. Real GDI increased 3.4% (saar) in Q2, an upward revision of 2.1ppts from the previous estimate. Real GDP rose an unrevised 3.0% during Q2. The average of real GDP and real GDI—a supplemental measure of US economic activity that equally weights GDP and GDI—increased 3.2% in Q2, an upward revision of 1.1ppts from the previous estimate.

Even Q1’s numbers were revised higher, likewise much to the bears’ chagrin. Real GDP was revised up from 1.4% to 1.6%, and real GDI was revised up from 1.3% to 3.0%. The average of the GDP and GDI was raised from 1.4% to 2.3%.  The statistical discrepancy between the two measures of the economy is tiny now (Fig. 3 and Fig. 4). In current dollars, it was revised down to 0.3% from 2.7% during Q2.

(2) Personal saving. Personal saving was $1.13 trillion in Q2, an upward revision of $74.3 billion from the previous estimate (Fig. 5). The personal saving rate—personal saving as a percentage of disposable personal income—was 5.2% in Q2, compared with 5.4% (revised) in Q1. The previous estimates for the saving rate were 3.3% in Q2 and 3.7% in Q1 (Fig. 6).

(3) Wages & salaries. The upward revisions to both the GDI and the personal saving rate reflected an upward revision in nominal wages and salaries compensation. So consumer spending was strong during the first half of the year, while the personal saving rate remained relatively high, and certainly higher than the “timebomb” forecast.

(4) Corporate profits. There’s more: After-tax corporate profits from current production (corporate profits with inventory valuation and capital consumption adjustments) was revised up by 3.5% to a record $3.1 trillion (saar) (Fig. 7). So corporate cash flow was also revised up, to a record $3.7 trillion (Fig. 8). Also rising to a new record high of $2.0 trillion was corporate dividends (Fig. 9).

(5) Q3’s GDP. The current quarter will continue to frustrate any remaining hard-landers. The Atlanta Fed’s GDPNow model shows real GDP up 3.1% (saar) during Q3. That’s an upward revision from 2.9% on September 18 (Fig. 10). Real consumer spending is tracking at a still robust 3.3%, down from 3.7%.

(6) No landing. The latest BEA revisions even erased the technical recession during H1-2022 when real GDP fell 2.0% and 0.6% during Q1 and Q2 of that year. Those two numbers were revised to -1.0% and 0.3%.

The “Godot recession” continues not to show up. Instead, a rolling recession has hit a few industries that were most sensitive to the tightening of monetary policy. But the overall economy has remained resilient and less interest-rate sensitive than in the past.

As a result of the latest benchmark revisions, Q2’s real GDP and real GDI are 1.3% and 3.8% greater than previously estimated. There’s no hard or soft landing in the revisions. The economy is still flying high, as it has been since the two-month pandemic recession during March and April 2020!

US Economy III: Is the Goods Sector in a Recession? Even the goods sector of the economy has turned out to be remarkably resilient. Indeed, contrary to the bearish signal emitted by the national M-PMI, there has been no recession in real GDP goods:

(1) Real GDP goods remained at a record high during Q2 (Fig. 11). Even real consumer spending on goods rose to a record high during the quarter.

(2) In the past, there was a very high correlation between the M-PMI and the y/y growth rate of real GDP goods (Fig. 12). The former has been mostly below 50.0 since November 2022. Yet the growth rate of real GDP has hovered around 2.0% over the same period. That’s a striking divergence from the past, when M-PMI readings below 50.0 were associated with negative growth of real GDP goods.

(3) In the past, there was a similar tight fit between the growth in real GDP goods and the y/y percent change in the Leading Economic Indicators (LEI) (Fig. 13). This time, they’ve diverged, with the LEI misleadingly forecasting a recession.
 
US Economy IV: So Why Did the Fed Ease? That’s a good question given all the above. The answer is that Congress told the Fed to ease by mandating that monetary policy must aim to keep both the inflation and the unemployment rates low. Fed officials can certainly claim that they have achieved this remarkable balancing act. In August, the unemployment rate was only 4.2%, and headline and core PCED inflation rates were down to 2.2% and 2.7% (Fig. 14).

Fed officials can declare “Mission accomplished!” And it was achieved without a recession as was required in the past to do the job (Fig. 15). However, the unemployment rate is up from last year’s low of 3.4% in April and January. That’s the main reason that Powell & Co. decided to lower the federal funds rate by 50bps last week.

They chose to ignore August’s sticky readings of the “supercore” inflation rate (i.e., consumer price inflation for services excluding energy and housing), which was 3.3% for the PCED and 4.3% for the CPI (Fig. 16). So their mission isn’t completely accomplished given that Fed Chair Jerome Powell first mentioned “supercore” inflation in his speech at the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution back on November 30, 2022. He made a big deal about it. He observed that it constituted more than half of the core PCE index. He no longer mentions it.

Meanwhile, layoffs remain subdued, as evidenced by the latest initial unemployment claims data (Fig. 17). Fed officials have acknowledged that the problem in the labor market is that unemployed new entrants and reentrants into the labor force are staying unemployed longer because job openings have declined.

So their easing of monetary policy is aimed at boosting economic demand and the demand for labor, i.e., job openings, which remained above the pre-pandemic levels in July (Fig. 18). That’s great unless the unemployed don’t have the skills and the geographical locations to match the job openings that are currently available. That could heat up inflation. So could the fiscal policies of the next occupant of the White House.

So why did the Fed officials decide to ease? And why might they continue to ease? They are willing to do so to avert a recession and to create more job openings. They are willing to risk inflating consumer prices as well as asset prices. We wish them luck. In any event, any remaining diehard hard-landers should remember the old adage: “Don’t fight the Fed!”

Movie. “The Perfect Couple” (+) (link) is an entertaining who-done-it miniseries on Netflix starring Nicole Kidman and Liev Schreiber as the not-so-perfect couple. It is based on the 2018 novel of the same name by Elin Hilderbrand, who writes mostly romance novels and has been described as “the queen of beach reads.” She resides on Nantucket, where most of her novels are set. A day before a lavish wedding at the couple’s Nantucket mansion, which is situated on the sea, the maid of honor is murdered by drowning and everyone is a suspect. See if you can catch the one clue early in the series.

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On Homebuilders, China & AI

September 26 (Thursday)

Consumer Discretionary: What’s Priced into Homebuilders Stocks? Last week, the Federal Reserve kicked off an interest-rate-cutting cycle by reducing the federal funds rate by 50bps. The futures market is anticipating another roughly 200bps of interest-rate cuts over the next 12 months (Fig. 1). Consumers have already begun to respond. Mortgage refinancings rose more than 20% w/w and 175% y/y off of historically low levels. Home purchase applications rose only 1.4% w/w and was up 2.0 y/y, again off of historically low levels (Fig. 2).

In a classic case of “buy the rumor, sell the news,” interest-rate-sensitive stocks may already have priced in the benefit of future rate cuts. The sharp gain in the S&P 500 Homebuilding industry’s stock price index is telling: 29.8% ytd through Tuesday’s close, nearly 50% higher than the S&P 500’s 20.2% ytd climb (Fig. 3). Following the Fed’s announcement last Wednesday, however, the Homebuilding index has underperformed, falling 0.7% from its close the day before the Fed’s announcement through Tuesday compared to the S&P 500's 1.7% increase.

Analysts are optimistic about the industry’s future. They’re calling for revenues growth of 5.1% this year and 6.6% in 2025 and earnings growth of 7.3% and 8.2% in 2024 and 2025 (Fig. 4 and Fig. 5). Forward revenues has finally surpassed the last peak, prior to the housing bust in 2006 (Fig. 6). Forward earnings has far surpassed 2006 levels and has almost surpassed the peak near end of the pandemic, when it seemed that everyone wanted a home with more space (Fig. 7).

Let’s take a look at what KB Home executives had to say on Tuesday’s earnings conference call about its fiscal Q3 (ended August):

(1) Strong growth misses the mark. KB Home reported a 10.4% y/y increase in revenues and also boosted its 2024 housing revenue forecast to $6.85 billion to $6.95 billion, up from a prior range of $6.7 billion to $6.9 billion. KB forecasted an 8.7% y/y increase in 2025 housing revenue to about $7.5 billion.

KB’s stock sold off in aftermarket trading, nonetheless. The company’s earnings per share (EPS) of $2.04 missed analysts’ target by two cents. And while share buybacks boosted EPS growth to 12.9% y/y, KB Home’s net income increased only 4.9%.

Also of possible concern: Net orders for new homes were largely unchanged y/y, at 3,085, with declines in the Southwest and the Southeast offset by increases in the West Coast and Central US regions. The backlog of 5,724 was down 18.3% y/y.

(2) Demand improved in August. Demand began to soften in late June through July as interest rates remained elevated and concerns about the economy increased. The company adjusted its pricing to “hold its pace” of sales. In August, interest rates moderated, demand strengthened, and weekly net orders improved sequentially in each of the month’s last three weeks.

“We continue to see solid sales quarter-to-date in September,” said CEO Jeffrey Mezger on the earnings conference call. The Fed’s interest-rate cut should further “benefit consumer confidence and affordability.” KB Home reduced mortgage concessions offered to buyers in August and expects to further reduce concessions in the current quarter because lower interest rates have improved home affordability. The gross margin should improve as a result.

(3) Stocking up on land. KB spent $845 million on land acquisition and development, a 50% y/y increase. Of that amount, more than $425 million was used to acquire new land. The company’s lot position is up 21% y/y, and its community count at the end of Q3 was up 10% y/y.

While housing inventories are ticking up for the overall housing market, homes are selling pretty quickly in most markets. And in the market for affordable homes where KB competes, inventory remains “pretty limited.” There’s currently a 4.2 months’ supply of homes in the entire market (not just for affordable homes), up from 1.6 months at the low in January 2022 (Fig. 8). (That is, it would take 4.2 months to sell all of the homes for sale assuming the current pace of sales.)

After rallying sharply this year, homebuilders’ stock prices may not reflect the risk that low interest rates could prompt existing homeowners who were previously reluctant to relinquish low-rate mortgages to list their homes, resulting in a surge of inventory that competes with the homebuilders’ new homes.

China: Close, But No Cigar. On Tuesday, China announced a raft of policies aimed at boosting the economy and encouraging consumption. The People’s Bank of China (PBoC) cut its seven-day reverse repo rate from 1.7% to 1.5%. The central bank will also cut the amount of funds that lenders must hold in reserve by 0.5ppt, with more cuts expected later this year. And regulators will recapitalize China’s largest commercial banks; their margins and profits had been eroded by fee reductions and interest-rate concessions. On Wednesday, the central bank trimmed the cost of medium-term loans it provides to banks.

Regulators directly targeted the real estate market by lowering the down payment required on second homes from 25% to 15%. It will also offer better terms on loans to state-owned enterprises that are buying unsold apartment inventory from property developers. (The program launched in May has seen slow adoption, with local governments borrowing only Rmb24.7 billion out of the Rmb500 billion local banks made available, according to an August 20 FT article.)

The Chinese stock market received some love as well. Regulators will provide the equivalent of $71 billion to help brokers, insurance companies, and funds buy stocks. The PBoC will also provide $114 billion to help companies buy back shares. Stock investors applauded, sending the CSI 300 5.9% higher on Tuesday and Wednesday (Fig. 9).

The good that these policies do may be offset by Chinese government actions that chill the willingness of consumers and companies to spend and invest in the country.

China’s recent threat to put Tommy Hilfiger’s parent on the national security blacklist doesn’t scream “come and invest in our country.” Neither does the detainment of an economist who criticized leaders in a private online chat. And China’s plan to increase its retirement age certainly won’t improve consumer confidence or encourage people to start spending. It’s almost as if China were writing a guidebook for economies on how to be one’s own worst enemy.

Here's a deeper look at government policies that may hurt future business investment and consumer spending in China more than the PBoC’s latest initiatives will help:

(1) How to scare corporations. China’s commerce ministry has threatened to put PVH, the parent company of Calvin Klein and Tommy Hilfiger, on its national security blacklist for not purchasing cotton from its western Xinjiang region. The company has 30 days to defend itself against the accusation that it has been discriminating against Xinjiang-related products over the past three years.

What was PVH thinking? Merely that it wants to sell its China-made goods in US markets: The US bans goods made in Xinjiang unless importers can prove that they were not made using the forced labor of the Muslim Uyghur population. So China’s blacklist threat places PVH between a rock and a hard place.

Five other companies are on China’s national security blacklist, including Lockheed Martin and Raytheon Technologies due to their sale of weapons to Taiwan. But they have no business in China at risk. PVH, on the other hand, has stores and warehouses in China. If placed on the list, the company could “face fines, have its activities in China restricted, or face other unspecified penalties,” a September 24 FT article reported.

(2) How to scare CEOs. Chinese officials placed a prominent Chinese economist under investigation and detention after his posts in a private chat group on WeChat criticized Xi Jinping’s management of the economy. Zhu Hengpeng, who was the deputy director of the Institute of Economics at the state-run Chinese Academy of Social Sciences, was detained this spring, a September 24 WSJ article reported.

He joins a growing list of executives—both Chinese and foreign—that the country has detained. A senior executive from Taiwan’s Formosa Plastics Group has been banned from leaving Mainland China since arriving in Shanghai earlier this month, a South China Morning Post article reported on September 19. The head of China Evergrande’s electric vehicle unit was detained earlier this year. In 2023, more than a dozen senior executives went missing, faced detention, or were subject to corruption probes, a November 10 CNN article reported. When Jack Ma, perhaps China’s most high-profile tech entrepreneur, disappeared from public view and underwent “supervisory interviews” in 2020 after criticizing the country’s regulators and state-owned banks in a speech, it became instantly clear that no one was immune.

This high-risk environment combined with the sluggish economy have sharply cut venture capital (VC) fundraising and new startups being founded. In 2017, Rmb124.9 billion of VC funds were raised; last year only Rmb16.6 billion was, according to a September 12 FT article. Likewise, the number of new companies started peaked in 2018 at 51,302; it was down to 1,202 last year. The numbers are on track to fall further this year.

Foreign direct investment (FDI) into China has dropped sharply over the past year too. It peaked at $87.8 billion in Q2-2023 on a quarterly basis; it has subsequently fallen sharply and turned negative in the past two quarters. FDI fell to -$27.1 billion in Q2-2024 (Fig. 10).

(3) How to depress consumers. No one likes to be told that retirement is going to be later than expected, but that’s what happened in China. Starting in January 2025, the retirement age for men in all jobs will jump from 60 to 63. For women in blue-collar jobs, the retirement age will rise from 50 to 55. For women in white-collar jobs, the retirement age will jump from 55 to 58.

The policy was changed because life expectancies have increased since the policy was established in the 1950s. The move will also increase the working population that pays into China’s pension system, a September 24 Benzinga article explained. The pension system has come under pressure as China’s birth rate has decreased and its population has aged, leaving fewer young working people to pay into the system to fund disbursements to retirees (Fig. 11).

The policy change will extend the life of the pension fund, which was estimated to run out of funds in 2035 if no action was taken. However, it could also exacerbate the high unemployment rate among young workers (Fig. 12). And it’s unlikely to put either the old or young in a spending mood. China’s consumer confidence was already depressed before the change was announced, at 86.0 versus a 105.9 average over time (Fig. 13).

Disruptive Technologies: AI & ETFs. Exchange-traded fund (ETF) companies seem to like nothing better than jumping on an investable trend. So we weren’t surprised to learn that there are 41 ETFs with assets of $10.9 billion that invest based on AI themes, according to etf.com. We were surprised that these 41 funds’ assets under management (AUM) aren’t bigger. We were also surprised that the five largest ones collectively underperformed the S&P 500 both ytd and over the past three years.

Here are the five largest AI ETFs, their AUMs, and their ytd and three-year performances: Global X Robotics & Artificial Intelligence ($2.6 billion, 9.9%, -20.5%), Global X Artificial Intelligence & Technology ($2.2 billion, 17.5%, 15.9%), ROBO Global Robotics and Automation Index ($1.1 billion, -3.2%, -19.5%), ARK Autonomous Technology & Robotics ($748.8 million, 2.8%, -27.7%), and iShares Future AI and Tech ($607.7 million, 0.2%, -22.7%).

Many of the ETFs appear to be underperforming because AI and robotics investments are being lumped together. Robotics companies haven’t fared nearly as well as AI poster child Nvidia.

The top performing large ETF in this category, Global X Artificial Intelligence & Technology, avoids robotics exposure and invests in developers of products incorporating AI systems, like software programmers and social media platforms. Its top holdings: ServiceNow, IBM, Alibaba, Oracle, and Meta.

Intelligent Alpha has created an ETF that uses AI to pick stocks. The fund, Intelligent Livermore ETF, uses ChatGPT, Claude, and Gemini as an investment committee. The committee is “taught” the investment practices used by great investors like Warren Buffett, predicts which investment style will perform best, and invests accordingly for long-term capital appreciation. Its top five holdings: PDD Holdings, Meta, Nvidia, Taiwan Semiconductor Manufacturing, and Procter & Gamble. And as you might expect, Intelligent Alpha has four more AI-powered ETFs slated to launch over the next three to six months.

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On Productivity Growth, SMidCaps & India

September 25 (Wednesday)

Strategy I: The Productivity Story as Told by the S&P 500. Our Roaring 2020s scenario is our highest probability scenario (at 50%) for the US economy due to our outlook for strong productivity growth. The other two scenarios are a 1990s-style stock market meltup (30%) and a 1970s-style inflation calamity (20%).

We have been beating the drum on the benefits of increased productivity growth: It widens corporate profit margins, supports real wage growth while suppressing unit labor costs (ULC), and boosts real GDP. It’s like fairy dust for the economy. But it can be difficult to see. Based on our favored measure—nonfarm business output per aggregate hours worked—productivity rose 2.7% y/y in Q2 (Fig. 1).

Let's see if stock market fundamentals corroborate the recent productivity gains:

(1) Don't fight forward earnings. S&P 500 forward earnings per share (EPS) rose to a record-high $268.89 during the September 19 week (Fig. 2). We expect it to reach our year-end target of $275 by the end of Q4.

Forward EPS is a year-ahead leading indicator of four-quarter trailing earnings, which was $243.12 through Q2 (we calculate forward earnings as a time-weighted average of analysts’ annual EPS consensus estimates for the current and coming year). It should continue to be a bullish leading indicator for actual EPS as well as for the labor market, as profitable companies tend to hire more workers (Fig. 3 and Fig. 4). That said, the labor market has been cooling, as evidenced by slower monthly payroll growth (Fig. 5).

Weaker payroll growth but rising earnings estimates point to productivity gains as driving economic growth, since companies are producing more with fewer workers (Fig. 6). Of course, bottoms-up stock analysts tend to be poor predictors of recessions. That’s where we come in. There is no recession in our outlook—as we have been describing, the Fed has raised the risk that the US economy overheats rather than freezes.

(2) Secular margin expansion. We are more a bit more bullish than the analysts’ consensus on S&P 500 profit margins. We expect margins to widen to 14.0% by the end of next year, whereas industry analysts collectively expect 13.6% (Fig. 7). Profit margins tend to be cyclical. However, the hyper-scalability of technology and growth of mega-capitalization tech stocks have led to a longer-term uptrend of higher profit margins (Fig. 8).

Similarly, unit profits from production for nonfinancial companies have risen to all-time highs in the past two years (Fig. 9).

(3) Use it or lose it. We believe that all companies are tech companies. They either make technology, use technology, or lose ground to their competition. Indeed, high-tech spending now represents roughly half of total capital spending in nominal GDP (Fig. 10). As productivity gains from AI, automation, robotics, and similar technologies expand from the mega-capitalization tech companies to others, we expect productivity growth and stock market performance to broaden. Value stocks are only just starting to expand margins (Fig. 11). Meanwhile, the equal-weighted S&P 500 has risen to new highs and outperformed the benchmark market-cap-weighted index since the start of July (up 8.4% versus up 4.7%) (Fig. 12).

S&P 500 companies’ aggregate EPS rose a healthy 12% y/y in Q2, but guidance for the rest of the year was weak and dragged H2 estimates lower (Fig. 13). CEOs’ economic outlook declined a bit in Q3 as well. We'll see how much Q3 beats in what we call the “earnings hook” (because analysts’ quarterly earnings expectations tend to fall ahead of earnings season, as mostly bad guidance hits headlines ahead of actual reporting; when actual results beat the lowered expectations, this creates a hook in the estimate/actuals data series).

We suspect that management teams, particularly in the “S&P 493” (i.e., the S&P 500 minus the Magnificent-7), are quite enthused by the Fed’s 50bps rate cut and commitment to easing further. We aren’t so bullish on the SMidCaps (i.e., the SmallCaps and MidCaps), however, as earnings expectations for those companies pale in comparison to LargeCaps’ (Fig. 14).

Strategy II: LargeCaps Versus SMidCaps. Let the party begin! On September 18, the Fed ended its two-year rate-hiking cycle with a 50bps cut in the federal funds rate. The timing of the Fed’s new rate cut cycle is unusual, beginning just as the S&P 500’s EPS hit a new record high in Q2-2024.

As Oktoberfest approaches, Joe reviews how much the last rate-hiking cycle hurt actual earnings for the companies in the three S&P market-cap style indexes and what’s on tap for their Q3 earnings and beyond:

(1) SMidCaps’ EPS lagged the most during the tightening cycle. When the Fed started hiking rates in 2022, actual quarterly EPS was hitting record highs for all three of the S&P market-cap indexes (Fig. 15). The rate hikes of the past two years affected LargeCap earnings the least. The S&P 500 LargeCap’s quarterly EPS actual fell only 7.9% from its Q2-2022 peak to its trough in Q1-2023. Aided in great part by the AI-spending boom, LargeCap’s EPS returned to a new record high in Q3-2023 after just five quarters below, and did so again in Q2-2024.

However, the SMidCaps’ earnings recoveries may be just starting. From their peak EPS in Q2-2022 to their recent lows in Q1-2024, MidCap’s quarterly EPS fell 23.8%, and SmallCap’s tumbled 30.7%.

(2) Record-high EPS for SMidCaps not expected anytime soon. The SMidCaps are climbing a relatively steeper hill back to record EPS, which was boosted in Q2-2022 by cyclically high commodity prices. During Q2-2024, MidCap’s EPS was at a two-quarter high but remained 20.1% below its record. SmallCap’s EPS was at a four-quarter high in Q2-2024, but still 18.7% below its record. The consensus does not expect SMidCap’s quarterly EPS to reach new record highs until the end of 2025 at the earliest, but y/y earnings comparisons will turn positive sooner. Q3 might be the one last quarter of declining EPS y/y for SMidCaps.

(3) LargeCap earnings growth continues to outpace SMidCap’s. The consensus expects a fifth straight quarter of positive growth for LargeCap in Q3, with earnings rising 4.9% y/y before accelerating again in Q4 to 12.2% (Fig. 16). If achieved, Q4’s growth rate would be LargeCap’s fastest since Q3-2021.

While the SMidCap’s earnings growth rates are expected to be negative again in Q3, the consensus expects positive and single-digit percentage growth to return for those indexes in Q4. Analysts think MidCap’s earnings will fall 3.7% in Q3 and rise 5.0% in Q4. SmallCap’s earnings is expected to drop 2.9% in Q3 before rising 6.0% in Q4. They also expect SMidCap’s growth to lag LargeCap’s through Q1-2025 before finally overtaking it.

For all of 2025’s quarters, all three of the S&P market-cap indexes are expected to record double-digit percentage y/y EPS increases.

India I: Growth Shines Amid Global Uncertainty. India’s economy stands out as a uniquely resilient emerging market in an increasingly volatile global climate. India is set to become the world’s third-largest economy by 2030—driven by growth in trade, agriculture, and AI; structural reforms; and rising energy demands—according to a recent S&P Global report.

India’s stock market has outperformed all the major global market indexes ytd except the US’s. The ytd performances of India's NSE Nifty 50 and S&P BSE Sensex trail only the Nasdaq and S&P 500, reported Reuters on Friday. India’s MSCI is up 26.1% ytd (Fig. 17). The runup has lifted the valuation of India’s MSCI to historical highs (Fig. 18). However, there is support from fundamentals, with forward revenues and earnings also showing positive momentum (Fig. 19 and Fig. 20).

India’s 10-year government bond yield is about 7%, offering a premium over similar bonds in developed markets (Fig. 21).

The country's growth trajectory, however, isn’t without its challenges. Here’s more:

(1) GDP getting hotter. Analysts at BCG project India’s GDP growth for fiscal 2025 (ending March) in the 6.8%-7.2% range, driven by robust domestic demand. Real GDP rose 6.7% in Q2 (Fig. 22).

(2) Inflation easing. Inflation climbed slightly in August, to 3.7% from July’s five-year low of 3.5%, driven by lower prices for food and fuel (Fig. 23). Persistent food inflation concerns India’s central bankers. The Reserve Bank of India targets a 4% inflation rate (plus or minus 2%) and has held the main policy rate at 6.5% for the nine months through August (Fig. 24).

(3) Labor market mixed. The unemployment rate has fallen to 7.0%, its lowest in 20 months. Labor force participation has been soft, edging down; but the working-age population is expected to grow over the next several decades.

(4) PMIs slowing. September's composite PMI showed the slowest expansion of 2024, reflecting cooling demand and rising input costs; but it remained north of 50, as it has for over three years (Fig. 25). Growth in both the services and manufacturing sectors moderated, with new business orders slowing. However, services employment increased the most since August 2022.

(5) Exports struggling. Weakening demand from China and rising shipping costs widened the trade deficit in August to a 10-month high. While exports have weakened, rising imports have helped the economy navigate global headwinds.

India II: ‘One Nation, One Election’ Gains Momentum. India’s “One Nation, One Election” (ONOE) concept is nothing new. In recent years, Prime Minister Narendra Modi and the Bharatiya Janata Party (BJP) have reignited ONOE efforts, contending that it could substantially reduce election costs, enhance governance, and increase voter participation. Skeptics see it as a calculated strategy by Modi 3.0 to rejuvenate his support base after the BJP’s disappointing performance in June’s general election, where the party lost its outright majority.

Here’s a closer look at the outlook for ONOE:

(1) The Union Cabinet, under Modi's leadership, recently “accepted” an extensive 18,626-page report on ONOE, following a rigorous 191-day consultation process led by former President Ram Nath Kovind.

(2) Implementing ONOE would be challenging, as it demands constitutional amendments requiring a two-thirds majority in both houses of Parliament, highlighted an article in The Week. That would take support from more than BJP’s coalition partners. Moreover, some proposed amendments would necessitate ratification by half of the states, some of which oppose it.

(3) Kovind’s report suggests a phased approach to simultaneous elections for the Lok Sabha, state assemblies, and local bodies. Among the 11 recommendations: synchronizing elections within 100 days and establishing a single voter roll.

(4) The Union Cabinet has approved the report’s recommendations. A bill detailing the required constitutional amendments is anticipated this winter, laying the groundwork for next steps.

(5) The proposal has elicited a spectrum of responses. The BJP and its allies largely favor ONOE, citing potential benefits such as cost efficiency and improved governance stability. Conversely, opposition parties, including Congress and several regional factions, have raised alarms about the possible erosion of federalism and regional representation and the muting of local constituencies’ voices in the national dialogue.

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The Consequences Of Cutting Rates

September 24 (Tuesday)

Weekly Webcast. If you missed Monday's live webcast, you can view a replay here.

The Fed: The Cost of Removing Recession Risk. What was Fed Chair Jerome Powell thinking when the Federal Open Market Committee (FOMC) cut the federal funds rate by 50bps last week? After all, doing so amounts to stoking an economy that’s already growing at a solid pace, raising a host of risks—among them, stretched stock valuations, upside surprises in inflation, and greater macroeconomic volatility.

It is clear he is unwilling to risk unemployment getting out of hand, having already allowed CPI inflation to rise uncontrollably a couple years ago (Fig. 1). By chopping off the adverse so-called “left tail” of economic outcomes, we believe Powell increased the odds of the “right tail”—an economic reacceleration. He likely surmised that achieving a soft landing would cement his legacy and possibly earn him a third term as Fed chair.

If our base-case expectation for the economy holds, Powell will receive his plaudits. After all, most developed economies suffered similar inflation spikes during the pandemic (Fig. 2). The US has been unique in its strong growth rebound coming out of the pandemic (Fig. 3). Nonetheless, removing the risk of recession has consequences. Hence, we raised our subjective probability for a 1990s-style stock market meltup from 20% to 30% last week.

With that said, let's review the potential consequences of over-easy monetary policy on the labor market and inflation.

US Labor Market: Simmering. The left tail that Powell likely sought to avoid was a spike in unemployment. In the past, when unemployment started to rise, it tended to continue as the economy entered a recession. That has been evidenced by the Sahm Rule (Fig. 4). In our opinion, the Sahm Rule sounded a false alarm in this cycle, as the unemployment rate rose from 3.4% to 4.3% largely due to increased labor supply rather than decreased demand.

Until the Jackson Hole economic symposium in August, it appeared that a sizable portion of FOMC members held our view. Powell seemed to agree with our assessment when he referenced the rule as a “statistical regularity” in his press conference on July 31. Fed Governor Michelle Bowman remains in our camp, based on her Friday comments when she describing the labor market as “near full employment.”

Governor Bowman also said, “Although hiring appears to have softened, layoffs remain low. I see the normalization in labor market conditions as necessary to help bring wage growth down to a pace consistent with 2 percent inflation given trend productivity growth. My reading of labor market data has become more uncertain due to increased measurement challenges and the inherent difficulty in assessing the effects of recent immigration flows. I am also taking signal from continued solid growth in the spending data, especially consumer spending, reflecting a healthy labor market.”

That's not a bad summary of how we have been thinking about the labor market. The flipside of this view was argued by Federal Reserve Bank of Minneapolis President Neel Kashkari in an essay yesterday morning. The balance of risks has shifted away from higher inflation and to higher unemployment, he wrote, leading him to opt for a 50bps rate cut rather than one of 25bps. He sees little evidence that inflation will rebound—which we'll get to later.

For now, let's dig into the labor market data:

(1) Credit Crisis Cycle. As we have often discussed, previous spikes in unemployment were not due to the “long and variable lags” of monetary tightening. Supporters of this theory hold that higher interest rates eventually cause banks to rein in credit, thus fostering an economic slowdown and higher unemployment. Some folks, such as former New York Fed president Bill Dudley, posit that unemployment begets unemployment in a slow-moving train of lower aggregate income, lower consumer spending, lower corporate profits, and thus further layoffs.

In our view, a financial crisis is required to induce the credit crunch that ultimately causes a recession (Fig. 5). Unemployment rises abruptly during recessions.

(2) Labor demand. The recent slowdown in hiring has caused some, including now Powell, to worry that layoffs soon will follow. The number of job openings available for unemployed workers has declined from record highs (Fig. 6). Some theorize that the labor market will slide precipitously down the Beveridge Curve and into higher unemployment (Fig. 7).

In our view, the decline in job openings is a function of labor supply and demand coming into balance after demand significantly outstripped the number of workers available (Fig. 8). Layoffs remain muted. Furthermore, the available workers do not match the skillsets employers are looking for (Fig. 9). It is mostly teens and those with less than a high school education who face scant opportunities (Fig. 10 and Fig. 11). Still, we recognize that finding a job takes longer now that hiring has cooled, though largely because quits have declined (Fig. 12).

(3) Labor supply. The growing supply of workers has largely filled the outstanding demand from employers over the past couple years. Rising unemployment has mostly been a function of entrants to the labor market rather than layoffs (Fig. 13). Women aged 25-54 are participating in the labor force at a record levels, thanks to both a secular trend and the emergence of remote work (Fig. 14). Employment levels are around record highs for this age group, for both males and females. Employment is strong across educational levels as well (Fig. 15).

But there's oversupply in some segments of the labor market, particularly among so-called unskilled labor. That's caused unemployment and part-time work due to economic slack to rise (Fig. 16). That said, full-time employment remains higher than pre-pandemic levels, and part-time employment has stabilized around pre-pandemic levels (Fig. 17).

(4) Immigration. After a record number of immigrants came over from Mexico during the Biden administration, immigration has plummeted in recent months. More than 2 million immigrants were encountered (apprehended or expelled) at the southwest border during each year from 2021-23 (Fig. 18). That pace continued this year until slowing dramatically starting in July, as the Biden administration clamped down on border security ahead of the election (Fig. 19).

If the next administration continues the clamp down, the results of fewer immigrants going forward will be slower payroll growth but also less upward pressure on the unemployment rate.

(5) Goods reacceleration. Easier monetary policy will have a direct impact on the goods-producing sector of the economy. For instance, residential construction employment has been rising to new highs. This has been partly driven by the 48% of construction workers focused on residential remodeling (Fig. 20). Looser financial conditions will encourage more renovations and protect employment in this sector. Rebounding housing starts and permits suggest that layoffs won't hit workers who build single- and multi-family homes, either. Construction labor is very fluid and can move to segments of the market most in need of additional workers.

(6) Productivity. We believe higher productivity growth can propel real GDP, particularly considering weaker employment growth. Inability to find the skills they seek in the labor market forces companies to invest in productivity-enhancing technology, which in turn reduces their demand for labor. But weaker hiring demand is less concerning in light of the drop-off in labor-supply growth owing to lower immigration and topped-out labor-force participation.

(7) Just right. The upshot of the Fed's preference for one side of the dual mandate—prioritizing unemployment over inflation—is likely to mean less stable inflation going forward. The community calling for rapid interest-rate cuts appears to believe that unemployment could have run nearly a percentage point below the long-term “natural” rate forever and inflation would have moderated all the same. Placing a lower weight on the importance of unemployment when the labor market is hot, then raising its importance as the labor market cools is not stable monetary policy.

US Inflation: On the Right Path (for Now). Since mid-2022, Debbie, Eric, and I have signaled that inflation was likely to fall to the Fed's 2.0% target by 2024-25 (Fig. 21). We still believe this to be the case, as goods deflation and moderating services inflation point to a 2.0% y/y PCED inflation rate being reached soon. Indeed, the PCED has run at a 1.7% annualized pace over the past three months (Fig. 22).

Fed Governor Christopher Waller told CNBC on Friday that the latest softening of inflation convinced him to favor cutting the FFR by 50 bps. He also declared that the Fed will use further declines in inflation as reason to continue cutting rates.

While inflation is in good shape over the near term, both the markets and the Fed seem unconcerned by longer-term inflation. Inflation that is more volatile or more frequently above 2.0% risks weaker consumer sentiment, price-price spirals, bond losses, and market volatility.

Consider the following:

(1) Market expectations. The difference between the 10-year nominal and inflation-protected Treasury yields—otherwise known as “breakeven inflation”—is currently 2.10%. Swap contracts linked to the average inflation rate over the period 5-10 years in the future are trading at 2.40% (Fig. 23). Both are around the lowest levels in at least two years.

The Fed sees the core PCED inflation rate falling to 2.2% y/y by the end of next year and 2.0% y/y by year-end 2026.

(2) Small changes add up. Long-term inflation expectations trade in a relatively tight range, but the impact of small moves can be large. For instance, averaging 2.0% inflation for 10 years leads to a cumulative 21.9% increase in prices. Averaging 3.0% inflation over the same period leads to a 34.3% increase in prices. One is more palatable than the other, particularly after the cost of essentials jumped nearly 50% in just a few years (Fig. 24).

(3) Lower rates and lower inflation? The futures market shows the Fed will reach its ultimate fed funds rate (FFR) of 2.9% in the next 12 months (Fig. 25). The Fed believes that it'll take about double that time but that it will get there nonetheless (Fig. 26). Is such a path of policy consistent with very subdued long-term inflation expectations? We aren't so sure.

Recession hedges, or bets on much lower interest rates, weigh down the median expected path of monetary policy. Is a recession likely? We don't think so, and apparently neither does the stock market. Even so, it makes sense that so many investors would be hedging such an outcome in rates markets. Owning a bulk of large tech stocks at historically elevated valuations may feel uncomfortable. Knowing that the Fed will be quicker to ease than tighten at the first sign of trouble, why not protect against the risk of an unknown crisis emerging?

In our view, however, real GDP growth will be much stronger than the 2.0% annual rate that Fed officials expect. We won't fight the Fed's predilection for easier monetary policy, however. Based on our 80% chance of strong economic growth in the coming years, we believe the Treasury yield curve likely has more steepening to go as inflation expectations rise.

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Fed’s Dream Economy Versus Ours

September 23 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
The Fed: Dream Economy Ignores Fiscal Nightmare. Believe it or not, there are still a few diehard hard-landers who are still predicting that the economy is heading into a recession, even though the Fed has started a new monetary easing cycle aimed directly at averting a recession. It isn’t even clear that the Fed needs to do so, since the economy, on balance, continues to grow at a solid pace. However, Fed officials have become increasingly concerned that the labor market may be weakening (not just normalizing as we believe) and might push the economy into a recession. They’ve concluded that inflation is now close enough to their 2.0% target that they can pivot from restrictive to less restrictive (or even accommodative) monetary policy to boost the labor market.

Fed officials can be justifiably proud that they have achieved a soft landing. They’ve managed to bring inflation down into the vicinity of their target rate without a recession. They’ve achieved a scenario we have often described as “Immaculate Disinflation” and has been our base-case scenario since 2022. Now they want to maintain it. We are betting they will do so.

We aren’t giving the Fed all the credit for delivering Immaculate Disinflation. There have been lots of forces in play that have led to this development. Most of the pandemic shocks that boosted inflation and tightened the labor market have normalized. Global supply chains have done the same. China’s economy remains weak and continues to export goods deflation and to depress commodity prices, especially the price of oil. Meanwhile, the US economy has remained resilient and less interest-rate sensitive than in the past.

In their latest Summary of Economic Projections (SEP), released on September 18, Fed officials provided a very rosy outlook for the economy over the next three years. They expect to accomplish that by lowering the federal funds rate (FFR) to 4.4% by the end of this year, then to 3.4% and 2.9% by the ends of 2025 and 2026 (Fig. 1). The projected results, according to the SEP, are as follow:

(1) GDP growth. The median projection of the FOMC participants is that real GDP will increase 2.0% every single year from 2024 through 2027 (Fig. 2). That seems too low to us given that it has grown on average by 3.1% since the late 1940s, including recessions (Fig. 3). The Fed’s projection is probably based on an assumption that the labor force will continue to grow by only 1.0% y/y, implying that FOMC participants think that productivity will grow by just 1.0% y/y. Immigration flows suggest that the labor force should grow at a faster pace. Productivity has been growing at least twice as fast recently, spurred by a host of technological innovations (Fig. 4).

(2) Unemployment rate. For now, 2.0% y/y real GDP growth is deemed to be just the right growth rate to keep the unemployment rate at or slightly below 4.4%. The SEP’s “longer run” estimate of the unemployment rate is 4.2%, which must be the FOMC’s current projection for NAIRU, i.e., the nonaccelerating inflation rate of unemployment (Fig. 5). The jobless rate was 4.2% in August. We are at NAIRU.

Isn’t the Fed risking reviving a wage-price spiral by stimulating an economy that is currently at full employment? In his presser last Wednesday, Fed Chair Jerome Powell explained that he and his colleagues agreed that it is time to “recalibrate” monetary policy to keep the jobless rate from rising.

We don’t have a problem with the Fed’s estimate of NAIRU. We agree that the economy is at it now. However, we question whether the Fed will need to lower the FFR as much as projected in the SEP.

In any event, the current monetary easing cycle will certainly boost demand for goods and services. However, we suspect that it will boost productivity more than it will boost the demand for labor. That’s because we perceive that there is a shortage of workers available with the right skills to match the demand.

(3) Headline and core inflation. We also agree with the Fed’s optimistic outlook for the PCED headline inflation rate, which is projected to fall from 2.6% this year to 2.2% next year and to 2.0% in both 2026 and 2027 (Fig. 6). Where we differ is on the FFR level that would be necessary to keep inflation down while providing enough stimulus to keep the economy growing.

In other words, Immaculate Disinflation is no longer a destination; rather, it is the economy’s current location. The answer to “When are we going to get there?” is “We have arrived.” The question now is “What FFR will it take to keep the economy there?” If the Fed overshoots the FFR on the downside, consumer price inflation might rebound.

In our Roaring 2020s scenario, which remains the most probable, that’s not likely to happen. Instead, more stimulative monetary policy will boost productivity-led economic growth, which will continue to subdue the unit labor costs (ULC) inflation rate, which was only 0.3% y/y during Q2 (Fig. 7).

In other words, our dream scenario is even dreamier than the one projected by the Fed because we see more technology-enabled productivity growth.

(4) In the short and long run. The main risk we see in the Fed’s heating up a warm economy with more monetary easing than necessary is a reprise of the second half of the 1990s’ stock market bubble. From a stock market valuation perspective, stock prices are about as overvalued as they were in 1999.

In the September 19 QuickTakes, we raised the odds of a meltup from 20% to 30%. We wrote: “The problem is valuation. Warren Buffett has been raising cash probably because his Buffett Ratio (measured as the S&P 500’s price index to forward sales) is in record high territory at 2.83 during the September 20 week [Fig. 8]. Somewhat less irrational is the S&P 500’s forward P/E [Fig. 9]. It’s elevated at 21.1. But it isn’t in record territory, yet. Its divergence with the S&P 500 forward price-to-sales ratio is attributable to the index’s rising profit margin causing earnings to rise faster than sales.”

Nevertheless, we decided to stick with our current year-end S&P 500 targets of 5800, 6300, and 6800 for 2024, 2025, and 2026. We concluded: “In a meltup scenario, the S&P 500 could soar to above 6000 by the end of this year. While that would be very bullish in the near term, it would increase the likelihood of a correction early next year.”

As we’ve previously observed, the S&P 500 Information Technology and Communication Services sectors together account for about 40% of the market capitalization of the S&P 500 (Fig. 10). That’s the same share as they had at the peak of the 1999-2000 tech bubble that burst. This time, they account for 34% of the forward earnings of the S&P 500 companies collectively versus 22% at the peak of the bubble.

Over the long run, we are still predicting 60,000 for the Dow Jones Industrials Average and 8000 for the S&P 500 by the end of the Roaring 2020s. That’s because we agree with the Fed’s long-run forecast, though we are expecting more productivity-led growth than it is.

(5) Fiscal nightmare. Among our various critiques of the Fed’s sudden and all-in pivot toward monetary easing is that it totally ignores this fact: Both presidential candidates are promoting reckless fiscal policies that will further widen the federal government deficit and that could be inflationary to boot.

In our Roaring 2020s scenario, we are counting on gridlock to stymie the extremes of either presidential candidate. We can always change our minds if there is a sweep by either party on November 3. The Fed, however, is risking its credibility if the next administration’s fiscal policies force another monetary policy pivot.

One more thought: By promising to lower interest rates, the Fed is enabling Washington’s fiscal follies to continue. The federal government budget deficit was $2.1 trillion over the 12 months through August, pushing Treasury debt held by the public up to a record $26.9 trillion (Fig. 11). Net interest outlays rose to a record $872.5 billion over this period (Fig. 12).

US Economy: Three Misleading Economic Indicators. Let’s update our analysis of the major misleading economic indicators that have led many economists to erroneously predict a recession since the Fed started to tighten monetary policy in early 2022:

(1) Philips Curve. The Fed started to raise the FFR in March 2022, from 0.00%-0.25% then to 5.25%-5.50% in July 2023, in response to soaring inflation. It was logical to expect such aggressive monetary tightening to cause a recession. It was also logical to believe that the only way to bring inflation back down was with a Fed-engineered recession. After all, the Phillips Curve shows an inverse relationship between inflation and the unemployment rate (Fig. 13).

This time has been different for several reasons. Demand for goods was overheated by fiscal policies and overwhelmed global supply chains. That inflationary shock during 2021 and 2022 dissipated in 2003 and 2024. In addition, the Chinese government encouraged exporters to dump goods at deflated prices over the past couple of years to offset weakness in China’s property market. China’s weak economy also depressed commodity prices, especially oil prices, especially this year. The prices of numerous services, including rents, also soared as a result of the pandemic. They’ve been mostly disinflating since mid-2023.

Most importantly, proponents of the Phillips Curve model rarely if ever mention productivity. That’s a major flaw in their analysis since there is an inverse relationship between the unemployment rate and productivity growth (Fig. 14). A tight labor market tends to be associated with faster growing productivity, which offsets the upward pressure on wages. As noted above, ULC inflation is down to only 0.3% y/y.

(2) Yield curve. Melissa and I literally wrote the book on the yield curve back in 2019. We observed that inverted yield curves neither cause nor predict recessions. They do predict that if the Fed continues to tighten, the result is likely to be a financial crisis that quickly turns into a credit crunch and a recession (Fig. 15).

More recently, hard-landers have warned that a disinverting yield has tended to be associated with an imminent recession. We’ve countered that this time is different because there’s been no unchecked financial crisis to generate a credit crunch and a recession. The Fed quickly doused the one mini-banking crisis there was, in March 2023, by providing an emergency liquidity facility; that prevented it from turning into an economy-wide run on the banks and a recession.

(3) Leading economic indicator. Back in 2022, we started to argue that the falling Index of Leading Economic Indicators (LEI) might be a misleading indicator of a looming economy-wide recession, mostly because it is a better indicator of the goods economy than the services one. That’s confirmed by the high correlation between the national M-PMI and yearly percent change in the LEI (Fig. 16). However, this time, both indicators have been signaling a recession in real GDP goods that remains a no-show (Fig. 17 and Fig. 18)!  The yearly percent change in real GDP goods has been solidly positive since Q3-2020. It really has been different this time.

Movie. “The Unlikely Pilgrimage of Harold Fry” (+) (link) is an odd film about an odd fellow, who walks 500 miles in the UK to bring comfort to an old friend who is dying of cancer. Along the way, he becomes a media celebrity and attracts a crowd of people who join his pilgrimage. Those scenes are very reminiscent of similar scenes in Forrest Gump. Jim Broadbent’s performance as protagonist Harold Fry is brilliant.

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China, Lithium & OpenAI o1

September 19 (Thursday)

China: Becoming the World’s Problem. China’s latest round of economic data continued to show its bifurcated economy. Chinese consumer spending continues to limp along, as consumers’ pocketbooks and confidence have been hurt by declining property and stock prices. China’s industrial production, on the other hand, has slowed to a much lesser extent thanks to government support.

However, a new problem has arisen: Chinese companies need buyers for their products. With demand low at home, they’re looking abroad for buyers and cutting prices to boot. Foreign governments, worried about the health of their domestic industries, aren’t happy about this development. The US and Europe are threatening to institute new tariffs to prevent low-priced Chinese goods from flooding into their markets.

Let’s take a deeper look:

(1) Dismal data. Recent data about August economic activity continued to show China’s consumer activity slowing much more sharply than its industrial activity. Retail sales decelerated to 2.1% y/y in August, down from 2.7% in July. August real retail sales growth sagged to only 1.4% y/y (Fig. 1).

Consumers have struggled under the weight of falling home prices and falling stock prices. A 70-city average of new home prices fell 5.3% y/y in August, continuing the declines of the past two years (Fig. 2). Consumers’ alternative major investment option, Chinese equities, also continue to deflate. The CSI 300 is down 14.9% over the past year and 45.4% from its February 10, 2021 peak (Fig. 3). A softening job market hasn’t helped, with the nationwide urban jobless rate inching up to 5.3% in August from 5.2% and unemployment for those aged 15-24 jumping to 17.1% in July, when the country stopped reporting the data (Fig. 4).

China’s industrial base has also decelerated, but to a much lesser extent thanks to economic incentives from the government. Industrial production increased 4.5% y/y in August, down from 5.1% y/y growth in July (Fig. 5). China’s auto production jumped to 26.8 million in August, up from 24.7 million in July but down 2.2% compared to year-ago production (Fig. 6). Despite the healthy output growth, industrial profits are relatively slim, growing 3.6% y/y (Fig. 7).

In response to recent economic data, Goldman Sachs and Citigroup lowered their forecasts for China’s 2024 economic growth to 4.7%, below the government’s target of “around 5%.” Bond investors appear even more gloomy; the yield on China’s 10-year bond fell to 2.08% as of Friday’s close (Fig. 8).

(2) Exporting deflation. China has to sell the boatloads of the goods it’s producing somewhere, and that’s where export markets come in. The country’s imports were flat y/y in August, but its exports rose 8.4% (Fig. 9). While the country’s exports have exceeded its imports for more than a decade, exports have grown much more quickly since 2020 than imports. Back in 2014, exports were 1.1 times larger than imports. By August, exports were 1.4 times larger than imports (Fig. 10).

China is exporting more than goods; it’s also exporting deflation. The country’s producer price index (PPI) fell 1.8% y/y in August; as goes China’s PPI, so goes the US’s CPI for goods excluding food and energy, which was down 1.7% in August. The US import price index from China also fell in August, by 1.4%. There’s a tight correlation between the three data points going back at least 10 years (Fig. 11). The same correlation exists between China’s PPI and the European Union’s PPI, which fell 1.9% y/y in July (Fig. 12).

(3) Diplomatic dancing. US and European politicians are not happy about low-priced Chinese goods undercutting prices of domestically produced goods. US officials, led by the Treasury Department’s Undersecretary for International Affairs Jay Shambaugh, are traveling to Beijing for discussions with their counterparts on Thursday and Friday.

“During our trip we will further our discussions on China’s macroeconomic imbalances and industrial policies that risk causing significant harm to workers and firms in the U.S. and around the world,” said Shambaugh in a September 17 WSJ article.

Meanwhile, China’s Commerce Minister Wang Wentao is in Europe to discuss the EU’s anti-subsidy case against China-made electric vehicles (EVs) ahead of a vote on more tariffs, a September 17 Reuters article reported. While in Italy, he said that the EU investigation into Chinese EVs was hurting Chinese companies’ confidence in investing in Italy. It was a thinly veiled threat; Italy has been encouraging Chinese carmakers to open factories and raise vehicle output in Italy.

Materials: Will Lithium’s Bust End? It’s been a tough two years for the lithium market. The toxic combination of excessive production, destocking, slower-than-expected EV growth, and economic uncertainty sent the price of lithium down 87% from its November 17, 2022 peak of CNY 542,000 per ton to a recent CNY 70,150 per ton (Fig. 13).

But in recent days, a large Chinese miner shut down production following news earlier this year that the planned construction of some new mines has been delayed. The commodity market is doing what the commodity market does: correct by reducing supply when prices fall. Now prices may have found their footing.

Let’s take a closer look at the forces that drove lithium prices down and why they may recover from here:

(1) Production surged in recent years. Excitement about surging demand for batteries in EVs and elsewhere combined with skyrocketing lithium prices encouraged miners to boost production. From 2011 through 2016, mine production of lithium worldwide bounced between 31,500 and 38,000 metric tons. Then production surged to 95,000 metric tons in 2018, 146,000 in 2022, and 180,000 in 2023, according to Statista’s data.

(2) EV sales disappointed. Global EV sales, including battery electric and plug-in hybrid EVs, have continued to grow, just less rapidly than was expected. EV sales from January through August of this year totaled 9.8 million; that’s up 20% over the same period last year but down from the same period in 2023, according to a September 12 Rho Motion press release. That 2023 period saw sales increase 39% y/y, an October 3, 2023 press release stated.

Sales in China have remained robust, with six million EVs sold ytd through August, up 33% y/y. More than one million EVs were sold during August alone, marking a new monthly record. Sales in the region benefitted from subsidies given to drivers trading in vehicles that produced more pollution. Sales were up 35% during the same period ytd in 2023.

In the US and Canada, sales increased 9% y/y to 1.1 million from the start of the year through August, a sharp slowdown from the same period in 2023 when sales jumped 57%. Going forward, sales could be affected by the US presidential election. While Vice President Harris would likely extend President Biden’s Green New Deal if she became president, the policies would likely be unwound if former President Trump is reelected.

Ytd sales in Europe fell 4% to 1.9 million, due primarily to a 23% drop in Germany after subsidies were cut last year. That’s a major reversal from the same period in 2023 when sales rose by 30%. The German government agreement on September 4 to reduce corporate taxes is expected to help boost sales going forward.

(3) Production slowing. Miners have responded to falling lithium prices by cutting production or postponing the development of new mines. Most recently, China’s battery giant CATL suspended production of lithium carbonate in Yichun, a September 11 Reuters article reported. The decision is expected to reduce China’s lithium carbonate monthly production by about 8%, or 5,000-6,000 tons, and the stocks of lithium mining companies responded by rallying from very depressed levels.

CATL isn’t alone. Albemarle announced in July that it will halt the expansion of its Kemerton manufacturing plant in Australia and idle a lithium processing line at the plant. The plant’s production will fall by half to 25,000 tons, and employees will be cut, a July 31 CNBC article reported. The expansion was going to increase capacity by 100,000 tons.

The news followed Albemarle’s announcement in May that it pushed back plans to reopen the Kings Mountain mine in North Carolina, originally slated for late 2026. The company is working on getting permits but has no new production start date, a May 3 CNBC article reported. The year began with Australia’s Core Lithium suspending mining at its Grants open pit, opting instead to process the ore it had already stockpiled. Mining has yet to restart.

The share price of US lithium producer Albemarle rose 14.2% in the days following the Reuters’ CATL news but is still down almost 70% from its 2022 peak. At the very least, recent news of lithium mining cutbacks may mean a floor is finally in place.

Disruptive Technologies: OpenAI’s New LLM. OpenAI has introduced a new large language model (LLM) that it claims “thinks” before answering. (Skeptics say thinking is merely computer processing.) The program, OpenAI o1, breaks apart complex problems into more manageable pieces before answering, and, through reinforcement, it learns to recognize and correct mistakes and try a different approach when the current approach isn’t working. OpenAI reports that the new program, which can take longer to generate an answer, is far more accurate than its predecessor large language model, GPT-4o.

Here are some additional details:

(1) A better test taker. OpenAI gave ChatGPT-4o and OpenAI o1 the same tests, and in most cases the new program came out on top.

Here’s how o1 scored compared to ChatGPT-4o on various tests: AIME 2024 math competition (o1 scored 83.3, GPT-4o scored 13.4), Codeforces coding competition (89.0, 11.0), AP Physics (81.0, 63.0), AP Chemistry (98.0, 76.0), and AP Calculus (83.3, 71.3).

Interestingly, it fared well on the reading and writing portions of the SAT, i.e., the SAT EBRW, (94.4, 92.8) and on the LSAT (95.6, 69.5). But both programs flunked the AP English Language exam equally (58.0, 58.0), which tests complex critical thinking, reading, and writing skills like understanding an author’s purpose and intended audience, according to the Princeton Review.

(2) Additional guardrails. OpenAI “taught” the new model human values and principles. “By teaching the model our safety rules and how to reason about them in context … o1-preview achieved substantially improved performance on key jailbreak evaluations and our hardest internal benchmarks for evaluating our model’s safety refusal boundaries.”

The model lays out what it is “thinking” and the various steps it’s taking to solve a problem. But in one scary sentence, OpenAI suggests an ability to manipulate versus merely inform, writing: In “the future we may wish to monitor the chain of thought for signs of manipulating the user.”
 
(3) Coders beware. OpenAI o1 could be “the final nail in coding’s coffin,” the folks at Windows Central wrote earlier this week. The program passed OpenAI’s research engineering hiring interview for coding at a 90%-100% rate. Earlier this year, Nvidia’s CEO Jensen Huang predicted that coding may be taken over by AI and suggested that the next generation of students should pick other areas of study. (Farming anyone?)

(4) What o1 lacks. The new OpenAI program doesn’t have web browsing, image generation, or file uploading. OpenAI plans to add these capabilities in the future, a September 12 ARS Technica article reports. It’s also roughly four times more expensive than GPT-4o.

That said, TechCrunch asked o1 various questions that were more open ended than your typical Google search. For example, one query asked o1 what he should ask when interviewing a data scientist with only 30 minutes for the task. Another asked o1 to help plan Thanksgiving, including determining whether the meal could be cooked in two ovens or whether a third oven was needed. The response said two ovens would be sufficient and broke down how to prioritize oven space. Now if o1 would only do the actual cooking!

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On Consumers, The Eurozone & S&P 500 Share Count

September 18 (Wednesday)

US Consumer: Still Shopping, Not Dropping. August’s retail sales beat the consensus expectation for a decline, rising instead. Many assumed that falling gas prices meant that nominal spending would fall. We’ve been expecting consumer spending to remain strong based on labor market growth and real wage growth trends.

We’ve heard a number of concerns regarding how much longer the consumer can shop without dropping. According to the die-hard hard-landers, pandemic-era savings are exhausted, a declining personal savings rate is fueling the final innings of spending, the labor market is on the brink, and high-net-worth households are distorting the data.

We’re not so gloomy. Consumer spending looks likely to continue going strong in our outlook. Consider the following:

(1) Earned income proxy. Americans are working more and earning more. Nonfarm payroll employment rose just 0.1% m/m in August, but average weekly hours increased 0.3%. So aggregate weekly hours rose 0.4% (Fig. 1).

Combined with August’s 0.4% m/m rise in average hourly earnings, our Earned Income Proxy (EIP) for private-industry wages and salaries in personal income increased 0.8% to a record high last month (Fig. 2). We expect the PCED inflation rate rose 0.2% m/m or less in August, so real incomes rose at least 0.5%. That suggested to us that consumer spending increased last month, even after strong spending in July.

(2) Wage growth. Real average hourly earnings (AHE) continue to rise (Fig. 3). For low-wage (production and nonsupervisory) workers, real AHE rose to a new record high in July (Fig. 4). Their wage gains have been beating the rate of inflation for over a year.

Collective bargaining has helped swaths of workers increase their wages in the past several months and quarters (Fig. 5). Resultant pressure on corporate margins might be something for stock pickers to keep an eye on. Broadly speaking, however, unit labor costs have been suppressed to multi-year lows thanks to strong productivity growth (Fig. 6).

(3) Retail sales. As long as US consumers are earning, they are spending. Retail sales rose 0.1% m/m in August, while the consensus expected a 0.2% drop (Fig. 7). Core retail sales (excluding autos, gasoline, building materials, and food services) rose 0.4% m/m, suggesting that the underlying consumption trend remains strong (Fig. 8). Falling gas prices are essentially a form of stimulus to consumers (what they don’t spend on gas, they’ll spend on other things). A 0.24% decline in goods prices has further boosted real purchasing power (Fig. 9 and Fig. 10). July’s spending was revised higher as well, from 1.0% to 1.1% m/m. Online sales boosted this month’s sales while auto sales surged in July after being hampered by a cyber-attack the prior month.

The New York Fed’s quarterly household spending survey was released on Monday. It showed nominal household spending increased from 4.6% y/y in April to 5.0% in August. The increase in spending was broad-based across education levels and income groups.

We aren’t blind to the fact that the cost of essentials has skyrocketed since the pandemic, causing some households to struggle to make ends meet. But in our opinion, concerns about a K-shaped economy (rosy for the wealthy, grim for lower-income households) are not supported by the data.

Better-than-expected retail sales boosted the Atlanta Fed’s GDPNow model’s Q3 real GDP growth forecast from 2.5% to 3.0% (Fig. 11). Personal consumption expenditures are estimated to rise 3.7% this quarter—hardly recessionary. While some components of retail sales are not included in GDP personal consumption expenditures (PCE) on goods (i.e., used car sales, building materials, food services, etc.), these series are highly correlated. Real core retail sales likely increased to another record high in August, suggesting another record high for goods PCE during Q3 (Fig. 12).

(4) Consumption per household. Our preferred measure for the health of the consumer is personal consumption expenditures per household. This series rose to a record high of $148,100 per household (saar) in July (Fig. 13). Real personal consumption expenditures per household rose to a record $120,200 (saar) in July (Fig. 14).

Some complain that these data represent a mean, rather than a median. Therefore, wealthy households’ consumption must be distorting the data. But in our opinion, that’s unlikely to affect personal consumption per household very much. The rich can only eat so much.

In any case, median income as measured by the Census Bureau rose 4.0% y/y in 2023. We believe this data series faultily understates income growth, having showed Americans’ standard of living has largely stagnated over the past 25 years despite record GDP growth, wage growth, and consumption growth. The Census Bureau data are derived from survey-based micro data on money income. The Census Bureau specifically gathers this data to report on income inequality and excludes fringe benefits, Medicare, Medicaid, the Earned Income Tax Credit, interest income, rental income, and dividend income. And yet this series still rose meaningfully last year.

(5) Consumer credit in context. Consumer credit rose $25.5 billion m/m during July, the most since November 2022. Revolving credit jumped $10.6 billion in July following a small decline in June (Fig. 15). There’s no consumer credit bubble looming, however. Consumer credit outstanding represents less than a quarter of disposable personal income, well below its pre-pandemic percentage (Fig. 16).

(6) Delinquencies. There are fair worries that rising credit card delinquencies signal consumer weakness, especially with student loan payments primed to start up again (Fig. 17).

However, delinquencies on the biggest source of borrowing—mortgages—have plummeted. So just 3.3% of total household debt is delinquent as of Q2, down from 4.7% in Q4-2019 (Fig. 18). That makes sense, as credit card debt makes up just 6.4% of total household debt, whereas mortgages represent 70.3% (Fig. 19). While credit card delinquencies are rising, they are mostly among borrowers under the age of 25 and with less education. We do not discount that these cohorts are struggling. However, they represent a relatively small slice of overall consumption. Is it surprising that some are delinquent on their credit cards when many cards charge APRs of 30% and the cost of living has risen substantially?

(7) Savings. The personal savings rate fell to 2.9% in July (Fig. 20). The immediate claim by hard-landers was that dissaving has fueled consumption, and therefore spending will peter out soon. In our opinion, lower savings rates are a result of: 1) Baby Boomers retiring early and spending without incomes (negative savings), and 2) record asset prices (e.g., stocks, homes, etc.) suppressing the need to save and boosting consumption via the very positive wealth effect (Fig. 21).

To put a bow on the state of the consumer—things look pretty good to us. The labor market is growing, real wage growth is outpacing inflation thanks to productivity gains, and incomes and net wealth are sources of spending rather than credit. There are pockets of concern, as well as decelerations in some of these positive trends. However, with the Fed gearing up for a large easing cycle, we see greater risk of an overheating economy than a recession.

Eurozone I: Mario’s Mega-State Ambitions. Mario Draghi—the former European Central Bank chief famous for his “whatever it takes” defense of the euro—has returned to center stage to push Eurozone governance toward a more unified state. During a December 2023 speech, he criticized the EU’s fragmented model, arguing that it must evolve to foster economic growth. He cited the exodus of growing startups to the US as an example of the limited market potential in Europe.

Though lacking an official title, Draghi was enlisted by European Commission President Ursula von der Leyen to tackle structural issues. His 400-page September 2023 report, The Future of European Competitiveness, outlines Draghi’s ambitious plan to boost innovation, energy, and infrastructure via centralized joint borrowing. His vision calls for deeper EU integration and a more centralized fiscal strategy, proposing annual EU investments of €750-€800 billion in digital innovation, green energy, and infrastructure through collective borrowing. He would emphasize tech sector reforms, important to productivity growth. He pointed to the stark contrast between the size of tech giants in Europe and the US; Europe hasn’t produced a firm valued over €100 billion in the last half-century, as a September 16 WSJ article discusses.

Neither right- nor left-wing factions can contest that, but the remedy for the EU’s diminishing global competitiveness remains a matter of debate. One critic of Draghi’s centralized fiscal approach is German Chancellor Olaf Scholz, who warns that financial risk-sharing among the countries could undermine their fiscal discipline. Other EU leaders have voiced concerns about Draghi’s policies potentially infringing on national sovereignty, apprehensive that increased centralization could erode individual countries’ autonomy.

Nonetheless, Draghi has strong advocates in pro-EU French President Emmanuel Macron and the progressive Spanish Prime Minister Pedro Sánchez. Their voices have become more pronounced amid shifting EU power dynamics as Germany’s economic influence wanes.

In his report, Draghi proposes horizontal EU policies aimed at bridging the skills gap, fostering innovative technology development, supporting productive investments, and boosting market competitiveness. These goals would be achieved via the creation of a Competitiveness Coordination Framework (CCF), helmed by a “Vice-President for Simplification” to streamline EU integration efforts. The CCF would work toward “deeper integration based on ‘concentric circles’, including enhanced cooperation or coalitions of the willing, where action at the EU level is hindered or blocked by existing procedures.”

Might Draghi himself aspire to be the CCF’s Simplification czar? Does anyone really draft a 400-page policy report without a personal agenda? Draghi is here to help.

Eurozone II: Made in Europe (TBD). Mario Draghi’s competitiveness report draws inspiration from the Biden administration’s Inflation Reduction Act (IRA) and China’s “Made in China 2025” strategy. Both emphasize state-led strategic direction and state-led funding for domestic industries deemed to be critically important, particularly technology.

Draghi’s vision pushes for centralized strategic planning, centralized procurement, and centralized public funding for key sectors across the EU. The report repeatedly underscores the need for “centralized” efforts, using the word 63 times, with terms like “harmonise” and “consolidation” also frequently appearing. His aim? Integrate and consolidate EU efforts to strengthen competitiveness and steer investment toward vital industries through “joint undertakings” (a.k.a. a larger EU governance body).

Here’s a rephrased summary of just a few of the vertical industry-specific policies described in Draghi’s report:

(1) Energy. EU strategy would be unified on energy security, joint EU gas procurement, and harmonized EU financial support. Centralized regulation and a collective public insurance system would mitigate market volatility. A “true Energy Union” with central governance is a key goal.

(2) Computing and AI. Investment in EU-wide AI and computing infrastructure would be prioritized, with ten key AI sectors targeted for development, including automotive and energy. Standardized EU cloud rules are recommended.

(3) Semiconductors. A coordinated semiconductor budget and public-private partnerships would enhance EU leadership in advanced chip production.

(4) Clean technologies. Streamlined EU funding access and new financing schemes would support green tech, with a focus on supply-chain monitoring and R&D.

(5) Automotive. Electric vehicles and autonomous driving innovation would be better coordinated, with a focus on collaboration in the sector.

(6) Defense. Improved demand aggregation for defense assets and EU-level funding would strengthen the defense supply chain across member countries.

Strategy: AI Investment Crowding out Share Repurchasing. Artificial intelligence (AI) spending decisions are Topic #1 in corporate boardrooms across America. With stock prices and valuations at or near record highs, managements are opting to allocate more cash to AI investments and less to buying back their companies’ highly appreciated shares. Even Warren Buffett has stopped buying shares of Berkshire Hathaway, according to a September 13 WSJ article. Furthermore, we’re expecting only a gradual decline in the federal funds rate this rate-cut cycle, so debt-funded acquisitions may not become less expensive very quickly. Companies may opt to use their richly valued shares as currency in acquisitions instead of cash.

We’re not surprised to report that the S&P 500’s aggregate basic shares outstanding declined q/q at rate lower than 0.1% for a third straight quarter in Q2-2024 (Fig. 22). That’s down substantially from an average 0.3% decline in the five quarters preceding that.

A company’s share count rises when more shares are issued to pay stock dividends, as currency to fund acquisitions, and when an employee’s stock option compensation is converted to shares. Counts fall when companies use excess cash to buy them back. That’s important because a steadily falling share count boosts EPS over time.

Here’s Joe’s look at the aggregate count of basic shares outstanding over time for the S&P 500 and its 11 sectors (see also our S&P 500 Shares Outstanding (sectors) report):

(1) Share count still declining, but at a slower rate. The S&P 500’s share count fell in Q2-2024 for an eighth straight quarter. Eight of the 11 sectors had declining share counts, unchanged from Q1’s count. Share counts rose for the Real Estate and Utilities sectors, as is typical since they typically issue stock as dividends in lieu of cash payments.

Other notable sector trends: Consumer Staples’ share count declined for a 15th straight quarter, the most of any sector, followed by Financials (14 quarters), Industrials (13), Consumer Discretionary (12), Health Care (12), and Communication Services (8). Real Estate’s share count rose for a 39th straight quarter. Also, Financials’ count dropped 0.6% q/q in Q2, the fastest quarterly rate of decline in 10 quarters. On the flip side, the share count for Consumer Discretionary and Industrials declined at their slowest rates in 12 quarters. Energy’s q/q share count gain was the highest in 10 quarters and its second in the past three quarters.
 
(2) Share counts mostly down since 2009. Since Q1-2009, the S&P 500’s share count has dropped 2.8% (Fig. 23). Consumer Staples led the declines among the sectors, down 19.5%, ahead of Industrials (-16.8), Information Technology (-14.9), Health Care (-6.0), and Consumer Discretionary (-3.5). The Financials sector’s share count is up 0.8% since Q1-2009, but that reflects years of share issuance after the Great Financial Crisis to shore up banks’ balances sheets; since Q2-2011, Financials’ share count has dropped 21.3%.

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QT, MBS & BOJ

September 17 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.

Federal Reserve: Quantitative Tightening, Qualitative Easing. The Fed’s quantitative tightening (QT) campaign has been slow and ineffectual. That’s a feature, not a bug. It’s a symptom of the Fed’s preference for easy financial conditions and stable financial markets over monetary policy that’s dictated solely by economic data. It also sets the Fed up with an inconvenient and historically uncommon policy stance: easing monetary policy by lowering interest rates while tightening it by shrinking the balance sheet.

Let’s review QT’s progress, and discuss how the Federal Open Market Committee (FOMC) may use its policy tools going forward:

(1) Reserving reserves. In June 2022, the FOMC began reducing its then-$9 trillion balance sheet (Fig. 1). It did so by refraining from reinvesting all of the proceeds from maturing Treasuries and mortgage-backed securities (MBS). The goal of QT is to reduce reserves, the opposite of quantitative easing (QE). By that metric, the Fed has failed. Bank reserve balances most recently totaled $3.32 trillion, more than double the sum just prior to the pandemic (Fig. 2).

(2) Why so many reserves? There are a few reasons that QT has been the grossly underachieving stepbrother of QE. For one, fewer MBS matured because homeowners ceased to refinance or prepay their mortgages as rates surged (Fig. 3). The Treasury Department also opted to issue the bulk of its debt in Treasury bills, which were easily financed by money-market funds’ cash in the reverse repurchase facility (RRP) (Fig. 4 and Fig. 5). The cash remaining in the RRP fell to $239 billion on Monday, the lowest since 2021. This lever is quickly evaporating, and reserves are likely to fall soon.

The FOMC slowed the pace of QT this June because it does not want to upend the short-term interest-rate markets, as it did in 2019.

(3) Navigating in fog. The FOMC doesn’t know what level of reserves is too low or would cause short-term interest rates to spike. Fed officials were shocked by how quickly reserves became scarce during their last go at QT in 2019, when Eric was on the New York Fed’s money market desk. When he probed New York Fed President John Williams and the System Open Market Account (SOMA) portfolio managers while working at the WSJ, their response was “you know reserves are scarce when you see it.” Essentially driving blind, the Fed put up bigger guardrails to prevent itself from going over a cliff.

In August, the Fed explicitly allowed banks to count their high-quality assets (i.e., Treasuries and agency MBS) that can be pledged to the Fed’s Discount Window in internal liquidity stress tests. This reduces banks’ overall demand for reserves to meet stress-testing requirements. Moreover, the new standing repo facility (SRF) can absorb any short-term pressure, like during corporate tax dates or quarter ends.

The upshot is that QT can go on for longer with these safety measures. Still, the FOMC might end QT in order to have harmonized interest-rate and balance-sheet policy. Ending QT—whenever it’s done—will put downward pressure on Treasury yields.

(4) QT on the surface, QE under the surface. One of the many idiosyncrasies of this tightening cycle has been the counteractive easing measures. The Bank Term Funding Program (BTFP) backstopped the banking system’s duration crisis (Fig. 6).

The Fed’s so called “deferred asset” has been a more subtle form of easing. It’s basically negative remittances to the Treasury Department. Typically, the Fed sends the Treasury the difference between interest income from its securities holdings and the costs of those holdings, such as interest paid on reserves and operating costs. These remittances totaled more than $800 billion from 2012 to 2021. But with short-term interest rates it pays on reserves so much higher than the interest income earned from the assets it purchased over the years, the Fed has operated at a cumulative $197 billion loss—its deferred asset—over the past two years (Fig. 7).

Once the Fed returns to profitability, it will “pay down” the deferred asset and then begin remitting to the Treasury again. But in the meantime, the Fed is stimulating economic activity by households, businesses, and consumers, essentially by borrowing from the future.

(5) Exorbitant privilege. The Fed’s deferred asset is far from the primary reason that the US economy has been so strong despite two years of tighter monetary policy. That said, Fed officials shouldn’t be so shocked that US households have $1.8 trillion of interest income to spend and therefore are less sensitive than usual to higher interest rates (Fig. 8). Other central banks aren’t as fortunate.

The Bank of England, for instance, is selling British gilts outright to tighten its monetary policy and provide more room for potential easing in the future. That’s drawn ire from taxpayers, who must fund the losses on sales of low-rate gilts via His Majesty’s Treasury! As a result, bazooka-style QE used during the pandemic is criticized more often by the public “across the pond” than in the US.

US households’ interest income should fall as the Fed cuts the FFR. But if asset prices rise, and companies are able to issue debt that yields more than Treasuries as their risk of default decreases, will there be any negative impact? In other words, the Fed isn’t pulling away the punch bowl by lowering rates. It’s just providing a different—more powerful—punch.

Interest Rates: Hunting for Yield. MBS have provided a particularly attractive income opportunity since the Fed began its last tightening round. Mortgage rates have traded 250-300 bps above Treasury yields, well above the historical average of 171 bps (Fig. 9). As the record $6.5 trillion sitting in money-market funds searches for higher yields once the Fed cuts the overnight rate, extra money flows into agency-backed MBS could compress that spread (Fig. 10). The narrowing may not be as great as investors are used to, however.

Consider the following:

(1) Doubly government backed. Agency MBS are implicitly backed by the government via their stamp of approval by the government-sponsored enterprises, a.k.a. GSEs. However, they received another support line from the central bank. The Fed grew its MBS book to a peak of $2.7 trillion in April 2022, or around 30% of the total market. Because of very slow prepayments, that’s down to just $2.3 trillion today, or a quarter of the $9.3 trillion market.

(2) Spreads widen. Without the buying power of the Fed suppressing yields, the MBS spread has widened to more than 291 bps currently—the highest level since 1986. Is the mortgage market really more stressed than it was during the Great Financial Crisis? Not exactly. MBS spreads are also wider because they’re highly correlated with interest-rate volatility (Fig. 11). The Treasury market has been more volatile over the past two years thanks to Fed tightening and elevated inflation. As the Fed begins cutting rates and inflation moderates further, those pressures fall.

Another source of pressure on MBS yields was the mini regional banking crisis in 2023. The Federal Deposit Insurance Corporation (FDIC) built a receivership fund out of the assets of failed Silicon Valley Bank and Signature Bank. The FDIC had to sell $114 billion of MBS, using the proceeds to repay the banks' creditors. The MBS spread widened 30 basis points to a new cycle high during this episode.

(3) New norm? MBS have negative convexity. That is, the price of the bond suffers more from rates rising than it benefits from rates falling, because homeowners have the option to prepay their mortgages in the latter scenario. But the negative convexity is pretty weak right now because prevailing rates are still higher than the rates most homeowners locked in during pandemic. In other words, there’s minimal prepayment risk. Convexity will grow more negative as rates are lowered, but we don’t expect rates to fall substantially in our Roaring 2020s scenario.

Long term, it's likely that the Fed will reinvest its maturing MBS holdings into Treasuries. In that case, the MBS spread is likely to reset to a new, higher norm than before the Fed started to tighten monetary policy in early 2022.
 
Japan: The Only Hawks in Town. The Bank of Japan (BOJ) has shifted from the easiest central bank in the developed world to the only one raising interest rates. The narrowing differential between Japanese rates and US rates has strengthened the yen from more than ¥160 to the dollar to ¥140 as of this weekend (Fig. 12).

Our base-case scenario assumes that Japan’s inflation scare (if you can call it that) is manageable and that the Fed will not lower rates by as much as financial markets expect. Consider:

(1) Committed to the bit. Did the BOJ find new hawkish wings after maintaining negative interest rates for much of the past decade? Perhaps. Governor Kazuo Ueda has brushed off political pressure, assuring that the BOJ would raise interest rates as long as the economic backdrop continues to call for it. BOJ policymaker Naoki Tamura said last week that the BOJ should raise rates to at least 1.0% next year, Reuters reported on September 12.

(2) Inflation problem? The BOJ does not want too much volatility in Japanese markets. Fortunately, it meets later this week after the FOMC does, so Japanese policymakers can digest the Fed’s initial impact on the markets first before making their decision.

But how much of a problem does the BOJ have to manage? Japan’s PPI slowed in August for the first time in eight months, from 3.0% y/y to 2.5% (Fig. 13). Producer prices declined 0.2% m/m, largely because energy inputs fell 4% y/y and the stronger yen weighed on import prices. That could lead the BOJ to leave the policy rate unchanged at 0.25% later this week.

Goods inflation has been the primary contributor to Japanese inflation. CPI goods prices were up 4.0% y/y in July, whereas services prices were only up 1.4% y/y (Fig. 14). The core CPI is already below the BOJ’s 2.0% target. We expect the stronger yen to weigh on consumer inflation.

(3) Yen outlook. With long-term Japanese rates at a 10-year high, the impetus for substantial interest-rate hikes seems weak (Fig. 15). The yen trading around ¥135-140 against the dollar may be enough to ease Japanese inflation back to the BOJ’s target 2.0%. Depending on the outcome of Japan's Liberal Democratic Party election in two weeks (the winner of which will likely become Prime Minister next year), the markets may shift their expectations to more dovish monetary policy. So plenty of question marks remain with respect to the path of BOJ policy.

It is not our base case, but there are a range of scenarios that could narrow the spread between US and Japanese rates. Betting on a stronger yen isn't a bad hedge for investors broadly positioned for our Roaring 2020s scenario.

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50 Basis Points: Baked Or Half Baked?

September 16 (Monday)

YRI Weekly Webcast. Join our live webcast with Q&A on Mondays at 11 a.m., EST, with Ed and Eric. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
The Fed: Fast or Gradual Dovish Pivot? During each monetary policy easing cycle associated with a financial crisis and a recession, the Fed started by cutting the federal funds rate (FFR) by at least 50 bps (Fig. 1). However, this time around is arguably more like the 1995 easing cycle, when the Fed cut the FFR in 25 bps increments to revive a slowing economy. Eric and I think that the Fed should cut the FFR by 25bps on Wednesday. Whether it will or not is unclear.

This time is especially different than the start of most easing cycles because the Fed is easing in response to concerns that the economy might fall into a recession if it doesn’t do so. That’s not obviously the case at this time. In the past, it was often obvious that a financial crisis had morphed into a credit crunch that was pushing the economy into a recession (Fig. 2).

Nevertheless, the FFR futures market is currently assigning probabilities of 50% for a 25bps cut and 50% for a 50bps cut on Wednesday (Fig. 3). Those betting on the larger cut must believe that what’s past is prologue. Indeed, during the past 10 easing cycles, the FFR fell by 418 bps on average from peak to trough (Fig. 4). So past experience suggests that the Fed has a ways to go before the easing is over and should get on with it—i.e., cut by 50bps rather than 25bps—especially if the Fed is trying to reduce the risk of an imminent recession.

The problem with the notion that “what’s past is prologue”—a phrase that comes from Shakespeare’s last play The Tempest—is that it’s not always the case (and indeed wasn’t even the case in the play). We prefer Mark Twain’s quip that “history doesn’t repeat itself, but it often rhymes.” We’ve been arguing since mid-2022 that the diehard hard-landers have been conjuring a tempest in a teapot. They’re still doing that.

Nevertheless, recession fears undoubtedly are influencing Fed officials more now that they’re much less worried about inflation than over the past two and a half years. That became quite clear after the CPI reports for July and August showed that inflation continues to moderate, while labor market reports showed that the hot labor market of the past couple of years has been cooling.

We’ve calmly concluded that this indicates that the labor market has been normalizing, not weakening as others have fretted, including Fed Chair Jerome Powell. His latest major pivot—this time from inflation hawk to employment dove—was evident in his August 23 speech at Jackson Hole:

“The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. We will do everything we can to support a strong labor market as we make further progress toward price stability. With an appropriate dialing back of policy restraint, there is good reason to think that the economy will get back to 2 percent inflation while maintaining a strong labor market. The current level of our policy rate gives us ample room to respond to any risks we may face, including the risk of unwelcome further weakening in labor market conditions.”

Got that? Powell said that any additional weakening of the labor market wouldn’t be welcomed. So why not go with a 50bps rather than a 25bps cut to avert that from happening? Here are the pros and cons of that notion:

(1) Pro: Provide stimulus where it is needed. A bigger rate cut would more quickly help to revive the sectors of the economy that have been the most depressed by the tightening of monetary policy. Both residential housing and commercial real estate (CRE) would get a boost. CRE loans would be easier to refinance, reducing the risk of a financial crisis in that sector. A pickup in housing starts would provide a boost to manufacturing, which has been in a growth recession (Fig. 5 and Fig. 6). A rebound in existing home sales would be good for housing-related retailers (Fig. 7).

(2) Pro: Revive consumer and business confidence. The consumer optimism index, which we calculate as the average of the consumer confidence index and consumer sentiment index, has been relatively depressed (Fig. 8). The small business optimism index dipped in August after a solid gain in July. It is also still relatively depressed and could use a lift from lower interest rates (Fig. 9).

(3) Pro: Good for the labor market. All of the above should create more job openings, leading to more hiring. According to the September 4 Beige Book, the labor market can use some more love from the Fed: “Five Districts saw slight or modest increases in overall headcounts, but a few Districts reported that firms reduced shifts and hours, left advertised positions unfilled, or reduced headcounts through attrition—though accounts of layoffs remained rare. Employers were more selective with their hires and less likely to expand their workforces, citing concerns about demand and an uncertain economic outlook. Accordingly, candidates faced increasing difficulties and longer times to secure a job.”

The various measures of layoffs show that they remain low (Fig. 10). However, the unemployment rate is up to 4.2% in August from 3.8% a year ago because there are fewer job openings for the unemployed to go after. Easier monetary policy should help to boost job openings, thereby putting a lid on the unemployment rate.

(4) Con: Too soon to declare “mission accomplished” on inflation. While inflation has moderated significantly, it isn’t at 2.0% y/y just yet. The moderation in the overall rate has been led by deflating consumer durable goods prices in recent months. They might continue to fall given that the US import price index for goods made in China has continued to decline (Fig. 11).

China’s weak economy is also putting downward pressure on the crude oil price, which is deflating the energy components of the CPI. A big decrease in the FFR may not be necessary if falling gasoline prices and falling durable goods prices boost consumers’ confidence, real purchasing power, and spending (Fig. 12).

Meanwhile, inflation remains relatively sticky in the CPI services component. Rent has a big weighting in the CPI and is moderating slowly but not so surely given its August uptick. Excluding shelter, CPI services rose 4.3% y/y during August (Fig. 13). This suggests that it might be too soon for the Fed to declare “mission accomplished” when it comes to the 2.0% inflation target.

(5) Con: There might be a shortage of skilled labor. As we observed last week, the rising pool of unemployed workers currently is attributable to teens with less than a high school education (Fig. 14 and Fig. 15). If the Fed lowers the FFR too fast, two results are likely to be an increase in demand for goods and services and an increase in job openings.

That would be wonderful. However, what if the supply of unemployed workers lacks the skills to meet the requirements of the increased job openings? During August, the NFIB survey of small business owners found that 56% said that they can’t find qualified workers for the jobs they have open (Fig. 16). That’s up from 49% in July and the highest since September 2023.

In our Roaring 2020s scenario, businesses would continue to solve this structural problem by boosting technology-driven productivity growth. However, the Fed is not in a position to bet the farm on YRI’s happy forecast. Fed officials must be concerned that by boosting demand for goods and services when the labor market is tight, the result could be a wage-price spiral.

(6) Con: The real federal funds rate is unreal. The Fed stopped raising the FFR 14 months ago, presumably because the rate was restrictive enough to bring inflation down to the Fed’s 2.0% y/y target. Powell often stated that might be accomplished without triggering a recession. So far, so good.

However, Powell & Co. seem to be concerned that the real FFR is rising as inflation is falling (Fig. 17). So the Fed’s monetary policy is automatically turning more restrictive. We’ve long observed that the real FFR is an unreal concept. It makes no sense to adjust the overnight lending rate in the bank reserves market with the yearly percent change in the CPI.

Real GDP is up 5.5% since the Fed started raising the FFR in March 2022. It is up in record-high territory since the Fed stopped doing so. Economic growth has been resilient and is showing few signs of buckling at the current level of interest rates.
 
(7) Con: Stock prices could melt up. If the Fed goes big, stock prices might resume soaring, with the potential of inflating a bubble that could be comparable to the dot.com bubble of the late 1990s.

What about the bearish carry-trade story that Eric and I have been telling since early August? We think the unwinding of the yen carry trade is mostly finished. The yen has strengthened over the past week, yet the Nasdaq has rallied—unlike the situations at the beginnings of both August and September (Fig.18). Eric wrote about last week’s carry-trade status in the September 11 Morning Briefing.

(8) Bottom line: No recession ahead. If the Fed cuts the FFR by only 25bps, that might alarm the hard-landers, who undoubtedly would claim that such a small cut is too little too late. We, on the other hand, think 25bps would be enough for now pending the next batch of data releases—which we expect once again will confirm the economy’s resilience.

If the Fed cuts by 50bps, the chances of a recession are lessened even more, of course. But the odds of igniting consumer price and/or asset inflation would go up.

(9) Another bottom line: Beware November 5. We hate to mix politics into this discussion. So do Fed officials, who regularly claim that the Fed is apolitical. In his July 31 press conference, Powell was adamant about that: “[W]e would never try to make policy decisions based on the outcome of an election that hasn’t happened yet. ... [T]hat would just be a line we would never cross. You know, we’re a nonpolitical agency. We don’t want to be involved in politics in any way.”

Maybe so. But shouldn’t the Fed consider the possibility of either a Democrat or Republican sweep? Unchecked and unbalanced political power would allow either party to conduct fiscal and trade policies that would further widen the federal budget deficit and possibly fan inflation flames. Certainly, that realistic possibility should temper the Fed’s readiness to cut the FFR by 50bps rather than 25bps.

After all, the 12-month federal government’s budget deficit rose to $2.07 trillion during August (Fig. 19). The government’s net interest outlays rose to a record $872.5 billion over the past 12 months (Fig. 20). Do Fed officials really want to enable such fiscal excesses by rapidly lowering interest rates?

Then again, we can’t ignore the possibility that some members of the FOMC strongly dislike Donald Trump, especially since he is more likely to challenge the Fed’s independence than Kamala Harris. That might sway them to go for 50bps on Wednesday if that is more likely to reduce Trump’s chances of winning than a 25bps cut. Of course, they will totally repudiate any such suggestion. After all, the Fed is apolitical.

Then again, we previously speculated that Powell’s abrupt shift from inflation hawk to employment dove in his August Jackson Hole speech might reflect his desire to be reappointed Fed chair when his term expires on May 15, 2026. That almost certainly won’t happen if Trump wins. If Harris wins, she might reappoint Powell; though Lael Brainard—who is the current director of the National Economic Council and more liberal than Powell—probably has a better shot at winning the prize.

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Defense, P/Es & DNA Origami

September 12 (Thursday)

Industrials: Time for Defense with Defense? Wars are bad for humanity but good for the defense industry. Many defense contractors have benefitted from bigger US defense budgets at home and abroad due to the wars between Ukraine and Russia and between Israel and Hamas as well as the political tensions between China and Taiwan.

The S&P 500 Aerospace & Defense stock price index has risen 14.2% ytd through Tuesday’s close, outperforming the S&P 500 Industrials sector’s 12.0% gain and keeping pace with the S&P 500’s 15.2% increase (Fig. 1 and Fig. 2). If perpetual underperformer Boeing—down 38.6% ytd—is excluded, the S&P 500 Aerospace & Defense stock price index’s performance improves to 27.1% ytd. The index’s performance is even more impressive over the past two years, when it climbed 33.3%—or 37.8% excluding Boeing—while the S&P 500 increased 35.1%.

Investors are expecting strong earnings growth. While the Aerospace & Defense industry’s revenues increased 5.7% in 2023, it’s expected to dip 3.2% this year and grow 8.6% in 2026 (compared to 3.4%, -3.6%, and 1.8% excluding Boeing) (Fig. 3). The industry’s earnings growth has been extremely strong, 29.5% in 2023, moderating to an expected 18.5% this year and reaccelerating to 30.5% in 2025 (or 10.1%, 13.0%, and 10.3% excluding Boeing) (Fig. 4).

However, the industry’s strong track record is well known. The Aerospace and Defense industry’s forward P/E has increased by almost five points over the past year to 24.8, close to its recent record of 25.0, which is also far above its average of 16.3 over the past 30 years (Fig. 5). Excluding Boeing, the forward P/E falls to 23.1.

What could make investors regret buying into the industry after its strong run? While it’s hard to imagine, peace could break out. More likely, a new president could go on a spending spree that pinches the government’s budget and limits future increases on defense spending.

Byron Callan of Capital Alpha Partners wrote an excellent report highlighting the potential impacts that the next administration’s policies may have on the budget deficit and defense spending. He also noted that President Trump’s proposal to put Elon Musk in charge of a government efficiency commission might cast a shadow over defense contractors. And as the number of high-school graduates peaks in 2025, the military might need to boost wages to recruit enough military personnel.

Let’s take a look at some of the most successful stocks in the Aerospace & Defense industry and some of the clouds that have been ignored:

(1) The outperformers. Howmet Aerospace is the top performing aerospace and defense stock this year, up 72.1% ytd through Tuesday’s close. The company makes aircraft parts and forged aluminum wheels for commercial transportation. It has benefitted from strong travel demand and an aging aircraft fleet that has resulted in large backlogs at aircraft manufacturers, CEO John Plant said in the company’s recent earnings press release.

The stock rode its latest leg up after Howmet reported Q2 adjusted earnings per share (EPS) of 67 cents, higher than last year’s 44 cents and analysts’ consensus forecast of 60 cents. The company also boosted its full-year EPS estimate to $2.55, up from a prior forecast of $2.35.

The Aerospace & Defense industry’s second-best performer, up 43.0% ytd, is RTX, the former Raytheon Technologies. It has bested the share price performance of other large defense contractors this year, including Lockheed Martin (26.2%), General Dynamics (16.5), Northrop Grumman (11.1), and L3Harris Technologies (8.2).

The large defense contractors have benefitted from massive government spending on munitions and equipment (Fig. 6). Most recently, Congress approved in April a $95 billion aid package, two thirds of which will fund new military equipment for Ukraine, Israel, and Taiwan, an April 28 WSJ article reported. RTX delivered Q2 results that beat estimates and raised its full-year earnings guidance to $5.40 a share from $5.33.

Rounding out the top three share price performers in the Aerospace & Defense industry is Axon Enterprise, which has jumped 39.1% ytd. The company makes tasers, body cameras, and cloud-based digital evidence systems used by law enforcement. Investors are excited about Draft One, which “writes the first draft of a police report based on Axon Body camera recordings,” an August 7 Investor’s Business Daily article reported. “Axon says the AI-enabled product saves more than 50% of the time in writing reports.”

(2) Spending constraint coming? The US Department of Defense’s (DoD) budget has been growing far faster than the US economy in recent years as it has juggled involvement in wars around the world. The budget, including supplemental spending, increased by 7.0% for the fiscal year ending this month, 9.7% in fiscal 2023, and 10.2% in fiscal 2022, according to this DoD report. Defense spending has risen under presidents of both parties, though the largest jump undoubtedly occurred during the Reagan years (Fig. 7).

The federal deficit is unusually high given the economic growth of recent years (Fig. 8). At some point, however, the growing federal budget deficit may force the US to slow—or even stop—the annual increase in military budgets. This might occur during the next administration if the same party controls the Oval Office and both houses of Congress, which would allow the new president to push through new, expensive policies. Former President Trump’s proposal to reduce the corporate tax rate to 15% would be particularly expensive. Both he and Vice President Harris have proposed spending increases and/or tax cuts without explaining how they'll fund their initiatives.

If the federal deficit balloons, Bond Vigilantes could force fiscal responsibility back into vogue. So oddly enough, defense investors would be wise to keep an eye on Treasury yields, which admittedly have shrugged off concerns over the growing deficit and fallen of late.

Strategy: A Look at P/Es. The S&P 500 has dropped 3.0% since its peak on July 16, but its forward P/E has barely budged: 21.2 as of September 9 versus 21.6 on July 16. That’s because internal shifts in the share price indexes and forward P/Es among the index’s 11 sectors have netted out to a wash: The stock price indexes of some sectors have fallen sharply since July 16 (e.g., Information Technology is down 9.5%) while those of other sectors have risen (like Utilities, up 9.3%). Similarly, the forward P/Es of some sectors and industries have increased while others have decreased.

Here’s a more detailed look under the S&P 500’s hood:

(1) Tech-related P/Es fall. Even though the S&P 500 has fallen since July 16, most of its sectors' forward P/Es have risen. Here are sectors with rising forward P/Es since the S&P 500 peaked on July 16: Real Estate (38.0 on September 9, 34.7 on July 16), Industrials (21.4, 20.3), Consumer Staples (21.4, 20.2), Materials (20.0, 19.1), Health Care (19.5, 18.7), Utilities (17.7, 16.5), Financials (15.9, 15.1), and Energy (12.2, 11.9) (Table 1).

Conversely, sectors with many technology-related industries have declining forward P/Es since the market’s July 16 peak: Information Technology (28.4 on September 9, 31.3 as of July 16), Consumer Discretionary (23.8, 25.3), and Communication Services (18.2, 19.8).

(2) Most sectors’ P/Es higher y/y. Notably, all but one of the 11 sectors—Consumer Discretionary—still have higher forward P/Es today than they did a year ago. Here’s the performance derby for the S&P 500 sectors’ forward P/Es currently and a year ago: Real Estate (38.0 on September 9, 33.0 a year ago), Information Technology (28.4, 25.8), Consumer Discretionary (23.8, 24.1), Industrials (21.4, 17.9), Consumer Staples (21.4, 17.9), S&P 500 (21.2, 18.7), Materials (20.0, 17.5), Health Care (19.5, 17.0), Communication Services (18.2, 16.7), Utilities (17.7, 15.6), Financials (15.9, 13.3), and Energy (12.2, 12.0).

(3) A look at industries’ P/Es. Two of the industries with the highest forward P/Es have nothing to do with Information Technology. Movies & Entertainment has a 31.5 forward P/E, up from 27.0 on July 16 and 24.4 a year ago. Likewise, the Consumer Staples Merchandise Retail industry—home to Walmart, Target, and the dollar stores—has a forward P/E of 31.3, up from 30.6 on July 16 and 24.4 a year ago.

The next three industries with the highest forward P/Es are each in the tech space, and two of them have forward P/Es today that are lower than they were at the market’s July 16 peak but still higher than a year ago. They are Systems Software (30.9, 34.4, 29.2) and Semiconductors (29.7, 33.9, 24.7). Application Software’s forward P/E is lower today, at 29.7, than it was at the July peak of 31.0 and a year ago, 30.8.

Almost every industry in the next grouping has elevated forward P/Es relative to the market’s July peak and year-ago levels—and none of them are from the Information Technology sector: Financial Exchanges & Data (28.3 currently, 25.0 a year ago), Consumer Discretionary Retail Composite (26.7, 28.6), Industrial Gases (26.4, 24.9), Aerospace & Defense (25.8, 19.9) Construction Materials (25.5, 24.8), Restaurants (24.9, 23.7), Automobile Manufacturers (24.9, 26.3), Health Care Equipment (24.6, 23.5), and Household Products (24.1, 22.8).

As technology-related industries have gotten less expensive during the recent selloff, a wide variety of other industries have grown more expensive. Which raises the question: Can the market’s selloff be over before all industries’ valuations get a haircut?
 
Disruptive Technologies: DNA Origami Fights Cancer. In DNA origami, a strand of DNA is folded to create 2-D or 3-D structures. These micro-structures have been around for a number of years, but scientists in Sweden have managed to use them to deliver cancer-killing materials to tumors. The result appears to be more effective drug delivery. That’s a big development in cancer treatment because cancer-fighting drugs released into the body the usual way can do as much damage to healthy cells as they do to cancerous cells.

Researchers at Sweden’s Karolinska Institutet had previously developed “structures that can organize so-called death receptors on the surface of cells, leading to cell death,” a July 1 institute press release stated. Unleashed in the body, these structures would kill good and bad cells alike. But when the researchers put the “death receptors” in DNA origami, they were released only in low acidic environments such as usually surround cancer cells.

The scientists’ DNA origami—sometimes called a “nanorobot”—worked as expected in a test tube, only releasing the cancer-killing material in a low acidic environment. When it was injected into mice with breast cancer tumors, there was a 70% reduction in tumor growth compared to mice given an inactive version of origami DNA.

Researchers need to evaluate the side effects before testing this on humans. They also plan to test whether putting proteins or peptides on the surface of the DNA origami would make it better able to bind and deliver the drugs to certain types of cancer.

Researchers at Harvard University have also been experimenting with DNA origami. They inoculated mice with a DNA origami vaccine on day zero and seven, then they inoculated the mice with cancer cells at day 14. By day 28, all unvaccinated mice developed tumors, whereas none of the vaccinated ones did, a May 6 article in The Scientist reported. However, when mice that already had cancer cells were treated with the DNA origami, none of the cancers were eliminated.

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More On The Carry Trade, The Eurozone & Earnings

September 11 (Wednesday)

Market Risk: How Worrisome Is the Carry Trade? We believe a further unwind of the yen carry trade caused US stocks to sell off last week. Some of our accounts have asked us about the risk of further selling pressure. We don’t think the carry trade is fully washed out. That said, macroeconomic conditions in Japan and the US lead us to believe that a third episode of the carry trade unwind is unlikely or won’t be extreme. Here’s why:

(1) Carry-trade refresher. Carry traders borrow cheaply in low-yielding currencies like the yen to buy assets in higher-yielding currencies. Many of those who’ve recently been unwinding their positions had bought US dollars, used to fund purchases of US momentum stocks. Some used the leverage to buy Japanese stocks, such as those in the Nikkei 225, which is why Japan’s equity markets suffered alongside the Nasdaq and S&P 500.

The yen carry trade opportunity emerged from the Bank of Japan’s (BOJ) highly unconventional, and stimulative, monetary policy. Near-zero interest rates were maintained even as the rest of the world’s central banks raised rates to multi-decade highs. That sank the yen to a historically low 162 against the US dollar earlier this year. Carry traders reveled—until the Fed was expected to lower US interest rates as the BOJ began to raise Japanese rates.

The spread between 10-year Japanese government bond (JGB) yields and US Treasury yields has narrowed from 381bpts at the end of April to 282bpts today, boosting the yen to below 143 per dollar (Fig. 1). Traders had to sell their US tech stocks and Japanese stocks to pay back their borrowed yen. The fact that they had levered positions, enabled by borrowed funds, exacerbated the impacts of the unwinding. That resulted in a stronger yen and weaker stocks than fundamentals suggested.

Accordingly, there’s been a strong inverse correlation between the yen and the Nasdaq 100 since last year (Fig. 2).

(2) How big is the carry trade? Our proxy shows there’s plenty of leverage left in the system. Foreign deposits (net short-term foreign liabilities) in Japanese banks reached a record ¥99.5 trillion in Q1-2024. That’s down to ¥89.7 trillion, still larger than the ¥74.3 trillion that sat in Japanese banks three years ago. This series is highly correlated with the yen (Fig. 3).

Roughly $622 billion are in Japanese banks as short-term deposits. Time to panic? We aren’t sweating. Those liabilities have grown just 20% (in yen terms) over the past four years, or by a third from the February 2020 level. We suspect that many of these deposits are structural. The generational carry-trade opportunity, which built up over more than a decade, isn’t likely to evaporate even as both Japan’s and America’s central banks “normalize” monetary policy.

We’ll hedge our optimism, though. Some commentators have pointed to data showing leveraged funds’ taking futures positions tied to the yen, which declined from a huge short to basically neutral during the August volatility (Fig. 4). They say that data show the carry trade is behind us. We don’t prefer that series to estimate the size of the carry trade. Levered funds using futures are primarily quant funds that follow trends—which no doubt contributed to “Carry Trade Unwind, Part I”—but they rode the final innings of the wave and do not represent the main carry traders.

(3) Why we are not panicking. The BOJ meets in the two days following the Federal Open Market Committee’s interest-rate decision on September 18. We expect the Fed will cut the federal funds rate (FFR) by 25 bps, and eventually ease slower and by less than the financial markets currently expect. FFR futures show the policy rate dipping below 3.0% in a year’s time. We doubt the easing cycle will be that extreme—barring a recession of course, which we do not foresee (Fig. 5).

The differential between US and Japanese bond yields has mostly been Fed-driven to this point. Weaker-than-expected US labor market data in particular have impacted yields and the yen. BOJ Governor Kazuo Ueda piled on recently by reiterating the BOJ’s commitment to raising rates. But we don’t expect Gov. Ueda to rebrand the central bank that’s long been the world’s most dovish into a hawk.

The BOJ might not need to do much more, anyway. Japanese inflation is heavily driven by imports. Japan’s services CPI hit a peak of 2.3% y/y in November 2023 (Fig. 6). Goods CPI reached 7.2% in January 2023. After sinking to 2.1% at the start of this year, goods CPI has rebounded to 4.0% as of July. The weak yen raised the cost of imports such as food, energy, and manufacturing inputs. The yen has strengthened by roughly 12% in the past couple months—that should help keep inflationary pressures in check.

The yen carry trade was a vestige of the pandemic period of free money. As the BOJ has only just started monetary tightening, it makes sense that financial markets are coming under pressure. We expect tamer inflation pressures in Japan and stronger growth data in the US to prevent the yen from strengthening dramatically from here.

Eurozone: Flatlining. The Eurozone economy is running on fumes. European stock markets are losing their spark, bond yields are under downward pressure, and the European Central Bank (ECB) is walking a tightrope between stabilizing inflation and maintaining economic growth. Fiscal support from the pandemic is fading, and the region is grappling with the structural headwind of an aging population. Inflation remains stubborn, unemployment low, and Germany—once the bloc’s economic powerhouse—is on the brink of recession.

Former ECB President Mario Draghi recently called for unprecedented action to support the flailing Eurozone economy, as discussed below. One of the key focuses of his voluminous report was Europe’s productivity gap with the US (Fig. 7).

We agree with Mr. Draghi that Europe faces a mountain of challenges to return to a positive growth trajectory and catch up to the US. That’s why we have been cautious on Eurozone markets and overweight the US. Here’s a closer look at why:

In light of the challenges, a cautious stance in Eurozone markets might still be prudent. Here’s a closer look at what lies beneath:

(1) Stocks losing momentum. The EMU MSCI has drifted 5.7% lower since May 15, after posting a 45.8% gain since September 2022 (Fig. 8). Slightly broader than the Eurozone, the EMU index includes the stock markets of two countries that have not yet adopted the euro, namely Denmark and Sweden.

The France, Germany, and Italy MSCI indexes rose 32.8%, 47.8%, and 71.1% in euros from September 29, 2022 through September 2, 2024 before each erased a portion of those gains through September 6 (Fig. 9).

(2) Fundamentals tracking sideways. Currently, the EMU MSCI index seems appropriately valued at a forward P/E multiple below 15, representing a discount from the historical average (Fig. 10).The time-weighted average of EMU MSCI revenues per share grew 5.0% from a recent low on February 1, 2023 through February 21, 2024, and has moved virtually sideways since then (Fig. 11).

From a recent low on February 21, 2024 through August 1, the EMU MSCI forward profit margin increased from 9.2% to 9.5%, but has failed to gain as much ground since through September 6 (Fig. 12). The EMU MSCI’s forward earnings per share gained 3.0% ytd, but the series seems to have peaked during the summer (Fig. 13).

Comparably, the All Country World MSCI’s forward revenues and earnings per share (including the EMU countries) are collectively tracking higher since the summer (Fig. 14 and Fig. 15).

(3) Bond yields pressured downward by global forces. Eurozone bond yields are being pulled by the gravitational forces of the global economy, particularly by weak US jobs data and heightened global expectations of central bank rate cuts (Fig. 16).

US 10-year bond yields fell from a recent high on April 25 of 4.70% to 3.72% on September 6. In turn, German, French, Italian, and Spanish 10-year bond yields have fallen from recent highs around July 1, 2024. Sovereign bond issuance is also expected to fall in the Eurozone, supporting prices and weighing on yields.

(4) Flat-to-sluggish indicators. Q2’s real GDP growth was a disappointing 0.6% y/y, dragged down by Germany’s result. Eurozone retail sales (excluding autos and motorcycles) edged up slightly in July after trending mostly flat since early 2023, signaling hesitant consumer confidence (Fig. 17).

The Economic Sentiment Indicator also has trended mostly flat this year, while the Industrial Production Index has slipped, reflecting the ongoing challenges facing manufacturers (Fig. 18 and Fig. 19).

Unemployment remains historically low at 6.4% as of July 2024 (Fig. 20). However, inflation remains a concern, with the core rate persisting at 2.8% y/y as of August. Only Italy has a core rate (2.3% y/y) near the ECB’s 2.0% y/y target (Fig. 21).

(5) Germany stuck in neutral. Germany’s economic engine is sputtering in 2024. After a mild contraction in 2023, the quarterly percent change (saar) for Q2-2024 declined 0.3%. On a yearly percentage change basis, Q2-2024 real GDP resulted in 0.0% growth (Fig. 22).

The industrial sector, once the backbone of Germany’s economy, continues to wrestle with weakened production (Fig. 23). Unemployment at 6.0% during August stands at its highest in over three years. Inflation, however, has cooled (Fig. 24).

Germany’s auto industry, led by Volkswagen, is a global leader in the production of electronic vehicles, but the outlook is dimming. Volkswagen faces fierce competition from cheaper Asian manufacturers. The recent scrapping of labor agreements with IG Metall has ignited fears of strikes and job losses, adding to the uncertainty.

(6) ECB holding rates. The delicate balance between curbing inflation and supporting growth requires careful avoidance of either stalling or overheating the Eurozone economy. The ECB’s strategy remains focused on maintaining inflation near its 2.0% target, even after successfully reining in inflation from its peak of over 10.0% in late 2022.

The ECB maintained an official deposit facility rate at 4.0% for roughly nine months, from September 2023 through June 2024. It lowered the rate to 3.75% during June but has refrained from cutting it further through September (Fig. 25).

(7) ECB tightening balance sheet. However, the ECB’s balance-sheet tightening signals its commitment to normalizing monetary policy after years of ultra-accommodative measures. By August, the unwinding of massive stimulus programs had shrunk the bank’s balance-sheet assets to around €6.5 trillion from a pandemic-era peak of €8.8 trillion (Fig. 26).

(8) Fiscal policy pulling support. Fiscal policy in the Eurozone has been the ballast for much of 2023, with energy subsidies and price caps helping to cushion the blow of inflation and the energy crisis. With fiscal support waning, the Eurozone must carefully manage its resources to ensure continued growth while safeguarding its financial stability amid the economic challenges of an aging population.

(9) Demographic crossroads. The aged dependency ratio—measuring those 65 and older relative to the working-age population—climbed from 25.9% a decade ago to 33.9% by year-end 2023. The aging population presents looming challenges for sustaining an adequate workforce, needed social services, and economic growth.

(10) Draghi’s unprecedented proposal. On September 9, former ECB President Mario Draghi called on the EU to launch a massive investment initiative, proposing spending twice what was invested post-WWII. He urged issuing new joint debt to fund industrial and defense sectors despite resistance from some member states. He also stressed the importance of embracing AI and emerging technologies to drive productivity and maintain global competitiveness. One pathway Draghi describes is to relax the regulatory regime in Europe. We’re all ears, but it will take much more than a single report to get Europe back on the right track.

Strategy: Record-High Q3 Earnings Expected Amid Growth Scare. With three weeks before the Q3 earnings season kicks off, let’s review the consensus forecasts for revenues and earnings growth and the profit margin for three groups: S&P 500 index, the Magnificent-7 stocks, and the S&P 493 (the S&P 500 minus the Magnificent-7).
 
The y/y growth rate comparisons are challenging for the S&P 500 and the Magnificent-7, as the year-ago quarter saw record-high quarterly EPS for the S&P 500 and the beginning of massive spending on artificial intelligence (AI). However, Q3 is expected to deliver record high earnings across the board. Here’s what Joe found:

(1) Record-high quarterly earnings in transitional growth slowdown. The consensus of analysts expects record earnings in Q3-2024 for the S&P 500 and the Magnificent 7. The S&P 493 is expected to record a nine-quarter high in total earnings, only 2% shy of its Q2-2022 record high. It should hit a new record too after the usual positive surprise bias.
 
(2) Revenues y/y growth rate to slow in Q3. The Magnificent-7 is expected to record its slowest y/y revenues growth in four quarters—13.5%, down from a peak of 14.8% y/y in Q4-2023. The S&P 500 and S&P 493 should also see y/y revenues growth slow, to 4.1% and 3.2%, from six-quarter highs in the previous quarter. However, all three groups should grow revenues y/y for the 16th straight quarter (Fig. 27).
 
(3) Earnings y/y growth rate to slow in Q3. Analysts expect the Magnificent-7 to post a sixth straight quarter of y/y earnings growth, but growth is forecasted to slow sharply to 18.3% from a 57.1% y/y peak in Q4-2023. With forecasts of 5.3% and 2.2%, the S&P 500 and the S&P 493 should see earnings growth slow in Q3 from Q2’s strongest y/y pace in 10 and eight quarters, respectively, marking their fifth and third straight quarters of growth (Fig. 28).

(4) Mixed direction for Q3 margin forecasts. The Magnificent-7’s profit margin is expected to edge down 0.3ppt q/q to 23.3% in Q3 from a record-high 23.7% in Q1-2024. Q1’s record-high margin compares to a pre-AI spending boom margin of 17.8% a year earlier! Profit margins for the S&P 500 and S&P 493 are expected to improve again in Q3, but markedly slower than the gains seen during five of the prior six quarters. The S&P 500 is expected to hit a nine-quarter-high profit margin of 12.9%, albeit below its 13.7% record high in Q2-2021. The S&P 493’s profit margin is forecasted to hit a four-quarter high of 11.7%, down from a 12.6% record high in Q2-2022. By the way, analysts expect a new record-high profit margin for the S&P 493 in Q2-2025 (Fig. 29).

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On The Labor Market & Productivity

September 10 (Tuesday)

US Labor Market: Layoffs Remain Mostly MIA. Unemployment trends continue to buck the widely held expectations for an employment-led recession induced by tighter monetary policy.

For instance, temporary layoffs due to extreme weather faded in August. Eric and I have observed that the growing labor force, rather than outright job losses, has been the source of rising unemployment since early last year. That was supported by Friday’s employment report. Importantly, several Fed officials agree with us rather than with those expecting the labor market to rapidly deteriorate. That aligns with our expectation for a gradual pace of interest-rate reductions rather than the rapid cuts that the financial markets expect.

Here's how we see the labor market:

(1) Reasons for unemployment. The headline unemployment rate fell from 4.3% to 4.2% in August, up from 3.8% a year ago. The primary source of the past year’s rising unemployment has been workers entering the labor force rather than permanent layoffs, suggesting that rising supply rather than weakening demand is driving the unemployment rate higher.

Temporary layoffs jumped to 14.8% of total unemployment in July thanks to weather- and summer-related factors, including Hurricane Beryl, extreme heat in California, and factory retooling (Fig. 1). Those layoffs then declined to 12.3% in August as weather-impacted employment plummeted from1.54 million workers to 152,000 in August (Fig. 2). Permanent and temporary job losers now account for 36.0% of total unemployment, below the 40.1% driven by new entrants and re-entrants to the labor force.

(2) Labor force flows. Layoffs are muted. As a percentage of the total labor force, just 1.06% of workers who were employed transitioned into unemployment last month, down from 1.09% in July (Fig. 3). Unemployed workers who remained unemployed edged lower, from 2.14% to 2.12% of the labor force. That's still elevated from around 1.80% at the start of the year, however, as hiring has slowed. Workers previously outside the labor force who are newly unemployed have risen above 1.00% of the labor force.

(3) Prime aged workers. Meanwhile, employment among prime-aged (25-54 years old) workers remained near record highs of 80.9% of the working-age population (Fig. 4). Workers are not reeling at the prospect of being laid off, as confirmed by Challenger data and unemployment claims (Fig. 5). That’s partly why real wages continue to rise.

Meanwhile, workers aged 16-19 years old have risen to 12.5% of total unemployment as of August, up from 6.3% in May 2021 (Fig. 6). Teen workers were in high demand during the pandemic to fill the labor shortage; as demand has normalized, so has unemployment for this cohort. There’s a similar story for workers aged 25 and over with less than a high-school degree (Fig. 7). We suspect both these groups are competing with immigrants for unskilled jobs.

(4) No recession. In periods leading up to previous economic slowdowns, the number of employed workers transitioning into unemployment fell to new lows or held steady at low levels. Then came a financial crisis, resulting from the tightening of monetary policy, which caused a rapid spike in layoffs and the unemployment rate.

The gradual rise in job losses over the past year does not match this trend; indeed, our Credit Crisis Cycle theory predicts it would not given current economic conditions. Absent a financial crisis causing a credit crunch and then a recession, there’s no wave of layoffs. (Our Credit Crisis Cycle theory posits that credit crises triggered by monetary tightening typically cause recessions, not the “long and variable lags” of economic reactions to tightening.)

Fed Governor Waller agrees with us, based on his speech last Friday: "Recession rules typically pick up demand-driven recessions. But this is not why unemployment is rising now. GDP forecasts for the current quarter all show solid growth, labor market data show lay off rates are stable, and consumer spending is growing at a healthy rate. These data suggest that demand is fairly strong. Instead, most of the increase in the unemployment rate is from workers entering the labor force and not finding jobs right away. So, the recent rise in the unemployment rate appears to be more of a supply-side-driven phenomenon, not demand driven.”

Gov. Waller repeatedly mentioned in his speech that the labor market is moderating rather than deteriorating.

New York Fed President John Williams’ Friday morning comments echoed a similar sentiment: “The increase in unemployment has occurred in the context of a strong increase in labor supply, rather than from elevated layoffs... these data indicate that the labor market is now roughly in balance and therefore unlikely to be a source of inflationary pressures going forward.”

(5) Hiring outlook. The Fed’s easing cycle will kick off on September 18. We are expecting a measured and shallow pace of rate cuts. The November presidential election will enter the rearview mirror in roughly two months. From there, we expect business certainty to increase and the hiring environment to improve. In Q2, CEOs’ outlook for the labor market over the following six months reflected a “normalization” (Fig. 8). The percentage of executives expecting to decrease employment over the next six months fell to the lowest since Q3-2022.

(6) Beveridge Curve. Aggregate weekly hours and average hourly earnings both increased 0.4% m/m in August. That supports our productivity-led Roaring 2020s outlook, which forecasts continued real GDP growth in line with historical averages. This would coincide with a halting of the fall in the ratio of openings to unemployed workers to a roughly equal level (Fig. 9). That would also mean that the Beveridge Curve—the relationship of vacancies to the unemployment rate—would not enter the elbow of the curve that precipitates a steep rise in unemployment (Fig. 10). Governor Waller is one of the most cited economists regarding the current state of the Beveridge Curve, and his comments suggest he’s not worried about it, either.

US Economy: Productivity Boom. US economic output was revised higher by the Bureau of Labor Statistics (BLS) for Q2-2024, while hours worked for the quarter remained unchanged. That boosted nonfarm business productivity growth to an impressive 2.5% q/q (saar) in Q2. Productivity has grown 2.7% y/y (Fig. 11).

This leads us to a few key conclusions regarding the economy’s trajectory:

(1) Fade the hard-landers. After the BLS payroll revisions reduced payroll growth from April 2023-March 2024 by 818,000, some said that meant the overall economy in fact was far weaker than previously realized over this period. However, there have been two quarters’ worth of economic data since that period that suggest otherwise.

We wrote in our August 22 Morning Briefing: “Reading through the lines, 0.5% lower employment implies 0.5% fewer aggregate hours worked for the same output. That means that Q1 y/y productivity growth was not 2.9% y/y but rather 3.4%.

Considering that hours worked was unchanged and GDP was revised higher to 3.0% q/q (saar) in Q2, that suggests that previous quarters’ growth and average hours worked won’t be dramatically revised lower, if at all (Fig. 12). Productivity therefore is even higher, as the output was higher with less labor.

(2) Disinflation. Thanks to rising productivity growth, unit labor costs (ULC) inflation was revised 0.5% lower to 0.4% q/q (saar) or just 0.3% y/y (Fig. 13). That’s the lowest rate since 2013. This series is the best metric for underlying inflation pressures.

(3) Capital, labor, and total factor productivity. Despite a stagnant manufacturing sector, capital intensity has been the primary driver of post-pandemic productivity growth. Record investment in software and R&D have been boons for tech companies that can scale up rapidly (Fig. 14). Non-tech companies are just beginning to reap the benefits of these new technologies. As non-tech companies start to use artificial intelligence (AI), robotics, and automation better to address the skilled-labor gap, that will boost total factor productivity (e.g., how well labor composition and capital intensity are used by companies in producing goods and now services).

Immigration has been a relative drag on productivity. As experienced Baby Boomers exited the labor force, new immigrants entered, many facing myriad barriers to job success (e.g., related to language, housing, work-status stability, and work experience). This improved GDP growth by growing the labor force but did not enhance productivity. Those workers will grow more experienced as they spend time in the US, supporting real wage growth rather than suppressing it (Fig. 15). Border apprehensions have plummeted in the past few months, so the exogenous increase in the labor force is declining just as the labor market cools.

(4) American ingenuity. Entrepreneurship took off during and after the pandemic. Monthly new business formation has slowed this year but continues to run at a pace of 420,000 applications per month (Fig. 16). That’s up from around 300,000 before the pandemic.

Surely, some of these applications were for single-person businesses. However, applications for businesses that the Census Bureau sees as having a high propensity to pay wages have surged as well, as have applications outlining concrete plans to pay employees wages in short order.

(5) Investment implications. Higher productivity increases profit margins by increasing output and weighing on ULC. It also supports real wage growth, and therefore personal consumption, while weighing on overall inflation. A sustained trend of higher productivity growth, which we foresee in our Roaring 2020s scenario, might even help to slow the burden of the federal debt relative to GDP (Fig. 17).

Corporate profit margins usually fall ahead of a recession. However, we expect the S&P 500 forward profit margin to widen to more than 14% next year. The companies best able to use AI, humanoid robotics, and other technologies will have the most to gain. The S&P 500 ex-Magnificent Seven have only just begun to improve their margins (Fig. 18). We expect above-trend productivity growth in the coming quarters to support those companies’ margins, improving stock market breadth as their stocks are re-rated to higher valuations (Fig. 19).

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Another Growth Scare

September 09 (Monday)

YRI Weekly Webcast. Join Dr. Ed’s live webcast with Q&A on Mondays at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Labor Market I: What Will the Fed Do Now? The financial markets have been expecting more cuts in the federal funds rate (FFR) than Eric and I have all year so far. At the start of this year, the markets anticipated six to seven rate cuts in 2024 (Fig. 1). We expected two to three at most.

The markets were more dovish on the rate outlook than we were because of investors’ widespread belief that the Fed would have to lower interest rates several times to avert a recession, following the historical script. At such times in the past after a round of tightening, the economy fell into a recession even though the Fed eased in response to its weakening. This time, we’ve had more confidence in the resilience of the economy. Since the summer, we’ve been predicting one rate cut in September for the rest of this year and thinking maybe two to four cuts in 2025. We’ve been more on the mark than the market so far in 2024: There hasn’t been even a single rate cut yet this year.

Now our one-and-done outlook for the remainder of 2024 looks less likely after Friday’s weak employment report. Consider the following:

(1) September odds at 100%. The market’s odds of a 25bps cut on September 18, when the latest FOMC Statement will be released, are now at 70%. The odds that the cut might be 50bps are 30% currently. That’s according to the CME Group’s FedWatch. Five of the last six rate cutting cycles began with 50bps rate cuts. (Hat tip to John Mauldin.) Rate cuts now are also widely expected following the November and December FOMC meetings.

(2) Markets expecting multiple cuts. The federal funds rate (FFR) futures market is currently anticipating 25bps rate cuts in November and December (Fig. 2). Six and nine 25bps cuts in the FFR are expected over the next six and 12 months. Those expectations suggest that the FFR will fall 150bps to 3.75% in six months and 225bps to 3.00% in 12 months. Of course, those expectations were heightened by Fed Chair Jerome Powell’s Jackson Hole speech on August 23, when he said: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”

(3) The Fed’s projections. Every quarter, the FOMC releases the committee’s Summary of Economic Projections (SEP). The last one is dated June 12, and it showed the FFR at 5.1%, 4.1%, and 3.1% at year-ends 2024, 2025, and 2026 (Fig. 3). The so-called “longer-run” FFR was estimated to be 2.8%, up from 2.6% in March’s SEP (Fig 4). Presumably, the longer-run FFR is the committee’s projection of the so-called neutral FFR.

So the FFR futures market is predicting that September’s SEP will show that the committee’s projections have been lowered. We agree, though perhaps not as much as currently suggested by the futures market. June’s SEP anticipated just one rate cut by the end of this year (Fig. 5). September’s SEP might show two or three rate cuts. It will be interesting to see whether and by how much FOMC participants lower their FFR projections for 2025 and 2026. Again, we doubt they will be as dovish as the market’s current projections. In addition, we won’t be surprised if they slightly raise their assessment of the long-run FFR given the resilience of the economy.

(4) Our assessment. What about our projections for the FFR? Our contrary instinct is that what’s happening now is no more than another growth scare that will pass. Once again, we expect that the economy will surprise to the upside. Our assessment of Friday’s employment report is that it wasn’t as bad as widely believed. Furthermore, some of the apparent weakness in employment suggests that productivity growth may continue to surprise to the upside.

(5) Don’t fight the Fed. In any event, we learned early in our careers to respect the following adage: “Don’t fight the Fed.” Powell & Co. have clearly signaled that they are intent on lowering the FFR to avert a recession now that they’ve in effect declared “Mission Accomplished” on inflation—i.e., they’ve brought it down close enough to their 2.0% target that they are confident it will get there shortly on its own even if they start easing monetary policy to keep the jobless rate from rising.

Again, we aren’t convinced that the economy needs much help from the Fed to keep growing. However, we do agree that inflation will end up this year even closer to 2.0%, as we’ve been predicting since the summer of 2022. So an easier-than-necessary monetary policy may very well boost real economic growth. We expect that might come from faster productivity growth, rather than employment growth.

As for inflation, we will worry about it much more if either the Democrats or the Republicans sweep the November 5 elections.

US Labor Market II: What Will the Bond Market Do Now? The yield curve disinverted at the end of last week in response to the soft employment report. The 10-year US Treasury yield closed at 3.71%, while the two-year closed at 3.65%, a spread of 6bps (Fig. 6). In our opinion, this means that fixed-income investors are coming around to our view that the economy won’t fall into a recession, especially now that the Fed seems to be committed to lowering interest rates to avert such an event. Easier monetary policy should boost economic growth but might also increase the risks that inflation heats up again. So the yield-curve spread is likely to widen further once the Fed starts to lower short-term interest rates.

Consider the following:

(1) Ascending yield curve. The yield curve tends to invert during monetary policy tightening cycles. It starts to ascend (with the 10-year yield rising above the two-year yield) during monetary policy easing cycles as short-term rates fall faster than bond yield.

(2) Disinverting without a recession. In the past, inverted yield curves were often leading indicators of recessions. When they started to disinvert, recessions often followed quickly (Fig. 7). As we’ve observed many times before, all that can be explained with our Credit Crisis Cycle model. What is different this time is that last year’s mini-banking crisis didn’t trigger a credit crunch and a recession. So the yield curve may continue to steepen without either of those events occurring, especially now that the Fed is easing.

(3) Peak yield curve spreads. During the past six cycles, the yield-curve spread peaked at 220bps on average, within a range of 161bps to 290bps. If the two-year bottoms at 3.00% during the current monetary easing cycle, then the 10-year yield should be 5.20%, well above its current reading of 3.71%. The current reading implies that the two-year yield could fall to 1.51%, which seems farfetched.

Obviously, there are lots of ways to play this yield-curve forecasting game. We think that the neutral two-year yield is around 3.00% and that the neutral 10-year yield is around 4.00%.

US Labor Market III: Payroll Survey Wasn’t That Bad. Yes, we know, payroll employment rose just 142,000 in August, and private industry payrolls increased only 118,000 (Fig. 8). But the weakness was mostly attributable to a 24,000 decline in manufacturing employment. There were solid gains in leisure & hospitality (46,000), health care & social assistance (44,100), and construction (34,000).

Yes, we know, July’s payroll gain was revised down by 25,000 to only 89,000. We blame bad weather for July’s weak reading. However, we don’t have a simple explanation for the downward revision in June’s employment by 61,000 to 118,000.

On the other hand, some of the best wage gains in August occurred in industries with relatively low employment gains (Fig. 9). This might be a sign that the supply of workers with the required skills in many industries isn’t as plentiful as the overall supply of workers!

Meanwhile, we found plenty of good news in the payroll survey section of Friday’s employment report:

(1) Hours worked. Private-industry payroll employment rose just 0.1% m/m, but average weekly hours increased 0.3%. So aggregate weekly hours rose 0.4% to a record high during August (Fig. 10). This series is up 1.1% y/y, suggesting that real GDP is growing by at least 3.0% y/y assuming that productivity continues to grow by over 2.0% y/y, as it has been since Q3-2023 (Fig. 11).

(2) Wages & salaries. Average hourly earnings rose 0.4% during August. So our Earned Income Proxy for private-industry wages and salaries in personal income rose 0.8% to a record high last month (Fig. 12).

(3) Real income. We estimate that the CPI rose 0.2% y/y during August. Therefore, real incomes probably rose solidly during August, suggesting that we’ll learn retail sales did too when it’s reported on September 17.

(4) Record highs. The following industries registered record-high employment readings in August: ambulatory health care (8.9 million), construction (8.3 million), financial activities (9.3 million), food services & drinking places (12.4 million), hospitals (5.6 million), government (23.3 million), leisure & hospitality (17.0 million), professional & business services (23.0 million), social assistance (4.8 million), and wholesale trade (6.2 million).

To be balanced, we should note a few weak series in the payrolls report in addition to the headline numbers mentioned above:

(5) Employment diffusion. The payroll employment diffusion index, which measures the percent of private industries reporting higher payrolls, fell to 49.8% on a three-month span basis during August (Fig. 13). That’s the lowest since just after the lockdown.

(6) Manufacturing. Aggregate weekly hours in manufacturing remained flat in August (Fig. 14). This suggests that industrial production did the same last month. However, it is likely to surprise to the upside led by rebounding motor vehicle production, which dropped 12.3% m/m during July (Fig. 15). Auto manufacturing employment edged down from its cyclical high during July.

US Labor Market IV: Household Survey Wasn’t That Bad. The household section of August’s employment report wasn’t bad either, as it showed a gain of 168,000 workers and a drop in the unemployment rate to 4.2% from 4.3% in July. Nevertheless, the unemployment rate is still up from 3.4% at the start of 2023.

Over this period, the unemployment rate rose mostly as the pool of unemployed workers rose because it has been getting harder to find a job; job openings have been declining over the past couple of years (Fig. 16). The data show that most of this problem is affecting teens with no more than a high school education. We wonder whether this might be at least partly attributable to illegal immigration. Tomorrow, we’ll have a closer look at the dynamics of unemployment in the labor market.

Movie. “Reagan” (+) (link) is a compelling biographical film that delves into the life and legacy of Ronald Reagan. It could have been a better movie without the narration provided by a fictious Soviet profiler. In any event, Reagan deserves lots of credit for bringing down the Soviet empire without firing a shot. His “Tear Down This Wall” speech on June 12, 1987 certainly contributed to that outcome. So did his secret campaign to slash the Soviets’ oil revenues by lowering oil prices. His Strategic Defense Initiative also unnerved the Soviets. Of course, another decisive event was the Chernobyl disaster on April 26, 1986, though it wasn’t mentioned at all in the film. Dennis Quaid delivers a decent portrayal of the “Gipper,” who was also called “The Great Communicator.” They don’t make presidents like Reagan anymore. 

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Retailers, Markets & AI

September 05 (Thursday)

Consumer Staples: Mixed Signals. Two retailers positioned for good insight into the health of the low-end consumer segment are Dollar General and Walmart. Yet their earnings reports for last quarter were so different that you might think the two sell their wares on different planets.

Dollar General’s results were so disappointing that it lowered its full-year earnings forecast, and the stock fell 32.1% on the day of the report. Conversely, Walmart’s results were so strong that it raised its full-year earnings target; its shares have climbed 46.9% ytd. And the managements of the two retailers told Wall Street opposite narratives about low-end consumers on their earning conference calls. Why?

A bit has to do with the two companies’ different business models. Walmart is a global and online behemoth, offering high-margin services such as club memberships. Walmart has also been attracting middle- and high-end consumers looking to save a buck or two, particularly on essentials.

Moreover, investors and analysts are concerned that there may be too many dollar stores competing with Dollar General and that the company lacks enough exposure to Internet retailing. On Wednesday morning, another dollar store, Dollar Tree, reinforced this tale of woe. It cut its full-year earnings targets after reporting Q2 results, and its shares slid more than 20%.

Here's a quick look at the two versions of reality that Dollar General and Walmart served up when they reported earnings in recent weeks:

(1) Different Q2 results. Dollar General and Walmart reported similar top-line increases. Dollar General’s Q2 sales (August 2) climbed 4.2% to $10.2 billion. Walmart’s Q2 sales (July 31) jumped 4.8% to $169.3 billion, within which US revenue climbed 4.1%.

The picture starts to differ when discussing same-store sales. At Dollar General, same-store sales increased 0.5%, thanks to 1.0% growth in customer traffic offset by a decline in the average transaction amount, driven by a lower average unit retail price. At Walmart, US same-store sales rose 4.2%, thanks in part to the sale of the GLP-1 drugs, hardlines, home, and fashion businesses. The number of US transactions jumped 3.6%, and the average ticket rose by 0.6%.

The divergence gets more dramatic further down the income statement. Dollar General’s operating income fell 10.6% to $550.0 million. The company’s gross margin shrank by 1.12ppts due to markdowns, increased inventory damage, mix of goods sold, and increased shrink. The company’s selling, general, and administrative expenses went up as a percentage of revenue due to labor costs, depreciation and amortization, store occupancy costs, and utilities. Conversely, Walmart’s adjusted operating income rose 7.2%, which it attributed to higher gross margins, growth in membership income, and reduced ecommerce losses.

(2) Different forecasts. In the wake of Q2 results, Dollar General reduced its full-year forecast, and Walmart did the opposite. Dollar General now expects full-year net sales to increase 4.7%-5.3% (down from 6.0%-6.7% previously), same-store sales to inch up 1.0%-1.6% (down from 2.0%-2.7%), and diluted EPS to come in at $5.50-$6.20 (down from $6.80-$7.55).

At Walmart, net sales expected this fiscal year was boosted to an increase of 3.75%-4.76%—up from 3.0%-4.0% earlier. Consolidated adjusted operating income is now expected to increase 6.5%-8.0% (up from 4.0%-6.0%), and adjusted EPS is now pegged at $2.35-$2.43 (up from $2.23-$2.37).

(3) Different commentary. Dollar General executives painted a picture of a consumer who is financially stretched and having a tough time getting from paycheck to paycheck. Walmart executives sounded a much happier tune.

The last week of each month was Dollar General’s weakest in Q2, which implies that customers are “less able to stretch their budgets through the end of the month,” said CEO Todd Vasos on the company’s August 29 earnings conference call. He added, “We believe the softer-than-anticipated sales performance in Q2 is at least partially attributable to a core customer that is less confident of their financial position.”

Dollar General’s core customers, who predominantly come from households earning less than $35,000 annually, “state that they feel worse off financially than they were six months ago as higher prices, softer employment levels, and increased borrowing costs have negatively impacted low-income consumer sentiment.”

Due to rising prices on rent, utilities, healthcare, and other items, “cash strapped” consumers are refraining from purchasing basic necessities. More are using credit cards to pay for basic household needs, and 30% of them have at least one maxed-out credit card. A quarter of customers surveyed anticipate missing a bill payment in the next six months. Dollar General executives described consumer spending softening in July and the company ramping up promotional activity in August.

Walmart’s CEO Doug McMillon sang a happier tune: “So far, we aren’t experiencing a weaker consumer overall.” Nonetheless, the company has been lowering prices. “Customers from all income levels are looking for value, and we have it,” he said.

“We're also seeing higher engagement across income cohorts, with upper-income households continuing to account for the majority of gains, even while we grow sales and share among middle- and lower-income households,” said CFO John David Rainey. Ecommerce sales in Walmart US were up 22% y/y, with weekly active customers up 20%.

Walmart execs also explained how artificial intelligence (AI) is helping their business: AI is being used to describe items in the catalog more accurately, and it would have taken the company 100 times longer to update the catalog had it used humans to do the job. AI is helping employees pick and pack items faster by showing them high-quality images of the items. And an AI-powered search engine is helping customers find the products they want.

(4) Industry data. Both Dollar General and Walmart are members of the S&P 500 Merchandise Retail stock price index, which resides within the Consumer Staples sector. The industry’s stock price index—which also includes Costco (up 33.1% ytd through Tuesday’s close), Dollar Tree (-42.5), and Target (6.5)—has risen 28.4% ytd (Fig. 1). Thanks to the contributions of Walmart and Costco, the index’s forward revenues and forward operating EPS have climbed sharply to record highs, and its forward profit margin is 3.3%, a record high (Fig. 2, Fig. 3, and Fig. 4).

The Merchandise Retail industry’s revenue is forecast to grow 4.0% this year and 5.1% in 2025; meanwhile, the industry’s annual earnings growth is expected to jump 46.6% this year and 43.6% in 2025 (Fig. 5 and Fig. 6). With the largest members of this industry rallying the hardest, it’s not surprising that the industry’s forward P/E is 30.8, near a four-year high (Fig. 7).

Strategy: Some Leadership Changes. The 2.1% decline in the S&P 500 on Tuesday made for a tough start to the always prickly fall trading season. It abruptly ended the strong rebound that the market was enjoying since the last major selloff finished on August 5.

Market selloffs and recoveries often shake up the leadership board, and the sharp summer selloff is no exception. The S&P 500 Financials sector has dethroned all things technology to become the best performing sector from August 5 through September 2, rising 11.7%. Of course, Financials and Technology underperformed during Tuesday’s market selloff. But August’s market action may provide some insight into what sectors and industries will rebound once the fall selloff concludes. Consider the following:

(1) Anticipating lower rates. The growing expectation that the Federal Reserve will lower interest rates at its meeting later this month bolstered many industry indexes in the S&P 500 Financials sector from August 5 through September 2, including Consumer Finance (13.6%), Diversified Banks (13.5), Property & Casualty Insurance (12.3), Transaction & Payment Processing Services (10.2), Reinsurance (10.1), Regional Banks (10.1), Investment Banking & Brokerage (10.0), and Multi-line Insurance (9.8).

Expectations that interest rates will fall have also helped the Consumer Discretionary sector, which is the third best performing sector in the S&P 500, an improvement from its second-to-last ranking in the year prior to August 5. The S&P 500 Consumer Discretionary sector’s stock price index jumped 9.5% from August 5 to September 2. Industries that bolstered the sector’s performance during that period include Computer & Electronics Retail (25.1%), Footwear (15.9), Consumer Electronics (13.4), Hotels, Resorts & Cruise Lines (10.9), Restaurants (10.8), Broadline Retail (10.8), Apparel, Accessories & Luxury Goods (10.6), and Automobile Manufacturers (9.3).

(2) Sector performance derbies. Notably, the Energy sector is an underperformer both in the period since the August 5 selloff and in the year prior to the selloff.

Here’s the performance derby for the S&P 500 and its 11 sectors from August 5 through September 2: Financials (11.7%), information Technology (11.0), Consumer Discretionary (9.5), S&P 500 (8.9), Industrials (8.8), Real Estate (7.1), Health Care (7.0), Materials (7.0), Communications Services (5.9), Consumer Staples (5.8), Utilities (5.1), and Energy (4.7) (Table 1).

Here’s the performance derby for the S&P 500 and its 11 sectors for the year prior to the correction that ended on August 5: Information Technology (27.7%), Communication Services (26.9), Financials (17.2), S&P 500 (15.8), Utilities (13.0), Industrials (11.6), Health Care (10.9), Real Estate (9.6), Consumer Staples (6.6), Materials (5.5), Consumer Discretionary (1.4), and Energy (0.2) (Table 2).

(3) Nvidia weighs. One of the top performing industries in both time periods is Semiconductors. It’s up 16.5% from August 5 through September 2, making it the second-best performing industry during that time period. In the year prior to the August selloff, the Semiconductors industry was the top performer, up 66.2%.

The industry lost ground on Tuesday because of a report that its largest member, Nvidia, has received subpoenas from the US Justice Department, which is looking for evidence that Nvidia violated antitrust laws, a September 3 Bloomberg article reported. Nvidia shares fell 11.0% on Tuesday and Wednesday.

Here are the top five performing industries from August 5 through September 2: Computer & Electronics Retail (25.1%), Semiconductors (16.5), Independent Power Producers & Energy Traders (16.2), Footwear (15.9), and Passenger Airlines (15.7). In the doghouse were Drug Retail (-13.7%), Construction Materials (-4.0), Health Care Distributors (-2.2), Timber REITs (-2.1), and Food Retail (-1.3).

Disruptive Technologies: AI on Wall Street. Wall Street titans historically have been early adopters of technology, particularly if it enhances productivity and the bottom line. So it’s no surprise that AI has taken Wall Street by storm, with CEOs boasting of all the new AI programs being rolled out to summarize meetings, mine for potential investment banking clients, structure investment portfolios, and write legal documents. It’s still early days, but here are some of things the initial adopters have learned:

(1) Centralization helps. Firms that centralized their AI operations (instead of letting various business lines implement their own AI plans) have adopted generative AI more quickly. “Centralized steering allows enterprises to focus resources on a handful of use cases, rapidly moving through initial experimentation to tackle the harder challenges of putting use cases into production and scaling them,” a March 22 McKinsey & Co. report found.

(2) Limiting AI’s scope. Generative AI programs hallucinate, making up answers and leaving users unsure of their credibility. Morgan Stanley has addressed this problem by limiting its AI programs to searching only the firm’s data and content, not that of the Internet at large. Morgan’s AI program is available only to employees, it shows users justifications for each answer, and it provides links to source materials, a July 10, 2023 Investment News article reported.

(3) Talk of slimmer workforces. With AI making work easier and faster, there’s much speculation about how fast Wall Street firms will start trimming employees, particularly those in entry-level jobs. It turns out that AI is good at summarizing meetings, making PowerPoint presentations, and dumping data into Excel spreadsheets. This may mean that far fewer college finance majors hoping to become Masters of the Universe will be hired by Wall Street in the future, an April 10 NYT article suggested. For now, however, Wall Street firms are hiring briskly—but it’s technology folks they’re hiring, those able to build and implement AI platforms.

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GDP Vs GDI Debate; Mexico’s Failing Democracy

September 04 (Wednesday)

Weekly Webcast. If you missed Tuesday’s live webcast, you can view a replay here.
 
US Economy I: The GDP Vs GDI Debate. As you might know, Debbie, Eric and I have been bullish on US economic growth for some time. We’ve been bullish on US equities since early November 2022. As we discussed in yesterday’s Morning Briefing, our productivity-led Roaring 2020s scenario was confirmed at the end of last week by the upward revision to Q2’s real GDP growth and by July’s personal income and outlays data. Neither was enough to dampen the pessimism of the economy’s “nattering nabobs of negativity” (to quote former Vice President Spiro Agnew). Below, we discuss their latest protestations:

(1) In GDP we trust. Many pessimistic prognosticators correctly observe that Gross Domestic Income (GDI)—which measures economic activity via income such as wages and profits—was much lower than GDP last quarter. Real GDP rose 3.0% (saar) in Q2, while real GDI increased by 1.3%. That’s the largest gap between the two since Q1-1993, and before that, Q1-1980 (Fig. 1).

In the past, wide discrepancies between the two sometimes have been followed by downward revisions in GDP. Many bears are seizing on that fact to claim that GDI more accurately measures economic output. However, GDP has often been well above GDI without a recession emerging or very close to GDI ahead of a slowdown. If 1.3% real GDI is concerningly low, then surely the -3.0% print in Q4-2022 followed by two quarters of real GDI below 0.5% should have heralded a recession (Fig. 2). Hardly: Since then, employment has risen to new records, wage growth is accelerating faster than inflation, and the S&P 500 has climbed to new all-time highs.

The Bureau of Economic Analysis (BEA) has found no predictive value in initial estimates of GDI and subsequent revisions to GDP. Most official organizations recommend averaging GDP and GDI during the initial estimate phases for the best read on the state of the economy; the resultant 2.1% quarterly annualized growth would be consistent with our positive outlook. The Atlanta Fed GDPNow model is forecasting 2.5% Q3 GDP, another signal that the economy is growing at a solid pace.

Periods when GDP beats GDI tend to be followed by periods of the inverse, so GDP and GDI equal out over time. That could very well be the case this time around. However, we believe GDI has persistently undershot GDP in the post-pandemic period for structural reasons. Namely, the interest component of GDI is poorly calculated (Fig. 3).

(2) Interest income. GDI counts government interest expense on Treasuries, Fed reverse repurchase agreements (reverse repo), and interest on reserve balances (IORB) as interest paid rather than income. So these interest expenses weigh on GDI. In actuality, they are providing a massive amount of income to mostly domestic investors.

Net interest income has been a huge benefit to corporations and households alike. Personal net interest income ex-mortgage payments has risen to $1.3 trillion. Net interest payments for US nonfinancial corporations have fallen below 9% of profits, lows not seen since the 1960s (Fig. 4). Interest paid on reserve balances has been a huge boon for money-market fund (MMF) investors: More than $6.2 trillion of cash earns over 5.0% in MMFs. More than $2.5 trillion of those assets are owned by retail investors (Fig. 5).

(3) New regime. Why wasn’t this an issue for GDI in the past? When the Fed runs an ample reserve regime, as it does today, the renumeration of cash holdings is significant. This was not the case before the Great Financial Crisis (GFC), when the Fed operated in a scarce reserve regime and allowed supply and demand to set short-term rates. Today, there is $3.3 trillion earning 5.4% annualized, overnight and risk-free (Fig. 6). The Fed doesn’t have to fund these payments because they are booked to the deferred asset account—its line item of negative remittances to the Treasury Department. This is another example of how past monetary tightening cycles offer poor analogies for the current environment.

US Economy II: Less Interest-Rate Sensitive. We are sticking with GDP as our preferred indicator of economic growth. With that said, let’s look at what drives it and what has made it less interest-rate sensitive than in the past, thus reducing the likelihood that the so-called “long and variable lags” of monetary policy tightening will cause a recession soon:

(1) More than two-thirds of nominal GDP derives from personal consumption expenditures (Fig. 7). This has been fairly constant since the turn of the century, a time roughly coinciding with the Asian Financial Crisis, dot-com bubble, and China’s entrance to the World Trade Organization. US consumers spent more as foreign capital rushed into the US, boosting their purchasing power and pushing down savings. But the makeup of consumer spending has shifted dramatically: Services have risen to nearly 46% of overall GDP, while goods have slimmed to 22%. Goods were consumed at a higher rate than services entering 1970s and still represented a quarter of consumption entering the 1990s. Goods consumption spiked during the pandemic but quickly returned to its recent share.

(2) Private fixed investment in intellectual property (IP) has more than doubled over the same period to 5.5% of GDP. Investments in software and R&D, the predominant subcategories of IP, have surged since the GFC (Fig. 8). IP’s contribution to GDP now surpasses those of nonresidential equipment investment (which includes info processing equipment, another high-tech sector), residential investment, and structures. And that’s excluding R&D that’s booked overseas by US corporations for tax purposes. Software tends to be rented, requiring no large capital investment for the majority of companies using cloud services such as Amazon Web Services or Google Cloud.

(3) US consumers increasingly prefer services to goods, and US producers are providing more services or investing in high-tech sectors that require less financing. As the US economy shifts away from capital-intensive businesses, its sensitivity to higher interest rates decreases. It’s no surprise that weakness in the goods producing sector, consistent with several years of the ISM M-PMI remaining below 50.0, hasn’t made much of a dent in overall economic activity. It’s also no surprise that higher interest rates haven’t put inordinate pressure on US growth. We expect this to remain the case.
 
Mexico I: Mexican Muddle. Melissa and I first raised concerns about Mexican markets on May 29, noting that the once-promising economic indicators and the “nearshoring” narrative were losing their luster. The increasing grip of domestic organized crime and the growing influence of Chinese “backdooring” into Mexico were overshadowing these positive developments. Today, we’re further outlining why investors should tread carefully before investing in Mexico domiciled companies:

(1) Liquidity mirage. One of our contacts, a former Mexican equity analyst, corroborates our concerns, highlighting that companies domiciled in Mexico are virtually uninvestable due to illiquidity. Dominant Mexican families retain major ownership, resulting in meager public float and daily trading volumes, even among top-market-cap firms. Additionally, the nearshoring narrative is facing significant infrastructure challenges, the analyst believes.

(2) Market rollercoaster. The Mexican stock market has experienced turbulent highs and lows this year, with high inflation and political instability damping investor enthusiasm (Fig. 9). Claudia Sheinbaum’s imminent leadership as Mexico’s president, starting October 1, is unlikely to restore confidence in the market.

(3) Risky business. Morgan Stanley Research’s August note “Downgrade Mexico to Underweight” highlighted concerns about President Andrés Manuel López Obrador’s (AMLO) proposed judicial reform. This reform is expected to increase Mexico’s risk premium, according to the WSJ.

(4) Authoritarian overtones. AMLO’s Morena party, with its progressive agenda, continues to wield significant influence, raising concerns about authoritarian tendencies. Under Morena rule, cartels have thrived and backdoor dealings have proliferated, further undermining investor trust.

(5) Seat shuffle. In the last election, Morena manipulated seat allocations to secure 74% control of the lower house despite winning only 54% of the votes. Critics argue that this maneuver undermines democracy. The judiciary tribunal, under AMLO’s influence, is expected to decide whether Morena and its allies should be treated as a coalition.

(6) Final act. As AMLO’s term winds down, he is pushing for sweeping reforms, including electing all judges by popular vote. If not enacted before his departure, the Morena party, under Claudia Sheinbaum, is likely to continue these so-called reforms. US Ambassador Ken Salazar and the American Chamber of Commerce in Mexico have criticized the reforms as a threat to judicial independence and a potential strain on trade relations with the US. Sheinbaum, however, defends them as a legitimate enhancement of democracy.

(7) Musk’s reality check. Elon Musk, in his 2023 biography by Walter Isaacson, revealed why Tesla abandoned plans to build a new gigafactory in Mexico: Musk realized that success would require moving engineering operations to Mexico to closely integrate them with production. He noted, “Tesla engineering will need to be on the line to make it successful, and getting everyone to move to Mexico is never going to happen.” Additionally, concerns over potential political instability and tariffs, especially if Donald Trump were to return to office, influenced the decision to keep key operations in the US.
 
Mexico II: Growth & Challenges. Mexico’s present economic situation shows both positive and challenging aspects. Although the country is experiencing strong GDP growth and steady job creation, a closer look reveals slowing industrial production and high inflation:

(1) Growth and employment. Mexico experienced modest but steady real GDP growth of 1.0% y/y in Q2 (Fig. 10). Although total employment increased that quarter, jobs growth has slowed this year (Fig. 11).

(2) Inflationary pressures. Inflation reached a rate of 5.6% y/y during July, fueled by rising labor costs and a stronger peso (Fig. 12 and Fig. 13). The peso has moved up since early 2022, but it depreciated in recent months due to the uncertainty over the presidential election.

(3) Industrial and export performance. Mexico’s industrial and export sector growth is fragile. Industrial production saw a slight rebound in recent months after falling slightly from record highs during 2023 (Fig. 14). Total global exports from Mexico fell 1.1% y/y during the first four months of 2024, with oil exports down 8.7% and manufacturing down 0.7%, according to a July Dallas Fed Mexican economic update.

(4) Trade with the US. Trade with the US remains crucial, with two-way trade at a record $415.38 billion through June, reported an August 10 Forbes article.

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Someday, There Will Be A Recession

September 03 (Tuesday)

YRI Weekly Webcast. Join Ed’s and Eric’s live webcast with Q&A on Tuesday at 11 a.m. EST. You will receive an email with the link one hour before showtime. Replays of the weekly webcasts are available here.
 
US Economy I: This Time Has Been Different, So Far. Recessions don’t happen very often, and they don’t last very long. Most of the nine recessions since 1960 were caused by the tightening of monetary policy, which triggered a financial crisis and a credit crunch that caused a recession (Fig. 1). On four occasions since then, the recessions were precipitated by an energy crises, which caused the prices of crude oil and gasoline to spike (Fig. 2). On a few occasions, the recessions resulted from the bursting of speculative bubbles.

The Fed almost always responded immediately to previous financial crises by lowering the federal funds rate significantly. That helped to mitigate the credit crunch and shorten the recession. The one exception occurred in 2023, when the Fed responded to the March banking crisis by rapidly creating an emergency bank liquidity facility (Fig. 3). Of course, automatic fiscal stabilizers kicked in, providing income support through the unemployment insurance system (Fig. 4). That helped to moderate the downturns. Activist fiscal policy was usually late to the game, providing tax cuts and other stimulative measures that mostly helped to boost the recovery.

This time has been different so far, as Debbie, Eric, and I have observed on numerous occasions since early 2022:

(1) Normalizing vs tightening monetary policy. The tightening of monetary policy during 2022 and 2023 raised the federal funds rate by 525bps (Fig. 5). That was certainly among one of the biggest increases in this rate during monetary policy tightening cycles in history. However, the federal funds rate was raised from zero. So we’ve characterized some of the increase in the federal funds rate as normalizing rather than tightening monetary policy.

(2) Fed’s liquidity facilities. As noted above, there was a mini-banking crisis last year. But thanks to the Fed’s liquidity facility, there has been no credit crunch and no recession. The Fed played Whac-a-Mole during the Great Financial Crisis (GFC) and again during the Great Virus Crisis (GVC), learning to stabilize the credit system rapidly by creating emergency liquidity facilities.The difference last year was that the Fed didn’t also lower the federal funds rate as it did during the GFC and GVC.

(3) No need to cut the FFR often and rapidly. Therefore, it is very unlikely that the Fed will have to lower the federal funds rate as rapidly and by as much as was necessary during previous monetary easing cycles when financial crises triggered credit crunches and recessions. So far, there has been no credit crunch, as evidenced by the ongoing growth in loans and leases at commercial banks and the narrow yield spread between high-yield corporate bonds and the 10-year US Treasury bond (Fig. 6 and Fig. 7).

(4) Godot recession is still MIA. So far, the most widely anticipated recession of all times remains a no-show. Real GDP has been rising to new record highs since Q3-2022 through Q2-2024, which was revised last Thursday from up 2.8% (saar) to 3.0%. On Friday, following the release of July’s consumer spending report, the Atlanta Fed’s GDPNow tracking model estimate for Q3-2024 real GDP growth was raised from 2.0% to 2.5%, with real final sales revised up from 2.2% to 3.3% (Fig. 8)!

(5) The long-and-variable-lags myth. And what about the dreaded “long and variable lags” between the tightening of monetary policy and economic downturns? It may be that as more borrowers have to refinance their debts at higher interest rates, they will be forced to retrench. If enough of them do so, that could cause a recession.

That’s possible, we suppose. However, we ascribe previous long and variable lags to the time between the initial hike in the federal funds rate during monetary policy tightening cycles and the triggering of a financial crisis (Fig. 9). Once that happened, there were no lags as the financial crisis quickly turned into a credit crunch and a recession. There is no precedent for the current situation to be found in previous monetary policy cycles. It really is different this time, so far.

(6) Bottom line on the FFR outlook. So we are sticking with our one-and-done outlook: For the rest of this year, we think the Fed will cut the FFR once by 25bps on September 18. Next year, we expect from two to four rate cuts, though much will depend on the outcome of the presidential and congressional elections.

US Economy II: Another Quarter of Immaculate Disinflation. Also different this time, without any question, is that inflation has moderated without a recession. We first referred to this scenario as “Immaculate Disinflation” to describe our outlook in the September 6, 2022 Morning Briefing. We wrote: “What seems to be different this time (so far) is that the credit system is less vulnerable to a credit crunch than it was in the past. The result is what we now have: a rolling recession hitting different sectors of the economy at different times; we expect it to bring inflation down without precipitating an economy-wide downturn.”

Sure enough, the GDP deflator inflation rate peaked at 7.7% y/y during Q2-2022 before dropping to 2.6% during Q2-2024 (Fig. 10). Over this same period, the personal consumption expenditures deflator peaked at 6.8% and fell to 2.6% as well. Yet real GDP rose 3.1% over this period to a record $22.9 trillion (saar).

Here’s more:

(1) Consumption. Real personal consumption expenditures (PCE) rose 2.7% y/y to a record high too during Q2 (Fig. 11). Real PCE services increased 2.4% y/y to a record high, and real PCE of goods rose 3.3% y/y almost back to its Q4-2023 record high. Both real PCE nondurable and durable goods have been rising for the past five months after a brief growth recession following the pandemic goods buying binge (Fig. 12).

The personal savings rate fell to 3.3% during Q2 from 3.7% during Q1, providing a boost to consumer spending. We’ve previously observed a strong inverse correlation between the personal saving rate and the ratio of consumers’ net worth to their disposable personal income (DPI). The inverse correlation is even better using the ratio of their owners’ equity in household real estate to their DPI (Fig. 13).

That makes sense since consumers need to save less when their net worth is rising as a result of rising asset prices. In addition, as we’ve previously observed, the Baby Boomers are retiring with a record net worth of $78.6 trillion. They are no longer saving out of earned income but living on their retirement income and net worth. That should keep the saving rate low at least through the end of the decade.

(2) Capital spending. Also rising to a record high during Q2 was business capital spending in real GDP (Fig. 14). Two of its components—intellectual property (which includes software and R&D) and equipment—rose to record highs (Fig. 15). Spending on structures has stalled recently near its previous cyclical highs.

Spending on software in real GDP has soared well above spending on information processing equipment since Q2-2018 and well above spending on R&D since Q1-2021 (Fig. 16).

(3) Profits. After-tax profits from current production has remained stalled since Q2-2022 through Q2-2024 in record-high territory (Fig. 17). The same can be said about undistributed profits. Nevertheless, corporate cash flow rose to a record $3.5 trillion (saar) during Q2 as tax reported depreciation rose to a record $2.6 trillion (Fig. 18). That helps to explain why business capital spending remains so strong despite the tightening of monetary policy.

(4) Residential investment. The housing market remains in a recession but is showing signs of bottoming. Residential investment in real GDP bottomed recently during Q2-2023, but its recovery has been weak so far, and it ticked downward during Q2 (Fig. 19). It should continue to recover once the Fed starts lowering the federal funds rate in September, as widely expected.

(5) Trade. Exports of goods and services in real GDP edged up to a record high during Q2, confirming that the global economy is growing, albeit slowly (Fig. 20). Real imports of goods and services rebounded to a record high during Q2, led by goods imports. This confirms that demand remains strong in the US, and perhaps is getting stronger.

(6) Inventory investment. Inventory investment in real GDP contributed 0.78bps to real GDP growth during Q2 (Fig. 21). Both wholesale and retail inventory investment were positive following negative readings in Q1. In retailing excluding autos, Q2’s inventory accumulation followed seven quarters of liquidation. In the retail auto industry, inventory accumulation has been ongoing for the past 11 quarters, with Q2’s pace exceeding those of all the previous quarters.

(7) GDP vs GDI. The diehard hard-landers are warning that there will be a significant downward revision in real GDP growth because it doesn’t jibe with the much weaker growth rate of gross domestic income. Eric and I will explain why we aren’t concerned in tomorrow’s Morning Briefing. Stay tuned.
 
US Economy III: Another Month of Immaculate Disinflation. July’s batch of economic indicators confirmed that Immaculate Disinflation is likely to be the operative scenario during Q3. That’s despite weakness in July’s employment and industrial production reports. Both were depressed by bad weather. Nevertheless, both nominal and real consumer spending rose to record highs during the month (Fig. 22). So did nominal and real DPI (Fig. 23). The personal saving rate fell from 3.1% in June to 2.9% in July, which also boosted consumer spending.

Further boosting spending since early 2023 have been faster increases in wages than in consumer prices (Fig. 24). That can only happen sustainably if productivity is increasing, which is the case. During July, real average hourly earnings rose to a record high for production and nonsupervisory workers, who account for about 80% of private industry payroll employment.

Over the past 12 months through July, the core PCED rose 2.6%, the same as it did through June (Fig. 25). However, it was up just 1.7% over the past three months at an annual rate. On a y/y basis, PCED goods inflation was down to zero in July, while PCED services was down to 3.7%, with the supercore services inflation rate down to 3.3% and the lagging PCED housing and utilities at 5.3% but falling (Fig. 26).

So Q3 is already shaping up as another quarter of Immaculate Disinflation. The Cleveland Fed’s Inflation Nowcasting is projecting that the headline and core CPI rose just 0.20% and 0.26% in August. As noted above, the Atlanta Fed’s GDPNow tracking model is currently showing Q3’s real GDP up 2.5% (saar) with real consumption up 3.8% and real capital spending on equipment and intellectual property rising 10.2% and 5.6%. The one big downer is residential investment with a drop of 12.5%.

US Economy IV: The Sun Also Rises. Above, we observed that recessions don’t happen very often and don’t last very long. Let’s have a look at the data on this topic:

(1) Since 1945, there have been 13 recessions (Fig. 27). The Great Recession, which began in December 2007, officially ended in June 2009. This economic downturn was the longest since World War II, lasting 18 months. The shortest one lasted two months, from February through April 2020, and resulted from the pandemic lockdown.

(2) Since 1945, the 13 recessions lasted 10.3 months on average, or a total of 133.9 months. That’s just 14.2% of the time since the start of 1945.

Movie. “The Tourist” (+) (link) is a Netflix series about Elliot, a man who wakes up one day in a hospital in Australia’s Outback after he is nearly killed when a huge truck rams his car. During the first season, he loses his memory and tries to find out who he is. He finds comfort and some help from local cop Helen Chambers. The plot has plenty of bad guys working for Kosta, a Greek drug lord, who is on LSD. Elliot is a good guy without his memory, but he might have been a bad guy when he had it. This all takes place in the Outback with lots of characters and dialogue that are very reminiscent of the equally quirky movie “Fargo.” So it is both fun and funny, though the plot often veers off the straight path. The film stars Jamie Dornan and Danielle Macdonald, who do admirable jobs in their roles.

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