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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