On Japan, Crude Oil & Earnings

March 11 (Wednesday)

Global Strategy: Carry-Trade Calamity 2.0? Japanese government bond yields have surged on the back of stronger economic data. Hotter inflation data have also raised the odds of further Bank of Japan (BOJ) interest-rate hikes, boosting the yen. This has come while US Treasury yields have fallen, thus making the yen even stronger against the US dollar.

All of this is reminiscent of the carry-trade “blowup” last summer, when declining US interest rates and rising Japanese interest rates jeopardized the positions of traders who had borrowed cheaply in yen to fund trades abroad. Even if unwinding carry trades has put some pressure on global markets this time around, the latest Japanese data suggest it won’t last for long. Consider the outlook for Japan and the BOJ:

(1) Rates up. The 10-year Japanese government bond yield traded as low as 0.80% last September, and since has climbed above 1.50% (Fig. 1). While the yen hasn’t quite reached its peak of 140 to the dollar from last fall, it has strengthened from 158 in early January to around 147 today (Fig. 2).

(2) Nikkei down. The Japanese Nikkei has sold off alongside US tech stocks, now down 5.6% over the past month (Fig. 3). However, the rout hasn’t reached the extremes of last year, when Japanese stocks fell 25% in just two weeks.

(3) Not-so-hot economic data. Yesterday, Japan’s Q4 real GDP growth was revised down from 2.8% to 2.2% (saar) (Fig. 4). Private consumption was revised down from 0.1% to unchanged, while residential investment flipped from up 0.1% to down 0.2%. Japanese government bond yields and the yen pared some of their recent rise.

(4) BOJ is still a flock of doves. Inflation is still sticky in Japan, with the BOJ’s target rate rising to 2.5% in January—the highest since March 2024 (Fig. 5). We think the BOJ might stay on hold at its meeting next week after hiking to 0.5% in January—the highest since 2008 (Fig. 6).

(5) Carried out. There are plenty of signs that the carry trade is a fraction of its size last year. We think the most leveraged traders were already carried out by last year’s volatility shock. For instance, leveraged shorts against the yen have already been washed out by the latest strength (Fig. 7). However, the buildup of net short-term foreign assets in Japanese banks—which we believe are parked there to fund carry trades—remain fairly close to last year’s peak (Fig. 8).

In short, the latest Japanese data and our belief that the US economy remains resilient give us confidence that Carry Trade Calamity 2.0 isn’t a worry. But rising fears of a recession in the US combined with anticipation of BOJ rate hikes could prompt more carry-trade unwinds and therefore pressure on global markets.
 
Global Oil: Why Oil Prices Should Stay Range-Bound. Despite President Trump’s imposition of tariffs, including on Canadian oil, we expect global oil prices to remain within a historically low range for the foreseeable future. The tariffs may actually have a deflationary effect on oil, dampening global aggregate demand and suppressing prices, in our view.

On Monday, the price of a barrel of Brent crude oil hit below $70 for the first time in three years, at $68.33 (Fig. 9). It had traded mostly in a range of $75-$80 since September. The immediate trigger wasn’t Trump’s tariffs but OPEC+’s unexpected announcement of a supply expansion. Trump has been pressuring OPEC+ to lower oil prices, which tilted oil traders into a net bearish position.

A confluence of factors suggests to us that global oil prices will stay within a narrow, $65-$75 band through the end of this year. That's barring a severe global recession, which we are not expecting this year despite Trump’s Tariff Turmoil 2.0. In most scenarios, we can’t see oil prices dropping into the $50s, as at least one forecaster projects. That’s because geopolitical factors, such as tensions between the US and Iran and further meddling in the market by Trump and OPEC, likely will result in oil prices remaining around current levels.

Also supportive of oil demand would be the potential refilling of the US Strategic Petroleum Reserve, as the US energy secretary intends. On the other hand, the global addition of renewable energy sources to the energy mix should limit demand.

These countervailing influences support our case for a range-bound oil price. Let’s examine these and related factors:

(1) Demand-side factors. Three demand-related factors should help keep a lid on global oil prices:
Weak demand from China. The world’s second-largest economy is slowing, and we aren’t overly optimistic on the success of its recently announced stimulus plan (see yesterday’s Morning Briefing). The country also is shifting away from fossil fuels and growing its reliance on renewable energy sources, which will contribute to a steady decline in its oil consumption growth rate. China now generates 31% of its electricity from renewables, including wind, solar, hydro, and geothermal. Despite its dependence on coal, solar is expected to surpass coal as the leading energy source by 2026. In 2024, China led global energy transition investment, according to BloombergNEF data.
Weak demand from Europe. While our concerns about Europe’s economic slowdown have eased with the potential boost from defense spending under the European Union’s ReArm initiative (see yesterday’s Morning Briefing), Europe is quickly shifting to cleaner energy. Reliance on renewable sources is a pillar of Europe’s commitment to completely phase out Russian gas imports and to achieve energy independence. Last week, the European Commission (EC) replaced its Green New Deal with the Clean Industrial Deal, designed to support dual goals of decarbonization and economic growth.
Global shift toward renewables & mainstreaming EVs. As renewable energy sources continue to gain ground, catalyzed by government policies, the long-term outlook for fossil fuels, especially oil, appears increasingly uncertain. Renewable energy technologies—including solar, wind, and electric vehicles (EVs)—are fast becoming mainstream. As the EV market expands, a major inflection point is approaching: The sticker price will soon match that of a gas-powered car, perhaps as soon as this year. The rise of EVs is expected to dent demand for gasoline and diesel, pressuring oil prices downward.
(2) Supply-side factors. We see three major influences on oil supplies:
OPEC+ production increases should expand supply. Oil prices sank last week after OPEC+ agreed to increase crude production for the first time since October 2022. Over the next year and a half, the group will pursue a “gradual and flexible return” of 2.2 million barrels a day. This followed a long-delayed hike in production by eight countries: Saudi Arabia, Russia, Iraq, the United Arab Emirates, Kuwait, Kazakhstan, Algeria and Oman. Even before the OPEC+ alliance announced additional supplies, the International Energy Agency was already forecasting a surplus, with supply growth expected from non-OPEC+ sources. We expect OPEC+ to maintain global oil prices within a manageable range that protects producers.
Geopolitical risks threaten oil supplies. Geopolitical tensions in the Middle East consistently introduce uncertainty into oil pricing. Middle East tensions and Russia’s war in Ukraine are the two biggest known risk factors for energy in 2025, followed by trade-related disruptions. However, we note that supply disruptions from geopolitical causes are typically short-lived, causing oil price spikes but not rallies, as alternative oil sources usually step in to stabilize the market. Topping our list of geopolitical risks to oil prices are the tensions between the US and Iran over Iran’s evasive international shadow network that ships millions of barrels of Iranian oil to China amid US sanctions. Pressure on Iran could offset a global supply surplus, especially given the Trump administration’s aim to reduce the regime’s oil flows by 90%.
Shale backstops supply. The US shale industry has become a key counterbalance to global supply disruptions. President Trump’s executive order to "unleash America’s energy" lifts restrictions on oil and gas extraction and reverses several climate-related policies enacted by the Biden administration. Despite his tariffs, Trump has pledged to lower US energy costs. Even with falling oil prices, US shale producers are able to reduce costs and maintain output, helping to stabilize oil prices within a set range. Shale producers may be able to remain profitable at oil prices as low as $50 per barrel, the US energy secretary recently stated. While shale production provides a buffer against supply shocks, major shale producers are unlikely to significantly increase production, prioritizing returns to shareholders over aggressive drilling.
US Strategy: Earnings Growth Scare in Q1? The earnings warning season is upon us. On Monday evening, Delta Air Lines warned analysts that their revenues and earnings forecasts for Q1 were too high. The company said corporate and consumer spending stalled in Q1, growing at a slower-than-expected rate y/y. However, the company did not foresee a recession ahead and actually left its 2025 guidance unchanged on expectations of lower energy prices.

For the S&P 500 companies in aggregate, consensus estimates call for earnings to rise y/y for an eighth straight quarter, albeit at a slower “back-to-trend” rate. The consensus growth forecast for S&P 500 Q1-2024 earnings has dropped to 6.8% as of the March 6 week from over 11% at the beginning of the quarter (Fig. 10). The steep decline in recent weeks is typical of quarters’ final weeks, when bad earnings news tends to dominate estimate revisions activity.

However, there are still pockets of strong earnings growth within the S&P 500 sectors, as Joe shows below:

(1) What’s ahead for Q1 sector earnings growth? Eight of 11 sectors are expected to show positive y/y earnings growth, down from 10 sectors in Q4. Among the three lagging sectors, Consumer Staples’ earnings is expected to fall y/y in Q1 for the first time in ten quarters; Materials is expected to fall after rising in Q4 for the first time in 10 quarters; and Energy is expected to fall for a third straight quarter. Among the six sectors expected to post single-digit earnings growth in Q1, for Consumer Discretionary and Utilities such a result would end their double-digit percentage growth streaks at eight and six quarters, respectively.

(2) Health Care and Tech are Q1’s and 2025’s growth leaders. Just two sectors are expected to post double-digit percentage earnings growth in Q1, Health Care and Information Technology. That would mark the lowest count of sectors with double-digit percentage earnings growth since Q4-2022, when only Energy and Industrials posted such growth. The Health Care and Information Technology sectors are expected to grow revenues and earnings faster than the S&P 500, not just in Q1 but for all of 2025’s quarters (Fig. 11 and Fig. 12).

(3) Review: S&P 500 sectors’ Q4 revenues growth. Joe recently updated his analysis of Q4’s revenue and earnings results for the S&P 500’s sectors in our S&P 500 Quarterly Metrics publication. During Q4, eight of the 11 S&P 500 sectors recorded positive y/y growth in revenues, unchanged from Q3’s count. Here’s how the S&P 500 sectors’ y/y revenues growth rates stacked up in Q4: Information Technology (12.1%), Health Care (9.2), Real Estate (8.6), Communication Services (7.3), Financials (7.3), Consumer Discretionary (6.2), S&P 500 (5.2), Consumer Staples (1.4), Utilities (1.0), Materials (-1.8), Energy (-1.9), and Industrials (-3.0).

(4) Review: S&P 500 sectors’ Q4 earnings growth. On the earnings front, ten of the 11 S&P 500 sectors posted positive y/y earnings growth in Q4. That was the broadest sector growth since Q4-2021. Seven sectors posted double-digit percentage y/y earnings growth, the highest count since 12 quarters in Q1-2022. Here are the S&P 500 sectors’ y/y earnings growth rates for Q4: Financials (35.1%), Communication Services (31.5), Consumer Discretionary (27.2), Information Technology (19.8), S&P 500 (17.0), Real Estate (15.4), Health Care (14.3), Utilities (12.5), Industrials (8.0), Materials (2.0), Consumer Staples (1.5), and Energy (-29.1).

(5) Review: S&P 500 sectors Q4 profit margin. Profit margins improved q/q for just four of the 11 sectors in Q4: Financials, Industrials, Information Technology, and Real Estate. However, nine sectors, all but Energy and Materials, had higher Q4 margins y/y. Here’s how the sectors’ profit margins ranked in Q4: Real Estate (31.0%, six-quarter high), Information Technology (27.5, record high for the first time since Q4-2021), Communication Services (19.6), Financials (15.8, 10-quarter high), Utilities (13.1), S&P 500 (12.8, 10-quarter high), Industrials (11.0, six-quarter high), Materials (8.9, 18-quarter-low), Consumer Discretionary (8.9), Energy (7.8, 14-quarter low), Health Care (7.6), and Consumer Staples (6.5).

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Going Global Slowly

March 11 (Tuesday)

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

Strategy I: Time To Go Global? A much more favorable macroeconomic and political backdrop in the US had kept us icy on international stocks for the past 15 years, even during the recent rally in the MSCI All Country World (ACW) ex USA Index. However, just this month, developments in both the Eurozone—particularly Germany—and China have thawed our stance a bit toward investing in advanced foreign economies.

We’ve preferred to “Stay Home,” favoring US large-cap stocks over international ones since at least 2010. The resilience of the US economy and favorable stock market fundamentals, including earnings growth, mean we’re maintaining our Stay Home posture. However, we’d caution against continuing to shun international stocks, successful as that strategy has been, simply out of inertia. Given that developments abroad have allayed some of our macroeconomic concerns, providing more support for a “Go Global” strategy, it makes sense to consider reallocating some funds to international stocks.

In portfolio parlance, we’re reducing our overweight on the MSCI US and paring our underweight of the MSCI ACW ex-US. Before we get into the macroeconomic factors underpinning this decision, consider some of the stock market fundamentals:

(1) Relative performance. The MSCI US index peaked relative to the MSCI ACW ex-US on Christmas Eve of last year (Fig. 1). In dollar terms, the US index has fallen 12% versus the ACW ex-US since. That’s been exacerbated by the dollar’s losing 4.3% ytd (Fig. 2). In local currency terms, the US index is down roughly 9.5%.

The international catch-up trade has a very high ceiling. The MSCI US is still trading at more than 21 times forward earnings, whereas the MSCI ACW ex-US index is trading at just 14 times forward earnings (Fig. 3). Arguably, European and Japanese stocks should represent much more than a combined 21% of the global market cap anyway (Fig. 4).

(2) Dollars versus local currency. This argument is perhaps even stronger for international investors, as they stand to lose doubly if US stocks and the dollar both underperform. The dollar’s underperformance could extend considering that its run since the pandemic means it may still be overvalued.

The reasons for the dollar’s fall are perhaps a better indicator of the outlook from here. We think it’s led by the outperformance of the euro and yen as their countries’ long-term bond yields jumped (Fig. 5). The economic growth scare in the US may have some impact but probably a limited one since 10- and 30-year Treasury yields haven’t fallen dramatically. The positive performance of the euro and yen are the results of the improving macro picture abroad, and a positive for the global economy. So unless the US government’s tariff turmoil and federal firings spark a recession that the rest of the world avoids, we aren’t overly worried about dollar downside.

(3) Productivity and profit margins. Another reason we’ve kept an underweight position on international stocks was the poor productivity growth abroad. While US productivity growth has been sustained since the Great Financial Crisis and accelerated after the pandemic, productivity growth has largely plateaued in the rest of the world for the past 17 years (Fig. 6).

However, forward profit margins suggest that may be changing. Analysts’ consensus estimates for the MSCI ACW ex-US index forward profit margin have risen from 7.7% before the pandemic to 9.6% today (Fig. 7). That included 50bps of forward margin expansion over the past year.

Strategy II: German Rearmament. Trump 2.0 may finally have prodded Europe into getting its act together. Germany is looking to exempt expenditures above 1% of GDP from the debt brake as part of a €500 billion infrastructure and defense fund. The European Union (EU) has followed suit by removing limits on European countries and adding new defense loans, potentially allowing for up to €800 billion of defense spending through the end of the decade.

These measures should help Germany meet NATO’s 2% of GDP defense spending target and instill fiscal stimulus into a very sluggish economy that needs it (Fig. 8 and Fig. 9). Notably, the EU almost never has met NATO’s 2% target. Markets have reacted swiftly, though nothing is set in stone and obstacles are emerging.

Consider the outlook for the European economy:

(1) Debt deluge. German bunds have sold off in anticipation of a flood of new debt issuance. The 10-year bund yield has risen from below 2.40% at the end of February to as high as 2.88% last Thursday (Fig. 10). French President Emmanuel Macron wants to raise defense spending to 3.0%-3.5% of GDP from its current 2.0% without raising taxes, another sign to the markets that the European economy finally will get the benefit of a looser fiscal stance.

(2) Strings attached. Germany’s Green party rejected the defense and infrastructure spending package on Monday. Germany’s center-right coalition of Christian Democrats and Social Democrats has until March 25 to pass the package; but it needs a two-thirds majority and is relying on the Greens. The Greens thus far have felt left out and emphasize the need for climate-related initiatives.

(3) Alleviating our concerns. Two broad factors have prevented us from upping our long-term opinion on Europe: fiscal conditions and political conditions (see our June 26 Morning Briefing titled “EU’s Foundation Cracking?”). Brussels has been threatening to rein in already austere fiscal policies, which hampered the EU’s recovery from the pandemic. Meanwhile, many European countries’ internal politics, along with the EU’s parliamentary politics, were fracturing. Increased tensions among parties led us to be concerned about the bloc’s future.

If Germany successfully gets this spending package through, it will address both of our concerns and effectively remove barriers from shifting to a neutral stance on European equities.

Strategy III: Chinese Consumption Soon? We’ve long believed that until China figured out how to spur domestic demand, it would be uninvestable over any long-term horizon. Consumer confidence has been crushed for years, especially after the property bubble burst and evaporated most households’ savings (Fig. 11). The most likely way of achieving greater domestic demand would be to increase fiscal stimulus to households. China’s cultural and political institutions thus far have prevented such a reallocation of capital.

The latest announcement on China’s annual economic targets and a seeming newfound commitment to the consumer may show that the Chinese Communist Party (CCP) has finally accepted what it takes to internally balance its economy. Consider the following:

(1) New targets, more lending. China’s roughly 5% real GDP growth target for 2025 will be accomplished via more government spending. The CCP recently raised its budget deficit plan from 3% of GDP to 4% (Fig. 12). The larger deficit will be funded via ultra-long-term government debt and local government debt. More money will be raised to recapitalize the state banks. Overall, China’s total social financing is likely starting a new uptrend after falling for two-plus years (Fig. 13). That’s a positive for global liquidity and stimulus.

(2) Consumer in need. Retail sales have been weaker than industrial production, as China targets manufactured exports to grow its economy rather than households (Fig. 14). Hopes that stimulus measures thus far were starting to take hold quickly faded when February’s CPI fell into deflation for the first time in roughly a year (Fig. 15).

We’re not yet convinced that China is ready to stimulate its household sector enough to increase domestic demand. It also does not appear to be willing to stop artificially boosting industrial capacity. China lowered its inflation target from 3% last year to 2% in 2025, a sign that the export-led strategy will continue. However, we believe the drip-drops of stimulus and increasing focus on the consumer are likely to build up enough counterweight to offset the effects of a trade war, which is a positive for the global economy and markets. So while we’re not bullish on investing in China, we are incrementally less bearish and therefore more positive on global markets broadly.

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High Noise-To-Signal Ratios Unnerving Stock Investors

March 10 (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: The Economy’s High NTSR. The economy’s noise-to-signal ratio (NTSR) has been rising rapidly in recent weeks. As a result, it has gotten harder to get a read on the economy lately. Washington’s rapidly increasing NTSR is also troubling. Indeed, last Wednesday, our Morning Briefing was titled “Trump Turmoil Raises Odds Of A Recession.” We raised our subjective odds of a recession this year from 20% to 35%.

We are considering raising the odds again given that Trump officials recently acknowledged that they expect that their policies will cause some short-term pain. The near-term outlook for the economy and stock market has soured rapidly over the past few weeks.

The DOGE Boys have been firing government workers faster than we expected. That might slow now that various Cabinet secretaries reportingly are pushing back against Elon Musk’s terminators. The Trump administration’s tariff policies are instigating a retaliatory trade war rather than the negotiations to reduce tariffs that we had expected. More “reciprocal” tariffs will be imposed on April 2 by the Trump administration, which also aims to raise revenues with tariffs, implying that some of the tariffs will be permanent.

Stock investors are confused and seem to have concluded that the economy may be falling quickly into a recession. We’ve been betting on the economy’s resilience, but we can understand why risk-off is the stock market’s current default option.

The Nasdaq is in correction territory, and the S&P 500 seems to be headed in the same direction (Fig. 1). The Nasdaq fell below its 200-day moving average at the end of last week and has found support at the bottom end of its short-term upward trending channel. There is another uptrend line that started in 2010, which would provide support for the Nasdaq but in bear market territory (Fig. 2). The Nasdaq index is currently 9.8% below its record high of 20173.89 on December 16.

The S&P 500 is down 6.1% from its record high on February 19 (Fig. 3). It is slightly below its 200-day moving average. It has been a very rapid decline. It reminds us of the plunge in the S&P 500 during the Kennedy Slide of 1962 (also known as the “Flash Crash of 1962”). The stock market did not experience a stable recovery until after the end of the Cuban Missile Crisis in October 1962 (Fig. 4). The crash was partly attributable to a big price increase by US Steel that was loudly and successfully opposed by the Kennedy administration. This time, the selloff is largely attributable to Trump Tariff Turmoil 2.0.

Corrections are caused by fears that the economy is falling into a recession. During these events, stock prices fall 10%-20%. But they recover relatively quickly once those fears abate. During the bull market from 2009 through 2020, we counted 66 “panic attacks,” which included a few corrections. Bear markets occur when the correction turns into a decline of more than 20%, usually because a recession happens. There have been only three bear markets that occurred without an accompanying recession: the one in 1962, the one late in 1987, and the one in 2022.

There is certainly a recession scare currently. Our bet on the resilience of the economy is keeping us in the correction camp. However, Trump Tariff Turmoil 2.0 has the potential to cause a fourth bear market without a recession.

Yes, but what about the latest batch of economic indicators that are heightening recession fears? Consider the following:

(1) Atlanta Fed versus New York Fed Nowcasts. The Atlanta Fed’s GDPNow tracking model is currently showing Q1’s real GDP decreasing by 2.4% (q/q saar). However, the New York Fed’s Nowcast tracking model shows it increasing 2.7%! Go figure.

We usually favor the Atlanta Fed model over the New York Fed one. However, this time, we are betting on the New York Fed’s forecast. We don’t know why the two models differ so much.

What we do know is that the Atlanta Fed estimate dropped from +2.3% to -1.5% following the release on February 28 of a big jump in January’s imports, led by an odd jump in gold imports. In addition, on that same day, January’s real personal consumption expenditures showed a big decline of -0.5% m/m. The GDPNow estimate was lowered again to -2.8% on March 3 after the release of the ISM manufacturing index for February. It is currently -2.4%.

(2) Surging (gold) imports. In a March 7 post on LinkedIn, Pat Higgins, the creator of GDPNow, explained that much of the widening of the trade deficit in January was due to an increase in nonmonetary gold imports from $13.2 billion in December to $32.6 billion in January. This accounted for nearly 60% of the widening of the goods trade deficit. Higgins concluded: “Removing gold from imports and exports leads to an increase in both GDPNow’s topline growth forecast and the contribution of net exports to that forecast, of about 2 percentage points.” That’s obviously a significant swing.

(3) Weak (and strong) retail sales. Furthermore, the drop in real consumer spending during January undoubtedly was caused by inclement weather that month, which was the coldest since 1988. Industrial output of utilities soared to a record high in January (Fig. 5). Auto sales fell sharply in January and rebounded slightly in February (Fig. 6).

Retail sales excluding food services dropped 1.2% m/m during January. Again, we blame the weather. Nevertheless, it still rose 4.0% y/y (Fig. 7). The Redbook retail sales index rose to 6.1% y/y during the February 28 week. Then again, the Consumer Confidence Index survey showed a sharp decline in vacation plans during February (Fig. 8).

Furthermore, Target said on Tuesday that it expects little to no sales growth this year, with CEO Brian Cornell telling CNBC that higher prices are on the way. Walmart and electronics retailer Best Buy also recently warned about expectations for 2025.

(4) Mixed signals from the PMIs. February’s purchasing managers added to the dissonance provided by the latest batch of economic indicators. The M-PMI dipped to 50.3 in February from 50.9 in January (Fig. 9). However, those were the first back-to-back readings above 50.0 since September and October 2022. Then again, February’s M-PMI subindexes for new orders (48.6) and employment (47.6) fell below 50.0. The regional business surveys conducted by five of the 12 Fed district banks showed better growth during February.

February’s NM-PMI remained solidly above 50.0 at 53.5 (Fig. 10). All its major subindexes did the same. Just as we expected, the S&P Global flash NM-PMI provided a misleadingly weak estimate of the ISM version of this index (Fig. 11).
 
Strategy II: Labor Market’s High NTSR. Friday’s employment report for February also provided plenty of mixed signals. The payroll employment series (which measures the number of full-time and part-time jobs) rose 151,000, while the household employment series (which measures the number of workers with one or more jobs) fell 588,000. The latter is very volatile. It was up 2.2 million during January following an annual benchmark revision. The former was weaker than we expected, as we had anticipated a rebound from January’s cold blast. Well, it turns out that the weather was also bad in February. Consider the following:

(1) Bad weather again? The household employment survey shows that 404,000 nonagricultural workers were not at work during February, the most since February 2014. The survey also found that 1.31 million nonagricultural workers who work full time had to work part time last month because of the weather. That’s the most since February 2021 (Fig. 12).

We had expected average weekly hours to rebound in February. Instead, it remained flat at January’s level. If bad weather depressed both months’ readings, then there should be a solid rebound in average weekly hours during March.

(2) Payroll employment. While February’s payroll employment gain was weaker than we’d expected, the three-month average gain was 200,000 (Fig. 13). That’s a robust reading. Excluding government, the three-month average was 169,000. That’s also a solid reading.

The questions ahead are how much will federal government employment fall in coming months as a result of the activities of the DOGE Boys, and will private payroll gains more than offset the losses of federal jobs? We think so, though this is certainly one of the great uncertainties resulting from Trump Turmoil 2.0. The losses started in February with federal government employment down 10,000 (Fig. 14). This number could potentially double, triple, or even quadruple in coming months.

(3) Earned income proxy. During February, private-sector payrolls rose 0.1%, the average workweek for private-sector workers was unchanged, and average hourly earnings in the private sector rose 0.3%. So our Earned Income Proxy edged up 0.4% m/m (Fig. 15). We expect bigger rebounds in February’s retail sales and total consumer spending from January’s deep freeze, unless bad weather kept shoppers at home during February too.

(4) Unemployment and layoffs. The bad news is that February’s Challenger Report showed that government-announced layoffs totaled 62,240 (Fig. 16). The private sector isn’t likely to significantly offset such job cuts if they all hit in March and April, especially since the Trump administration is planning even more layoffs.

In the private sector, announced layoffs in retailing during February totaled 38,960, the second highest tally on record. Retail payrolls fell 6,300 during the month. Information employment rose 5,000 last month. Announced layoffs in technology totaled 14,550. This means that we should expect sizeable increases in weekly initial and continuing unemployment claims in coming weeks.

While the official headline unemployment rate remained low at 4.1% during February, the U-6 rate rose to 8.0%, the highest since 2021 (Fig. 17). The latter was boosted by more workers employed part-time for economic reasons (Fig. 18). Both jobless rates are bound to increase during the next few months.
 
Movie. “A Complete Unknown” (+ +) is a 2024 musical drama about Bob Dylan, starring Timothée Chalamet. Lots of Dylan’s great songs are featured, with Chalamet doing a good job of singing them. Dylan comes across as self-absorbed and obsessed with his privacy. He has a couple of girlfriends in the film, including Joan Baez. Both women are frustrated that he doesn’t share more about himself with them. He comes across as socially awkward and a complete unknown. However, he does relate well to Woody Guthrie, Pete Seeger, and Johnny Cash. (See our movie reviews archive.)

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China, Tariffs & Quantum Computing

March 06 (Thursday)

China: Putting on a Brave Face. In a trade war with President Trump, China won’t win if it fights fire with fire. The US runs a trade deficit of $1.5 trillion, and the vast majority of US imports comes from either the EU, China, Mexico, or Canada (Fig. 1 and Fig. 2). China, on the other hand, has far more exports than it has imports, resulting in a trade surplus of $1.0 trillion, using a 12-month sum (Fig. 3).

More specifically, the US imports $273.5 billion more from China than it exports to China. Due to that imbalance, China will never be able to match the US’s 20% tariffs dollar for dollar. Nor would it want to risk angering the current resident in the Oval Office because China needs US exports to bolster its weak economy.

After meeting on Tuesday, Chinese leaders announced a GDP target of 5.0% for 2025, the same target it had last year and a touch slower than its Q4 GDP of 5.4% (Fig. 4). The 2025 target is a tall order given the economic headwinds the economy faced last year, which will be amplified by the US tariffs this year. Last year, exports represented nearly a third of China’s 5% GDP growth, a March 5 WSJ article noted.

China also announced targeted import restrictions on US goods and tariffs on certain US imports. But the moves aren’t considered excessive, indicating the country’s desire to avoid escalating the already delicate trade situation. If the country did decide to get more aggressive, sharply raising prices on its exports sold in the US, it would inflict more pain on US companies and consumers. Imagine the howls if the country doubled or tripled the prices of China-made goods that US consumers are accustomed to having, like gaming consols, smartphones, or pharmaceutical ingredients.

China announced on Tuesday several measures it will be taking to help achieve its economic growth target and gave some details on how it would counter Trump's tariffs. Let’s have a look:

(1) Spend more money. The Chinese government set a budget deficit target of around 4.0% of GDP, up from 3.0% last year and the highest level in years. It’s an indication that the government plans to open its purse strings and spend to boost economic growth, the March 4 WSJ reported.

(2) Impose tariffs. In response to the latest round of Trump tariffs, China announced targeted tariffs on US imports that will begin on March 10. It’ll place a 15% tariff on US chicken, wheat, corn, and cotton products and a 10% tariff on sorghum, soybeans, pork, beef, seafood, fruits, vegetables, and dairy products. In addition, the Commerce Ministry added more than 24 American companies to export control and corporate blacklists. The country also said it was suspending imports of US wood and US soybeans from three companies.

US farmers no doubt aren’t happy; China was the third largest importer of US agricultural products last year.

(3) Keep expectations low. Chinese leaders set a target of 2.0% for consumer inflation, down from last year’s goal of 3.0%. The Chinese economy’s sluggishness has weighed on inflation, which came in at 0.5% y/y in January, or 0.2% excluding food and energy (Fig. 5). The country’s producer price index registered deflation, coming in at -2.3% y/y in January (Fig. 6). China’s economic woes and dance with deflation are reflected in its 10-year government bond yield of 1.76% and tepid demand for bank loans (Fig. 7).

Conversely, investors have received two good pieces of economic news recently. China’s official manufacturing purchasing managers index (PMI) indicated that the industrial sector entered expansion territory above 50.0 in February, rising to 50.2 from January’s 49.1 (which may have been weakened by the Lunar New Year holiday). New orders in February also rose, to 51.1, but new export orders registered at only 48.6. The non-manufacturing PMI edged higher as well, to 50.4 from 50.2 in January (Fig. 8). However, some of this activity may have been artificially inflated by US companies racing to import goods before the Trump tariffs hit.

The excess capacity and excessive debt in China’s residential real estate market have been drags on the general economy in recent years. Data remain mixed, with new home sales from China’s 100 biggest property developers climbing 1.2% y/y in February after a 3.2% decline in January.

The Shenzhen Real Estate stock price index has popped up 27.8% from its 17-year low on August 28, but remains depressed and is down 1.1% ytd (Fig. 9). Likewise, the CSI 300 has dropped 1.3% ytd through Tuesday’s close, but the China MSCI has jumped 12.7% (Fig. 10).

Strategy: CEOs Do the Tariff Tap Dance. Companies have been preparing for US tariffs and the expected responses from targeted countries for months. From moving production to cutting costs, here’s a quick look at what some executives in the retailing, refining, and farming industries are saying about their companies’ tariff-readiness:

(1) Tariffs create uncertainty. Given the uncertainty created by tariffs, Target aims to maintain a “larger-than-normal cushion” on its balance sheet, said CFO Jim Lee on Tuesday on the company’s earnings conference call. The company has been pulling production out of China and moving it to other countries in Asia and Latin America. The increased diversity of production locations gives them more flexibility.

The uncertainty surrounding the tariffs and its impacts on consumer demand contributed to Target’s decision to eliminate its quarterly earnings guidance and give extremely wide 2025 earnings guidance. The company now forecasts net sales growth of around 1% this year and adjusted EPS of $8.80-$9.80 compared to last year’s adjusted EPS of $8.86. Granted, Target had operating issues last year before tariffs were even an issue. So it’s certainly possible that the retailer is using tariffs as an excuse that buys it more time to turn around operations.

(2) Tariffs hit refiners. Trump’s tariffs will impact US imports of Mexican and Canadian crude oil, much of which is of the “heavy” variety that US refiners use. Valero executives discussing tariffs noted that the company’s operations on the US Gulf Coast could limit the impact by importing crude from other countries in the world. But if the tariffs are extended, they could reduce the refiner’s throughput by 10%, said an executive on the company’s January 30 conference call.

(3) China retaliation hurts crops. The folks at ADM were well aware that tariffs wouldn’t be a problem for ADM. Rather, it was the retaliation in response to the tariffs that would potentially cause the problem. “[W]e saw in 2018 how the corn imports from China were reduced by almost like 9 million tons from the U.S. Whether that's going to be something that's going to happen again or not, we'll have to see,” said ADM CEO Juan Luciano during the company’s February 4 earnings conference call.

And as we noted above, China did announce on Tuesday that it will impose additional tariffs of up to 15% on certain US farm products, including soy, wheat, and corn. The company plans to cut up to 700 jobs globally this year after reporting a 16% decline in adjusted EPS in Q4 due to falling crop prices and reduced trade flows.

Disruptive Technologies: Big Guys Elbow into Quantum Computing. Recently, tech giants Amazon, Google, and Microsoft all have announced breakthroughs they’ve made in quantum computing. Conversely, small startup quantum computing companies have watched their stocks tumble ytd, as they are racking up losses. In this David vs Goliath tale, it looks like Goliath may win.

Here’s some of the recent news out of the quantum computing industry:

(1) Lots of new chips. Amazon, Google, and Microsoft each has developed new chips that can be used in quantum computers. Some aim to reduce computing errors; others hope to increase the number of qubits a chip can hold.

Amazon’s quantum computing chip, dubbed “Ocelot,” will lower the cost of reducing quantum computing errors by up to 90%. “It’s designed to test our ability to perform quantum error correction, and once we have that building block, then we can scale it up to a much larger size,” said Oskar Painter, head of quantum hardware for Amazon Web Services, as quoted in a February 27 WSJ article.

Microsoft has developed a new state of matter—one that’s not a solid, liquid, or gas—and uses it in its new quantum chip called “Majorana 1.” If successful, the quantum processing unit, or QPU, will ultimately hold a million quantum bits.

Google’s new chip, Willow, helps to reduce errors “exponentially.” It performed a computation in under five minutes that would have taken one of today’s fastest super computers 10 septillion years to calculate, the company’s December 9 blog stated. The more qubits Google added to its computer, the fewer errors it experienced. The system, which uses 105 qubits, was also able to fix errors in real time.

(2) China & others in the mix, too. Chinese scientists at the University of Science and Technology introduced a quantum computer prototype called “Zuchongzhi 3.0,” with 105 qubits, reported a March 4 article in Global Times, a publication controlled by the Chinese Communist Party. The scientists claim that the quantum computer can process quantum random circuit sampling tasks one million times faster than Google’s Sycamore processor. This follows news of a Chinese prototype quantum computer named “Wukong,” which has 72 qubits and can be accessed in the cloud.

Finnish company IQM Quantum Computers launched Europe’s first 50-qubit quantum computer located at the facility of its partner, VTT Technical Research Centre of Finland. Companies and researchers will have access to the computer through the VTT QX quantum computing service. The 50-qubit computers follow earlier models that had five and 20 quibits, a March 4 article in HPC Wire reported.

Meanwhile, Dutch startup QuantWare has developed a 3D quantum chip architecture it calls “vertical integration and optimization,” or “VIO.” This 3D architecture should allow for more qubits on one chip. A single chip may ultimately be able to hold one million qubits, making it much faster than current chips linked together with fewer qubits. QuantWare is currently accepting orders for its first QPU, Contralto-A, for quantum-error correction. It aims to be the quantum equivalent of what TSMC is to Apple or to Microsoft in traditional computing, a March 4 article in The Next Web reported.

(3) US startups slump. Quantum startups rallied sharply in late 2024 on a batch of good news. Google announced the strong performance of Willow, its quantum chip. IonQ shipped its first quantum computer to a European customer. And Quantum Computing and D-Wave took advantage of the market’s rally to sell stock and raise cash. The industry was also hopeful that the Trump administration would provide support because during Trump’s first term he signed the 2018 National Quantum Initiative Act, which bolstered government research in the area.

In 2024, shares of quantum startups soared: Quantum Computing (up 1,606.2%), Rigetti Computing (1396.1%), D-Wave Quantum (800.8%), and IonQ (215.7%). Then in January, Nvidia CEO Jensen Huang said in response to a question that practical quantum computers are still roughly 20 years away. A few days later, Meta Platforms CEO Mark Zuckerberg shared a similar opinion, stating that quantum computers are “still quite a ways off from being a very useful paradigm” and that many people think it’s a “decade plus out.”

January’s CEO comments cooled investors’ enthusiasm, and they began to focus on the large losses that the quantum startups were racking up, as well as their need to raise additional cash to continue operations. IonQ, for example, doesn’t expect to be profitable until 2030. And D-Wave recently sold $150 million of stock to boost its cash balance to around $320 million. The deal gives D-Wave the necessary capital and ability to get to sustained profitability and positive cash flow, said its CEO.

In short, the quantum stars of last year have fallen to Earth this year. Here are their ytd performances through Tuesday’s close: Quantum Computing (-68.2%), Rigetti Computing (-48.5), IonQ (-46.5), and D-Wave (-36.7).

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Trump Turmoil Raises Odds Of A Recession

March 05 (Wednesday)

Strategy I: Trump Turmoil 2.0. We haven’t had to change our subjective probabilities for our three alternative economic scenarios for quite some time. We are doing so today and may have to do so more frequently in coming months or even coming weeks in reaction to the volatile nature of policymaking under President Donald Trump. The initial animal spirits of Trump 2.0 have been trumped by the uncertainty unleashed by Trump Turmoil 2.0. The administration has been in office for less than two months. The whirlwind of tariffs imposed on America’s major trading partners, federal job cuts implemented by the DOGE Boys, and the upending of the world order have been head spinning.

We held off changing our probabilities because we expected that the master of the art of the deal was going to get a deal with Canada and Mexico that would allow him to declare victory and bury his threat to impose 25% tariffs on America’s only two neighbors and biggest trading partners. In fact, on February 28, US Treasury Secretary Scott Bessent said Mexico proposed matching Washington’s tariffs on China and urged Canada to do the same—signaling a potential path for Mexico and Canada to avert levies on their own exports in the coming days.

“I do think one very interesting proposal that the Mexican government has made is perhaps matching the US on our China tariffs,” Bessent told Bloomberg Television. “I think it would be a nice gesture if the Canadians did it also, so in a way we could have ‘Fortress North America’ from the flood of Chinese imports,” he said.

Here is a quick timeline of related events since then:

(1) On Monday, March 3, Trump said that that there was “no room for delay,” and he implemented the tariffs on Canada and Mexico on Tuesday. Trump has said the tariffs are means to several ends: force the two US neighbors to step up their fight against fentanyl trafficking, stop illegal immigration, eliminate the Americas’ trade imbalances, and push more factories to relocate in the US.

(2) Trump had already put a 10% tariff on imports from China in February. The rate was doubled to 20% on Tuesday. Instead of rapid-fire trade deals, the US has triggered a trade war. Canada imposed retaliatory tariffs on the US on Tuesday. Mexico will announce similar measures on Sunday.

(3) On Tuesday, a foreign ministry spokesperson in Beijing warned, “China will fight to the bitter end of any trade war.” China is one of the biggest customers for US agricultural produce such as chicken, beef, pork, and soybeans, and now all those products will face a 10%-15% tax, which will take effect on March 10. Beijing’s relatively limited response suggests that the Chinese would like to negotiate with the US on trade issues.

Beijing is not ramping up the rhetoric or the tariffs in the same way as it did in 2018, during the last Trump administration. Back then, it imposed a tariff of 25% on US soybeans.

(4) Last weekend, Warren Buffett made a rare comment on Trump’s tariffs, warning of their negative effects on consumer spending. “[W]e’ve had a lot of experience with [tariffs]. They’re an act of war, to some degree,” said Buffett. “Over time, they are a tax on goods. I mean, the tooth fairy doesn’t pay ’em! … And then what?”

Strategy II: Recalibrating the Odds. Now that Trump has started a trade war, it could escalate. Or it could de-escalate. Either way, uncertainty has increased significantly, as evidenced by the sharp decline in stock prices on Monday and Tuesday (Fig. 1 and Fig. 2). Interest rates have continued their recent decline, as the odds of more Fed rate cuts have increased—notwithstanding evidence that inflation remains stuck above the Fed’s 2.0% target and the likelihood that tariffs will boost inflation, at least initially (Fig. 3 and Fig. 4).

In recent commentaries, we’ve downplayed the likelihood of a recession in 2025. Indeed, in recent days, we’ve observed that the downward revision in the Atlanta Fed’s GDPNow tracking model from 2.3% (q/q saar) on Thursday to an estimated -2.8% for Q1 reflects two temporary factors: a surge in January’s imports, due to importers’ frontrunning tariffs, and the coldest January since 1988, which depressed consumer spending (Fig. 5, Fig. 6, and Fig. 7). We expect that these big drags on GDP will be reversed in February and March. So we are projecting that real GDP will be up by at least 1.5% during Q1.

However, the negative consequences of Trump 2.0 policies are occurring before the positive ones. Tariffs, deportations, and federal government job cuts are weighing on the economy. An extension of the 2017 tax cuts has yet to occur. Business deregulation is unfolding slowly. Onshoring is underway, and more companies are committing to increase their capital spending in the US.

Considering the above, we are recalibrating our subjective probabilities for our three scenarios:

(1) Roaring 2020s (55%, unchanged). Our subjective probability of our base case remains the same at 55%. We are assuming that the trade war doesn’t escalate. We are continuing to bet on the resilience of the economy and on a technology-driven boost in the growth rate of both productivity and real GDP.

In this scenario, the economy continues to grow, a tariff-related spike in inflation proves transitory, and the stock market remains choppy during the first half of the year, with the S&P 500 remaining below its February 19 record high. The index resumes its climb in record-high territory during the second half of the year, reaching 7000 by year-end (Fig. 8).

(2) Meltup/meltdown (10%, down from 25%). Arguably, there has already been a meltup in some areas of the stock market. They’ve been melting down since mid-February. Combining the odds of these two bullish scenarios reduces the odds that the bull market remains intact, without a correction or bear market in 2025, from 80% to 65%.

(3) Bearish bucket (35%, up from 20%). Over the past three years, we’ve assigned a 20% subjective probability to the various prospects that could go wrong for the economy, resulting in a recession and a bear market for stocks. We are raising it to 35%. During 2022 and 2023, our main concern was that geopolitical crises (including the war between Russia and Ukraine and the proxy war between Israel and Iran) would cause oil prices to soar, forcing the Fed to maintain a restrictive monetary stance and causing consumers to retrench. That seems less likely, as the oil price has remained weak.

Over the past couple of years, the risk of a federal government debt crisis also rose a few times along with bond yields. But now the 10-year US Treasury yield is down from a recent high of 4.79% on January 13 to 4.24% today. That’s despite signs that Trump Tariffs 2.0 are already boosting expected and actual inflation. Bond investors are giving more weight to the “stag” than the “flation” components of a stagflation scenario. We are doing the same by raising the odds of a tariff-induced recession from 20% to 35%.

Trump’s tariffs and DOGE-mandated job cuts are depressing consumer confidence. Trump delivered on his promise to stop illegal immigration. Oil prices are falling as he promised, though that may have more to do with weak demand than more supply. Mortgage rates are falling. However, he promised to lower consumer prices. Instead, his tariffs will drive these prices higher.

We are still betting on the resilience of consumers and the economy. However, Trump Turmoil 2.0 is significantly testing the resilience of both. That’s why we’ve recalibrated our subjective probabilities.

Global Commodities: Dr Copper Goes Rogue. You may recall that we often call copper “the metal with the PhD in Economics.” That’s more than a quip: This malleable metal’s price activity usually correlates with the currents of the global economy. But not lately. Is Dr Copper hanging up her economic forecasting hat?

Copper can be thought of as the lifeblood of progress. It’s critical to industries that are critical to modern life including defense, infrastructure construction, and emerging technologies (e.g., electric vehicles, clean energy solutions). As the second most consumed material, copper is strategically important geopolitically. This deep integration into the word’s essential systems suggests price action that’s predictably tied to global economic fundamentals. Yet that hasn’t been the case of late.

Copper has rallied 8.6% from the start of this year to $9,394 per metric ton (MT) as of March 3. The ascent has not mirrored the state of the global economy, which has been stagnating this year, according to our Yardeni Research Global Growth Barometer.

Why has the copper price disconnected from the forces that typically move it and commodity prices generally (Fig. 9)? Two factors stand out:

(1) Metals tariffs revisited. Investors are probably positioning themselves for the likely fallout of Trump’s impending tariff regime. It’s not a new story: Under both Trump 1.0 and Trump 2.0, tariffs on various metals were framed as measures to protect American industries, ostensibly on national security grounds. Next week, on March 12, 25% tariffs on steel and aluminum take effect; whether copper will be next must be on commodities traders’ minds.

President Trump, on February 25, suggested as much in a social media post, referring to the “decimation” of the American copper industry and calling for an investigation by executive order into whether copper tariffs should be levied under the same Section 232 provisions that justified the steel and aluminum tariffs. We expect copper tariffs in the range of 10%-25% to become effective shortly after the investigation window closes in November.

For the administration, the inflationary consequences of such tariffs are seen as a necessary price to pay for the fortification of domestic production.

(2) Refining China’s copper production. Meanwhile, the world’s largest copper producer—China—made supply-altering moves in February. A regulatory shift aims to curb the overcapacity in China’s refining sector. Construction of new copper smelters could be halted unless there is sufficient concentrate to support them in an attempt to rebalance an industry long plagued by excess production.

This is important because China is the world’s largest producer of refined copper, controlling over half of global copper refining production; Chile and Peru dominate unrefined copper output (Fig. 10 and Fig. 11). Notably, neither Chile nor Peru have ramped up production much in recent years (except for a restart in Chile after a temporary interruption in January owing to widespread power outages).

Besides producing the most refined copper, China is also the world’s most voracious consumer of unrefined copper. In 2023, China mined a mere 1.7 million tons of unrefined copper while producing over seven times that amount in refined form.

To address this imbalance, China is not just slowing new construction of smelting facilities. Over the coming years, the country aims to boost its domestic copper mining efforts by as much as 10% to reduce its dependency on foreign copper concentrate. If it succeeds, China’s copper refinery expansion may get a reboot, boosting global supply once again. However, it could be a long wait.

On the demand side, China's government is expected to unveil a large stimulus package at the National People's Congress on Wednesday. China has struggled to match the government's 5.0% growth target, under pressure from its property market slump. The stimulus could revive domestic aggregate demand along with the demand for copper. However, the effects of China's stimulus efforts so far have been limited.

Looking ahead, we think the current copper price may already reflect these developments. Our gut sense is that copper won't rally much further in the near term toward the previous high of $10,800 per mt set on May 20. That assumes that the US will impose a probable 10% tariff on copper and that China's refined copper supply constraints are offset by continued weakness in global aggregate demand.

The global economy may continue to muddle along or weaken further, especially considering the recent trade developments. In other words, the divergence between the copper price and global economic indicators likely won't get much wider; but the neat correlation of the past might not return unless and until the global economy powers up again.

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Trump’s Crypto Reserve Put & US GDP Math

March 04 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Cryptocurrencies: Trump’s Crypto Reserve Put. Under Trump 2.0, every week is likely to be an action-packed week for financial markets and the economy. That’s because President Donald Trump likes to issue Executive Orders and to post on Truth Social, his social media outlet. He does both on almost a daily basis.

On Sunday, he announced the creation of a “strategic crypto reserve” that will include bitcoin (BTC), ether, XRP, Solana’s SOL token, and Cardano’s ADA, in a post on Truth Social. CNBC noted: “This is the first time Trump has specified his support for a crypto ‘reserve’ versus a ‘stockpile.’ While the former assumes actively buying crypto in regular installments, a stockpile would simply not sell any of the crypto currently held by the US government.” On Friday, Trump is hosting the first White House Crypto Summit.

It’s hard to say how this will all play out. The immediate impact was to boost the price of bitcoin by 10% to $94,343.82, up from a three-month low of $78,660.00 on Friday morning (Fig. 1). This level is likely to provide strong downside support to bitcoin now that we have the Trump Put in the crypto market.

Here are some of the possible implications of this development:

(1) Bitcoin was created with the notion that it would be completely independent of any influence by central banks and other government institutions and officials. The supply of bitcoin is limited to 21 million bitcoins by the program that created it. Now, the US Treasury will have the power to support its price and drive it higher simply by purchasing more bitcoin for the US crypto reserve. In addition, the supply of cryptocurrencies (which has no self-imposed limits) includes other cryptocurrencies that also now have the support of Trump’s “crypto reserve put.”

(2) In effect, the US government is adopting the business model of Strategy, the bitcoin company operated by Michael Saylor. Instead of issuing convertible bonds to purchase bitcoin, the US government can issue US Treasury securities to purchase bitcoin and other cryptocurrencies.

(3) Tesla already owns quite a bit of bitcoin, almost 10,000 BTC, and now must report its market value quarterly. On January 31, Yahoo!Finance reported: “The Financial Accounting Standards Board (FASB) rule change related to digital assets resulted in Tesla recording $600 million extra in net income during Q4 2024. Under the new mandate, companies need to update the values of digital assets through market evaluations each quarter, which allows Tesla to show its Bitcoin holdings at the current fair market price.”

(4) Increasingly, publicly traded companies are buying bitcoin as part of their financial strategies, joining those like Tesla with significant bitcoin holdings already (e.g., Saylor’s Strategy and Marathon Digital Holding). They claim that bitcoin is a potential hedge against inflation and a way to diversify their assets. The bitcoin holdings of public companies are tracked on CoinGecko’s website. (We at YRI are considering joining the list too!)

(5) We’ve previously observed that BTC’s price has been highly correlated with that of Proshares UltraPro QQQ (TQQQ) (Fig. 2). TQQQ is one of the largest leveraged ETFs that tracks the Nasdaq-100 index. TQQQ is typically used by day traders because it was built for short holding periods. If more of the companies in the Nasdaq-100 become leveraged plays on bitcoin, the correlation between the two of them will be even tighter. In effect, the Trump crypto put will support the Nasdaq-100 and the broader stock market.

(6) President Trump might believe that if the government’s US crypto reserve appreciates significantly in value, then it can be used to pay off the US federal debt. That would be a “beautiful thing.” The problem is that when and if the Treasury announces such a move, the price of bitcoin and other cryptocurrencies would probably crash. A less market disrupting plan might be for the Treasury to add its bitcoin reserve to its cash management account and use some of the bitcoin reserves to fund government outlays.

(7) We are wondering if there are any historical analogies for the US crypto reserve. What if the federal government had established a US Beanie Babies Reserve? Beanie Babies are a line of stuffed toys created by American businessman Ty Warner, who founded Ty Inc. in 1986. He created a shortage of them by producing limited editions during the 1990s. They were collected not only as toys but also as a financial investment due to their high resale value. However, the Beanie Baby Bubble eventually burst.
 
US Economy: Imports & M-PMI Turn Q1-GDP Growth Negative. The latest economic indicators aren’t supporting our resilient-economy thesis. Nevertheless, we are sticking with it for now. Consider the following:

(1) Atlanta Fed’s GDP Now & CESI. The Atlanta Fed’s GDPNow tracking model lowered the estimated growth rate of Q1’s real GDP from 2.5% (q/q, saar) to -1.5% on Friday and then further to -2.8% on Monday (Fig. 3). Friday’s downward revision was attributable to a huge increase in imports during January and to a significant drop in consumer spending during the month. Monday’s downward revision was attributable to weak construction data in January and to a drop in the new orders index of February’s M-PMI.

The Citigroup Economic Surprise Index (CESI) has turned negative over the past few days and was -16.5 on Friday (Fig. 4).

(2) Purchasing managers surveys. Monday’s M-PMI report for February was weaker than expected at 50.3, down from 50.9 in January (Fig. 5). Those were the first back-to-back readings above 50.0 since late 2022. However, the new orders index (48.6) and employment index (47.6) were both below 50.0 last month.

We’ve previously observed that the correlation between the M-PMI and the quarterly growth rate in real GDP of goods isn’t very high, especially of late (Fig. 6). While the former has been mostly below 50.0 since late 2022, the latter has been mostly positive.
 
The same can be said about the correlation between the NM-PMI and the quarterly growth rate of real GDP of services (Fig. 7). Neither the M-PMI nor the NM-PMI is particularly useful for assessing the current growth rates of goods and services in real GDP when the economy is expanding. They are more useful for that purpose when they fall significantly below 50.0, signaling a recession.

February’s NM-PMI will be released on Wednesday. Stock investors were spooked on February 21 when the S&P Global “flash” estimate showed a sharp drop to 49.7 from 52.9 in January (Fig. 8). We don’t expect a similar drop in Wednesday’s report from the Institute of Supply Management.

In any event, the Atlanta Fed and the financial markets may be giving both the M-PMI and NM-PMI more weight than they deserve. Nevertheless, we will continue to track the regional business surveys conducted by five of the 12 Federal Reserve district banks for insights into the national M-PMI (Fig. 9). The former misleadingly indicated a stronger national M-PMI in February.

We will also be monitoring the prices-paid and prices-received indexes in the regional and national business surveys. February’s M-PMI prices-paid index jumped to 62.4, the highest reading since June 2022 (Fig. 10). The bond yield fell as investors focused more on the “stag” than the “flation” in the stagflation scenario that’s been gaining credibility.

(3) Construction. Following the release of Monday’s construction report for January, the GDPNow model slashed the residential construction component of Q1 real GDP from 1.4% to -4.9% y/y and lowered the nonresidential structures component from -2.0 to -2.5% y/y (Fig. 11). January’s actual m/m changes in these two categories were -0.4% and 0.1%.
 
(4) Imports. Following the release of the advance report for January’s merchandise trade data, imports growth in Q1’s real GDP was boosted from 5.4% to 29.7% y/y (Fig. 12). That remarkable jump was attributable to importers front-running Trump 2.0 tariffs.

Real GDP is basically a measure of domestic production that is calculated by adding up the sources of domestic demand and adding exports (which are not included in domestic demand, but boost domestic production), while subtracting imports (which need to be subtracted from domestic demand to calculate domestic output). So soaring imports depressed GDPNow’s real GDP growth estimate for this quarter significantly. Some of that surge was attributable to imports of gold.

Imports are likely to have fallen in February and to fall again in March, which would boost Q1’s real GDP in the GDPNow tracking model.

(5) Personal income, consumption & saving. Personal income jumped 0.9% m/m during January (Fig. 13). Total wages and salaries rose only 0.4% m/m. Total personal income was boosted by a 1.8% increase in government social benefits and a 1.2% increase in nonlabor income (from dividends, interest, rents, and proprietorships).

Despite the jump in income, personal consumption fell 0.2% m/m, resulting in a 32% increase in personal saving. The personal saving rate jumped from 3.5% during December to 4.6% during January (Fig. 14). We attribute the weakness in January’s consumption to inclement weather. It was the coldest January since 1988. In addition, December’s m/m rate in consumer spending was revised up from 0.7% to 0.8%.

In the GDPNow tracking model, Q1 real consumption growth was lowered from 2.2% to 1.3% y/y after the release of the personal income report on Friday. It was lowered again to 0.0% on Monday. We aren’t sure why, so we submitted an inquiry.

In any event, we are reasonably sure that consumer spending will rebound in February and March.

(6) Q1’s GDP. Our bottom line is that we expect to see real GDP increase during Q1 between 1.5% and 2.5%. We are betting on the economy’s resilience. We are keeping the stagflation scenario in our what-could-go-wrong bucket with a 20% subjective probability.

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Testing The Resilience Of The US Economy

March 03 (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: Addressing the Growth Scare. On Friday, the Atlanta Fed’s Q1 GDPNow model fell from 2.3% to -1.5% (q/q, saar) (Fig. 1). Naturally, that amplified the ongoing concerns that the US economy is quickly slowing, perhaps due to uncertainty attributable to Trump 2.0. While much of the drop in the model’s estimate did have to do with Trump 2.0, January’s trade data that triggered it don’t portend a significant economic slowdown. Neither do January’s consumption data, in our opinion. Both were released on Friday.

Here’s more:

(1) Frontrunning tariffs. In the GDP calculation, when US imports rise faster than exports, that weighs on real GDP growth. In January, goods imports soared to a record high, causing the trade deficit to widen 70% y/y to $153.3 billion, or a $1.8 trillion annualized deficit (Fig. 2). The bulk of this surge represented importers getting ahead of potential tariff increases. Imports of industrial supplies increased by 63.2%, and imports of consumer goods rose by 25.9%.

The trade data went from weighing on the GDPNow model’s expected Q1 growth by -0.41% to -3.70%, leading to the huge swing (Fig. 3).

(2) Wait for the February data. The problem with the GDPNow model is that it can be erratic, and its latest swing catches only the surge in imports. The reason net exports are subtracted from overall GDP is that usually imports are already accounted for in consumption and inventory investment data—that’s why they typically correlate with US economic growth. Consumption was weak in January because of the coldest January weather since 2011. We expect that consumption will rebound while imports weaken in February and March. If so, then real GDP should grow at least 1.5% in Q1 and 2.5% in Q2.

(3) Markets’ reaction. The 10-year Treasury yield now stands just below the bottom of our 2025 expected range of 4.25%-4.75%, hovering around 4.20% (Fig. 4). It had been around 4.25% on Friday—and stocks had been up on the day—until Ukrainian President Volodymyr Zelenskyy’s public meeting with President Donald Trump and Vice President JD Vance turned into a chaotic shouting match. Stocks managed to finish the day higher thanks to some month-end markups (or window dressing).

In any event, the markets may be reading too much into the trade data that are temporarily weighing on GDP expectations. We’re still expecting a rebound in the February and March economic data; however, growth will likely slow during Q1 and perhaps Q2 before accelerating in the back half of the year as uncertainty fades.

Strategy II: Animal Spirits Trump Uncertainty. If you’re searching for a bearish narrative, take your pick. Bearish prognosticators have been licking their wounds since the no-show recession of 2022 and 2023 and since the 2024 summer slowdown proved to be a head fake. Trump 2.0 seems to be bringing them out of hibernation.

Among the many economic challenges ahead cited by the growing cohort of bears are:
Fiscal stimulus will diminish, weighing directly on GDP. In other words, a fiscal cliff is coming soon.
Consumers will retrench because they are too leveraged or have run out of excess savings.
The positives of Trump 2.0’s pro-business stance are outweighed by the negatives of policy uncertainty, drummed up by daily executive orders and tariff announcements. This uncertainty will restrain capital spending and is already spurring a slowdown in the services economy.
The Department of Government Efficiency (DOGE) is slashing the federal workforce and contracted workers. That will jack up unemployment and knock down consumer spending.
Should DOGE fail in its aims of narrowing the budget and slowing the growth in federal spending, then higher interest rates and a fiscal crisis are inevitable. Corporate defaults, slimmer profit margins, and lower stock prices surely would follow. The reduced net wealth effect would weigh doubly on consumer spending. Construction employment would suffer from the housing market malaise under higher rates.
So whether DOGE succeeds or fails, the thinking goes, the economy is doomed. Woe is us! The wall of worry grows a brick row higher each day.

We believe the current uncertainty will be offset by the US economy’s dynamism. The economy has demonstrated its resilience since the pandemic started. That’s especially true over the past three years, when monetary policy turned restrictive to beat down inflation yet the economy continued to grow. There hasn’t been a recession since the pandemic lockdowns during the first two quarters of 2020.

We expect that pro-business policies, as they emerge, will boost longer-term confidence, allaying short-term uncertainties related to Trump 2.0. We think the naysayers are hanging too much significance on what drove economic growth in the years that followed the pandemic and not enough on what will drive it going forward.

Ironically, their excuse for being wrong in expecting a recession over the past three years is that fiscal policy was stimulative, which staved off the downturn. Now that it is likely to turn less stimulative, the odds of a recession are increasing again, in their opinion. That is such yesterday thinking! We are thinking ahead to tomorrow, focused on future developments that are already stimulating the economy such as the tech-led productivity boom at the crux of our Roaring 2020s outlook. In short, our long-held bullish stance remains intact.

Consider some rebuttals to the bears’ concerns:

(1) Government vs private sector spending. There’s a certain fatalism in believing that the US economy is heading for a debt crisis but at the same time believing that anything done to avert it would plunge the economy into a recession caused by a fiscal cliff anyway.

Some chalk up America’s real GDP growth in the post-pandemic period mostly to massive fiscal stimulus. We agree that the pandemic-time fiscal stimulus was excessive, as the sticky inflationary pressures still evident four years later attest. But more importantly, we believe that the private sector can offset the slowdown in government spending and is likely to do so by allocating capital to more productive projects and sectors.

For instance, the Biden administration focused too much on electric vehicles and green energy and not enough on semiconductors, defense, and the electric grid. The CHIPS and Science Act (around $53 billion in appropriated funds) paled in comparison to the Inflation Reduction Act (a $400 billion hit to the federal deficit), and the Infrastructure Investment and Jobs Act (around $550 billion in new spending). But the AI boom is already boosting massive private-sector spending on R&D, information processing equipment, and software, which now account for half of all nonresidential fixed investment (Fig. 5 and Fig. 6). Between Apple’s latest announcement and Stargate (Microsoft/OpenAI, Oracle, and SoftBank), there’s $1 trillion of planned capital spending over the next four years.

(2) Offering outlay relief. We were encouraged by the latest budget bill passed by the House of Representatives, which includes $2 trillion of directed spending cuts over the next decade. All else equal, lower federal spending means slower economic growth. If federal spending does fall by $2 trillion by 2035, GDP growth will be lower unless consumption and investment rise and/or the trade deficit narrows. We are optimistic that all three of these will occur.

Can personal consumption expenditures and fixed investment increase by an extra $2 trillion over the next 10 years? Certainly. Consumption is 68% of GDP, or $19 trillion, and will likely breach $25 trillion within the next decade (Fig. 7). Investment is 18% of GDP, or $5 trillion, and will likely breach $7 trillion. Given our expectations that productivity growth reaches 3.0%-3.5% by 2030, an extra $2 trillion is achievable (Fig. 8). We expect both tax cuts and deregulation to accelerate consumption and capital spending, helping to quicken those productivity gains.

(3) Taming trade. The trade deficit can also do some lifting. Reducing net exports from the current -3.1% of GDP to -1.5% would improve GDP by $663 billion by 2035 (assuming annualized nominal GDP growth of 4%). So consumption and investment combined would have to pick up by only $1.3 trillion. These are not mutually exclusive events. Increased domestic investment is the likely result of Trump 2.0’s nascent trade policies, which are also aimed at improving the trade deficit. This scenario includes consumers’ spending more on domestically produced goods and services.

(4) Reducing revenues? Or raising them? The $2 trillion of spending cuts in the House bill were paired with $4.5 trillion in tax cuts. The reduction in receipts from the baseline would roughly reduce federal revenues by about 1.0%-1.5% of GDP through the next decade (Fig. 9). In our opinion, the stimulative impact of lower taxes and encouraged investment in the US will offset a portion of the cuts with higher growth.

(5) Putting a dent in the deficit. If outlays grow at a 5% average annualized rate—which is roughly average for the 2014-19 period—then the $2 trillion in spending cuts will push federal outlays down to about 20% of GDP. That would be historically normal and consistent with a budget deficit that’s 3% of GDP (Fig. 10 and Fig. 11).

We’re doing very back-of-the-envelope math here, but the point is that lower federal spending is not a doom scenario for the US economy and Trump 2.0’s economic goals are more realistic than they get credit for. In other words, the markets aren’t pricing in these optimistic possibilities.

(6) Consumers keeping it cool, not cooling. The US consumer is fine. Since the root cause of rising unemployment last year was mostly immigration and increased labor force participation, we do not believe DOGE-related firings will spiral into mass layoffs (Fig. 12). Government employees make up just 12.5% of total payrolls, and state and local governments should be less affected by DOGE than the federal government (Fig. 13). As long as the unemployment rate remains in the 4.0%-4.5% range that we expect—which is likely now that immigration has slowed substantially—consumers will continue to spend apace.

Last Monday on CNBC, JP Morgan CEO Jamie Dimon, long bearish on consumer spending, said he now sees consumers as nearly “back to normal”: “[T]hey don’t have all the extra money, but they have jobs. Wages are going up. …So you are starting to see what I put at normal. Credit costs have normalized. So it’s just almost back to what I call a normal environment.”

Dimon was among the most worried about the consumer throughout 2022 and 2023. As he suggests, real wages are rising (Fig. 14). We expect rising productivity growth to keep that train on track (Fig. 15).

(7) Uncertainty abounds. Certainty is good for business. The outlook has gotten more uncertain over the past few months (Fig. 16). But we do not expect this uncertainty to persist. While the S&P Global NM-PMI contracted slightly this month, it tends to be more volatile than the ISM NM-PMI (Fig. 17). Redbook retail sales are still up 5.9% y/y (Fig. 18). And based on regional Fed manufacturing surveys, we expect the ISM M-PMI to post a second straight month above 50.0, indicative of expansion (Fig. 19). Last month marked the index’s first foray into expansion territory since the Fed started tightening in early 2022 and suggests the manufacturing sector has finally entered a rolling recovery.

(8) Housing horror show. The housing market has been a mess for several years, if not since the turn of the century. With overall construction employment around record highs, several observers have insinuated that the economy is entering a cyclical slowdown as housing permits and starts fall (Fig. 20 and Fig. 21).

But as Austin, Texas shows us (see this recent Bloomberg story), deregulation is the answer to high home prices. We believe Trump 2.0 will tackle this on a national level, stimulating more housing starts and permits and thereby keeping employment elevated.

Meanwhile, the supply of construction employment has fallen with decreased immigration, so employers are likely to hold onto their workers. And though many in construction are working on nonresidential buildings, it’s notable that roughly half of residential construction employment is remodelers (Fig. 22). That suggests that construction employment is relatively shielded from any potential housing slowdown, and that construction skills are transferable across different types of projects.

(9) Winning with the wealth effect. The excess-savings-depleting story that led to a lot of worry about the economic outlook over the past couple years was a nonstarter, in our opinion, mostly because retiring Baby Boomers were sitting on huge nest eggs that continued to appreciate. Between near-record stock prices and high home prices, the Baby Boomers now hold roughly $83 trillion of the $160 trillion in US household wealth (Fig. 23). So we haven’t been worried about the relatively low personal savings rate; in fact, we think it may fall into negative territory by the end of the decade.

Could the wealth effect reverse? A bear market in stocks and much lower home prices likely would lead consumers and businesses to pull back some of their spending. But that would be likely only in a recession, which we see as improbable at the moment. If a recession were to become more likely, automatic stabilizers and the ease-first-ask-questions-later Fed would quickly restimulate markets and the economy. Both a recession and a fiscal crisis are in our 20%-probability what-could-go-wrong bucket of economic scenarios. We still apply an 80% subjective probability to outcomes that are bullish for US stocks.

Movie. “Zero Day” (-) stars Robert De Niro as former US President George Mullen, who is tasked with heading a commission to investigate a cyber-attack that kills thousands of Americans. It is a who-done-it Netflix series. De Niro seems to be bored by the plot. That’s because it is boring and predictable, mostly because it is inane. The problem with conspiracy movies is that they are competing with all too many conspiracy theories swirling around on social media. So it is hard for screenwriters to come up with an original conspiracy. (See our movie reviews archive.)

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Homes, Earnings & Clunkers

February 27 (Thursday)

Consumer Discretionary: Gimme Shelter. After a couple of tough months, the housing industry enjoyed positive news this week. The interest rate on home mortgages fell to the lowest level this year, 6.85%. While that’s still more than twice the interest rate that lucky homebuyers enjoyed in 2021, it’s an improvement from 2024’s peak of 7.22% (Fig. 1).

Positive news also came from Home Depot and Lowe’s, members of the S&P 500 Home Improvement Retail industry. Both reported Q4 earnings that beat expectations and said their slow but steady improvement should continue this year. Indeed, the industry’s stock price index looks like it’s about to break out from a multi-year consolidation.

Members of the S&P 500 Homebuilding industry, on the other hand, may need more time before their correction since October concludes. Home prices remain high, and housing inventory is building, no pun intended.

Here's a look at these giant home-related industries:

(1) To-do lists grow. Both Home Depot and Lowe’s reported positive same-store sales for the first quarter in two years during Q4, and both managements are optimistic that the improvement will continue in 2025.

Both Home Depot and Lowe’s have been working to increase revenue ever since it peaked on an annual basis in 2023. Over the past year, that’s become more difficult due to rising interest rates, which make funding large home remodeling projects more expensive.

Home Depot executives aren’t counting on a large drop in interest rates this year to hit their targets. Instead, they believe consumers are slowly acclimating to higher interest rates and have the flexibility to tap home equity—which has surged in recent years—to fund projects. The pandemic was five years ago, and even the new things purchased back then are starting to wear.

The S&P 500 Home Improvement Retail stock price index peaked during the pandemic buying surge in 2021 and subsequently fell sharply. In the ensuing years, it has gradually risen and appears close to setting a new high (Fig. 2). The industry’s forward operating earnings per share remains 10.2% below its October 2022 peak, but operating earnings is expected to grow 4.8% this year (Fig. 3 and Fig. 4). The Home Improvement Retailers’ forward P/E at 23.2 is extended for the industry but should improve as earnings growth resumes (Fig. 5).

(2) Homebuilders face a changing market. S&P 500 Homebuilders have defied pessimists’ expectations for the longest time. Their profitability improved for much of past five years, notwithstanding doomsayers’ predictions of slowdowns during the pandemic or the Fed’s rate-hiking cycle, which began in 2022 (Fig. 6). Analysts expect y/y earnings comparisons to bungee from an 11.4% drop this year to 13.7% growth in 2026 (Fig. 7).

Such a quick rebound seems optimistic. If interest rates and inventories remain elevated, homebuilders might be forced to cut selling prices or offer higher financing incentives to move inventory. If interest rates fall, the new home market could face increasing competition from existing homeowners, who have been stuck in their homes and need to sell.

Nationally, home prices have been rising and inventories climbing. Home prices in the Case-Shiller 20-city index rose in December by 0.5% m/m and 4.5% y/y. January saw new home sales (counted at contract signings) tumble (10.5% m/m and 1.1% y/y), dragged down by cold weather in the Northeast (Fig. 8). Inventory levels remain unusually high, with the ratio of new homes for sale to new homes sold at 9.0 months (Fig. 9 and Fig. 10).

The S&P 500 Homebuilding stock price index has rallied almost nonstop since 2020. From its four-year low on March 23, 2020, the index has gained 347%, and that includes its recent 29% correction from its October peak (Fig. 11). The spring selling season has never been so important.
 
Strategy: Searching for Earnings Growth. With market volatility on the rise and stock indexes under pressure recently, investors may be looking beyond the richly valued S&P 500 Information Technology sector for earnings growth opportunities. The S&P 500 Health Care sector stands out as a strong earnings grower this year based on analysts’ 2025 consensus estimates; so do certain insurance industries in the Financials sector. And several industries with expected earnings declines this year look bound for double-digit earnings growth in 2026. Bargain hunters, take note.

Here are the 2025 earnings growth estimates for the S&P 500 and its 11 sectors: Information Technology (20.0%), Health Care (18.6), Industrials (16.7), Communication Services (12.2), S&P 500 (12.0), Consumer Discretionary (7.5), Utilities (6.7), Financials (6.4), Materials (5.2), Real Estate (3.4), Consumer Staples (2.7), and Energy (1.5) (Table 1).

Let’s dive deeper into some of the details:

(1) Health Care: Strong earnings, bad politics. As investors have turned away from high-valuation areas of the stock market, they’ve embraced the S&P 500 Health Care sector. Its stock price index has risen 7.9% ytd through Tuesday’s close, and it sports a below-market forward P/E of 17.8 (Fig. 12 and Fig. 13).

Investors may have decided that the uncertain politics sounding the Health Care sector are outweighed by the strong 2025 earnings growth forecast for most industries in the sector including: Biotechnology (34.0%), Pharmaceuticals (29.3), Health Care Facilities (13.3), Health Care Distributors (10.5), Health Care Equipment (10.1), Health Care Services (9.1), Managed Health Care (5.8), and Health Care Supplies (-1.9).

Here's how the stock price indexes of the Health Care industries have performed ytd through Tuesday’s close: Health Care Services (21.9%), Biotechnology (14.8), Health Care Equipment (10.8), Pharmaceuticals (8.9), Health Care sector (7.9), and Managed Health Care (-3.7) (Fig. 14).

CVS Health has been the standout stock in the Health Care Services industry, having risen 41.8% ytd after a dismal 2024. CVS replaced its CEO last fall and recently reported Q4 earnings that soundly beat analysts’ consensus estimate. For now, worries about the Trump administration potentially changing reimbursement policies for pharmacy benefit management companies, like CVS’s CVS Caremark, appear to be on the back burner.

Within the Biotechnology industry, Gilead Sciences is the standout recent performer, with its share price up 20.7% ytd and 51.6% y/y. Gilead shares started 2024 depressed after the company’s cancer drug proved ineffective against lung cancer. But the disappointment was quickly swept away by accelerating sales of its HIV drugs. The company recently projected earnings per share of $7.70 to $8.10 for 2025, above the $7.61 analysts had been expecting.

Other Biotechnology outperformers include Amgen (up 21.1% ytd), Vertex Pharmaceuticals (19.3), and AbbVie (14.9).

The Health Care sector’s ytd stock returns would be an even more impressive 9.5% excluding the dismal performance of one of its largest members, United Healthcare. UNH stock has dropped 7.0% ytd, pulling down the ytd gain of the Managed Health Care industry index to -3.7% (Fig. 15). The stock’s weakness reflects federal investigations into United Healthcare’s billing practices as well as earnings hits from higher medical costs.

The Managed Health Care industry has the weakest 2025 earnings growth forecast in its sector, at 5.8%, though its outlook improves in 2026, when analysts are forecasting 11.5% earnings growth.

(2) Insurance is steady eddy. Analysts anticipate strong earnings growth this year for several insurance industries. In most cases, rate increases and investment portfolio gains should more than offset insurance claims.

The Reinsurance industry is expected to be the third fastest earnings grower in the S&P 500 this year as it recovers from a drop in earnings last year. Here are the consensus expectations for the insurance-related industries’ earnings growth (and in one case contraction) this year: Reinsurance (63.6%), Multi-line Insurance (25.2), Insurance Brokers (9.7), Life & Health Insurance (9.1), and Property & Casualty Insurance (-4.7).

While the Reinsurance industry’s stock price index has fallen 5.3% ytd, the rest of the industries’ stocks have had positive ytd performances: Insurance Brokers (11.7%), Multi-line Insurance (8.5), S&P 500 Insurance Industry (6.6), Property & Casualty Insurance (5.4), and Life & Health Insurance (1.1) (Fig. 16).

(3) A peek into 2026. Among the industries with declines in earnings growth forecast for 2025, a handful looks poised for earnings rebounds in 2026, with double-digit growth forecast. For example, the S&P 500 Agricultural & Farm Machinery industry is expected to see earnings fall 25.3% this year, only to enjoy a 14.1% increase in earnings in 2026.

Other industries that fall under this umbrella are: Construction Materials (-23.2% in 2025, 16.2% in 2026), Steel (-16.2, 44.9), Agricultural Products & Services (-12.2, 10.9), Homebuilding (-11.5, 13.7), Personal Care Products (-9.5, 16.3), Property & Casualty Insurance (-4.7, 17.9), Construction & Transportation Equipment (-3.6, 15.4), Oil & Gas Refining & Marketing (-3.1, 54.4), Integrated Oil & Gas (-2.7, 20.2), Commodity Chemicals (-0.9, 38.8), Home Furnishings (-0.9, 20.9), Cable & Satellite (-0.2, 11.4), and Automobile Manufacturers (-0.1, 17.0).

Disruptive Technologies: Startups Pay the Piper. Several startups we’ve discussed here in recent years have announced bankruptcy filings.

Some of their problems arose from technology that didn’t quite make the grade despite compelling concepts (what’s not to like about beating traffic in a flying taxi or generating electricity from solar panels on your home?). Other problems derived from the changing capital markets and political environment. Low interest rates and the roaring IPO market of 2021 has been replaced by high interest rates and a picky IPO market. And while the Biden administration threw money at anything green, the Trump administration is yanking it back.

Here's a look at some of the ashes:

(1) Electric trucker crashes. Nikola, an electric truck maker that once had a market value north of Ford Motor’s, filed for bankruptcy protection earlier this month. The company will forever be remembered for its video of a prototype truck apparently operating but actually gliding downhill. The company, whose founder was convicted of securities fraud, went public via a special purpose acquisition company in 2020 and made 235 hydrogen electric trucks before closing shop.

The use case for electric semis hasn’t exactly played out. Using electric trucks to drive between ports and nearby warehouses seems smart, but building an electric charger system cross country has been tough. Electric trucks can cost two to three times what diesel trucks cost, and the added weight from the batteries means drivers can’t transport as much cargo, according to an August 28, 2023 article in Marketplace.

Now the political environment is growing tougher as well. Regulations to incent/force manufacturers to produce more electric vehicles may be eliminated by the Trump administration. These include 11 states’ rules requiring the manufacturers of trucks, including large semis, to sell an increasing portion of emission-free models as part of their total sales; a California state law requiring fleet owners to buy more zero-emission trucks; and tightened federal tailpipe emissions requirements. Moreover, a group of 19 states is challenging the legality of California’s requirements for truck manufacturers, a February 25 Bloomberg article reported.

That said, there are electric trucks in operation. Schneider National’s 92 Freightliner eCascadia all-electric semi trucks have racked up more than 6 million miles around the ports of Southern California. The company’s 92 trucks were purchased using funds from environmental or governmental groups.

Amazon recently ordered more than 200 Mercedes-Benz eActros 600 electric semi trucks to add to its UK and German fleets this year, a January 14 Electrek article reported. The company already has 30 electric semis in Europe and 50 in California, in addition to thousands of electric delivery vans.

Tesla appears to be moving ahead with its development of electric semis. Two were spotted in January pulling two tandem trailers, according to a post on X, and more should hit the road later this year. Tesla is actually late to the party and faces competition from EV truck manufacturers like Peterbilt and Volvo.

(2) Solar company goes dark. Last summer, one of the largest solar panel companies, SunPower, filed for bankruptcy protection. It was just one of the many solar companies to fall on hard times as Chinese solar panels, with better technology and lower costs, hit the US market. Higher interest rates and funding costs made solar projects too pricey for some homeowners. And in 2022, the California Public Utilities Commission slashed by 80% the rate that utilities are required to pay solar customers for electricity exported to the grid.

(3) Air taxis crash. German air taxi manufacturer Volocopter filed for bankruptcy but continues to look for a new investor to keep the company afloat, a December 30 article in Deutsche Welle reported. Another German air taxi, Lilium, declared bankruptcy and shut operations on Tuesday.

US air taxi companies are encountering turbulence as well. Shares of Joby Aviation and Archer Aviation both are trading in the single digits. Both companies’ shares are down roughly 20% ytd.

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On Bitcoin, India, And S&P 500 Earnings

February 26 (Wednesday)

Crypto: Leveraged Bitcoin with Convertible Bonds. We have viewed bitcoin as a digital tulip. That’s not to rag on bitcoin or its investors; rather, we’re suggesting that speculation in high-beta novel assets like bitcoin has evolved in the modern financial system.

Unlike tulip bulbs, bitcoin can be traded online, 24/7, globally, and has multiple uses. It can be used as a currency for transacting or stored for its appreciation potential. While bitcoin tends to trade like a triple-levered Nasdaq 100, it did not collapse during the recent Fed tightening cycle, a fact that has encouraged institutional players to join the fun (Fig. 1).

Michael Saylor’s Strategy (a.k.a. MicroStrategy, ticker: MSTR) has garnered attention for its strategy of accumulating bitcoin during its meteoric rise. Even after falling roughly 40% since November (including 10% on Tuesday), MSTR is still up about 220% over the past year and about 2,180% since it began purchasing bitcoin in August 2020 (Fig. 2). Levering up to purchase bitcoin via a combination of equity and debt issuance has led to MSTR’s trading at a premium to its nearly 500,000 of bitcoin holdings, which are worth roughly $47 billion. Bitcoin is up 706% since MSTR began buying it.

A key part of Strategy’s strategy is to issue 0% coupon convertible bonds to fund its bitcoin purchases. Let’s explain why this works, and perhaps how it unravels:

(1) Bitcoin goes up. A core component of Strategy’s playbook is to issue 0% convertible bonds at little cost, buy bitcoin with the proceeds—driving up bitcoin’s price, which in turn causes MSTR’s share price to rise—then issue more debt or equity at a higher valuation, buy more bitcoin, and so on. Rinse, wash, repeat.

Since 2020, Strategy’s bitcoin holdings have risen from $250 million to nearly $50 billion. The company’s “21/21 Plan” aims to raise $42 billion over three years to buy more bitcoin.

(2) Convertibles can’t go belly up ... right? On February 20, Strategy issued $2 billion in convertible senior notes due in 2030 with a 35% premium, meaning that investors could convert their bonds into MSTR shares if the price rose more than 35% and pocket the difference. That followed a $3 billion issuance of convertibles due in 2029 last November, which were priced at a 55% premium.

So if the convertibles pay no coupon and investors can only experience upside after sizable price appreciation, why don’t they just buy MSTR? Or bitcoin?

Institutional investors are big fans of buying convertibles because they can participate in bitcoin’s/MSTR’s rise while limiting their downside risk. Bondholders still get their principal back if they choose not to convert into shares (i.e., if MSTR falls substantially, as it has been doing in recent days). In the event of bankruptcy, the notes are senior to shareholders. MSTR also has a legacy software business that brings in roughly $500 million in annual revenue, so there are some assets to fall back on, even in the event of a bankruptcy.

All that said, convertibles aren’t “risk free.” For instance, MSTR’s zero-coupon convertibles issued in November are now trading at a 23% discount to par (or 77 cents on the dollar). The stock would now have to more than double in price for it to make sense for an investor to exercise the conversion option. Hedge funds using arbitrage strategies, such as shorting MSTR and buying the convertibles, might still profit from the price difference as well as the embedded long-volatility component of the convertibles. So there’s protection in buying convertibles, but no free lunch.

(3) When does the gravy train end? Rather than repay principal on maturing convertibles, MSTR tends to roll them over, or issue more debt to pay off the old ones. If demand for bitcoin dries up or the price falls substantially, MSTR may not be able to tap the capital markets to repay investors their principal. Selling bitcoin to finance those repayments would lead to a downward spiral, as is often the case in the post-mortem of many leveraged bets.

We think bitcoin is probably here to stay. MSTR may or may not be. Trump 2.0 seems invested in crypto’s success, but a recession or economic slowdown undoubtedly would hurt bitcoin’s price. If you choose to invest, caveat emptor.

Following today’s 3% drop, bitcoin is now down more than 16% from its December 17 peak. And after discounting its future cash flows and assessing the quality of its management team, we see additional downside as a reasonable possibility. Still, we do expect US macroeconomic data to improve next month, so we could see bitcoin back above $90,000 in short order.
 
India I: Is the Party Over? India’s equity and credit markets have become hotbeds of speculation. Deputy Governor Rajeshwar Rao recently voiced concerns about over-leveraging in unsecured credit markets and a “frenzy” in capital markets. Overheating of Indian equities, a theme we’ve discussed since last summer, is now more evident.

Investor demand for India’s government debt soared following its inclusion in global bond indices, helping to lower the spread between the 10-year Indian government bond yield and the comparable US yield to only 231bps (half as much as five years ago) (Fig. 3). But now, the upside in India’s financial markets may be fading—especially with signs of a potential economic slowdown.

Let’s have a closer look:

(1) Equity valuation has downshifted. India’s MSCI stock market index surged from a low in October 2023 to a record high in September 2024, peaking at a valuation of 25 times forward earnings per share (EPS). This multiple since has retreated to a 14-month low of 20.8 as of Tuesday’s close, marking a souring of investor sentiment.

(2) Equities have retreated. The India MSCI index is down 7.0% ytd (Fig. 4). Real Estate stocks, collectively down 22.1% ytd, have been a major drag on the index so far this year, while Communications Services stocks have bucked the trend with a modest ytd increase of 2.4% (Fig. 5).

(3) Earnings momentum has stalled. Forward EPS for Indian companies in the India MSCI rose 21.4% from August 2022 through the start of 2024 (Fig. 6). From mid-2024 until now, however, the index’s forward EPS has stalled out.

(4) Bond yields have cooled. India’s 10-year government bond yield fell below 7.00% in mid-2024 and has continued to inch lower; it now stands at 6.70% (Fig. 7).

India II: India’s Make-or-Break Moment. India’s real GDP growth has cooled from its heady 8.4% y/y rate during India’s last fiscal year, ended March 2024, and the Reserve Bank of India (RBI) projects continued slowing to around 6.5% y/y by fiscal 2026.

But Prime Minister Narendra Modi’s government isn’t sitting idle. To put growth back on the 8% track, fiscal and monetary policymakers have introduced stimulus measures that include substantial tax cuts and easing of credit rules. Driving these moves is Modi’s ambition to transform India into the world’s third-largest economy by 2030, his Make India Great Again (MIGA) plan. But whether the country can return to its previous pace is an open question.

To help support the economy, the RBI’s new chief (as of December), Sanjay Malhotra, has moved the monetary policy needle to neutral from his predecessor’s hawkish position. Accommodative measures taken include delaying new banking regulations that might have hampered credit flows and lowering the RBI’s key short-term rate in February.

In addition to monetary policy support, the government recently has slashed taxes to reinvigorate consumption. But the fiscal supports are a mixed bag. Modi’s budget for next fiscal year cuts spending on social programs. Modi has been criticized for allowing the economy to fall into a middle-income-trap.

It is not yet clear whether these fiscal and monetary supports will be enough to restore and sustain a growth trajectory near the previous 8% y/y pace. Here’s more:

(1) Growth slowdown is apparent. India’s Q3-2024 GDP fell 7.9% q/q but increased 5.6% y/y; that compares with year-earlier growth of 8.6% y/y (Fig. 8).

(2) Sentiment is weakening. Worsening this slowdown are weakening consumer and business sentiment (Fig. 9).

(3) Fiscal support waivers. Fiscal spending reached nearly 90% debt-to-nominal GDP shortly after the pandemic but eased to 83.5% by Q2-2024 (Fig. 10).

(4) Monetary easing & inflation. The RBI lowered the short-term rate to 6.25% in February 2025, after having held it steady at 6.50% since February 2023.

India’s inflation remains above the bank’s 4.0% target despite having fallen from above 6.0% in October 2024 to 4.3% in January 2025 (Fig. 11).

India III: Modi’s MIGA Vision. India’s path to becoming the third-largest economy by 2030 is fraught with challenges, from internal inefficiencies to geopolitical issues. But with monetary easing, fiscal support, and bold initiatives, India aims to reattain close to an 8% y/y growth trajectory. Whether these efforts can overcome the structural hurdles facing the economy remains to be seen; but for now, India continues to push ahead on the global stage.

Vineet Jain of The Times Group introduced Prime Minister Narendra Modi at the 2025 Global Business Summit, highlighting Modi’s broad growth strategy and listing its key initiatives:

(1) MIGA: Modi’s strategy for global leadership. Modi’s MIGA plan seeks to position India as a global leader in key industries by 2030, promoting both self-sufficiency and stronger international partnerships.
 
(2) US-India COMPACT. The expanding US-India alliance is focused on technology, defense, and trade. This strategic partnership is designed to counterbalance China, creating new opportunities for collaboration in AI and space exploration.
 
(3) “Make in India.” The Make in India initiative has revitalized domestic manufacturing, attracting significant foreign investment and positioning India as a competitive hub for manufacturing.

(4) AI & “Digital India.” India is emerging as a global leader in AI, with a young population and increasing government support. The Digital India initiative is transforming the country, enhancing everything from e-commerce to government services.

(5) “Startup India.” The Startup India initiative has fostered a flourishing entrepreneurial ecosystem, with growing investment in sectors like fintech and edtech.

(6) India as a global manufacturing alternative. India’s push to become a global manufacturing hub is positioning the country as an alternative to China in the global supply chain.

(7) Global technological leadership. India’s success in space exploration and its growing role in semiconductor production underscore its rise as a technological power.

Strategy: Are Earnings Forecasts Stalling or Falling? Ready or not, the Q4 earnings season is set to add Nvidia to the S&P 500’s results as the index passes the 90% complete mark by week’s end. It has been a “less strong” earnings season so far for the Magnificent-7 companies, with their future guidance less encouraging than in recent quarters. That has doused investors’ enthusiasm for most of the group. Last week’s earnings warning from richly valued Walmart unnerved investors even further, and some of them removed the stock from their shopping carts.

At a time when valuations are priced for perfection, investors urgently want to know: What’s happening with earnings forecasts now? Below, Joe lends some perspective on recent consensus earnings estimate trends:

(1) No sign of an earnings pothole ahead. Estimates are pausing just below their recent record highs amid uncertainty about tariffs and lingering inflation. A return to estimate cutting as usual following the unusually strong post-pandemic years is occurring now. However, the recent declines have been relatively minor in the grand scheme of estimate revisions history even if they don’t seem so in the context of recent years: From 2021 to 2024, consensus annual earnings forecasts on the whole fell less than usual and sometimes even improved from initial forecasts.

Since 1978, I/B/E/S has been calculating consensus bottom-up S&P 500 earnings forecasts, derived from each individual analyst’s estimate for an S&P 500 company that they follow (Fig. 12 and Fig. 13). Over time, professional investors—and hopefully the investing public generally—have learned that analysts’ initial forecasts are typically too high and decline steadily until the company reports results.

It has been a good bet to make, as the annual forecast fell during 76% of time—or in 34 of the 45 years—from 1980 to 2024 (Fig. 14). Our measure tracks how much each calendar year’s forecast changed in the 24 months from the initial estimate to actual reported earnings (e.g., for calendar year 2024’s EPS forecast, we track how much that estimate changed from its initial forecast in February 2023 to its final value in February 2025).

(2) Estimates are declining, but much less than in the past. To give some perspective, the S&P 500’s consensus annual earnings forecast fell an average of 11.1% during the past 45 years. During the 11 years that ended with results that were surprisingly better than initially expected, forecasts posted an average gain of 7.2%. During the 34 years with declining annual EPS forecasts, they tumbled an average 17.0%.

(3) 2024 estimate rallied higher. The S&P 500’s reading for the 2024 estimate ranked an impressively high 12th, with a 24-month decline of just 1.4%. The cumulative estimate change for 2024 actually improved as the finish line approached, something that typically occurred during one-third of the 45 years. So 2024 was a very good year, and we think that bodes well for the 2025 forecast.

(4) How is the S&P 500’s 2025’s estimate looking at the halfway point? The S&P 500’s consensus annual earnings estimate for 2025 is down just 1.7% so far, after 12 months—the halfway mark between initial estimates for the year and the final results we’ll see about a year from now.

When similar low-single-digit percentage 12-month declines occurred—which they did during 10 of the past 45 years—the actual earnings finally reported were down from initial estimates by percentages in the single digits for most years (all but 1981 and 1984).

We think that the momentum clocked at the halfway mark bodes well for the direction of the consensus 2025 estimate over the final 12 months.

(5) Forward earnings remains strong for nine S&P 500 sectors. Relatively few of the S&P 500 sectors have forward earnings still well below their post-pandemic record highs in 2022. In fact, most sectors still have forward earnings near their record highs. During the February 20 week, the S&P 500’s forward earnings was just 0.3% below its record high in late January (Fig. 15). A whopping nine of the 11 sectors are less than 2.0% shy of their all-time record-high forward earnings! Just two sectors, Energy and Materials, remain far below their record highs and show few signs of improving.

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DOGE & The Deficit

February 25 (Tuesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy I: The DOGE Days. We’re optimistic that Trump 2.0 can cut federal spending. However, we doubt that will be accomplished via the Department of Government Efficiency (DOGE).

Our measuring stick for success is cutting outlays as a percentage of GDP, currently 23.9%, to 22.0% by 2028, where it stood in the months leading up to the pandemic. An even better scenario would be lowering it to 20%, its pre-Great Financial Crisis level (Fig. 1). Using Q4 US nominal GDP of $29.7 trillion and assuming it grows by around 5% each year, that would require roughly $650 billion of cuts annually. That's about half of total discretionary spending (Fig. 2). There appears to be little to no chance that this can be achieved via DOGE.

In the next section, we detail the strategies President Trump is using to rein in spending, and their likelihood of success.

We do applaud the virtues of what DOGE—and many of Trump's cabinet picks—are trying to accomplish. Politicians from both sides of the aisle and nearly all investors agree that the federal government spends profligately and often inefficiently. Trimming the fat and cutting out waste will help bring down the federal debt and boost productivity, as well as usher in an ethos of cost savings and spending scrutiny that may bring longer lasting benefits. Moreover, deregulation will free up the private sector from administrative and compliance expenses that cost much but produce negative returns.

Unfortunately, DOGE’s early start suggests it may cause more collateral damage than any achieved savings justify. Consider why the DOGE Boys may have bitten off more than they can chew:

(1) Savings don’t add up. Doge.gov states that the department’s estimated savings amount to $55 billion, to be achieved through “a combination of fraud detection/deletion, contract/lease cancellations, contract/lease renegotiations, asset sales, grant cancellations, workforce reductions, programmatic changes, and regulatory savings.”

DOGE says it’s working to upload all of the data transparently and has started with contract and lease cancellations, which “account for approx. 20% of overall DOGE savings.” The list, however, has been shrinking. A WSJ analysis found the canceled contracts totaled $16.5 billion on February 17, but are down to just $7 billion as of the 20th, or 13% of stated savings. The WSJ’s analysis found that the true savings were more like $2.6 billion. That is roughly what the US will spend to service its debt each day this year (Fig. 3). The WSJ also suggested that some of these cancelled contracts were already spent or represented budget allotments that may or may not have been used in full eventually.

Cutting spending won’t help balance the federal budget deficit if it also reduces assets or prevents an investment from yielding a return, for instance. That seems to be lost on DOGE's “shoot first, ask questions later” approach to cuts. One canceled $230 million contract was to modernize the Social Security Administration’s (SSA) technology. This arguably would have helped to address the SSA’s organizational malaise and alleged fraud, problems that Musk has targeted.

(2) Lower wage costs? One benefit of the wave(s) of federal resignations and layoffs is that it lowers the government’s wage expenditures. The federal government employs about 2.4 million civilian workers, or 1.4% percent of the US workforce (Fig. 4). The federal government spent around $293 billion to compensate its employees last year, including benefits. That’s less than 4.5% of federal outlays. And roughly 60% of total compensation goes to workers in the Department of Defense, the Department of Veterans Affairs, and the Department of Homeland Security. Feasibly, the government can’t save much here.

(3) But less income for workers! Personal incomes may fall more than government savings on compensation.

One reason: According to the Congressional Budget Office (CBO), around 13% of federal government employees have less than a high-school education. That’s less than the private sector, where non-diploma workers comprise one-third of employees. However, strong federal benefits mean these workers earn 40% higher compensation working for the government than their private sector counterparts.

Rising unemployment was mostly concentrated in this part of the labor market last year (Fig. 5). While it has subsided in recent months, and less immigration may cap the unemployment rate for less educated workers, those vulnerable to federal layoffs are likely to see fewer job opportunities and less compensation as they exit.

(4) Shadow government jobs. The private sector is likely to lose more jobs than the public sector, too. Federal funding and grants, including via environmental and educational agencies, pay a lot of employees’ wages. For instance, the Mercatus Center found that in some states (e.g., Maryland, New Mexico, and Virginia) between 7.7%-10.7% of nonfarm payroll jobs are funded by the federal government through contracts to private-sector firms.

Government data also show that federally funded research centers account for around 18% of total US R&D expenditures as of 2022. So it’s no surprise that some US research universities are pausing doctoral admissions in anticipation of funding cuts and that China is advertising itself as a safe haven for aspiring PhDs as a result. The prospective brain drain, if sustained, would be an unquantifiable loss in the precise fields in which the US is seeking to compete with China and lead the world. We hope that this pro-tech administration will find a way to correct course shortly.

(5) Budget deadline & tax cuts. The federal government is currently operating under a continuing resolution until March 14, so there's only three weeks for Congress to pass a new budget deal for fiscal 2025. Republicans in the House and Senate are working on tax cuts as part of a giant, all-encompassing, bill (or two). Extending the 2017 Tax Cut and Jobs Act, a core component of whatever deal the GOP constructs, is estimated by the CBO to reduce revenues by $4.6 trillion over the next decade. No tax on tips, Social Security benefits, or overtime pay are also Trump priorities. But reducing federal receipts to below the current 17.5% of GDP would complicate plans to rein in the budget deficit (Fig. 6).

That said, individual income taxes continued to rise during Trump 1.0 as the economy grew (Fig. 7). Cuts to social programs are also likely, which would reduce “mandatory” outlays.

Strategy II: Putting the Budget on a Sustainable Path. The US federal budget deficit is driven by Americans consuming and investing more than we produce and save. The causes of this imbalance and who bears the ultimate responsibility for it are up for debate. Trump 2.0 believes that it can reduce the pressure on the fiscal deficit by producing more at home and therefore helping to balance the trade deficit.

As we wrote in our February 19 Morning Briefing, defense makes up $1.1 trillion of the federal government’s annual spending, or 3.7% of GDP. The Eurozone spends less than €330 billion annually, less than 2% of its GDP (Fig. 8). Meanwhile, NATO wants to spend more than 3% of GDP on defense, which would roughly double Europe’s defense expenditures and could allow for a lot of relief from our deficit funding.

But going line item by line item isn’t a viable solution to getting the fiscal train back on the tracks. A rewiring of global trade may be necessary. Consider how that may be achievable:

(1) Current account deficit. The US current account balance, which comprises net trade but also earnings and payments on foreign investments, is around historical lows. At 4.2% of GDP as of Q3, the current account deficit has only been lower in the runup to the Great Financial Crisis (GFC) (Fig. 9). One reason is that the US primary income balance—what America earns on assets overseas versus what it pays to foreign creditors—has turned negative for the first time on record (outside of one brief blip in 2001).

It’s no secret that the rest of the world (ROW) owns more US assets than the US owns foreign assets. And despite a net international investment position of nearly -$24 trillion, very low US interest rates have allowed America to pay little to creditors while earning much more on assets abroad. For instance, a few selected foreign countries own $3.34 trillion of Treasuries (Fig. 10). Most of these were acquired during the zero-interest era following the GFC and therefore have very low coupons relative to current rates (Fig. 11).

Notably, members of Trump’s economic team have proposed debt-issuance strategies that would lessen the debt-servicing burden. However, action is already being taken on the secondary income balance, which is at a record low of -0.84% of GDP. This balance includes foreign aid, remittances, and contributions to multinational institutions. By pulling out of several of these organizations, limiting foreign aid, and reducing immigration right out of the gate, we believe half a percentage point of GDP can be saved here alone.

(2) Latest executive orders. President Trump issued two executive orders (EOs) regarding trade and investment on Friday. Both target unfair practices by China and protect the US private sector abroad.

The “America First Investment Policy” encourages foreign investment into the US while limiting US investment in China. An expedited process for allies to invest in the US will help restructure the grossly negative international investment position, help US companies like US Steel, and encourage domestic employment.

While the EO expands restrictions on investing in Chinese military-linked companies and instructs the Treasury Department to crack down on Chinese investments, it will also encourage allies to pivot away from China to receive favorable terms for investing in the US.

And domestically, the EO will expedite environmental and regulatory reviews for large investments of over $1 billion. Given the outsized burden that these reviews place on projects in the US, this could encourage a manufacturing boom that revitalizes the US industrial base.

The “Defending American Companies and Innovators from Overseas Extortion and Unfair Fines and Penalties” EO is meant to investigate foreign digital services taxes, regulations, and IP transfer requirements in the name of creating reciprocal tariffs to balance trade. We believe this is part of the “race-to-the-bottom” tariff measures that will lead to reduced trade barriers, not greater ones.

(3) Upshot. One of the most contrarian positions right now is to be bullish on global trade and domestic manufacturing. We believe Trump 2.0 will aid US companies and domestic investment without creating a Smoot-Hawley redux. The imbalances that have sidelined US goods producing and led to a huge wave of offshoring since China entered the World Trade Organization in 2001 are finally being remedied. The Roaring 2020s may very well lead to the Roaring 2030s in this outlook. While markets in Europe and other countries are likely to benefit from finally investing in their own economies, we remain bullish on the US and continue to favor our long-standing “Stay Home” investment stance—overweighting US equities in global portfolios—over a “Going Global” one.

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A Tale Of Woes

February 24 (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: Accentuating the Negatives. I was on the road again last week, speaking at the MoneyShow conference in Las Vegas and meeting with a couple of our accounts in Texas. At a client appreciation dinner for one account in Houston, I learned a lot about the oil and gas business from the folks at my table. I told them that everything I know about their business I picked up by watching the TV series Landsman, starring Billy Bob Thornton.

In my presentations, I accentuated the positives for the US economy and stock market while acknowledging the negatives. The S&P 500 rose to a record high of 6144.15 last Wednesday. But then it fell 2.1% during the last two days of the week to close at 6013.13, nearly back down to its 50-day moving average (Fig. 1). That minor decline from the record high seemed to unleash lots of negative chatter in the financial press about what could be going wrong for the economy and the stock market. It didn’t take long to hear stock market pundits accentuating the negatives.

On Friday, for example, billionaire Steve Cohen, founder of Point72 Asset Management, described a bearish outlook at the Future Investment Initiative Institute’s summit in Miami Beach. He pointed to sticky inflation, slowing growth, and the possibility of retaliatory tariffs as drags on the US economy. “I’m actually pretty negative for the first time in a while,” Cohen said. “It may only last a year or so, but it’s definitely a period where I think the best gains have been had and wouldn’t surprise me to see a significant correction.” Cohen also accentuated the possible negative effects of the Musk-led Department of Government Efficiency (DOGE).

Such concerns have been building for the past few weeks, particularly in response to the Trump administration’s policies, which are widely viewed as chaotic and uncertainty stirring, with unclear effects on the economy and stock market. Uncertainty is often a negative for business spending, consumer sentiment, the outlook for corporate earnings, and the stock market. Is it this time too?

Consider the following:

(1) Animal spirits vs policy uncertainty. The unleashing of animal spirits by the election of President Donald Trump for a second term has already been offset by “policy uncertainty” under Trump 2.0. For instance, the survey of small business owners conducted by the National Federation of Independent Business (NFIB) shows a dramatic increase in the outlook for general business conditions. This series, which measures the percentage of better minus worse assessments soared from -5% during October 2024 to 47% during January (Fig. 2). On the other hand, the NFIB’s uncertainty index was 100 during January, one of the highest readings of this series since it started during 1986 (Fig. 3).

(2) Walmart. The selloffs in the S&P 500 and the Dow Jones Industrial Average on Thursday and Friday were led by an 8.9% drop in Walmart’s stock price. The company’s earnings rose to a record high during Q4-2024, but management provided cautious guidance for 2025. Given that the stock’s forward P/E had nearly doubled since September 2022, from 20 to last Wednesday’s peak of 38, it took only that whiff of a headwind to send it sliding (Fig. 4).

Specifically, what Walmart’s CFO John David Rainey said was that consumers’ “wallets are stretched.” But he also said that their spending remains steady. He noted that Walmart’s shoppers in Mexico seemed to be pulling back, maybe on tariff talk. Walmart will also have to pay an additional 10% tariff on goods imported from China. If the company can’t find alternative cheaper vendors for these goods elsewhere, it will have to either accept a smaller profit margin or pass the prices increases on to consumers, who might respond by buying less.

(3) Consumer sentiment. Also weighing on the stock market on Friday was the release of January’s Consumer Sentiment Index (CSI) survey. It seems to be more sensitive to inflation than the Consumer Confidence Index survey, which is more sensitive to employment. In any case, the former showed a sharp decline in the overall CSI from 71.1 in January to 67.8 in February, the lowest since July 2024 (Fig. 5). There was a significant 12% decline in buying conditions for durable goods, partly due to concerns about the impact of tariff policies.

It seems many people are worried about the potential return of high inflation soon. Year-ahead inflation expectations surged from a recent low of 2.6% during November to 4.3% in February, the highest since November 2023 (Fig. 6). Interestingly, Republicans expect zero inflation, while Independents and Democrats expect 3.7% and 5.1%! This survey clearly is biased by extreme partisanship. Inflation expectations for the next five to ten years is now up to 3.5%, the highest since April 1995. The increase over the past two months has been the largest since February 2009.

In the past, the CSI survey’s year-ahead inflation expectations series was driven mostly by the price of gasoline (Fig. 7). The latter has been relatively subdued recently. So the current jump in inflation expectations is probably attributable to tariff talk or maybe soaring egg prices or both.

(4) Retail sales. Retail sales fell 0.9% m/m during January (Fig. 8). That was a significant drop suggesting that consumers might be retrenching. We attribute the weakness to bad weather and to faulty seasonal adjustment. This is confirmed by the weekly Redbook retail sales series, which was up 5.8% y/y through the February 14 week (Fig. 9). We expect to see a strong rebound in retail sales during February and March.

(5) Consumer credit & delinquencies. Consumer credit jumped $40.8 trillion during December, one the biggest monthly gains in the history of the series (Fig. 10). We view that as an aberration rather than an indication that consumers’ budgets are stretched. The ratio of consumer credit to disposable personal income remains relatively low (Fig. 11).

Alarmists are also ringing their alarm bells about delinquencies on consumer credit cards that are overdue by 90 days or more. They rose to 11.4% of credit card balances during Q4-2024 (Fig. 12). Furthermore, 7.2% of credit cards transitioned to such delinquency status at the end of last year (Fig. 13). Those are concerning developments, but they’re hardly alarming when compared to past experience.

(6) Purchasing managers’ survey. Another reason that the stock market sold off on Friday was the release of February’s S&P Global services PMI, which showed a steep decline from 52.9 in January to 49.7 this month (Fig. 14). We doubt that the services economy stopped growing in February. We expect that February’s ISM nonmanufacturing PMI will show a stronger reading when it is released in early March.

(7) Inflation & the Fed. Also unnerving investors last week was the jump in February’s prices-paid and prices-received indexes in the regional business surveys conducted by the Federal Reserve Banks of New York and Philadelphia (Fig. 15). Both were released last week. They suggest that tariff talk is already putting upward pressure on prices. If so, then the Fed’s rate-cutting will remain on pause for a while. We are already fielding questions from accounts wondering if the Fed’s next move might have to be a rate increase if inflation heats up. It's possible, but not likely.

We attribute the spike in these regional PMIs to tariff talk, including worrisome scenarios that we think won’t pan out. We are expecting lots of bilateral negotiations between the US and its major trading partners to lead to bringing down tariffs in a reciprocal fashion rather than to retaliatory tariff wars.

(8) Valuation & Buffett. Among the most unsettling development since early last year has been seeing Warren Buffett raising cash at Berkshire Hathaway Inc. The amount of cash and equivalents held by the firm rose to a record $334 billion at the end of last year.

In his annual letter to investors, released on Saturday, the Oracle of Omaha didn’t explain why he had raised so much cash. Instead, he wrote, “Despite what some commentators currently view as an extraordinary cash position at Berkshire, the great majority of your money remains in equities. That preference won’t change. While our ownership in marketable equities moved downward last year from $354 billion to $272 billion, the value of our non-quoted controlled equities increased somewhat and remains far greater than the value of the marketable portfolio.”

Buffett also avoided any mention of Trump 2.0 or recent macroeconomic developments. He also didn’t comment on the stock market. We suspect that Buffett believes that the stock market is overvalued since he hasn’t found much to buy in it lately. So he decided to cash some of his gains and park the funds in Treasuries, which he did discuss at some length in his letter. He noted that Treasury bills provided a good return, which boosted Berkshire’s earnings. He proudly wrote that his company “paid far more in corporate income tax than the U.S. government had ever received from any company—even the American tech titans that commanded market values in the trillions.”

Walmart’s selloff last week suggests that heady valuation multiples are vulnerable to fall if investors have second thoughts about their heady assumptions for corporate earnings. The Buffett Ratio, a measure of valuation, is in record-high territory (Fig. 16). That’s probably all we need to explain why Buffett has been raising cash!

(9) Time to sell? So why aren’t we recommending selling stocks? We are expecting that the bull market will be driven by earnings growth rather than higher valuations this year and likely through the end of the decade. We are sticking with our technology-driven, productivity-led Roaring 2020s scenario. It remains our base case, with a subjective probability of 55%.

We assign another 25% to a 1990s-style meltup. But unlike the meltdown that followed the meltup back then, we expect that any post-meltup meltdown will be short-lived and a great buying opportunity, because our base-case Roaring 2020s economic scenario will keep corporate earnings aloft.

We assign the remaining 20% subjective probability to a bucket of everything that can go wrong. These possible scenarios include a 1970s-style twin peaks in inflation. Another possible bearish outcome would be a debt crisis. And now that Trump is moving to impose tariffs, a trade war becomes a possibility.

Strategy II: Accentuating the Positives. The list of woes above seems to have hit the stock market hard during Thursday and Friday of last week. The list is mostly about developments suggesting that consumers might be retrenching because they have too much debt, inflation may be starting to erode their purchasing power again, and they are uncertain whether Trump 2.0 will or will not benefit them personally. Consider the following:
 
(1) Jobless claims. Economists are now watching initial unemployment claims in the area around Washington, DC as the DOGE Boys are firing federal workers in roles that they deem unnecessary. We are watching DC area unemployment too; but we will also continue to focus on the national claims data, which remained subdued through the week of February 14 (Fig. 17).

(2) Corporate earnings. We will also be monitoring the weekly data on the forward earnings of the S&P 500, S&P 400, and S&P 600 for signs that Trump 2.0 is weighing on the earnings estimates of industry analysts. All three dipped over the past couple of weeks (Fig. 18). However, the forward earnings of the S&P 500 remains in record-high territory, while that of the S&P 400 remains near its previous record high in early 2022.
 
(3) Capital spending. Policy uncertainty might depress capital spending. Maybe. We aren’t convinced. Technology accounts for about half of capital spending. We expect that business spending on technology won’t be slowed by uncertainties about Trump 2.0. Companies need to proceed with such spending to boost their productivity and to remain competitive.

(4) Reciprocal tariffs. As noted above, we expect that Trump’s threat to impose reciprocal tariffs is likely to lead to bilateral negotiations with America’s major trading partners which should lead to lower tariffs rather than a retaliatory trade war.

(5) Energy supremacy. One of the central pillars of Trump 2.0 is to exploit America’s abundant energy resources. Last week, the Trump administration issued its first approval for exports from a new liquified natural gas (LNG) plant, which Commonwealth LNG has proposed to build in Cameron Parish, Louisiana. The Houston-based company plans to build a natural gas export terminal on 150 acres where the mouth of Calcasieu Ship Channel meets the Gulf of America. The plant would export up to 9.5 million metric tons of LNG per year—the equivalent of just over 3,700 Superdomes filled with natural gas.

The facility that Commonwealth LNG plans to build will be one of 16 export terminals proposed on the Gulf Coast. It’s less than a third of the size of another LNG terminal proposed to be built just across the Calcasieu Ship Channel called “CP2,” which would be the world’s largest LNG plant if constructed. (See also U.S. LNG Export Terminals–Existing, Approved not Yet Built, and Proposed.)
 
Movie. “SAS: Rogue Heroes” (+ +) is a 2022 British historical series about the exploits of the British Army Special Air Service (SAS) during the Western Desert Campaign of World War II and the subsequent Allied invasion of Italy. Some of the characters are based on the actual commandos who fought in those campaigns. They were certainly a rogue group of heroes, with lots of success at weakening German and Italian forces so that the regular Allied armies could follow up and defeat them. It’s a fast-paced story with lots of good acting. (See our movie reviews archive.)

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On Crude Oil, Valuation & AI

February 20 (Thursday)

Energy: OXY & Oil. Perhaps now we know why Warren Buffett’s Berkshire Hathaway has built a 28.2% equity stake in Occidental Petroleum that’s worth more than $13.5 billion. Occidental managed to increase production, increase its dividend, and pay down debt last quarter even though the price of crude oil slid, bringing its y/y decline to 9.2% (Fig. 1).

The company benefitted from the production it acquired through a $38 billion purchase of Anadarko in 2019 and a $12 billion purchase of CrownRock last summer. Last year’s deal helped increase Occidental’s worldwide production to 1,463 million barrels of oil equivalent per day (MBOE/D), up from 1,230 MBOE/D in Q4-2023.

Let’s drill down for a deeper look:

(1) Adjusted earnings rise. Despite the oil price weakness, Occidental reported higher Q4 adjusted net income than a year ago: $792 million (80 cents a share) versus $710 million (74 cents). The adjusted figures exclude a long-term environmental liability the company had to recognize after a federal court ruling that’s being appealed.

On the earnings conference call, CEO Vicki Hollub noted that the company has been replacing higher-cost production with a higher volume of lower-cost new reserves, and its annual capital spend for oil and gas development is less than its annual depreciation, depletion, and amortization cost. “This is driving increased earnings per barrel and increased earnings per share,” she explained.

Earnings also benefit as the company reduces its debt and related interest expense. It plans $1.2 billion of divestitures in Q1, and the proceeds will be used to reduce debt. As debt is paid down, the cash that was used to meet interest payments can instead be returned to investors.

One major Occidental project launching this year removes carbon dioxide from the atmosphere. The project received funding under the Biden administration, as it would reduce greenhouse gasses. Hollub has been talking to President Trump about the need to continue the funding because the nation will need carbon dioxide pumped into depleted oil wells to increase the oil ultimately recovered. Enhanced oil recovery will add 50 billion to 70 billion barrels of oil to US reserves, which would increase US energy independence by more than 10 years—a business case she believes will resonate with Trump.

Occidental shares rose 4.4% on Wednesday to $50.99, an improvement from the slide off their recent peak of $69.26 on April 11.

(2) Producers keep producing. Having flexibility is important in an era when global oil production continues to outpace consumption, even as OPEC+ keeps 2.2 mbd of production off the market. According to a US Energy Information Administration report, global consumption of petroleum and other liquid fuels was less than production last year, which should continue: 2024 (102.77 mbd consumption, 102.84 mbd production), 2025 (104.14, 104.56), and 2026 (105.18, 106.16).

What could buoy consumption? If the aggressive fiscal actions taken by Trump 2.0 and the Chinese government improve global economic growth, that might increase business and consumer confidence and spending. We’ve been watching for signs of this in copper prices, which have popped 14.9% ytd (Fig. 2).
 
Strategy: Rising P/Es Outside of Tech. There’s much handwringing about the S&P 500’s forward P/E of 22.4, which is up two points from a year ago and well above its long-term average of 15.8 (Fig. 3). Is it precariously high, too high to be sustained? (FYI: The forward P/E is the multiple based on forward earnings, i.e., the time-weighted average of analysts’ consensus estimates for the current year and following one.)

The S&P 500 Information Technology sector is often blamed for pulling the broad index’s valuation skyward. It sports a forward P/E of 28.8, up modestly from 27.7 a year ago (Fig. 4). And the sector has industries with very lofty forward P/Es, including Application Software (34.7) Systems Software (30.4), Semiconductors (28.7), and Technology Hardware, Storage & Peripherals (28.2) (Table 1).

But the Information Technology sector isn’t solely responsible for the S&P 500’s recent multiple expansion. A forward multiple in the high 20s has been the sector’s norm during most of the post-pandemic era. And the sector has experienced only about one point of multiple expansion over the past year, whereas the S&P 500’s forward P/E is up two points.

Multiple expansion has been broad based, affecting 10 of the S&P 500's 11 sectors: Real Estate (forward P/E of 37.2 currently, 36.5 year ago), Information Technology (28.8, 27.7), Consumer Discretionary (28.5, 24.5), Industrials (22.9, 20.2), S&P 500 (22.4, 20.4), Consumer Staples (22.0, 19.4), Materials (20.7, 19.4), Communication Services (20.5, 18.2), Utilities (17.9, 15.1), Financials (17.4, 15.1), Health Care (17.3, 18.9), and Energy (14.5, 11.8).

The Consumer Discretionary sector's forward P/E jumped the most dramatically, boosted by the P/E multiple increases in stocks of companies that make autos, movies, and sneakers. Let's take a look at the changes in these and other notable industries:

(1) Rocketing retail. The S&P 500 Consumer Discretionary sector’s forward P/E has jumped to 28.4 from 24.5 a year ago (Fig. 5). Except for the period just after the pandemic, when its forward P/E soared to 40.5, the sector’s earnings multiple is as high as it has been at previous peaks in 2021 and 2009. But at those prior P/E peaks, the sector’s earnings were depressed, unlike today when they are at record levels (Fig. 6).

Some of the multiple expansion is due to the Automobile Manufacturers industry, which has a forward P/E of 41.2, almost double the 22.9 of a year ago. Tesla’s shares have jumped 77.1% over the past year to $354.11 as of Tuesday’s close, while its earnings per share is expected to decline from $4.30 in 2023 to $2.93 in 2025. The rise in share price and decline in expected earnings have pushed its forward P/E up to 126.7 (Fig. 7).

Other Consumer Discretionary industries rocking high forward P/Es: Broadline Retail (33.8 currently, 37.5 last year), Movies & Entertainment (32.0, 28.4), Footwear (30.5, 25.4), and Restaurants (27.9, 24.3).

The Consumer Staples Merchandise Retail industry, in the Consumer Staples sector, stands out with a forward multiple that has climbed to a record high of 36.8, up from 27.9 (Fig. 8). Blame the share price surges of Costco Wholesale, up 45.9% y/y, and Walmart, up a whopping 82.8% y/y—boosting their forward P/Es to 55.7 and 37.6.

(2) Defense & Meta. Another standout is the Aerospace & Defense industry, with a forward P/E of 27.7, near its record high and up from 21.1 a year ago (Fig. 9). This Industrials sector’s industry has some standout stocks, like GE Aerospace, and some clunkers like Boeing.

Given the 20-day record rally in Meta shares, it’s surprising that its industry, the S&P 500 Interactive Media Services industry, has such a reasonable forward P/E. The industry, which also includes Alphabet, has a such strong collective earnings growth outlook—45.8% in 2024 and 9.3% projected this year—that its forward P/E remains a reasonable 22.8 (Fig. 10 and Fig. 11).

(3) P/E compression hurts Health Care. The only sector in the S&P 500 to see its forward P/E drop y/y is Health Care, from 18.9 a year ago to 17.3 today (Fig. 12). The industry has been buffeted by rising costs, drug development misses, and uncertainty around how the Trump administration will address health care costs and insurance.

Here are some of the industries whose forward P/Es have fallen y/y: Life Sciences Tools & Services (24.0 currently, 27.8 one year ago), Health Care Supplies (18.1, 25.9), Biotechnology (16.5, 16.8), Health Care Distributors (15.6, 15.8), Pharmaceuticals (15.4, 18.4), Managed Health Care (14.5, 15.7), and Health Care Facilities (12.0, 14.6).

Disruptive Technology: AI Programs Improving. The number of artificial intelligence (AI) programs continues to multiply, and the programs themselves continue to grow ever more sophisticated. Large language models (LLMs), like ChatGPT and others, are being rapidly updated in a bid to avoid commoditization. Developers have also created AI agents that are like apps. They use LLMs and control the user’s computer or other device to execute a command—e.g., make a restaurant reservation or buy a product.

Here’s a look at some of the latest advancements:

(1) Something to honk about. Block—formerly known as “Square”—has introduced a free, open-source framework, dubbed “Goose,” that developers can use to develop AI agents that embed the LLMs of their choice. The program was originally developed to help programmers write and fix code. But it has the potential to execute numerous tasks, like organizing calendars and sending emails. It runs locally, allowing users to retain control over their information.

OpenAI also has developed an AI agent dubbed “Operator.” It was used by a NYT reporter to order a new ice cream scoop on Amazon and book a Valentine’s Day reservation, according to the February 1 article. Operator occasionally asked questions to clarify the task at hand. The reporter compared it to having an AI driver for one’s computer.

Operator has its limitations, however. It requires a human to actually execute a purchase; it isn’t allowed to gamble, so can’t play online poker; and it is prevented from entering websites that require users to prove they’re not robots. Operator is available to ChatGPT Pro subscribers for $200 a month.
 
(2) Grok aces the test. xAI’s Grok-3 is the best AI LLM based on testing in math science and coding. It outscored OpenAI’s GPT-4o, Claude 3.5, DeepSeek-V3, and Google’s Gemini-2 Pro, according to data reported by Elon Musk and the folks at xAI in an X video. The team expects Grok’s results to continue to improve as it undergoes additional training. The LLM also outperformed the competition on a crowdsourced platform, Chatbot Arena.

Additionally, Grok is developing a reasoning model that takes a bit longer to respond as it “thinks,” working its way through a question to offer higher-quality results. Grok can be creative and combine two games upon request. “We’re seeing the beginnings of creativity,” says Musk. To achieve this, xAI built a ginormous data center with 200,000 GPUs.

(3) ChatGPT’s still evolving. Sam Altman laid out the roadmap for ChatGPT in a recent post on X. OpenAI plans to roll out GPT-4.5, its last non-chain-of-thought model. It then will introduce GPT-5, which will be able to determine whether an inquiry can be answered simply or requires its chain-of-thought reasoning capabilities. In the latter case, ChatGPT will break down the problem into steps that are displayed and can be checked. GPT-5 at “standard intelligence” will be free to users, and smarter versions will require a subscription.

(4) Lots of new guys. At the heels of the large established LLM companies are a slew of startups hoping to replicate, if not exceed, their success. Earlier this week, OpenAI’s former chief technology officer Mira Murati launched Thinking Machines Lab, which aims to build AI systems that “encode human values and aim at a broader number applications than rivals,” a February 18 Reuters article reported.

Another OpenAI alum, co-founder Ilya Sutskever, has started Safe SuperIntelligence with Daniel Levy and Daniel Gross, a February 18 Fast Company article reported. The company, which aims to create a safe superintelligent AI system, has no product on the market but is in the midst of raising $1 billion of capital at a valuation north of $30 billion.

(5) China's LLMs improving too. China's tech gurus also aren't sitting on their laurels. In the January 23 Morning Briefing, we highlighted a number of Chinese tech developers creating LLMs, including Moonshot AI. It has developed a LLM and popular chatbot, both called “Kimi.” Moonshot recently updated Kimi, the LLM, with version 1.5, which can recognize text, images, and code as well as conduct advanced chain-of-thought reasoning. Founded in 2023, Moonshot is backed by Alibaba and valued at $3.3 billion, a February 2 article in The Guardian reported. Kimi 1.5 is free to use and has reportedly performed well in benchmark testing.

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European Renaissance?

February 19 (Wednesday)

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

Eurozone I: The EC’s Grand Plan To Revive Growth. Forget the US—Europe’s real enemy is self-imposed stagnation. That’s the conclusion of Mario Draghi, former prime minister of Italy and former president of the European Central Bank (ECB), in a February 14 opinion piece for the Financial Times. Draghi argues that internal barriers within Europe, from regulatory red tape to national protectionism, do more harm to economic growth than any tariff the US could levy. According to the International Monetary Fund, Europe’s internal hurdles act as an effective tariff: a staggering 45% for manufacturing and an even more crippling 110% for services.

But fear not, dear reader—help is on the way from Brussels. Ursula von der Leyen, president of the European Commission (EC), is spearheading a fresh initiative aimed at reviving the European Union’s (EU) flagging economic fortunes. If the EU were graded on its ability to churn out reports and blueprints, it would make the High Honors roll. But execution? That’s another story.

To kickstart the revival, von der Leyen tasked Draghi with drafting a comprehensive report on European competitiveness. This report, 80-some pages long, forms the backbone of the EC’s bold new five-year plan, the so-called Competitiveness Compass. The ambition of this sprawling vision for Europe’s future is evident. But the EU’s economic revival will take more than a fancy new compass. It will require the kind of political unity that the EU has never fully achieved.

The Compass, unveiled during von der Leyen’s January 21 keynote address at the World Economic Forum, presents several pillars that could redefine Europe’s economic landscape if only they were more than repackaged failed initiatives. Here’s why we say so:

(1) A centralized fiscal union: Been there, done that. To start, von der Leyen aims to tackle Europe’s chronic underinvestment in innovation by establishing a centralized fiscal union. “We do not lack capital. We lack an efficient capital market,” von der Leyen noted, lamenting the inefficient deployment of savings into early-stage, high-risk technologies with the potential to reshape industries.

Indeed, the EU sits on an enormous capital pool—€1.4 trillion in household savings, nearly double that of the US. The EU plans to unify EU capital markets by creating a Savings and Investments Union that facilitates cross-border investment and provides fiscal support for national governments.

But the road is already paved with disappointment. A similar vehicle launched in 2020, the Capital Markets Union (CMU), has failed to deliver thus far. A recent European Parliament report noted the CMU’s dismal performance, urging greater supervisory integration or abandonment of the initiative altogether. Are Draghi and von der Leyen making the same mistake again but hoping for a different result?

(2) A centralized, but optional, regulatory regime: Deregulatory in theory only? Next up is a move to simplify the EU’s regulatory maze. While European businesses have long battled 27 different national regulatory frameworks, the Commission’s proposed solution is to give them a 28^th set of rules to follow, if they wish. This new framework, optional for member states, would centralize EU corporate law, insolvency, labor law, and taxation under a single banner, with the goal of eliminating the costly and time-consuming differences between member states.

Von der Leyen framed the proposal as a deregulatory push, but it’s not as liberating as that sounds: To do any good, the new regime must be adopted by national governments. The Commission seems confident of widespread adoption because the new laws are “better.” But deeper integration of the member states is an idea floated in various forms since 2010, and it faces formidable opposition from member states with their own entrenched interests.

(3) A centralized energy directive: High hurdles. Then there’s the EU’s energy strategy. Energy independence is a top priority for the EU given that recent years’ geopolitical turmoil—most notably Russia’s invasion of Ukraine—has jeopardized energy imports. Von der Leyen has called for the removal of remaining energy trade barriers among member countries to create a truly integrated energy union across the bloc.

The Commission’s plan to centralize energy policy will focus on expanding renewable energy resources and improving storage and distribution. While the EU has made strides in wind and solar power generation, it has struggled with the all-important tasks of storing and efficiently utilizing this energy across borders.

Expect more details in February, but don’t be surprised if the EC reintroduces many of the same ideas that underpin the Green Deal that itself is on the brink of failure.
 
Eurozone II: Europe’s Enemy #1 Is Not Trump. Europe’s red tape is nothing new, but it has garnered renewed attention considering recent developments, particularly the return of US President Donald Trump to office. Conventional wisdom might suggest Europe should be worried.

But James Bianco, president of Bianco Research, LLC, shared a contrarian view worth some consideration in a recent LinkedIn post: “The best thing to happen to Europe is Donald Trump. Trump’s presence will force much-needed change in Europe/Germany.” With Trump back in the political spotlight, Bianco argues, his tariff threats and deregulatory policies might be the catalysts Europe needs to dismantle its trade barriers and revise its suffocating regulatory framework. Such reforms are what Europe long has needed to spark economic growth.
 
Indeed, investor optimism seems to be building. Bianco points to the upward momentum of the Stoxx Europe 600 (9.0%) and Germany’s DAX (18.4%) indexes since the November 4, 2024 US election. But do these outperformances reflect genuine expectations of a turnaround in Europe’s growth prospects or are investors simply drawn to European equities that have been battered into undervaluation (Fig. 1)?

Our read: It’s likely the latter. While the long-term investment horizon could offer opportunities in Europe’s beleaguered equities, the region’s growth prospects aren’t exactly lighting up the horizon. A near-term economic rebound still seems unlikely. The state of the Eurozone economy remains grim.

A few key metrics illustrate just how much work lies ahead:

(1) Eurozone earnings growth is weak. Eurozone earnings growth remains sluggish, underpinned by deep-seated structural challenges in key sectors (Fig. 2).

(2) Eurozone real GDP growth is dismal. The Eurozone’s economic growth continues to lag that of the global economy (Fig. 3).

(3) Eurozone manufacturing and services are struggling. Both the manufacturing and services sectors are finding it difficult to regain pre-energy-crisis levels of activity (Fig. 4).

(4) Eurozone productivity and investment are tepid. Productivity growth remains underwhelming, compounded by persistently low investment across the region (Fig. 5).

Eurozone III: European Renaissance 2.0, Defense Edition. Vice President JD Vance proposed an inverse Marshall Plan at the Munich Security Conference. He said what many American economists have been suggesting for years: The EU must have the gall to spend what’s needed to generate their own economic and defense security.

We do not believe the US security umbrella is vanishing under Trump 2.0; instead, we think the administration is attempting to alleviate the strains of US hegemony on America’s trade balance and fiscal deficit. If Europe can pony up to help Ukraine, defend itself, and spur economic growth, then the US government can spend less to those ends, while the American private sector—including S&P 500 companies—can benefit from greater global demand.

In response to Vance’s comments, NATO Secretary General Mark Rutte said the alliance’s defense spending target would rise from its current 2%-of-GDP guideline for nations to “considerably more than 3%.” European leaders, including British prime minister Keir Starmer, are now gathering in Paris for an emergency summit on the Russia–Ukraine war. An increase in EU defense spending is likely to be bazooka-style, large and fast. Consider some of the possible ramifications for the global economy and markets:

(1) Peace dividend. We believe that a significant coordinated fiscal impulse from the Eurozone could offset a slowing one in the US. “Coordinated” is the operative word, as national schemes like Italy’s superbonus largely used up the Eurozone's fiscal space without a commensurate increase in sustainable growth or productivity. Meanwhile, spending on infrastructure, energy, and defense is likely to make its way to US companies and exports. In fact, the US may be able to lower its own defense spending while increasing defense-related imports, a win on two Trump 2.0 fronts.

Defense constitutes $1.1 trillion of US government spending annually, as of Q4, or 3.7% of GDP. Meanwhile, the Eurozone spends less than 330 billion euro annually (projected as of Q4), below NATO’s 2%-of-GDP guideline (Fig. 6). Rebalanced trade and more productive fiscal spending worldwide are now probable outcomes.

(2) Debt. The spending would likely be financed by large-scale debt issuance. The EU's debt-to-GDP ratio was 81.7% at the end of 2023; we think it could reach 90% by the end of the decade even as strong growth offsets some of the issuance (Fig. 7). That’s likely to result in higher yields on German bunds, French OATs, etc. (Fig. 8). We do not think the Brussels-born constraints on national-level fiscal spending will be enforced.

(3) Tech. Shares of Rheinmetall, a German automotive, defense, electronics and engineering firm, rose 12.1% today and are up 124% over the past year. It has an American subsidiary, American Rheinmetall, which builds high-tech tanks. Perhaps the US auto sector can be repurposed to produce more high-tech goods, aiding employment and production in the Rust Belt. American defense and aerospace production has risen to new record highs for months (Fig. 9).

(4) Dollar. A “European Renaissance 2.0” could weaken the dollar in a way that doesn't threaten its reserve status, as favored by Trump 2.0. Treasury Secretary Scott Bessent has sought to “fix” the practice of foreign governments’ artificially weakening their currencies against the dollar, so as to help US exporters maintain international competitiveness.

The euro is down 3.0% against the dollar over the past year but up 1.7% over the past month (Fig. 10). While parity looked possible for a moment earlier this year, there are now a number of possible tailwinds for the euro over the long term.

Strategy: An Earnings Season for the Masses. Through midday Tuesday, 78% of the S&P 500’s companies have reported December-quarter earnings. Among the 390 reporters so far, the aggregate revenue surprise relative to analysts’ consensus estimate is lighter than usual at 0.6%, but the earnings beat is a hearty 6.6% (Fig. 11 and Fig. 12). Moreover, the vast majority of the index continues to report positive y/y growth.

Below, Joe shares additional data on how the S&P 500 companies collectively fared last quarter and how the Boeing strike impacted the aggregate Q4 results:

(1) Wider swath of companies growing now. While the S&P 500’s aggregate revenue surprise for Q4 has underwhelmed so far, close to three-fourths of the index’s members have shown positive y/y growth in revenues despite declining inflation. In fact, the percentage of S&P 500 reporters to date that achieved y/y revenues growth last quarter, 73.5%, is the greatest in more than two years. If it doesn’t change measurably when the rest of the Q4 results are in, the S&P 500 will reach its highest quarterly reading by this measure since Q3-2022 (Fig. 13). Likewise, the percentage of S&P 500 companies with positive y/y earnings growth rose to 71.8% from 66.3% in Q3 (Fig. 14). That’s the first reading above 70% since Q4-2021, and we expect this measure to remain strong in the coming quarters.

(2) Boeing overshadows results again. Looking at the earnings surprise results so far for the S&P 500’s 11 sectors shows broad-based beats (Fig. 15). Industrials was the only sector to miss on the bottom line, and that was primarily due to Boeing’s miss. Without Boeing, the sector’s earnings surprise improves from a miss of 2.0% to an earnings beat of 3.5%. In addition, Industrials’ Q4 earnings growth improves when Boeing is excluded, from a decline of 5.9% y/y to a 4.3% gain.

Boeing’s earnings miss in Q4 was large enough to tamp down the overall S&P 500’s figures as well. Without Boeing, the S&P 500’s earnings surprise improves to 7.1% from 6.5%, and y/y earnings growth improves 1.0ppt to 14.0% from 13.0%.

(3) S&P 500 on target for record-high quarterly EPS. The S&P 500’s blended Q4 EPS (i.e., estimates blended with actual results reported so far) slipped 52 cents w/w to $64.19 from $64.71 a week earlier (Fig. 16). Despite that minor hiccup, the S&P 500 is still on track to post its third straight quarter of record-high EPS. As the remaining 110 companies release their results over the next month, the blended actual should start moving higher again.

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The Gunfight At DOGE City

February 18 (Tuesday)

YRI Weekly Webcast. Join our live webcast with Q&A on 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.

Federal Budget I: The DOGE Boys. “The Gunfight at Dodge City” is a 1959 Western film. After his brother the sheriff is murdered, Bat Masterson is elected to the job of sheriff and is determined to find the killer and make Dodge City safe. Today, there are gunfights going on in DOGE City to restore law and order to fiscal policy. Will the new sheriff in town get the job done, or will the Bond Vigilantes do it?

The Department of Government Efficiency (DOGE), led by Elon Musk (who reminds us of a superhero on a mission to save humanity), is scrambling to uncover waste and fraud in the federal government. That should be easy. The question is whether he and his team—a.k.a. the DOGE Boys—can find enough waste and fraud to make a big difference to the federal budget outlook if eliminated.

The reason the boys are scrambling is that the Democrats are regrouping and coming to DOGE City for a gunfight. The Democrats have rounded up a posse of Democratic district attorneys from all around the country to stop Musk’s muckrakers by filing motions in courts to block them from raking the muck they find.

Treasury Secretary Scott Bessent probably also alerted the DOGE Boys that the Bond Vigilantes might be coming to DOGE City for a shootout if the Trump administration doesn’t convince them there’s no need for a gunfight because the President will deliver fiscal discipline and resist telling the Fed to lower interest rates.

After all, the Fed did lower the federal funds rate (FFR) by 100bps from September 18 through December 18 last year, but the Bond Vigilantes immediately expressed their dismay that monetary policy was stimulating an economy that didn’t need to be stimulated and enabling fiscal excesses. They did so by pushing the bond yield higher by 100bps (Fig. 1). In the past, the Fed lowered the FFR from cyclical peaks because the peaks were followed by recessions (Fig. 2). There has been no recession this time.

Now, consider a few of the recent developments that led up to the trouble brewing in DOGE City:

(1) Summer 2024. Elon Musk floated the concept of DOGE in discussions with Donald Trump during the summer of 2024 as the then-former President campaigned for a second term. In an August campaign event, Trump said that, if elected, he would consider giving Musk an advisory role on how to streamline the government. Musk immediately tweeted, “I am willing to serve.”

(2) October 27, 2024. Elon Musk first declared that DOGE would cut $2 trillion from the federal budget on October 27, 2024, during a Trump rally at Madison Square Garden. Over the 12 months through January, the federal government’s budget deficit totaled $2.14 trillion (Fig. 3).

(3) January 8, 2024. However, on January 8, 2025, Musk stated in an interview with Mark Penn that achieving the $2 trillion cut was unlikely and that the best-case outcome would be around $1 trillion. Over the past 12 months through January, federal government outlays totaled $7.1 trillion, with $6.0 trillion in mandatory outlays (including Social Security, Medicare, health, income security, national defense, and net interest) (Fig. 4). Net interest outlays alone totaled $920.6 billion, exceeding the $910.2 billion spent on defense over the last 12 months (Fig. 5).

(4) January 20, 2025. On Inauguration Day, President Trump signed an Executive Order titled “Establishing and Implementing the President’s ‘Department of Government Efficiency.’” The order renamed the existing United States Digital Service “the United States DOGE Service” (USDS). Within the USDS, a new organization was established, the US DOGE Service Temporary Organization, which is headed by the USDS administrator (Musk) and is scheduled to be terminated on July 4, 2026.

Each government agency must establish a “DOGE Team of at least four employees, which may include Special Government Employees, hired or assigned within thirty days of the date of this Order. Agency Heads shall select the DOGE Team members in consultation with the USDS Administrator. Each DOGE Team will typically include one DOGE Team Lead, one engineer, one human resources specialist, and one attorney.”

The goal of this Executive Order is to modernize “federal technology and software to maximize efficiency and productivity.” To achieve that, the DOGE Teams will have “full and prompt access to all unclassified agency records, software systems, and IT systems.”

Needless to say, DOGE has stirred up lots of controversy in Washington. There are almost daily headlines on DOGE’s success at finding lots of inefficiencies, waste, and possible fraud within the government accounts. Many of these headlines are generated by Musk’s tweets on X.

There is lots of pushback by Democrats, who are challenging the legality of the DOGE Boys’ flipping through government files. Douglas Holtz-Eakin, who had served as the director of the Congressional Budget Office, compared DOGE to the former Grace Commission, which had zero of its 150 proposals enacted.
 
Federal Budget II: In Bessent We Trust. It’s too soon to tell how much DOGE will reduce government spending. However, Treasury Secretary Bessent is certainly aware of the need to reduce the federal budget deficit relative to nominal GDP. He has committed to halving this ratio from 6% to 3% (Fig. 6).

This ratio was last at 3% during Q4-2015 (2.93%, to be exact). Since then, Trump 1.0 tax cuts drove it up to 4.65% during Q4-2019 (just before the pandemic), and Biden’s outlays raised it over 6% during Q4-2024.

Trump 2.0 is borrowing a page from the Clinton administration’s playbook, specifically the one in which Robert Rubin and James Carville warned Clinton that he had to respect the power of the Bond Vigilantes and maintain fiscal discipline. On February 6, US Treasury Secretary Scott Bessent said that he and President Trump are less concerned about the federal funds rate (FFR) and instead are hoping to contain the 10-year Treasury yield. Bessent’s message to the Bond Vigilantes was that he has explained to President Trump that they have the power to stymie his fiscal agenda.

However, on February 12, Trump posted the following on his Truth Social platform: “Interest Rates should be lowered, something which would go hand in hand with upcoming Tariffs!!!” That assertion flew in the face of economists’ expectations that tariffs would fuel inflation and postpone rate cuts as well as what Federal Reserve Chair Jerome Powell told US lawmakers the day before: that the Fed was in no rush to cut its short-term interest rate again given an economy that is strong overall.

The Bond Vigilantes are biding their time, waiting to see how much the Trump administration can slow the increase in federal spending because of the efforts of the DOGE Boys. If they don’t deliver enough spending cuts, there could be a gunfight at DOGE City, with the Bond Vigilantes shooting holes in the Trump administration’s fiscal agenda, including the extension of his tax cuts.

It is good that Bessent understands the power of the Bond Vigilantes. In effect, he represents their interests within the Trump administration. Eric and I believe that by appointing Bessent as Treasury Secretary and establishing DOGE, Trump bought his administration some time to deal with the federal budget mess.

Federal Budget III: Tracking The Bond Vigilantes. “Bond Vigilantes” is the phrase I coined in July 1983 to refer to bond investors, acting in their own financial interests, when their activity drives up bond yields out of belief that the government will fail in its duty to keep the budget deficit from ballooning and inflation contained via fiscal and monetary policy. They’ll demand greater yield for their long-term bond investments if they think the value of their investment will be eroded by inflation over the term. Higher bond market yields effectively push up other interest rates—so it’s as if bond investors are taking fiscal and monetary discipline into their own hands, vigilante style, when the government drops the ball. (See The Bond Vigilantes excerpt from my 2018 book Predicting the Markets.)

One way to monitor the activities of the Bond Vigilantes is to compare the 10-year Treasury bond yield to the growth in nominal GDP on a y/y basis (Fig. 7 and Fig. 8). When the spread is positive while the economy is growing, they are doing what they can to slow it down. They were asleep at the reins during the 1960s and 1970s, when inflation got out of hand. They were much more vigilant during the 1980s and early 1990s.

The Bond Vigilantes were stymied by the Fed’s QE (quantitative easing, i.e., buying bonds) and ZIRP (i.e., zero-interest-rate policy) from 2008 through 2022, i.e., between the Great Financial Crisis and the Great Virus Crisis, when the Fed’s monetary stance was ultra easy. The bond market was rigged by the Fed during this period. The Fed tightened monetary policy by raising the FFR and ending QE from March 2022 through August 2024, allowing the bond yield to normalize.

The 10-year Treasury bond yield is currently about 4.50%, having risen back up to around where it was before the Great Financial Crisis (Fig. 9). The spread between the bond yield and the growth rate in nominal GDP was -70bps during Q4-2024. It remains around zero currently. Nominal GDP growth was 5.0% y/y during Q4.

We conclude that the Bond Vigilantes aren’t saddling up just yet to ride into DOGE City for a gunfight with the Trump administration. But ask us again if the yield jumps above 5.0% with attendant widespread fear that it is heading toward 6.0%.

The Bond Vigilantes have never been potentially more powerful than right now given that total federal public debt outstanding is a record $36.2 trillion with a record $28.5 trillion in marketable US Treasury securities (Fig. 10).

Economy I: Seasonal Sales Issues. Retail sales fell 0.9% m/m in January, one of the worst monthly readings in years. And because of the 0.7% m/m increase in CPI goods inflation, real retail sales fell by 1.6% m/m last month (Fig. 11 and Fig. 12). Those are ugly numbers, and they brought a few bears out of hibernation to proclaim that the long-awaited economic slowdown is here!

We’re not too worried about January’s one-off dip in spending; January is always a bad month for retail sales after December’s spending bonanza and before seasonal adjustment. We continue to be optimistic on the US consumer. Here’s more:

(1) Smoothing out seasonals. The Census Bureau’s seasonal adjustment is an attempt to smooth out the December surge and January plummet in spending each year. For instance, retail sales fell 16.5% m/m in January on a non-seasonally adjusted basis, a tad less than it fell in January 2024 (-16.8%) and 2022 (-17.0%) and a bit more than it fell in 2023 (-14.8%) (Fig. 13).

In several economic indicators, including retail sales, the seasonal adjustments haven’t fully caught up to the post-pandemic shifts in consumer behavior. January's retail sales rose 4.2% y/y on a seasonally adjusted basis and 4.8% not seasonally adjusted.

The Redbook retail sales series shows a solid increase of 5.3% y/y through the week of February 7, 2024 in nominal terms (Fig. 14). It has a good correlation with the comparable growth rate for monthly retail sales excluding food services. We also note that the winter deep freeze, and perhaps the fires in California, likely weighed on consumer activity last month (Fig. 15).

(2) Auto regression. After a very strong Q4, auto sales fell off in January (Fig. 16). The seasonally adjusted annualized rate for total new-vehicle sales fell from 16.9 million units in December to 15.6 million in January. We believe auto dealers used discounts to clear out their inventories heading into the end of last year, which contributed to the big drop in Q4-2024 GDP inventory investment but also spurred a lot of sales. So in Q1, we're likely to see inventories rebuilt but sales slow a little.

Auto sales (-2.8% m/m) was the biggest overall drag on January retail sales. Sporting goods, hobby & bookstores (-4.6%) experienced the largest monthly drop off. We expect that the category also suffered from some seasonal adjustment misreads and will likely rebound next month.

Economy II: Manufacturing Mojo. Hours worked by manufacturing employees fell by 0.7% m/m in January, which typically would suggest that industrial production fell by about the same amount. However, industrial production rose 0.5% m/m after adding 1.0% in December (Fig. 17). We had expected the bad weather to weigh unduly on hours worked, but we thought it would be less likely to influence manufacturing. So the increase was encouraging and suggests US manufacturing may be in the first inning of its rolling recovery. The 2.0% y/y increase in production is the largest increase since the Fed began its last round of rate hikes in 2022 (Fig. 18).

Looking deeper at the latest industrial production data, the restarting of Boeing’s production after worker strikes accounted for 0.2ppts of the total 0.5% increase, according to the Fed. Aerospace rose 6.0% m/m, while the index for utilities jumped 7.2% due to demand for heating (Fig. 19). Utilities production continues to make new monthly highs, and the demand for data processing and new energy sources from the AI boom suggest it won’t be stopping (Fig. 20).

Autos fell 5.2% m/m, dragging on the index for manufacturing output. Given Trump 2.0 initiatives to reshore auto manufacturing, we think OEMs have enough stick and carrot to pick up production by the end of the quarter.

Movie. “September 5” (+ +) is a 2024 docudrama thriller about the 1972 Munich Olympics massacre of Israeli athletes from the perspective of the ABC Sports reporters as they admirably rose to the occasion and covered the terrible events. It is a harrowing reminder of the fact that jihadist terrorists have been terrorizing all too many countries for all too long. By staging this attack in Germany, the Black September terrorists meant to send a signal that they remained committed to killing Jews, as did the Nazis in World War II. The brutality of the October 7, 2023 attack by Hamas on Israeli civilians including men, women, and children was also aimed to be a reminder of the Holocaust. The world remains a dangerous place for all too many innocent civilians. (See our movie reviews archive.)

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On Tariffs, IPOs & AI Tools

February 13 (Thursday)

China: Tussling with Trump's Tariffs. The trade war between the US and China continues to heat up as Trump 2.0 approaches its second month and the US merchandise trade deficit hits record levels (Fig. 1). Placing tariffs on goods from China and other countries is part of Trump’s efforts to boost US manufacturing, level the global trading field, and raise revenues to pay for the tax cuts he plans to extend. The tariffs are also aimed at increasing national security by securing the border with Canada and Mexico against illegal immigration and drugs.

Until 2019, the US imported more goods from China than any other country. Now US imports from China ($444.9 billion, 12-month sum) account for about 13.5% of total US imports, trailing imports from the EU ($605.8 billion) and Mexico ($505.9 billion) (Fig. 2). Some Chinese manufacturers have relocated to Mexico and other nations to dodge tariffs, but plenty still ship directly to the US. While off its highs, the US merchandise trade deficit with China remains extremely large at $273.5 billion, using a 12-month sum (Fig. 3).

Let’s take a look at Trump 2.0’s recently announced trade policies and China’s responses:

(1) Trump wastes little time. Less than a month into the job, President Trump has imposed an additional 10% across-the-board tariff on goods imported from China, reportedly to encourage China to do more to stop the flow of fentanyl into America. His actions elevate the US tariff rate on Chinese goods above the tariff rate that China imposes on foreign goods: 7.5% using a simple average and 3.0% using a time-weighted average (Fig. 4).

President Trump initially canceled the de minimis trade exemption allowing duty-free importing of goods valued at less than $800, which benefits Chinese online retailers like Temu and Shein. But he subsequently reversed that decision, delaying the rule’s suspension.

Just this week, Trump announced a 25% tariff on steel and aluminum; but that shouldn’t affect Chinese producers much, as only 2% of US steel imports came from China in 2024 (most came from Canada, Brazil, Mexico, and South Korea).

Finally, Trump announced plans to impose “reciprocal” tariffs on a country-by-country basis. In other words, if a country imposes a 10% tariff on American cars sold there, the US will impose at least a 10% tariff on all cars it imports from that country. In setting the tariffs, the US reportedly will also take into account any barriers the country erects to disadvantage US manufacturers, such as value-added taxes on goods made by US companies, government subsidies that tilt the competitive playing field in domestic companies’ favor, or regulation preventing US companies from doing business in the country. “[T]he administration could attempt to calculate how much US trade is diverted by foreign trade barriers, and then devise a US tariff rate to reflect that trade volume,” a February 11 WSJ article reported.

(2) China responds. China responded to Trump’s 10% tariffs on Chinese goods by launching a trade dispute at the World Trade Organization (WTO). The country claims the Trump administration made “unfounded and false allegations” about China’s role in the fentanyl trade to justify tariffs on Chinese products. The dispute is expected to have little impact because the WTO’s dispute settlement system has been neutered by the Trump and Biden administrations, which blocked the appointment of new judges.

China’s response also included a 15% duty on coal and natural gas imports from the US and a 10% duty on US petroleum, agricultural equipment, high-emission vehicles, and pickup trucks. The US tariffs apply to about $450 billion of Chinese goods, while the Chinese tariffs apply to only $15 billion to $20 billion of American goods. In addition, China added tungsten, tellurium, bismuth, molybdenum and indium to its export control list.

China has placed restrictions on US technology companies that could be used as trading cards when negotiating with Trump regarding tariffs. China started an antitrust investigations into Google, which follows an investigation of Nvidia launched last year.

Financials: IPOs Heat Up. The S&P 500 Financials sector is starting 2025 near the top of the ytd performance leader board. Investors hope that some of the sector’s largest players will benefit from the Trump administration’s business-friendly policies reducing regulation and keeping the capital markets humming along.

Here’s the performance derby for the S&P 500 and its 11 sectors ytd through Tuesday’s close: Communication Services (7.1%), Financials (6.5), Health Care (6.0), Materials (6.0), Energy (6.0), Consumer Staples (5.2), Industrials (5.1), Utilities (4.7), Real Estate (3.8), S&P 500 (3.2), Consumer Discretionary (-0.1), and Information Technology (-0.5) (Fig. 5).

Within the Financials sector, the Investment Banking & Brokerage and the Diversified Banks industries have turned in the strongest performances. Both are helped by the strong stock market and the anticipation of healthy capital markets activity including mergers and acquisitions.

This week will provide clues as to whether the largely moribund IPO market can return to life. Seven deals are scheduled to price this week, including a $1.1 billion offering from SailPoint, an enterprise security firm that secures digital identities.

The following is the ytd performance derby for the S&P 500 Financials sector’s industry indexes through Tuesday’s close: Investment Banking & Brokerage (11.3%), Diversified Banks (11.3), Insurance Brokers (8.0), Consumer Finance (6.8), Regional Banks (6.7), Financials Sector (6.5), Financial Exchanges & Data (6.1), Asset Management & Custody Banks (-1.3), and Reinsurance (-7.4) (Fig. 6).

Here’s a look at some of the week’s upcoming IPO deals and a few launched earlier this year:

(1) Improving IPO market. After an extremely strong market in 2021, when 397 IPOs priced, IPO issuance activity fell off a cliff, with only 71 deals pricing the next year, according to data from Renaissance Capital. Activity has slowly been improving in the subsequent years—108 deals in 2023 and 150 in 2024—and the initial 2025 pace looks promising (Fig. 7).

So far, 24 deals have priced this year through Tuesday, up 26.3% over same period last year; but the proceeds were only $4.4 billion, down 23.6% y/y. That said, 31 IPO deals have been filed with the Securities and Exchange Commission ytd, marking a 19.2% y/y improvement. And the deals that have come to market are performing well. The Renaissance IPO ETF has climbed 6.0% ytd through Tuesday’s close, besting the S&P 500’s 3.2% performance over the same period.

(2) A big test. The pricing and performance of SailPoint’s $1.1 billion IPO will be the latest indicator of whether the market can continue its recovery. In a positive sign, the price range of the shares being offered was increased to $21-$23 from $19-$21 originally.

(3) Health care IPOs faring well. Some of the best performing IPOs so far this year are in the health care industry.

Medical device manufacturer Beta Bionics has developed the iLet Bionic Pancreas, an insulin delivery device cleared by the Food and Drug Administration that autonomously determines insulin doses without requiring a user to count carbohydrate intake. The $204 million offering, which priced on January 29, has traded up 32.7%.

Biotechnology company Metsera is developing injectable and oral nutrient stimulated hormone analog peptides to treat obesity and related conditions. The company is in the midst of a phase 1/2 trial for its injectable, with results expected midyear. The $275 million IPO was priced at $18 a share, above its initial $15-$17 range, and it has since traded up by 70.9%.

Another biotech company, Sionna, is developing a treatment for cystic fibrosis that is in phase 1 trials. Shares of the $191 million IPO have traded up 13.4% since coming to market.

(4) Industry numbers. Both the S&P 500 Investment Banking & Brokerage and the Diversified Banks stock price indexes are at record highs (Fig. 8 and Fig. 9).

The Investment Banking & Brokerage industry’s forward operating earnings per share has broken out to a recent new high and is approaching levels last seen before the 2008 financial crisis (Fig. 10). The industry is expected to grow operating earnings by 14.8% this year and 13.2% in 2026 (Fig. 11). Diversified Banks’ forward operating earnings per share is at a new record high (Fig. 12). Its earnings growth is expected to rebound from 3.9% this year to 13.6% in 2026 (Fig. 13).

However, both industries’ forward P/Es are extended relative to historical levels: 15.4 for Investment Banking & Brokerage and 13.1 for Diversified Banks (Fig. 14 and Fig. 15).

Disruptive Technologies: AI Loved by the Masses. We’ve been writing about large language models (LLMs) since early 2023, shortly after ChatGPT made its historic splash. It’s been interesting to watch AI gain acceptance. First, just techies were excited about what AI could offer. Then kids started using it to cheat on their homework. Now, recognition of AI’s capabilities is on everyone’s radar and experimentation with AI has gone mainstream.

Last weekend, Jackie and a group of fifty-something friends discussed how they were using AI at work. One was experimenting with an AI program that turns textbooks or long passages into podcasts. Another uses it to respond to her emails more quickly and to help format Excel spreadsheets. A teacher uses AI to produce lesson plans. None of these folks are techies, but each was excited about using AI to save time at work.

Here’s our latest look at some of the popular and novel ways that AI programs are being used at the office:

(1) The AI podcast. Google’s NotebookLM will summarize and make connections between materials that a user uploads. The materials may be a long book, academic pdfs, websites, videos, or all of the above. But what makes NotebookLM eye-popping is its Audio Overview feature, which presents the uploaded material in a conversational podcast format, hosted by two “people.” Teachers are using it as a way to reinforce lessons. Students, however, may consider it to be a more entertaining version of Cliff Notes.

(2) AI monitors customer feedback. Frame AI analyzes customers’ calls, chats, surveys, and emails to alert companies to risks or opportunities they might otherwise miss. According to the company’s website, Frame AI can use unstructured data to glean insights about what customers want and ways they might use a product. Customer testimonials on Frame AI’s website said the AI program allowed them to respond more quickly to customers, anticipate their needs, and improve both customer experience and efficiency.

(3) AI sees if you’re sleeping. Read AI can do all the things you’d expect AI can do with a meeting, like providing a transcript and a summary. What caught our attention is its ability to measure the engagement of those attending online meetings by using AI, natural language processing, and computer vision technology. Read AI measures meeting attendees’ verbal and non-verbal cues and translates that into real-time and post-meeting sentiment and engagement metrics. It can also apply AI to past meetings to give presenters coaching metrics and recommendations to help them become better speakers.

(4) AI at school. Magic School and Google’s Gemini are the AI apps used to save time by our schoolteacher friend. Magic School can generate lesson plans, worksheets, rubrics, quizzes, academic content, report-card comments as well as questions, summaries, or presentations based on YouTube videos or a text. Gemini offers many of the same functions. They both make tedious tasks simpler and faster to accomplish.

(5) Lots of overlap. Lots of AI apps aim to do roughly the same things, and not all are likely to survive. For example, many AI apps do voice-to-text translation, and many read text out loud. Multiple apps create pictures, edit photos, turn data into charts, help with grammar and schoolwork, and of course answer questions. We wish AI could help us determine which of them will survive and which will go the way of Pets.com.

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On Liquidity, Tariffs & Earnings

February 12 (Wednesday)

Weekly Webcast. If you missed Monday’s live webcast, you can view a replay here.
 
Strategy: Lacking Liquidity? Fed watching is important insofar as we can generate alpha in identifying economic developments that Fed officials may be misinterpreting.

For instance, the Federal Open Market Committee’s (FOMC) mistaken concern about last summer’s labor market weakness led to 100bps of rate cuts. Whether due to confirmation bias, institutional groupthink, or simply a desire to avoid a recession at any cost, we believed the Fed wasn’t acting appropriately based on the economic fundamentals. Economic growth was strong, and inflation remained sticky, leading us to grow increasingly bearish on long-term bonds as the rate cutting cycle proceeded last year (Fig. 1).

But one ball that the Fed is not likely to take its eyes off is liquidity. For all the hoo-ha about the ill effects of quantitative tightening (QT) and balance-sheet rundown, there’s next to no chance that the Fed will endanger market liquidity and let short-term interest rates spike. Some commentators have pointed to the nearly drained Overnight Reverse Repurchase Facility (RRP)—with $76 billion in it as of Tuesday—as evidence that a malfunctioning of short-term funding markets is imminent, which will make the financial markets go haywire (Fig. 2). Such episodes have cascaded into broader financial markets and sparked volatility across asset classes before. We are confident that this won’t be the case this time around.

Here’s why:

(1) QT refresher. The Fed’s balance sheet has shrunk from a peak of around $8.9 trillion in 2022 to $6.5 trillion of Treasuries and mortgage-backed securities today (Fig. 3). However, bank reserves have barely budged, remaining around $3.2 trillion or roughly double pre-pandemic levels (Fig. 4). One reason reserves have remained elevated is that the RRP drained as opposed to bank reserves.

(2) Will reserves start to drain? Yes, but probably not much. The Fed is likely to end QT later this year, or as soon as repo markets exhibit any signs of potential stress.

Frankly, there are more tailwinds to liquidity than headwinds. Fed Governor Michelle Bowman, who may be tapped as the Fed’s next vice chair of Supervision, recently highlighted several bank regulations that need to be relaxed. Included were measures that will make it easier for large banks to absorb Treasury supply. That’s a good thing considering that we don’t see Treasury supply slowing anytime soon (Fig. 5). We also believe the Fed will start to reinvest maturing mortgage-backed securities into Treasuries, another positive for Treasury market functioning.

(3) Money supply. The Fed’s lowering the federal funds rate by 100bps and banks’ easing of lending conditions in response have led to a pop in M2 money supply, which was up 3.9% y/y as of December (Fig. 6). In fact, M2 is rising in nearly every region and country globally, with the notable exception of China, which is firing several stimulus salvos as we write.

The theme of this story is to not sweat QT, as that’s one area the Fed is on top of.

Global Trade I: National Security—Steel Matters. On Sunday, Trump announced global tariffs of 25% on steel and aluminum, with no countries exempted. These followed earlier threats of 25% tariffs on most Canadian and Mexican goods and 10% on all Chinese imports. The tariffs on Canada and Mexico were postponed for 30 days as Trump worked out a deal with both countries to tighten border security, limiting the flow of immigrants and drugs into the US.

The broad tariffs on Canada and Mexico imports were likely a negotiating tactic, aimed at increased border security versus tit-for-tat tariffs. However, we think the new steel and aluminum tariffs reflect a different approach that prioritizes domestic industry and rebalancing trade. Boosting US steel production and prohibiting Chinese dumping practices are priorities of their own, and thus we believe these tariffs may stand longer than the initial Canadian and Mexican proposals. This comes with the usual caveat that everything in Trump World remains negotiable.

It's important to understand why steel gets extra attention from this administration:

(1) Peter Navarro’s intentions. Peter Navarro, Trump’s senior trade advisor, emphasized that the tariffs are not just about trade. “It’s about ensuring America never has to rely on foreign nations for critical industries like steel and aluminum,” he recently told reporters. The tariffs aim to end foreign dumping, boost domestic production, and secure the steel industry as vital to both economic and national security, he added. Under Trump 1.0, Navarro dismissed concerns about modest inflationary effects from eliminating unfair trade practices.

(2) A familiar story. In January 2018, Trump 1.0 imposed tariffs on steel and aluminum following a US Department of Commerce Section 232 report. It concluded that steel is critical to national security, expanding that to include industries beyond defense.

The 2018 report noted that steel imports were harming the US steel industry. To sustain it, mills need to operate at 80% or more of their capacity, which requires reducing imports via quotas or tariffs. US steel production capacity utilization was 74.6% in September 2024, according to the International Trade Administration.

(3) No exceptions this time. Back under Trump 1.0, Canada, Mexico, and Australia were exempt from the tariffs. South Korea, Brazil, and Argentina agreed to quotas. In April 2022, President Joe Biden then replaced European and Japanese tariffs with quotas as well. These exemptions ultimately weakened the impact of the broader tariffs on the US steel industry, the current administration believes.

(4) Economic consequences in 2018. In Trump’s view, sustaining these domestic industries is worth the economic costs. When these tariffs were last imposed, they raised prices for consumers and reduced domestic growth, according to a May 2024 Tax Foundation report. The US International Trade Commission found that steel and aluminum prices increased by 2.4% and 1.6%, respectively, following the 2018 tariffs. Removing these tariffs would have led to a modest increase in real GDP growth of 0.02% y/y.

Given steel's importance in construction (e.g., rebar) and auto manufacturing, it's a critical commodity in the reshoring efforts.

(5) Targeting Chinese dumping. These tariffs also aim to undermine China’s steel industry, which is plagued by overproduction. China’s share of global steel production exceeds 50%, while the US accounts for just 5%.

While China’s steel isn’t a top US import, it impacts global prices. Price differentials between US steel and the world remain elevated at $762 per metric ton as of September 2024 versus the world at $480 and Chinese prices at $376, according to the US International Trade Commission’s data.

China is the world’s largest steel producer, and its steel exports have been on the rise, further pressuring domestic US producers. Exports from China are expected to top 100 million tons in 2024, the highest since 2016. Only 1.0% of Chinese steel mills are profitable, according to a Chinese consultancy quoted in the Financial Times.

(6) Canada’s major role. Canada, though not a major global producer of steel, supplies the largest portion of US imports in the world. It accounted for 22.5% of US imports through September 2024. Canada also imposed tariffs on Chinese steel in October 2024 to protect its domestic industry from China’s oversupply, though China’s prices remain competitive even with the added tax.

We’ve suggested before that Trump’s desire to incorporate Canada into the US is driven by energy security. We believe US steel industry security is also a part of Trump’s short list of reasons to bring Canada into the US.

Global Trade II: Required Reading on Reciprocal Tariffs. Along with the 25% steel and aluminum tariffs, Trump hinted at imposing reciprocal tariffs on more countries and imports soon. To understand this, we return to our March 8, 2018 Morning Briefing, in which we analyzed Peter Navarro’s views on reciprocal tariffs. Navarro repeatedly has championed the idea of “free, fair, reciprocal trade,” aiming to level the playing field in global trade.

Here’s more:

(1) Navarro’s identity crisis. Navarro believes trade deficits are harmful because they must be offset by foreign investment. This investment could benefit US investors, increasing demand for financial assets and pushing US interest rates down. But protectionists like Navarro see this as problematic, fearing increased foreign control over US assets.

(2) Conquest by purchase. Navarro’s primary concern is “conquest by purchase,” whereby large trade deficits allow foreign rivals to buy US companies, technologies, and farmland. This, he argues, could ultimately affect national security if these entities control critical industries.

(3) Focus on trade in goods. Navarro emphasizes that the US must rebuild its manufacturing base to secure national defense. Only one company in the US can repair Navy submarine propellers, and no US company can produce certain critical military technology, he argued in 2018.

(4) Fast forward to 2025. For those interested in a deeper dive into US trade deficits with specific countries and the dynamics of reciprocal tariffs, Navarro’s chapter in the Heritage Foundation’s Project 2025 Mandate For Leadership (starting on page 765) offers valuable insights. This section, which outlines a comprehensive vision for US trade policy, aligns closely with what is unfolding in the Trump 2.0 trade agenda.

Strategy: Q4’s Earnings Hook Has Arrived. Through midday Tuesday, 65% of the S&P 500’s companies have reported December-quarter earnings. Among the 325 reporters so far, the aggregate revenue and earnings beats relative to analysts’ consensus estimates are 0.7% and 6.7%, respectively (Fig. 7 and Fig. 8). Below, Joe shares data on how these S&P 500 and the six Magnificent-7 reporters to date fared last quarter:

(1) S&P 500 looks bound for record-high quarterly EPS yet again. The S&P 500’s blended Q4 EPS (i.e., estimates blended with actual results reported so far) jumped $2.32 to $64.71 from $62.39 a week earlier (Fig. 9). That boost is typical of past quarters, when earnings “hooks” in the charted blended data appeared after companies reported results that beat expectations. The current blended EPS of $64.71 is on track for the index to post its third straight quarter of record-high EPS (Fig. 10).

The Q4 quarterly EPS growth rate soared 4.1ppts w/w to 13.3% from 9.2% (Fig. 11). That’s ahead of the forecasted 11.8% at the beginning of the quarter and 8.2% at end of the quarter. It’s also the highest y/y quarterly earnings growth rate since Q4-2021, when growth was winding down from the fast-paced recovery that followed pandemic lockdowns (Fig. 12).

(2) Don’t fear falling growth expectations for Q1-2025. This is always a busy time of year for analysts as company managements share their expectations for the year ahead. This year, it’s been even busier as Trump 2.0 plans have come to light.

Adjustments to analysts’ models for news on tariffs and dollar impacts have lowered the S&P 500’s Q1-2025 earnings estimate by 2.5% since the start of the quarter (Fig. 13). We’re not worried since that’s less than the average 4.2% decline seen for Q1s since 1995. The consensus now expects S&P 500 earnings to rise 8.3% y/y in Q1-2025 (Fig. 14). That’s down from 9.8% a week earlier and 11.1% at the start of the quarter six weeks ago. The most affected S&P 500 sectors have been Financials (due to California fires) and Consumer Discretionary (Tesla).

For the rest of the 2025, analysts are expecting y/y earnings growth of 9.8% for Q2, 11.9% in Q3, and 12.6% in Q4. The 4.1ppts decline w/w in Q4-2025’s growth forecast to 12.6% from 16.7% turns out to be a nothing-burger. All of the change in the growth rate this week was due to higher base period earnings from Q4-2024.

(3) Mag-7 results. Among the Magnificent-7 companies, only Nvidia has yet to cross the Q4 reporting finish line. Tesla undershot estimates on both the top and bottom lines, and Alphabet missed on the top line. The six companies mostly recorded double-digit percentage revenues and earnings growth. Tesla managed to eke out single-digit y/y percent gains in both those measures. Also underperforming the group on both measures was Apple, which posted earnings growth of just 10.1% on a revenue gain of 4.0%.

Tesla’s weakness dragged down the Mag-7’s aggregate surprise and y/y growth numbers, causing the group to be a negative contributor to the overall S&P 500’s revenue surprise metrics among reporters so far. However, the Mag-7 remains a net positive contributor to the S&P 500’s y/y growth rates in revenues and earnings and the aggregate earnings surprise.

Excluding the Mag-7’s December-quarter results from the S&P 500’s improves the revenue surprise to 0.7% (from 0.6%), lowers the earnings surprise to 6.5% (from 6.7%), and drops revenues growth and earnings growth to 3.5% y/y (from 4.5%) and to 10.8% y/y (from 14.9%). The Mag-7’s six reporters to date posted a collective 0.2% revenue surprise, 7.2% earnings surprise, 9.8% y/y revenues growth, and 26.6% y/y earnings growth.

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Roaring 2020s & Reciprocal Tariffs

February 11 (Tuesday)

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

US Economy I: On the Road Again. Taylor Swift’s “The Eras Tour” was her sixth tour. It started on March 17, 2023 in Glendale, Arizona and concluded on December 8, 2024 in Vancouver, British Columbia. My “Roaring 2020s Tour” started in California at the end of January 2024. My latest stops were in Georgia and Tennessee last week. Next week, I’ll be in Las Vegas and Houston.

My tour has been well received, though not as well as Taylor’s. My main Roaring 2020s themes are the following:

(1) Resilient economy. We should be impressed by how well the US economy has grown over the past three years despite the significant tightening of monetary policy. The most widely anticipated recession of all times has been a no-show, attesting to the resilience of the economy. That increases the chances that the current economic expansion, which began in Q3-2020, will continue for longer than it has lasted so far; maybe there will be no recession through the end of the decade. Perhaps the Roaring 2020s will even be followed by the Roaring 2030s.

Real GDP has increased 23.5% since Q2-2020 (the bottom of the two-quarter recession) through Q4-2024 (Fig. 1). The full recovery from the recession in early 2020 took only 20 months, one of the shortest recovery periods on record (Fig. 2). The post-recovery expansion has lasted 38 months so far through the end of 2024. We think it could last at least as long as the 1990s expansion (i.e.,105 months) in our Roaring 2020s scenario. It could be even longer if the 2030s also roar.

(2) Washington matters less. We should also be impressed by how well the US economy has performed for many years despite the meddling of Washington. We attribute this to the work ethic of American workers and the business acumen of American company managements. Together, they’ve driven real GDP to new record highs for decades despite quixotic government regulations and fiscal policies.

Americans also do entrepreneurial capitalism extremely well, creating new technologies and businesses. Since the pandemic, the 12-month sum of new business applications has consistently exceeded 5.0 million, according to the US Census Bureau (Fig. 3). That’s certainly an important driver of both employment and capital spending in the US economy.

The number of sole proprietorships was approximately 29 million in 2021 (Fig. 4). Within the category “personal income,” proprietors’ income in December totaled a record $2.0 trillion (saar), while rental income totaled a record $1.1 trillion, for a record $3.1 trillion combined (Fig. 5). Nonlabor income, which includes these two sources plus interest and dividend incomes, accounts for 28.1% of personal income, up from 24.6% at the start of the 1970s (Fig. 6). Americans’ high nonlabor income helps to explain why consumer spending has become increasingly resilient.

(3) Capital markets. America’s capital markets survived the Great Financial Crisis and have become increasingly sophisticated and diversified ever since. Venture capital is readily available for startups. The capital markets also have more shock absorbers since the Great Financial Crisis. Private debt markets allow for restructuring bad debts without causing financial crises. Distressed asset funds do the same.

Since the Great Financial Crisis and the Great Virus Crisis, the Fed has become more adept at rapidly establishing emergency liquidity facilities to stop financial crises from spreading and becoming economy-wide credit crunches, which then cause recessions. That’s exactly what happened during March 2023, when a banking crisis in California was quickly contained (Fig. 7 and Fig. 8).

(4) Technology and productivity. The US economy has been experiencing a Digital Revolution since the 1950s, when IBM mainframe computers proliferated in business, government, and academia. 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 large language models (a.k.a. LLMs) to make some sense of it all and use it to increase productivity.

When the use of personal computers proliferated during the 1990s, the only “apps” widely run on them were Excel and Word. Now tens of thousands of apps are available with more being produced every day, some written by AI coding software! Most are for entertainment, but many are also boosting productivity.

High-tech now accounts for 50% of nominal business capital spending, up from close to 20% in the mid-1960s (Fig. 9). This obviously doesn’t include lots of consumer spending on technology hardware and software (Fig. 10).

(5) Resilient consumers. As noted above, consumers collectively have diverse sources of income that help to explain why the tightening of monetary policy didn’t depress their spending. On balance, higher interest rates benefit more consumers than they hurt. During December 2024, personal interest income totaled a record $2.0 trillion, while personal nonmortgage interest payments totaled $0.6 trillion (Fig. 11).

Furthermore, as we have noted often in the past, the household sector has a record $159.9 trillion in net worth, with about half of that held by Baby Boomers, a group that’s continually retiring (Fig. 12). These seniors will probably turn the overall personal saving rate negative as they spend down their retirement assets in coming years. While they are doing so, the values of their homes and stock holdings continue to rise!

(6) Accentuating the positives. The theme song of the Roaring 2020s might be a 1944 tune titled “Ac-Cent-Tchu-Ate the Positive.” It was nominated for the Academy Award for Best Original Song at the 18th Academy Awards in 1945 after being used in the film “Here Come the Waves” with Bing Crosby and Betty Hutton.

During my “Roaring 2020s Tour,” I encourage our accounts to accentuate the positives and to consider the possibility that the US economy will continue to grow and the stock market will continue to rise to record highs. It’s happened more often than not in the past.
 
US Economy II: The 1920s Ended Badly. Invariably, the pushback that Eric and I get on our Roaring 2020s scenario is that the Roaring 1920s ended badly. It was followed by the Great Crash in the stock market and the Great Depression in the economy. These calamities had multiple causes. We believe that the most important cause was the Smoot-Hawley Tariff, which was enacted during June 1930.

Roughly half of the stock market drop in late 1929 was reversed during the first few months of 1930, with the S&P 500’s predecessor index (the Standard Statistics Company’s index of 233 US companies) back to where it had been the year before. That was not the Great Crash. Rather, the Great Crash started in May 1930, a few weeks before the Smoot-Hawley Tariff was enacted (Fig. 13). Industrial production also crashed after the tariff was enacted (Fig. 14).

The tariff act prompted retaliatory tariffs by many other countries. The resulting trade war caused commodity prices to collapse along with global trade. Farmers were especially hard hit and were forced into bankruptcy, which exacerbated the banking crisis.

On June 12, 1934, Congress enacted the Reciprocal Tariff Act. It authorized the president to negotiate trade agreements with separate nations to reduce tariffs in return for reciprocal reductions in tariffs. Between 1934 and 1945, the United States signed 32 reciprocal trade agreements with 27 countries.
 
US Economy III: Retaliatory vs Reciprocal Tariffs. On Friday, President Donald Trump indicated that reciprocal tariffs might replace the proposed 10%-20% universal import duty that was a key part of his economic agenda during the campaign. He is leaning toward implementing “mostly” reciprocal tariffs rather than broad import duties applied across the board. Trump announced on Sunday that he is slapping a universal 25% tariff on all imports of steel and aluminum. It will apply to Mexico and Canada as well, even though on February 3 he gave both countries a 30-day extension of an across-the-board 25% tariff on imports from them (except for a 10% tariff on Canadian oil).

Is this the start of Smoot-Hawley 2.0? We doubt it. Much will depend on whether Trump views his tariffs as retaliatory or reciprocal. The latter implies that the US is matching tariffs imposed on US goods and that there is a willingness to negotiate to lower or no tariffs. We think that’s Trump’s goal.

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Anatomy Of Full Employment

February 10 (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.
 
Labor Market I: Finding Full Employment. Friday’s January employment report confirms every part of our optimistic outlook on the labor market. The unemployment rate fell to 4.0%, its lowest since last May, even though more Americans decided to participate in the labor force (Fig. 1). Before we discuss the January data, let’s review our labor market outlook.

As we’ve argued since last summer, the post-pandemic period was historically anomalous and led many to misread an apparent slowdown in the jobs market as harbingering a looming recession. In fact, the largest wave of immigration on record helped raise the unemployment rate without any material layoffs. Also, labor market indicators such as hiring and quits fell. Such cooling has preceded recessions in the past, but this time it was simply the natural result of the pandemic’s massive labor market churn settling down. Normalization was to be expected, but it was widely misinterpreted as a sign that the “long and variable lags” of a Federal Reserve tightening cycle finally had clamped down on the economy.

The labor market is likely to chart a slightly different path going forward than it did over 2023 and 2024. Greatly reduced immigration and mostly topped-out labor force participation and employment metrics from native-born workers mean that the labor force will grow at a slower pace. However, we believe demand for workers is stronger than most do. Thus, we think it is likely that the unemployment rate will remain at full employment around 3.7% to 4.3%.

Barring unexpected events, we’re expecting monthly payroll growth to average around 150,000-175,000 workers over the coming quarters and years, below the roughly 175,000-180,000 average pace just before the pandemic. Despite the slowdown of employment growth, strong productivity gains and a full-employment labor market should spur robust real wage growth.

This should maintain the solid pace of consumer spending growth and real GDP growth. Furthermore, consumer spending should continue to get a boost from rising nonlabor income, including interest and dividends. In addition, retiring Baby Boomers will continue to spend their retirement funds, which may very well cause the personal saving rate to turn negative.

Now let’s assess the implications of the January data for the remainder of this year—and consider the outlook for the rest of President Trump’s second term:

(1) Payroll growth. Despite January’s lower-than-expected payroll gain of 143,000, the three-month average monthly increase in payrolls reached 237,000, as November’s and December’s initial figures were revised up by a collective 100,000 (Fig. 2). At the end of last year, we had an above-consensus forecast that the three-month average would be at least 200,000 after the January report. In fact, were it not for the Los Angeles fires, it might even have topped 250,000.

Roughly 591,000 workers weren’t at work in January due to bad weather, the highest monthly total since February 2021 (when winter storms blanketed the country and led to the Texas freeze and power crisis) (Fig. 3). Based on the increase in California’s jobless claims over the past few weeks, this was likely due to the multiple weeks of LA fires—despite the Bureau of Labor Statistics’ (BLS) specious declaration that the fires had no impact on employment. That seems to be the BLS’ go-to response to seemingly all extreme weather events whether it’s the case or not. But we suspect the fires had at least some impact on payroll growth because of the significant drop in average weekly hours worked to the lowest since the pandemic (Fig. 4). This series should rebound sharply in February.

(2) Labor market reacceleration. The labor market may be picking up, as it has been doing since last November’s Election Day. Exhibit A is that the birth/death adjustment provided a boost to January’s payrolls gains, and we expect it will continue to so, as business applications are rising due to Trump 2.0 business optimism, a.k.a. Animal Spirits (Fig. 5). Exhibit B is that the percentage of private industries reporting high payrolls over the past three months (a.k.a. the payroll diffusion index) surged to 64.8%, the highest since January 2023 (Fig. 6).

(3) Goods gaining ground? Dragging on payroll employment have been the goods-producing sectors, i.e., mining, lodging, construction, and manufacturing. Even as construction employment has climbed to new highs, overall goods employment has stagnated and even fallen over the past few years (Fig. 7). However, we’re expecting a turnaround as manufacturing enters a rolling recovery.

The ISM M-PMI rose above 50.0 in January after 26 months in contraction, propelled by strong new orders, expanding employment, and higher production (Fig. 8). The payroll diffusion index for manufacturing industries also surged to a multiyear high, of 57.6% (Fig. 9).

Demand for labor in goods industries ostensibly is increasing. But the growth in labor supply is undoubtedly starting to wane. New unskilled immigrants find much of their work in goods-producing sectors. Southern border crossings have plummeted since last summer and are very likely to remain low under the current administration (Fig. 10). So over-the-table hiring (that is recorded by government statistics) is likely to accelerate. Over a longer-term horizon, if Trump 2.0 succeeds in its goals of rebalancing global trade, domestic manufacturing employment should increase as well. A lower US corporate tax rate plus tariffed foreign goods should make producing in the US more cost-competitive despite the higher cost of employing American workers.

(4) Leaving, not losing. The number of workers who were unemployed due to layoffs fell in January, while the number of job leavers rose (Fig. 11). Workers reentering the labor market, currently the largest source of unemployment, also increased. On balance, these conditions helped to boost the employment-population ratio for prime-age (25-54 years) workers to a historically high 80.7% (Fig. 12).

If you want a job, you can find one: While it started taking longer for unemployed workers to find jobs, January’s duration of unemployment fell for those seeking jobs for the longest time periods (Fig. 13).

And if you have a job, you’re in good shape: The number of employed workers losing their job remained at one of the lowest rates on record in January (Fig. 14).

(5) Not so bad for natives. The fact that foreign-born workers have made up most of the employment gains since the pandemic has roused some concerns about the state of the labor market (Fig. 15). We believe that to be misleading without proper context. While native-born employment has remained relatively steady post-pandemic, plenty of native-born workers have entered the labor market and/or found news jobs. However, these additions have largely been offset on a net basis by the wave of retirements, masking the actual increase, which is evident from the boom in payroll growth. Moreover, foreign-born workers account for only about a fifth of US employment, so a small absolute increase in their ranks (from around 27,000 to 31,000) represents a large percentage change, which can sound alarming.

(6) Revisions are a non-event. The final revision of the BLS’s Quarterly Census of Employment and Wages (QQCEW) reduced the initial downward revision for the period from April 2023 to March 2024 from -818,000 payrolls to -598,000. Also included in the January data were the Census Bureau’s update, which found that several million more immigrants came into the US over the past two years than initially estimated. Even after the big update to the size of the labor force, demand for labor continues to outstrip supply (Fig. 16).

The large upward revision in the labor force and household employment, to 170.7 million and 163.9 million Americans respectively, will likely correlate with upward revisions to real GDP growth, business output, and therefore productivity growth.

(7) Average hourly earnings. Wage growth beat expectations in January. Average hourly earnings increased 0.5% m/m and 4.1% y/y, and it increased 4.2% y/y for production and nonsupervisory workers. While we believe nominal wages growth will continue to outpace inflation, we think annual raises boosted the data. We’re expecting a gradual slowing in the y/y figure as it converges toward the Employment Cost Index, which is currently up 3.6% y/y (Fig. 17).

The jump in wage growth was offset by the drop in the average workweek in our Earned Income Proxy (EIP). Combined with the added 143,000 payrolls, our EIP rose 0.27% m/m in January. Typically, this would lead to an increase in retail sales by around the same amount, or less than 0.1% m/m in real terms. However, we wouldn't be surprised if consumer spending was a bit higher than that last month, as the fires in California may have boosted demand for services in the short run. In any case, we expect a rebound in consumer spending this month.

Labor Market II: Counting on Productivity. We believe productivity growth is on its way up from the cyclical lows of just 0.5% in 2015 to 3.5%-4.0% annually by the end of the decade. And that’s on an annualized 20-quarter moving average basis, meaning that productivity growth is accelerating now since this figure rose to 1.8% during Q4-2024 (Fig. 18).

As population and labor force growth wanes, productivity will be the source of real economic growth. Indeed, productivity is highly correlated with real wage growth because in a competitive labor market, workers are paid their fair wage in real terms. So with the economy potentially settling in at full employment, more productive and better paid workers will drive rising consumer spending going forward. Here’s more:

(1) Not more labor, but more productive labor. Productivity increases when workers produce more output for every hour they work. That productivity rate times the total number of hours worked equals real GDP growth. However, the rate of growth for aggregate weekly hours has slowed, and we wouldn’t be surprised if it slows even further through the end of the decade (Fig. 19). Fewer new employees and shorter workweeks will become the norm.

(2) Productivity and labor costs. Productivity growth declined from 2.1% to 1.6% y/y in Q4, while unit labor costs (ULC) increased from 2.2% to 2.7% y/y. Both represent changes in direction due to a big decline in durable manufacturing output amid higher hourly compensation.

We expect the trends in both (i.e., higher productivity growth, lower ULC inflation) to resume this quarter. Falling auto inventories and stalled auto production dragged down real GDP growth last quarter. As the latest labor force revisions are factored into growth data, we expect an upward revision to output to raise productivity growth and lower ULC inflation. Nonetheless, manufacturing productivity appears to be growing for the first time since the Great Financial Crisis (Fig. 20).

(3) Investing in capital. An economy at full employment means it is difficult and costly to hire new workers, so businesses are encouraged to invest in technologies to augment their workforce. Entrepreneurship also encourages productivity, and we’ve seen a boon in new business creation since the pandemic (Fig. 21). In our opinion, the normalized-interest-rate environment makes it difficult for so-called zombie companies to stick around and artificially boost capacity, instead inspiring actual innovation. Federal Reserve Governor Adriana Kugler highlighted both of these as factors driving the productivity boom in a speech on Friday.

The latest technological innovation is artificial intelligence. AI is much more likely to creatively disrupt services-providing and white-collar employment than production and supervisory workers, in our opinion. But because there is a shortage of highly skilled labor, this innovation will do more to alleviate labor cost pressures for employers and to benefit employees by making them more productive than it will to eliminate jobs and create an oversupply of workers. Indeed, we’re optimistic that AI will create more jobs than it displaces, or at least not raise the unemployment rate. In our base-case productivity-led Roaring 2020s scenario, American workers and consumers will prosper to a degree they haven’t in decades.

Movie. “Mothers’ Instinct” (2024, ++) stars Anne Hathaway and Jessica Chastain as neighborly mothers with sons who are the same age and best friends. When one of the boys dies in a terrible accident, the friendship of the two mothers is strained. More deaths are ahead as the plot thickens and suspicions mount. One of the mothers is a psycho, but which one? The film (and its musical score) is an homage to the directing style of Alfred Hitchcock. The two leading ladies deliver superlative performances. (See our movie reviews archive.)

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Palantir, Semis & Tesla’s Big Year

February 6 (Thursday)

Information Technology I: AI Software Reigns. Palantir is known for providing software to the US government, so when its AI business with corporate America accelerated sharply, surprised investors sent its shares surging higher. Companies are using Palantir’s AI software to cut costs and become dramatically more efficient. “AI is a pivotal component in driving innovation and efficiency, something companies need to embrace or fall behind,” said Palantir’s Chief Revenue Officer Ryan Taylor on its February 3 earnings conference call.

Palantir’s Q4 total revenue increased 36% y/y to $828 million, and revenue from its US government business grew 45% y/y to $343 million. But it was the 64% y/y jump in revenue from Palantir’s US commercial business, to $214 million, that captured investors’ attention. The company expects 2025 total revenue growth of 31% y/y, the midpoint of its estimate range. Palantir’s shares surged 24.0% on Tuesday to $103.83, far outpacing the S&P 500’s 0.72% gain.

Palantir executives shared some interesting perspectives on its conference call about large language models (LLMs), corporate adoption of AI, the unofficial US war with China, DeepSeek, and the Trump administration’s new Department of Government Efficiency (DOGE). Here’s a look:

(1) Palantir on LLM commoditization. Palantir has benefitted from the plethora of LLMs that have entered the market. LLMs are being commoditized as they grow more similar and the price of inference drops “like a rock,” said Chief Technology Officer Shyam Sankar on the conference call. That benefits the companies that use LLMs, like Palantir; but it hurts companies that make LLMs, like Alphabet’s Google.

Alphabet announced on Tuesday that its capital expenditures would increase to $75 billion this year, up nearly 50% from $52.5 billion in 2024. It’s not the only company spending like a drunken sailor. Microsoft plans to spend $80 billion on capital expenditures in its fiscal year ending June, up from $55.7 billion the prior year. It said most of the funds would be used to build AI infrastructure. Conversely, Palantir spent only $12.6 million on capex last year and didn’t state its plans for 2025. Ballooning capex spending on AI and related infrastructure has raised concerns about whether the big spenders will ever earn a reasonable return on their investments.

(2) Palantir on the power of its AI programs. Palantir executives illustrated how companies are deploying Palantir’s Artificial Intelligence Platform (AIP) to save time, increase efficiency, and cut costs with examples including:
A global insurance company’s two-week underwriting process was reduced to three hours.
A multinational bank’s back-office processes were shortened from five days to three minutes.
An engineering and construction firm now identifies risks culled from large technical documents in minutes instead of months.
Rio Tinto uses AIP to coordinate 53 driverless trains, improving throughput and safety.
Palantir is also using AI in its Warp Speed operating system to improve manufacturing. The software optimizes production schedules, reduces bottlenecks, streamlines engineering changes, automates visual product inspections, enhances material resource planning, and provides a unified interface connecting multiple systems.

(3) Palantir on DeepSeek & China. The folks at Palantir believe that the war between the US and China has already begun, pointing to the LLM DeepSeek as the latest evidence. Sankar described the engineering of DeepSeek’s R1 as “exquisite.” He concludes: “[We] have to wake up with the respect for our adversary and realize that we are competing. But they absolutely did steal a lot of that through distillation of the models.”

The AI race between the US and China is just the latest battle in the war that began when China entered into the World Trade Organization, said Sankar. Other battles include the opium war (fentanyl is the leading cause of death among 18- to 45-year-olds in the US), the diplomatic war (Belt and Road initiatives span the globe), and aggressions by the Chinese Communist Party that fall short of open warfare (e.g., Chinese ships are suspected of cutting underseas communications cables).

(4) Palantir on DOGE. Sankar sounded optimistic about Elon Musk’s leadership of DOGE, with good reason: Palantir stands to benefit if the government uses more of Palantir’s products to become more efficient. “[T]the work that we’ve done in government, it’s deeply operational, it’s deeply valuable, and we’re pretty excited about exceptional [DOGE] engineers getting in there under the hood and being able to see that for a change,” said Sankar.

(5) Investors’ new AI darling? Palantir joined the S&P 500 last fall as a member of the Application Software stock price index, which has climbed 9.7% over the past year, hitting a new high late last year (Fig. 1). The industry’s revenue growth has been extremely steady: 11.1% in 2024, 10.8% in 2025, and 11.1% in 2026 (Fig. 2). Earnings growth has decelerated from 29.2% in 2023 to an expected 12.6% this year and 14.5% in 2026 (Fig. 3).

The industry’s forward P/E has fallen a bit over the past few years, but not Palantir’s. The Application Software industry’s forward P/E is 34.4, down from a recent peak of 53.8 in November 2021 (Fig. 4). That looks like peanuts compared to Palantir’s forward P/E of 189.2—more than triple its P/E in mid-2024 (Fig. 5). Watch out, Nvidia, the stock market may have adopted a new darling.

Information Technology II: Semi Stocks Are Cheaper Now. A handful of semiconductor companies have reported mixed quarterly earnings results over the past few days.

Advanced Micro Devices shares fell 6.2% on Wednesday—bringing their one-year decline to 35.7%—even after reporting a 69% jump in chip sales to data centers. The segment’s $3.9 billion of revenue missed analysts’ $4.1 billion forecast. The reaction may be overdone given that the company posted 24% Q4 revenue growth and 43% adjusted operating income growth.

In the December quarter, Qualcomm's revenue rose 17% y/y, and its adjusted earnings per share jumped 24% to $3.41, beating analysts' estimates. Shares of the cell phone chip manufacturer fell roughly 4.5% in aftermarket trading on Wednesday, giving back some of the 14.5% ytd gains the shares had enjoyed.

Infineon Technologies, a German semiconductors manufacturer for auto and industrial use, reported an 8% y/y decline in December-quarter sales. Despite the decline, investors may be signaling that the worst is over because the shares have climbed roughly 13% over the past two days and are up 24.9% from November’s low.

Nvidia shares have tumbled 17.2% since their January peak, spooked by news that China’s DeepSeek managed to develop a competitive AI offering without spending billions on Nvidia’s most advanced chips. However, some have speculated that DeepSeek did have access to at least some of Nvidia’s highest-end chips and essentially used distillation to steal ChatGPT’s knowledge. Also reassuring for Nvidia investors has been the planned capex announced by Google and Microsoft, a sign that chip spending will continue. Nvidia’s shares have climbed 4.0% so far this week (through Wednesday’s close).

Nvidia’s recent downdraft has taken some of the excess out of the S&P 500 Semiconductors index’s valuation. While analysts expect the industry to produce robust earnings growth of 45.5% this year, its forward P/E has fallen to a more reasonable 25.6 from a recent high of 49.7 on June 19, 2024 (Fig. 6 and Fig. 7).

Disruptive Technology: Tesla’s Big Year. Ever effusive, Elon Musk recently said 2025 may be the most important year in Tesla’s history. The company plans over the next 12 months to introduce unmanned autonomous vehicles in the US, to produce Optimus humanoid robots, and to produce a semi-trailer truck.

Musk needs investors to focus on the future because sales of Tesla’s electronic vehicles (EVs) have slowed. Last year was the first time that the number of Teslas sold worldwide declined. In Q4, Tesla’s automotive revenue fell 8% y/y to $19.8 billion, its total operating income dropped 23% y/y to $1.6 billion, and the operating margin contracted to 6.2% from 8.2% a year earlier as the company cut prices to move inventory. Sales may fall further if President Trump successfully eliminates the rebates that EV buyers receive.

Nonetheless, Musk sounded optimistic during the company’s recent earnings conference call: “I’m highly confident that all transport will be autonomous electric, including aircraft, and that [the transition] simply can’t be stopped any more than one could have stopped the advent of … the internal combustion engine.” So far, investors are going along for the ride. The company’s stock price remains near its record high, and its forward P/E is a lofty 129.8 (Fig. 8 and Fig. 9).

Here’s a look what Musk had to say about Tesla’s 2025 product launches as well as the competition Tesla faces.

(1) Full self-driving arriving. Autonomous vehicles and humanoid robots have the same problem: Both require huge amounts of AI training that consumes vast amounts of computer processing. Yet both products are massive opportunities for Tesla. Optimus has the potential to generate more than $10 trillion in annual revenue, Musk said.

Tesla expects to launch in June unsupervised full self-driving (FSD) cars as a paid service in Austin, using Tesla’s fleet of cars. That will be followed by unsupervised FSD in California and in other regions this year and in all of North America in 2026. Next year, private Tesla owners will be able rent out their vehicles by adding them to the fleet of company-owned Teslas available for hire.

Also happening this year: Tesla owners will be able to use their FSD mode without watching the road (currently, they can use FSD but must keep their eyes on the road). During Q4, Teslas using Autopilot experienced one crash for every 5.9 million miles driven compared to the US average of one crash every 700,000 miles.

Internationally, the rollout of FSD is being delayed by “regulations and bureaucracy” in Europe and by the Chinese government, which won’t let Tesla train its software in China. Instead, Tesla is training its FSD software on videos of China’s streets that are publicly available. Musk estimates that unsupervised FSD will be available in most countries by the end of next year.

Tesla currently has thousands of unsupervised FSD cars operating at its California factory. Musk said other automakers are interested in licensing Tesla’s FSD technology, realizing that they’ll need to offer this feature to remain competitive.

(2) Optimus arriving. Optimus humanoid robots require even more training than autonomous vehicles due to their varied uses and complexity. Fortunately, the cost of training is dropping “dramatically,” said Musk. By year-end, Tesla should have several thousand Optimus robots working in its factories on the most boring, tedious, annoying, and dangerous tasks. We’ll be interested to see if profit margins improve when the company no longer has to pay humans for this work.

Tesla may start delivering Optimus robots to customers in 2H-2026. Once production rises to one million robots a year, the cost of production will fall to $20,000 per robot or less, and the robot’s price will be determined by market demand.

(3) Commercial trucks coming too. Telsla’s electric semi-trailer truck factory in Reno is under construction, and the first few semis are expected to roll off the production line late this year. With more truck drivers leaving the profession than joining it, there’s a need for autonomous trucks, which could grow into a $10 billion to $12 billion a year business for Tesla, Musk said.

(4) Tesla faces competition. As we discussed in the August 8 Morning Briefing, Tesla faces international competition. In China, Shanghai Qingbao makes robots used in tourism and conventions, and UBTech’s robots are on NIO’s EV factory floors, a February 4 South China Morning Post article reports. Unitree Robotics’ robots recently went viral dancing during China’s Spring Festival Gala.

At home, Figure AI has robots set for BMW’s factory floors later this year, and Boston Dynamics’ Atlas continues to improve. It can now analyze and adapt to its surroundings, functioning on its own without any preprogrammed sequences or remote control, as it reportedly did in this video.

The most recent addition to the party: OpenAI. The company filed a trademark application on January 31 for hardware that includes headphones, goggles, glasses, remotes, laptop and phone cases, smartwatches, smart jewelry, and virtual and augmented reality headsets, a February 3 PYMNTS article reported. The application also mentioned robots, and OpenAI has begun putting together a robotics team—of human hires (for now?).

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Investing Outside The Mag-7

February 5 (Wednesday)

Strategy I: Digging for Value in US Stocks. Our equity market preferences have been heavily biased toward US large-capitalization stocks for the past few years and remain so. We’ve preferred the Stay Home investment style—i.e., overweighting US stocks in global portfolios—over Go Global, which we’ve recommended underweighting since at least 2010. While ex-US developed market indexes look cheap on a relative valuation basis and may even have spurts of outperformance relative to US stocks, that’s been the case since roughly 2009. At the moment, we see don’t see enough fundamental economic reasons to inspire us to go neutral on the US and upgrade foreign markets.

Within the US, we still like the LargeCaps, but have grown increasingly interested in the S&P 493. We think there’s room for the ex-Mag-7’s collective profit margin to expand as productivity increases and the high-tech solutions (i.e., artificial intelligence, automation, etc.) utilized and churned out by the Mag-7 firms are implemented (Fig. 1). To be clear, we do not believe the Mag-7 are grossly overvalued—in fact, we think their current collective forward P/E of 29.4 is supported by strong profit margins and earnings growth expectations. However, we see room for the S&P 493 to outperform as its collective multiple expands above 20 times forward earnings (Fig. 2).

That's not to say that we have S&P 500 blinders on. In fact, we believe that the US MidCaps (represented by the S&P 400) present an interesting opportunity, especially for investors who share our optimistic outlook for the US economy and markets. We'll also touch on the possible opportunity in Value stocks.

Here’s more on how we’re thinking about US equities:

(1) A smidge of SMids. For much of the Federal Reserve’s latest tightening cycle, it’s been an S&P 500 story with seven main characters. Indeed, it’s been tough sledding for SMidCaps as far back as Trump 1.0. The S&P 400 and 600 have both been trounced by the S&P 500 (Fig. 3). Part of that story is that SMidCaps tend to have more leverage and less resilient cash flows, so two Fed hiking cycles and a pandemic took their toll.

It’s also a Growth versus Value story, as SMidCaps tend to trade at cheaper valuations given their sector composition (lighter on the new economy tech-y industries, heavier on the old economy sectors like Industrials), greater earnings uncertainty, and survivorship bias. Both the SmallCaps and MidCaps are trading around 16 times forward earnings versus the S&P 500’s 21.8 (Fig. 4). The best performing smaller stocks have often been Growth names that either grew into the S&P 500 or were picked off in a buyout by an S&P 500 company. So perhaps SMidCaps are just a big Value trap that should be avoided at all costs? We think that applies broadly to SmallCaps, but not so much for MidCaps.

(2) Not-so-mid Mids. The S&P 400’s forward earnings per share (EPS) is just a touch away from notching a new record high for the first time in 33 months (Fig. 5). The S&P 600’s forward EPS has plateaued at 11% below its 2022 record high and shows few signs of acceleration.

Analysts expect MidCaps’ earnings growth to be strong this year (13.7%) and next (16.5%) after a 1.5% dip last year (Fig. 6). We believe last year’s poor earnings have rendered MidCaps unappreciated by the broader investor community.

(3) Buy the dip? We’re still in buy-the-dip mode for the US LargeCaps on the basis of volatile macro news but solid fundamentals. (The same goes for Super Bowl hors d’oeuvres, especially since the tariffs on Mexican goods won’t be taking effect.) But beware of apparent dips that are actually traps. US Value stocks might be a case in point.

Part of the S&P 493 is indeed Value stocks. Within this cohort, we broadly favor cyclical sectors such as Financials, Industrials, Consumer Discretionary, Information Technology, and Communication Services (in no particular order). We would also avoid overly cheap plays (Fig. 7).

It can be tempting to dip into names trading cheaply relative to fundamentals when Growth has done so well for so long and the spread in valuations is so wide (Fig. 8 and Fig. 9). Active portfolio managers can certainly find good buys in this pile, and we would suggest identifying companies that have the highest opportunity to replace labor costs with automation and/or higher productivity and thus to expand profit margins. But from a factor perspective, we’d hesitate to rotate into broad-based Value.

To those managing global portfolios, we understand that the MSCI World ex-US is trading below 14 times forward earnings (Fig. 10). And plenty of Value stocks in the Eurozone trade below 10 times forward earnings. Combing through underappreciated stocks may produce strong returns; cigarette butts are often still smokable. But we do not see the caliber of fundamentals to suggest longer-term outperformance.

Strategy II: Financials Shine Among Q4 Reporters to Date. Through midday Tuesday, just over 41% of the S&P 500’s companies have reported fiscal Q4 earnings. Among the 211 companies that have reported so far, the aggregate revenue and earnings beats relative to analysts’ consensus estimates are 1.3% and 6.6%, respectively (Fig. 11 and Fig. 12).

We have more Q4 data in hand for some of the S&P 500 sectors than others at this point. Two-thirds of the companies in the S&P 500 Financials sector have already closed their books on Q4, for example, but less than 10% of firms in the Utilities sector have done the same. However, enough data has been reported to begin seeing takeaways about the quarter for the S&P 500, a few sectors, and the Magnificent-7.

The results to date combined with the Trump 2.0 policy agenda particulars suggest a higher growth path ahead for the Financials sector. Below, Joe compares the sector’s Q4 results with those of the S&P 500 companies and the four Magnificent-7 companies that have reported so far.

(1) A breakout quarter for Financials? The firms in the S&P Financials sector collectively overshot analysts’ consensus earnings estimate by 12.1%--the sector’s biggest earnings beat since Q3-2021—outperforming the S&P 500’s Q4 earnings beat reported to date (Fig. 13 and Fig. 14). Financials, primarily viewed as a Value sector, bested its consensus revenue estimate by 2.0%, also ahead of the S&P 500.

In another solid performance for the sector, a record-high 89.8% of the firms recorded higher Q4 revenues than in the year-earlier quarter (Fig. 15). Looking at the bottom line, Q4 earnings rose y/y for 85.7% of the sector (Fig. 16). That’s the highest percentage of companies with earnings growth since Q2-2021 and ranks among the best readings in the 60-plus quarters since the Great Financial Crisis.

(2) Financials’ strength casts shadow over early Mag-7 results. Four of the Magnificent-7 companies have reported Q4 already. Tesla undershot estimates on both the top and bottom lines, but it did manage to eke out single-digit y/y percent gains in those measures (notwithstanding all the Tesla Cybertrucks on the road). Tesla’s weakness dragged down the Mag-7’s aggregate surprise and y/y growth numbers, causing the group to be a negative contributor to the overall S&P 500’s revenue and earnings surprise metrics among reporters so far. However, the Mag-7 remains a net positive contributor to the S&P 500’s y/y growth rates in revenues and earnings.

The S&P 500’s revenue surprise of 1.3% improves to 1.4% when the Magnificent-7’s revenue surprise of just 0.3% is excluded. Likewise, the S&P 500’s earnings surprise improves to 6.9% from 6.6% when the Mag-7’s 5.7% surprise is excluded. Looking at their y/y growth rates, S&P 500 revenues growth drops to 3.0% from 3.6% when the Magnificent-7 (8.6%) is excluded. Earnings growth drops to 11.1% from 1.5% with the Magnificent-7 (16.9%).

(3) New era ahead for Financials and US? We think the Financials sector’s strong performance in Q4 is a sign of better times ahead. Trump 2.0 promises to be a growth catalyst for the sector as regulatory restraints are released. President Trump’s announcement on Monday of the creation of a Sovereign Wealth Fund could be a positive for the industry too. How it will be funded remains to be seen, though initial indications suggest a plan to monetize the asset side of the US balance sheet. As government agencies and offices are closed for good, there will be physical assets left over to deal with.

This reminds us of the Resolution Trust Corporation (RTC). The RTC liquidated assets from failed financial institutions; it was a temporary government-owned agency created in 1989 by the Financial Institutions Reform, Recovery, and Enforcement Act (a.k.a. FIRREA) and operated until 1995.

Strategy III: S&P 500 January Revisions Activity Stable, But Few Leaders. Early this week, LSEG released its January snapshot of the monthly consensus earnings estimate revision activity over the past month. While the company provides raw data for all its polled measures, we focus primarily on the revenues and earnings forecasts, captured in our S&P 500 NRRI & NERI report. There, the analysts’ estimate revisions activity is indexed by the number of upward revisions in forward earnings less the number of downward ones, expressed as a percentage of total forward earnings estimates. We look at this activity over the past three months because that timespan encompasses an entire quarterly reporting cycle. Since analysts’ tendency to revise their estimates differs at different points in the cycle, three-month data are less volatile—and misleading—than a weekly or monthly series would be.

Joe highlights what’s most notable about the January crop of earnings revisions data below:

(1) S&P 500 NERI negative for a fifth month. The S&P 500’s NERI index, which measures the revisions activity for earnings forecasts, was negative for a fifth straight month, but ticked up to -1.8% from an 11-month low of -1.9% in December (Fig. 17). A zero reading indicates that an equal number of estimates were raised as were lowered over the past three months. January’s -1.8% is an improvement from its year-earlier reading of -3.8% and is nearly spot on with the average reading of -1.9% seen since March 1985 when the data were first calculated.

(2) More sectors have positive NERI than a year earlier. Three S&P 500 sectors had positive NERI in January, down from four sectors in December. But that’s up from just one sector with positive NERI a year earlier in January 2024, when Energy made a brief appearance above ground level.

Financials’ latest readings were best in class among the S&P 500’s 11 sectors (Fig. 18). This sector’s NERI was positive for a 12th straight month and at a 35-month high of 7.9%. Among the poorer performing sectors, Industrials’ NERI dropped to a 24-month low, followed by the NERIs of Materials (at a 22-month low) and Health Care and Information Technology (both 12-month lows). Tech’s NERI turned slightly negative for the first time in 13 months.

Here’s how the NERIs ranked for the 11 sectors in January: Financials (8.0%, 35-month high), Communication Services (6.3), Utilities (0.6), Information Technology (-0.2), Real Estate (-1.5), S&P 500 (-1.8), Consumer Discretionary (-2.6), Industrials (-4.2, 12-month low), Health Care (-4.6), Consumer Staples (-8.8), Energy (-9.5), and Materials (-11.1).

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Trump’s Tariffs: The Art Of The Deal

February 4 (Tuesday)

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

Geopolitics I: What Trump Wants from Canada & Mexico. It’s become abundantly clear to Melissa, Eric, and me what President Donald Trump wants from Mexico. To Trump, Mexico is a looming security threat. In his view, the country must reclaim control over the drug trade and the migrant flows spilling over the southern US border. His demand is simple: curb the cartels and stem the flow of illegal substances. But there’s more to it—Trump is furious that Chinese companies are increasingly using Mexico as a gateway to sidestep US tariffs. For Trump, Mexico’s economic proximity to China is an unacceptable strategic liability.

But what does Trump really want from Canada? That’s less obvious. The dealmaker-in-chief has an end in mind beyond the revenues from the 25% tariffs slapped on Canadian and Mexican goods (10% for Canadian oil).

A closer examination of this administration’s foreign policy blueprint hints at an overarching objective of economic and national security. For Trump to secure the US’s energy future, he needs the Western Hemisphere to function as a coherent energy bloc. This means both a reliable, unimpeded flow of oil and natural resources from Canada and a safer Mexico. And that means both countries under the US’s thumb.

Let’s break it down:

(1) The first global trade war punch. Trump’s recent flurry of tariffs is a textbook example of his “America First” foreign policy.

In late January, Trump fired a 25% tariff salvo at Colombia, punishing the nation for failing to control its citizens illegally present in the US. Colombian President Gustavo Petro initially brushed off Trump’s threats. But he quickly backed down, acknowledging publicly his responsibility for his country’s undocumented citizens. Why the sudden 180?

Trump had sent an unmistakable message on social media: “FAFO” (standing for “F*** Around, Find Out”) accompanied by an AI-generated image of a steely-eyed Trump in a gangster-style fedora. Leaving to the imagination what happens when one disrespects US interests packed a more powerful punch than any diplomatically worded retaliatory threat ever could.

Mexican President Claudia Sheinbaum earned a one-month pause on any tariffs after speaking with President Trump. She agreed to send 10,000 soldiers to the US–Mexico border to prevent the trafficking of fentanyl and other drugs, and assured Trump that Mexico is committed to stymying China. Speaking ostensibly to her domestic shareholders but using a Trumpian tone, Sheinbaum spoke about onshoring and “Made in Mexico” products. We think Mexico’s president is onboard with Trump 2.0 and the realignment of global trade/security.

(2) Canada’s strategic value. Unlike Mexico, Canada doesn’t pose a direct security threat to the US. It’s a peaceful, stable country with a population of just 38 million—roughly 10% of the US population—but one that controls vast tracts of resource-rich land.

Canada’s oil exports to the US make it an indispensable partner. It ships about 3.9 million barrels per day across the border, easily outpacing Mexico’s second-place 397,000 barrels. In fact, Canada is the largest foreign oil supplier to the US. Canadian and Mexican imports account for roughly 25% of the crude oil processed in US refineries. Trump’s tariffs on Canadian goods may appear as a protectionist move on the surface; but in reality, they’re a negotiation tactic aimed at asserting greater control over Canada’s most vital commodity, energy.

(3) The 51st state? Trump’s frequent suggestion that Canada should be the 51st US state has raised eyebrows in both Ottawa and Washington. Is it just bravado, or does Trump have a genuine vision for further integration with Canada? Given the current geopolitical landscape and Trump’s well documented tendency to push the envelope, we doubt this is idle talk. The tariffs are more than a mere trade measure; they are part of a larger bargaining strategy to bring Canada closer into the US orbit, especially when it comes to energy resources. Posturing aside, a North American security zone appears to be taking shape as of Monday afternoon.

It appears that Canadian Prime Minister Justin Trudeau, like Sheinbaum and Petro, has come to terms with the reality that not accepting the US’s demands would mean facing a dire economic future. Trudeau announced that tariffs would be paused for at least a month on the basis of a $1.3 billion border plan and a U.S.-Canada Joint Strike Force.

(4) The blueprint for US–Canada relations. Trump’s second term will likely be shaped by the Heritage Foundation’s Project 2025 mandate. This framework calls for a hemisphere-wide energy strategy that aims to reduce US reliance on foreign, often unstable, sources of fossil fuels.

In this context, Mexico and Canada become critical. The Project 2025 document states: “The [US] must work with Mexico, Canada, and other countries to develop a hemisphere-focused energy policy that will reduce reliance on distant and manipulable sources of fossil fuels. ...” If Trump is serious about achieving energy independence and security, Canada’s vast reserves and Mexico’s proximity to the US become indispensable components of this vision.

(5) Day One priorities. Trump’s goal isn’t just about curbing illegal immigration or stifling drug imports; it’s about reclaiming US sovereignty over energy and countering the destabilizing influence of external powers like China. Among Project 2025’s Day One priorities is tackling the proliferation of socialist and progressive regimes across the Western Hemisphere. The document also states that halting the fentanyl crisis—largely facilitated by Mexican cartels—is an urgent priority.

Reshaping US relations with its North American neighbors isn’t about dollars and cents; it’s about ensuring that the US holds the reins on global energy production and security—effecting a geopolitical recalibration.

Geopolitics II: Will Tariffs Boost Inflation? They didn’t in 2018, at least for US consumers. PPI finished consumer goods inflation averaged around 4.5% y/y from 2017-18, until the Federal Reserve’s monetary tightening started to weigh on price pressure in 2019 (Fig. 1). Yet CPI and PCED goods inflation remained subdued. Services inflation across measures failed to breach 3.0% y/y during Trump 1.0 as well (Fig. 2). Ultimately, substitution and shifting consumer preferences can offset increases in the prices of certain goods.

All that said, goods deflation has been a major tailwind for the Fed’s latest rate-cutting campaign. Because services disinflation has been slow and may be stuck at levels higher than would be consistent with 2.0% overall inflation, a supply shock that raises good prices would likely raise interest rates. The biggest risk in this for the Fed is that inflation expectations become unanchored and rise above 3.0%.

But we’re less worried about tariffs sparking an inflationary spiral than we are about them weighing on economic growth. A global trade war that severely hurts economic growth would be among the worst-case scenarios. However, it remains in our lowest-subjective-probability (20%) “what could go wrong” bucket. That’s because, in our view, it is better to think about such a shock as a tail risk with large consequences rather than a high probability event. So let’s dig deeper into the possible inflationary impact of tariffs:

(1) Inflation expectations. President Trump has inherited a very different economy than he did in his first term. Then, the economy was still relatively stagnant in the wake of the Great Financial Crisis. Policymakers were worried about deflation, not inflation. Today, the economy is at full employment, inflation is elevated, immigration is slowing, fiscal conditions are very loose, and monetary conditions are relatively neutral. Consumers are fed up with inflation—so the margin for error is thinner. The New York Fed’s consumer survey shows expected inflation running at y/y rates between 2.7% and 3.0% over the next several years (Fig. 3). Treasury breakeven inflation remains historically normal, though a recent decoupling of its relationship with oil prices suggests that bond investors may be getting more worried about inflation (Fig. 4).

But tariffs may not feed through to inflation expectations unless there is substantial stimulus to demand.

(2) Demand. Tariffs during Trump 1.0 neither boosted overall consumer inflation nor dented demand. Personal consumption expenditures (PCE) across goods and services were normal throughout Trump 1.0 (Fig. 5). Durable goods spending fell negative in Q1-2019; however, the Fed was also reducing its balance sheet and raising rates during this time (so much so that the Fed overdid it and reversed course later that year).

Lower tax rates are a form of stimulus, but the delta from a 21% corporate tax rate to 15% rate and the extension of the TCJA is dwarfed by Trump 1.0’s fiscal stimulus. If anything, the overall fiscal impulse is likely to decline. Given the ISM M-PMI’s latest rise into expansion above 50.0 and normalizing consumer demand for goods, we do not think demand will dramatically fall due to tariffs nor will it accelerate because of stimulus (Fig. 6). This would be somewhat of a Goldilocks outcome amid a reordering of global trade.

(3) Labor. We understand concerns about the cost of labor rising, as producers may have to shift from reliance on foreign workers to more expensive US labor, and many of the cheapest workers in America are either being deported or prevented/discouraged from entering the country. That said, labor costs weren’t a major issue during Trump 1.0 (Fig. 7). Despite record immigration over the southern border, labor costs soared during the Biden administration due to massive amounts of fiscal stimulus and monetary easing. We believe productivity growth will contain unit labor costs while boosting real wages as it rises toward 3.0% y/y (Fig. 8).

Also, more money to American workers means more spending power for American consumers.

(4) China. China’s exports are surging. China’s imports have plateaued for years (Fig. 9). Export-oriented economies like China rely on the US to consume their goods. That’s especially true for China these days given the Chinese Communist Party’s (CCP) attempt to export its way out of the economic malaise stemming from a property-market bust. Outside of certain critical minerals, the US is far less dependent on China than China is dependent on the US and its other trading partners.

While China could devalue its currency to offset the impact of tariffs—which we expect will be substantial once they are implemented (either late Q1 or in Q2)—the yuan is already nearing levels that risk capital flight (Fig. 10). Maneuvering around tariffs via Vietnam or Mexico is unlikely to prove as successful as it was during Trump 1.0 this time around. Unless China’s autocratic state completely reorders its economy, the burden to reach a “deal” by making concessions is much more likely to fall on the CCP than the US.

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Anatomy Of Gross National Product

February 3 (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: The Year of the Consumer. The American economy put up impressive numbers in 2024. Much of the financial media chatter has focused on the advent of artificial intelligence (AI) and Trump 2.0. But lost in hullabaloo is the fact that the US consumer is powering the economy to new heights. We expect that the consumer will continue to do so in 2025.

We are big believers that improvements in automation, robotics, and data processing (i.e., AI and quantum computing) will continue to boost worker productivity, alleviate high-skilled labor shortages, and stimulate capital spending. We are also Trump 2.0 bulls, expecting deregulation and lower taxes to fuel more domestic investment, hiring, and consumption.

However, the strength of the consumer is the engine of economic growth. Indeed, personal consumption expenditures on goods (21.4%) and services (46.8%) make up 68.2% of US nominal GDP (Fig. 1).

Many hard-landers who had been calling for a recession over the past three years have thrown in the towel. But even more people now seem to be expecting an economic slowdown this year. The pervasive pessimism hinges on the consumer, specifically the prospect that consumer spending will slow as the result of weakening hiring, rising consumer credit delinquencies, depleted saving, and perhaps deportations.

Even if the consumer doesn’t buckle, Trump 2.0 trade wars might cause a recession after all. US export industries might suffer as America’s trading partners retaliate. American consumers and businesses will have to pay more for imported goods, parts, and materials. Tariffs are taxes, which could depress economic growth. But considering that the economy withstood the most rapid Federal Reserve tightening cycle in four decades without a slowdown, we are optimistic about its resilience to shocks.

Our base-case outlook remains our technology-driven, productivity-led Roaring 2020s scenario, with a 55% subjective probability. As a result, it’s more than likely that the current bull market in stocks is not nearing its final inning, nor even the seventh inning stretch. Our S&P 500 price targets of 7000 by year-end 2025, 8000 by the end of 2026, and 10,000 by the end of the decade remain intact.

Here's more on the sources of last year’s GDP growth and what we expect this year:

(1) New records. Last year, real GDP rose 2.8% to yet another record high of $23.5 trillion (saar), increasing 2.3% q/q (saar) in Q4 (Fig. 2). The quarterly slowdown in headline GDP growth from Q3’s 3.1% was largely due to volatile inventory investment. Importantly, real personal consumption expenditures (PCE) rose to a new record high, reaching $16.3 trillion after growing 4.2% (saar) in Q4 and 2.8% for the whole of 2024. That was the highest quarterly growth since Q1-2023 and up from 1.9% in Q1-2024. Real consumer spending on both goods and services rose to record highs last quarter (Fig. 3).

(2) Goods boom. Real consumer spending on goods jumped 6.6% q/q (saar) during Q4, led by a 12.1% leap in durable goods purchases. Perhaps some of the increase stemmed from consumers’ front-running potential tariffs. More likely, it was driven by year-end incentives that boosted auto sales. However, we note that durable goods consumption had been accelerating throughout the year. After falling 1.8% in Q1, real durable goods PCE increased 5.5%, 7.6%, and 6.6% in Q2, Q3, and Q4, respectively, to a new record high (Fig. 4).

Demand for goods, especially durables like autos and appliances, surged during the pandemic. So consumer demand that goods producers normally would have seen in 2022 and 2023 was pulled forward into 2020 and 2021. But consumers were back buying briskly during 2024 despite higher interest rates. This is one sign that higher-for-longer (or, in our view, normal-for-longer) interest rates won’t slow consumers’ purchasing of big-ticket items.

One tailwind for goods consumption has been deflation. PCED durable goods prices fell 1.1% y/y in December and have been falling since June 2023 (Fig. 5). However, nondurables prices are starting to increase, and durable goods prices are likely to follow. That's even before the Trump administration’s tariffs take effect. Goods inflation will weigh on inflation-adjusted real consumption. The question is how much rising prices impact demand. As of now, we aren’t expecting overall demand to decrease meaningfully. Still, a negative hit to growth from trade wars is in our “what could go wrong” bucket, to which we currently assign a 20% subjective probability.

(3) Incomes rising on all cylinders. Driving consumer spending has been real income growth. In December, disposable personal income (DPI) rose 5.0% y/y to a new record high of $22.1 trillion (saar) (Fig. 6). In real terms, DPI rose 2.4% y/y in December and has been increasing at roughly its pre-pandemic pace, if not a bit faster.

The historically tight labor market and rising productivity have fueled real wage gains, particularly for lower-wage workers, who represent roughly four-fifths of US employment. Their nominal wage gains have been outpacing inflation for nearly two years after stagnating for much of the early-to-mid 2010s (Fig. 7).

While the overall labor market has been red hot, the white-collar job market was much cooler over the past few years. Inflation eroded the wages and salaries of higher-wage workers for much of the post-pandemic period. Now, their real income growth is accelerating rapidly.

While higher-wage workers’ real wages fell during the pandemic, rising nonlabor income and a huge wealth effect from rapidly rising stock and home prices more than offset that. Interest, dividend, rental, and proprietors’ incomes all have risen to record highs, totaling $7.1 trillion (saar) in December (Fig. 8).

Nonlabor income has been a boon, particularly to the retiring Baby Boomers and high-income households, as have rising asset prices. A reduced need to save leaves even more after-tax income to be spent. That’s one reason that the savings rate is down to 3.8% as of December (Fig. 9). We expect it to turn negative over the remainder of this decade as retirees continue to spend without the benefit of any labor income.

Slowing immigration is likely to weigh on the growth rates of the labor force and technology-led productivity enhancers may and aggregate weekly hours. So it’s likely that real average hourly earnings growth and the wealth effect will be the main drivers of consumer spending over the next few years (Fig. 10, Fig. 11, and Fig. 12).

US Economy II: Investment Slowdown? While last year was a bright one for business capital spending, it finished with a whimper rather than a bang. For much of 2023 and 2024, government incentives and real business needs sparked a boom in nonresidential fixed investment, particularly in high-tech sectors and construction of manufacturing facilities. The weakness in Q4 was an anomaly in this respect, but we don’t expect it to be the start of a trend.

Technological innovation, of course, is a linchpin of our Roaring 2020s scenario, and we expect areas like software and research and development (R&D) to continue growing into a bigger part of the overall economy. The pro-tech, pro-business stance of Trump 2.0 and real demand for AI will continue to drive the high-tech investment boom that now accounts for more than half of US capital spending (Fig. 13).

While the Mangificent-7 tech companies will continue to shell out cash for new AI- and energy-related projects, the rate of growth for that spending may slow this year and next. However, we believe that slowing capex growth by the Mag-7 will be offset by hastening of the S&P 493’s collective investments in technology to augment the productivity of their workforces. Eventually, even small- and medium-sized businesses will be investing in AI-enabled products to increase productivity and efficiency. No doubt, venture capital and private equity firms will implement these technologies across their portfolio companies to boost profit margins.

Here’s more on the capital investment front:

(1) Temporary weakness in Q4. Overall economic growth was strong during Q4. Real final sales, which excludes business inventory investment, rose 3.2% q/q (saar) in Q4. Real private domestic demand—the Fed’s preferred measure of core real GDP, which excludes federal spending, business inventory investment, and trade—also rose 3.2%. However, these were mostly consumer driven. Real business investment rose just 1.5% q/q (saar) in Q4 and 1.7% for the whole year. Though it did reach a record high of $3.5 trillion (saar), annual growth was down from 3.2% in 2023 and 7.8% in 2022 (Fig. 14).

Intellectual property (IP)—which includes software, research and development (R&D), and entertainment, literary, and artistic originals—rose 2.6% q/q (saar) to a new high of $1.5 trillion (Fig. 15). However, annual growth was down from 5.8% in 2023 to 4.1% in 2024.

Capital equipment investment fell 7.8% q/q (saar), its worst quarter since the pandemic. On a y/y basis, it slowed marginally from 3.5% to 3.4%. However, we expect equipment investment to rebound this quarter as information processing equipment reaches a new record high alongside R&D and software investment (Fig. 16).

(2) Volatile inventories. Slower private inventories investment reduced real GDP growth by 0.93ppt in Q4 after dragging it down in Q1, largely due to inventory drawdowns by wholesalers and auto dealers (Fig. 17). We expect inventory investment to rebound during the first half of this year.

US Economy III: Trade Wars & DOGE. On Saturday, President Trump imposed tariffs of 25% on imports from Canada and Mexico. Chinese imports were slapped with an additional 10% tariff. These developments are bound to weigh on US economic growth unless trade negotiations between the US and these three trading partners move quickly to reverse the tariffs. Also weighing on the economy might be the Trump administrations moves to cut government spending through executive orders and the efforts of the Department of Government Efficiency (DOGE).
 
(1) Trade wars could weaken global economic growth. The US trade deficit impacted Q4’s GDP growth only minimally, but naturally it will be highly topical this year. Trade is not a large portion of US nominal GDP but invariably is interconnected with intermediate prices, labor costs, and the revenues of domestic producers. Given our optimistic outlook for the US consumer—especially relative to Chinese and European consumers—we do not expect tariffs to significantly reduce the trade deficit, which stood at $1.3 trillion (saar) in Q4 (Fig. 18).

YRI’s real global growth proxy accelerated to 3.8% y/y in Q4 (Fig. 19). It is simply the sum of real US exports and imports. It is currently growing about as fast as just before Trump 1.0 tariffs turned its growth rate negative in 2019. Trump 2.0 tariffs could turn it negative again.

(2) Government spending slowdown. Even if the Department of Government Efficiency (DOGE) manages to cut federal spending and therefore weigh on real GDP growth, we expect businesses and consumers will fill the gap. Deregulation and lower tax rates are likely to spur more hiring and investment in an economy already at full employment. That should drive increased productivity growth and real wage gains.

Movie. “Woman of the Hour” (2023, +) is another serial killer movie based on a true story. Too bad there is no shortage of films of this genre. This one is about Rodney Alcala, who appeared in 1978 on the television show “The Dating Game.”  He was captured in 1979 and identified as a serial killer for murdering numerous women and girls. Anna Kendrick is the director and stars in the movie. Beware of strangers taking your picture and striking up a conversation. Evil may lurk behind that charming veneer. (See our movie reviews archive.)

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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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