The big banks kicked off Q4 earnings season this morning.

As we discussed yesterday, this is expected to be the highest earnings growth quarter for the S&P 500 in three years, at 12% year-over-year (yoy) earnings growth.

If the banks are any indication, it’s going to be another quarter of big positive earnings surprises.  From this morning’s reports, the average earnings growth for JPM, Wells Fargo and Citi was 48%.

The banks have been putting up big tech-like growth numbers, but trading at an average valuation of less than half the market forward P/E.  And between the three (JPM, WFC and C), they have over $60 billion in loan loss reserves that they can turn into earnings at their discretion.

And the tailwinds of M&A, IPO activity and deregulation are coming.

Does this indicate a resurgence of inflationary pressures?

Two vocal Fed voters (Waller and Goolsbee) have been countering this narrative over the past two weeks.

They’ve been reminding markets that the “base effects” in PCE and lagging features within CPI are propping up the year-over-year inflation data.

What does that mean?

The headline CPI number ticked UP to 2.9% in this morning’s report.

Waller (Fed governor) has made an attempt to cool the perception of an inflation resurgence by pointing to the lagging features in the data.

Here’s what he’s talking about:  Of that 290 basis points of year-over-year increase in prices (CPI) in December, 163 basis points of it was auto insurance and rent (Owners’ Equivalent Rent – OER).

It’s heavily influencing CPI.

In the case of OER (which is nearly a third of CPI), it’s old data – not reflecting the current rent climate.  As you can see below, the national median asking rents (from rent.com) have been mostly declining for more than a year.

Happy New Year!  Stocks are already off to a good start, globally.

Commodities are climbing.  And so are government bond yields, at least in the Western world.

It all appears to reflect expectations of a more business friendly, market-determined economic environment coming to the U.S. on January 20th.   

And the political regime change in the U.S. is beginning to influence change elsewhere, as we discussed in my note last month. The populist pushback is bubbling up in Europe and in Canada (with Trudeau’s resignation today).

Like the beginning of last year, the market is expecting rate cuts this year.  But unlike the beginning of last year, the expectations on how many have already been tamed by the Fed over the past three months.  

With that, the easing cycle today isn’t the powerful tailwind for stocks. The tailwind is growth, driven by Trump policies — more specifically, the probability of a positive surprise on what is a very low expectation bar set by the Fed.  They are looking for just 2.1% GDP growth for 2025.

The other, bigger tailwind:  the new industrial revolution.  It’s driven by generative AI, and continues to be in the early innings of adoption.

And we should expect the attention to this tailwind to be amplified this week, as the most powerful tech event in the world will be hosted in Las Vegas.

The big Computer Electronics Show (CES) kicks off tonight with a keynote by Nvidia’s Jensen Huang.

It was the excitement around Jensen’s CES talk last year, in early January, that sparked the big Nasdaq rally — and as you can see, it never looked back.  

Last year, CES was all about “the digital world meeting the physical world.” 

The CEO of Siemens called 2024 a “turning point” where real and digital worlds converge.

We should expect the clear emergence of that theme in 2025, as AI-powered robots become part of the workforce, and soon-to-be part of everyone’s daily life. 

As we near year-end, let’s take a look at the bond market.

As you can see in the chart below, since the Fed kicked off the easing cycle back in September, the 10-year Treasury yield has moved almost 100 basis points higher as the Fed has taken the Fed Funds rate 100 basis points lower.

And as you can see in this next chart, with this rise in the 10-year, the big downtrend in yields has broken.

The Fed cut by a quarter point today, in line with market expectations.

Stocks were crushed.  Yields spiked. The dollar rallied.

Let’s take a look at the culprit.

This is the Fed’s latest “SEP” (Summary of Economic Projections).

Going in, we expected them to dial UP the 2025 end of year level of the Fed Funds rate, by a quarter point.  They took it up by half a point.

That means they now see two cuts next year, not four.  They see inflation higher now (highlighted in red).  And they see growth a tick higher next year (also in red).

Remember, we talked about the Trump effect on the Fed back in 2016.

Just a month following the Trump 1.0 election, the pro-growth Trump agenda influenced the Fed to a proactive rate hike in an economy that had averaged only slightly above 1% PCE inflation that year.

Also in that December 2016 meeting, the Fed revised UP inflation forecasts, saying “some of the participants” incorporated the “assumption of a change in fiscal policy” into their projections.

This time around, they’ve revised UP growth, inflation and taken two projected Fed rate cuts off of the table (a tightening effect).

It probably wasn’t a regime change type of day, but Powell acknowledged that it has indeed a “new phase in the process” of finding the neutral level for rates.

When asked if it was because of Trump, Jerome Powell revisited the script from 2016, begrudgingly admitted “some people” did “incorporate effects of policies into their forecasts.”

Now, today’s market reaction reminded me of the shakeout from an inflation report earlier this year (on February 13th).

In revisiting my note from that day, indeed we had another rare type of day.

Today makes just the fourth time in four years that shared the features of 1) a down greater than 4% Russell 2000 and 2) at least a 14 basis point spike in the 10-year yield.

> It happened on February 25, 2021.

What was going on?

It was about inflation.  The 10-year yield had risen from 1% to 1.6% in less than a month.  And the move was quickening.  And this quickening was driven by the market’s judgement that the additional $2 trillion fiscal package coming down the pike from the new President and his aligned Congress was inflationary at best, and recklessly extravagant, at worst.

The $2.2 trillion Cares Act and the additional $900 billion in stimulus passed in December, before Trump’s exit, had already driven a nearly full V-shaped economic recovery (by late January ’21).

The prospects of more, massive spending packages looked like an inflation bomb.

> It happened on June 13, 2022.

What was going on?

It was a Monday meltdown, following a hot Friday inflation report.

The Fed had just started tightening and was way behind the curve.

Inflation was near 9%, the Fed Funds rate was below 1%.  With a Fed meeting just days away, the market ratcheted up expectations for an aggressive 75 basis point hike.  And history suggested they needed to take rates a lot higher in order to stop fueling inflation, and start curbing it.

So, these two episodes (in 2021 and 2022) were clearly about significant inflation threats — potential runaway inflation. 

Now, let’s contrast that with the two episodes from this year, which share the features of the 4%+ down day in small caps and the 14 basis point+ spike in yields …

> What happened on February 13, 2024?

Remember, heading into 2024, the Fed had telegraphed the beginning of the easing cycle, projecting three rate cuts for the year — while the market was looking for six.  And the Fed then spent the month of January trying to curb the market’s enthusiasm about the rate outlook.

With that, the inflation data reported that day came in a touch higher … and markets unraveled.

But unlike the two prior market episodes discussed above, the market reaction was unwarranted.  The disinflation trend, at this point, was well intact.  And the inflation data reported was the lowest level of the cycle, and a tenth consecutive lower year-over-year reading.

It was an overreaction.  Stocks recovered in two days.

Today’s market reaction was, too, about the inflation outlook — but it’s inflation that’s well into the 2s, in an environment of high productivity, and (still) restrictive monetary policy.

So, while inflation is the common theme in these four episodes that share these rare extreme market reactions, it’s fair to say the circumstances are quite different in these recent episodes, relative to the inflation backdrop of 2021 and 2022.

With that in mind, was the selloff in stocks (and bonds) today an overreaction in a thin holiday market?  It looks that way.