Pro Perspectives 12/13/23

 

 

 

 

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December 13, 2023

Six weeks ago, following the Fed's November meeting, Jerome Powell said there was "significant" tightening in financial conditions in recent months.
 
The Fed had projected one more rate hike for 2023, but he implied, at that moment, that the rise in bond yields (to 5% on the 10-year Treasury), weakness in stocks and strength in the dollar had already done the Fed's job (i.e. added additional tightening).  He signaled the end of the Fed's tightening cycle. 
 
With that, a month later, Jerome Powell was on stage giving prepared remarks at a fireside chat at Spelman College.  The S&P 500 had just recorded its best November in over 40 years, 10-year Treasury yields had fallen almost three-quarters of a point and the dollar had weakened by three percent. 
 
The conditions he cited a month prior had all reversed. 
 
But he did nothing to push back against the idea that the tightening cycle was over.  He did nothing to push back against a market that was pricing in the next move as a rate cut (and perhaps as early as March).
 
Fast forward to today, and the financial conditions referenced by Jerome Powell six weeks ago have continued to ease.  However, not only did Powell (and his Fed colleagues) show little-to-no concern, he all but explicitly claimed victory on inflation.
 
That's a greenlight for stocks.  And stocks had a big day.
 
Add to this, there's one major data point for markets between now and year end, and it's the Fed's favored inflation gauge, core PCE.  But now we don't have to wait for it.  Powell leaked it this afternoon, in his press conference prepared remarks.  They expect it to have fallen from 3.5% to 3.1% year-over-year.   
 
So, there should be little resistance against the momentum for stocks into the year end.  
 
With that, we've talked about the opportunity in small caps, which have dramatically lagged the broader market indices.  The Russell 2000 was the bigger winner today, up 3.5% — and it could catch up very quickly.  
 
The S&P 500 is 2% away from the record highs (of about two years ago).  The Nasdaq is 5% away.  The Dow is just 1% away. 
 
The Russell 2000 is 26% away from the all-time highs marked two years ago.  And as you can see in the chart, it's just breaking out of this downtrend.  
 
 
 

Pro Perspectives 12/12/23

 

 

 

 

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December 12, 2023

The November inflation data was in-line with expectations this morning.
 
What's notable?  The impact of rising insurance premiums on shelter, physician services and (mostly) transportation.
 
The change in the motor vehicle insurance component of CPI was up 19.2% compared to November of last year.  It's now up 35% from pre-covid levels. 
 
Here's how that chart looks …
 
 
The good news:  This is a lagging feature (likely a late stage feature) of a hot inflationary period.
 
Remember, the massive monetary and fiscal response to the pandemic (plus the subsequent agenda spending binge) ramped the money supply by 40% in just two years.  That was almost a decade's worth of money supply growth (on an absolute basis), dumped onto the economy in a span of two years.  
 
That inflated asset prices. 
 
And the insurance industry just spent the past two years raising the price to insure those higher priced underlying assets.
 
Are the insurance price hikes over? 
 
If we look at the index on new car prices, it's up 21% from pre-covid levels.  The used car index is up around 35%.  The numbers, and the level and trajectory of inflation, seem to suggest the answer is yes.
 
With the above in mind, tomorrow we have the Fed meeting.
 
The market expectations for interest rate cuts next year barely budged following this morning's inflation data.
 
With that, we'll get an update to the Fed's Summary of Economic Projections tomorrow.
 
This is how it looked last September (the orange and the blue lines).   
 
   
Remember, we looked at this chart early last month.  It shows the current effective Fed Funds rate (5.3%), along with the Fed's projected path, all in orange. 
 
In blue, we have the current inflation rate (the Fed's favored core PCE, which has fallen to 3.5% now), along with the Fed's projected path for inflation. 
 
The difference between the Fed Funds rate and inflation is the "real interest rate" (black numbers in the above chart).  The real rate puts downward pressure on inflation and the economy.  And as you can see, it's currently 1.8%. And as you can also see, the Fed's September projections had the real rate rising substantially next year (i.e. tightening financial conditions even further).  Those real rate projections are in the blue circles in the chart.
 
In their new projections tomorrow, we should expect the Fed to project a real rate in 2024 at no more than the current real rate, which is 1.8%.  After all, the current real rate is successfully pushing the inflation rate and the economic growth rate lower. 
 
And as you can see on the far right side of the chart, the Fed itself projects the long-run real rate to be just 0.5%. 
    

Pro Perspectives 12/11/23

 

 

 

 

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December 11, 2023

We get the November inflation report tomorrow, and the Fed meeting on Wednesday.
 
Before we talk about what to expect for tomorrow, let's revisit the October inflation report.
 
Leading up to that big event, we talked about the trend of falling inflation, the continuation of which would put pressure on the Fed to cut rates aggressively next year, or subject the economy to the consequences of higher and higher (more and more restrictive) real interest rates (i.e. the difference between the Fed Funds Rate and the inflation rates). 
 
Of course, rising real rates would create even tighter financial conditions.  And with that, by overtightening the Fed could find itself following the mistake of 2021 (pouring fuel on the inflationary fire) with the opposite mistake in 2024 (inducing recession, if not a deflationary bust).
 
So, continuing with our revisit of last month's economic event, October inflation did indeed show the trend of falling inflation was intact.  The core inflation rate (excluding food and energy) broke 4% (at 3.96% on the index) for the first time since May of 2021, and markets immediately declared the rate hiking cycle as over. 
 
Stocks exploded higher.  Yields fell sharply.  And the dollar had one of its biggest declines of the past three years. 
 
These key markets have continued in those respective directions since that October inflation report.  And following that report, the interest rate market is now pricing in more rate cuts and sooner, to arrive at something closer to 4% by the end of next year (from current 5.33% effective fed funds rate).
 
So, what should we expect tomorrow, from the November inflation report? 
 
More of the same.
 
The consensus view is for little change from the last report (core at 4%, and the headline a touch lower at 3.1%).  But if we do have a surprise, it should be skewed toward weaker inflation. 
 
Why?  If we look at November prices globally, we've already seen deflation in the month-over-month price data out of both the euro zone and China.  Add to that, the biggest contributor to the sharp fall in U.S. inflation from 9% to 3% has been energy prices.  On that note, if we look at the price records from the EIA for November (Energy Information Administration), oil was down 8%, retail gas prices were down 9%, and natural gas was down 50% (all for the same period a year ago).  
 
So, the energy component will continue to weigh on the November consumer price index (CPI).  Although the Fed cares most about the core inflation rate (excluding food and energy prices), expect the media to celebrate the headline number tomorrow, particularly if we get a surprise breach below the 3% level.   

Pro Perspectives 12/7/23

 

 

 

 

 

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December 07, 2023

There has been a lot of chatter about the shrinking money supply.
 
Reuters reports the "money supply falling at the fastest rate since the 1930s."  Goldman Sachs points out money supply "has been shrinking for the first time since 1949."  These are references of the deflationary depression era.  
 
Let's take a look …
 
 
Indeed, as you can see money supply has been contracting on a year-over-year basis since last December.
 
And what is historically associated with a contraction in the supply of money and credit (which is not contracting, but slowing)?  Deflation.
 
So, some think this contraction in money supply is signaling a deflationary bust.
 
What are they ignoring?
 
Consider this:  The massive monetary and fiscal response to the pandemic (plus the subsequent agenda spending binge) ramped the money supply by 40% in just two years.  That was almost a decade's worth of money supply growth (on an absolute basis), dumped onto the economy in a span of two years.
 
With that context, this is the chart of money supply that matters …
 

 

As you can see in the chart, the level of money supply remains significantly elevated.  If we extrapolate out the pre-pandemic trend growth in money supply, the economy still has more than $3 trillion in excess money sloshing around.  That's why we continue to have hot nominal growth (a nearly 9% annual rate of GDP growth last quarter). 

Pro Perspectives 12/6/23

 

 
 

 

 

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December 06, 2023

It’s jobs week.

Remember, the Fed explicitly targeted jobs early in the rate hiking cycle.  They wanted a softer job market, because they feared that wage gains would add fuel to the inflation problem.

In a tight labor market, employees have leverage in negotiating higher wages, particularly in what was a hot inflation environment.  With that, the Fed feared an upward spiral in wages, where wages would feed into higher prices, which would feed into higher wages … a self-reinforcing cycle of rising inflation.

With the above in mind, the job market has softened a bit, but remains strong.  Meanwhile, wage growth has been strong.

But inflation has been on a steady decline since June of last year.

Why haven’t stronger wages fueled the inflation fire?  Productivity.

On that note, we looked at Q3 productivity data last month.  It was big, at 4.7%.

This morning it was just revised UP to 5.2% (annual rate).  That’s five-times the rate of the decade prior to the pandemic, and more than double the long-term rate of productivity growth, on data going back to 1947.

And despite some of the hottest wage gains we’ve seen in decades, productivity gains are outpacing wage gains. The annual growth in the costper unit of output last quarter was actually negative (-0.8%).  And that was revised even lower in this morning’s report.

So, wage growth is more than being offset by productivity gains, which means wages can go higher without stoking inflation — a lot higher.

Remember, Jerome Powell has said in the past that wage gains should equal productivity gains plus inflation.

The latest inflation of 3.2% plus 5.2% productivity, gives us year-over-year wage gains of 8.4%.

The Atlanta Fed’s wage growth tracker is at just 5.2%.

So, we should expect bigger wage agains.  And we should expect persistent wages gains.  Remember, we are in the early innings of generative AI, which might be the most productivity enhancing technological advancement of our lifetime.  That means high productivity gains will be with us for a while.

 

Pro Perspectives 12/5/23

 

 

 

 

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December 05, 2023

The United States Congress has appropriated over a trillion-dollars to the climate agenda over the past three years. 
 
And yet the biggest clean energy ETF has done this …
 
 
As you can see in the chart, this Blackrock clean energy ETF is down 60% from the highs, back near pre-covid levels. 
 
This is after direct funding of the clean energy agenda through the Cares Act, the American Rescue Plan, the Infrastructure bill and the "Inflation Reduction Act" — the latter of which, the administration doesn't even try to deny that its purpose (the "IRA") was to fund its clean energy agenda (branded as an inflation fighter).
 
Beyond the unprecedented magnitude of fiscal spending on this agenda, all financed via debt, there has been plenty of collateral damage to the economy. 
 
It was clear along the way that unnecessarily prolonged covid restrictions and the Fed's unimaginable unwillingness to recognize the inflationary fire that was already upon us, contributed to the ability of the democrat aligned Congress and White House to get the final and largest tranches of clean energy agenda funding across the finish line.
 
Still, as you can see in the chart above, it hasn't materialized into value creation — at least yet.  
 
Why?
 
Apparently, it's not enough – not even close.  
 
The politicians meeting at the latest climate summit in the United Arab Emirates have realized that their experiment to transform the global energy system is very, very expensive.  But they are not only doubling down, they are tripling down.  Over 100 countries pledged over the past few days to triple global renewable energy capacity by 2030.
 
According to the European Commission President, they need trillions of dollars of funding every year, not billions. 
 
How are they going to fund it, with global sovereign debt already at record levels?  I suspect they will find a way to incentivize private money (institutional/pension investors) to follow the government money. 
 
What would open the flood gates?  Rating agencies stamping AAA ratings on corporate "green bonds" (i.e. bonds issued by companies to specifically finance building clean energy capacity). 
 
We already know the rating agencies are coercible.  Remember, the real estate bubble was primarily driven by Fitch, Moody's and Standard & Poors unexplainably stamping AAA ratings on high risk/high yielding mortgage securities.  With a AAA rating and a high yield, massive pension funds had no choice, if not an obligation to plow money into those investments.  

Pro Perspectives 12/4/23

 

December 04, 2023

On Friday we heard from Jerome Powell.  He delivered some prepared remarks for a Fireside Chat at Spelman College.

Keep in mind, in the last Fed meeting, Powell signaled the end of the tightening cycle, and attributed it (in part) to the tightening of financial conditions over the preceding months, resulting from: 1) the bond market (higher bond yields), 2) the stock market (lower stocks) and 3) the dollar (stronger).

All of these market measures have since reversed course.

That said, he did nothing to push back against the market expectations on rates, which now projects the next move as a rate cut (perhaps as early as March).

Notably, in his prepared remarks he included a footnote directing attention to the way the Fed measures financial conditions — its new index to gauge the impact of financial conditions on future economic growth.

With that, let’s take a look at where that new index stands …

This index is designed to incorporate the lags of monetary policy, and project (in this case) one-year forward what the impact will be on real GDP growth.  If the line is above zero, it’s a drag on growth (restrictive policy).  If it’s below zero, it’s a boost to growth (stimulative policy).

 

 

So, when factoring in the current Fed Funds rate, the 10-year yield, the 30-year fixed mortgage rate, the lowest investment grade corporate bond rate, the DJIA stock market index, the Zillow house price index, and the value of the dollar, the Fed’s new index projects a nearly 1% drag on real GDP one-year forward.

Does it mean recession is indeed coming?  Keep in mind, this index has been in headwind territory for economic growth since the middle of last year, which would project a drag on recent growth, yet Q3 grew at a 5.2% annual rate.

Despite the pains, it’s a strong economy.

For perspective on the outlook, let’s take a look at what this financial conditions index looks like with some longer history …

 

As you can see in this longer term chart, these current levels tend to be turning points for financial conditions.

Remember this is projecting the effect on growth one-year forward.  If we look at stock market performance one-year forward from these historical turning points (in the chart), stocks do very well in the subsequent 12-month period.  And small caps outperform.

This aligns with the rotation trade we discussed in my last note, where money appears to be moving out of the dominant big tech stocks (which put in technical reversal signals last week) and into small caps, which have (dramatically) lagged in performance on the year.
Pro Perspectives 11/30/23

 

 

 

 

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November 30, 2023

Today we had the report on the Fed's favored inflation gauge, core PCE.  It confirmed the continuation of a steady decline, with a fall to 3.5% year-over-year change.
 
As we've discussed often here in my daily notes, the Fed has historically beat inflation by taking interest rates above the rate of inflation.  If we measure that by the Fed Funds rate (interest rate) against core PCE (inflation rate), the Fed has been there (above inflation) since March.  That "restrictive monetary policy" position puts downward pressure on inflation, and economic activity. 
 
And as we discussed on Monday, as inflation continues to fall, the level of restriction rises (i.e. real rates rise).
 
With that said, we'll hear from Jerome Powell tomorrow.  He's speaking at an event at Spelman College.  We should expect him to comment on the sharp slide in bond yields since the Fed's last meeting, particularly because it was the preceding sharp rise in bond yields that gave the Fed pause on doing more. 
 
Does it mean he will convince markets tomorrow that a December hike is back in play?  Highly unlikely.  The reality of rising real rates, and an economy running at a much more modest rate in Q4, relative to Q3, should keep the market focused on aggressive rate cuts next year. 
 
Let's talk about the big tech stocks …
 
Last month, we talked about the technical reversal signals that were flashing in the interest rate market.  First it was the 2-year Treasury yield.  Then the 10-year.  And then the big corporate bond and Treasury bond ETFs.  That indeed predicted the turn in the bond market.  
 
Now we have a reversal signal in big tech stocks. 
 
It came yesterday in Microsoft, at the record highs ….
 
 
We have the same signal (yesterday) in Google, Apple and Meta.
 
Is this a predictor of some regulatory uncertainty (brakes) to come, related to AI?  Maybe.
 
It comes as these stocks are up 80% on the year, as an equal-weighted basket.  Meanwhile the equal-weighted S&P is up less than 5% on the year.  Small cap stocks are up just 3%.  This looks like a rotation out of big tech, and into value. 

Pro Perspectives 11/29/23

 

 

 

 

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November 29, 2023

Elon Musk had a lengthy interview after the market close today.  
 
He's a co-founder and key donor of OpenAI, the developer of ChatGPT.
 
He's also the founder of competitor xAI which has its own generative AI platform called Grok.
 
What did he have to say about AI?  He said we are within three years of computer intelligence exceeding human intelligence (not human intelligence + machine intelligence, but human intelligence alone). 
 
With that, let's revisit the drama that unfolded at OpenAI over the past two weeks. 
 
Yesterday, we talked about the speech by China's President Xi at the recent APEC forum in San Francisco.  At the same forum, the OpenAI CEO, Sam Altman, participated in a panel discussion on artificial intelligence.  He was fired a day later.
 
Here's what he said:  "Four times now in the history of OpenAI, the most recent time was just in the last couple of weeks … we sort of pushed the veil of ignorance back and the frontier of discovery forward."  There is a lot of speculation around the comment and his firing, but at the very least, it's fair to say he's referring to a large leap in the model capabilities (if not a stronger form of AI).
 
He's since returned to his role at OpenAI.
 
With the above in mind, as we discussed back in June, the speed of change in this new technology revolution is already unlike those of the past.  It's fast moving.
 
How do you position for the new technology revolution?  Join my new subscription service, the AI-Innovation Portfolio.  We’ve recently added an eleventh stock to our portfolio, a dominant-high growth, high margin business that’s delivering the productivity enhancing capabilities of generative AI to its customers.  Join here, and I’ll send you all of the details. 

Pro Perspectives 11/28/23

 

 

 

 

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November 28, 2023

A year ago this month, China's President Xi opened China's International Import Expo with an opening ceremony address titled: "Working Together for a Bright Future of Openness and Prosperity."
 
He said, China remains committed to "opening up to the outside world." 
 
The speech was full of language suggesting China wanted to play nice in the world for "mutual benefit," working with "all countries" to share opportunities from "deepened cooperation."
 
As a signal, Xi (the PBOC) strengthened the yuan that day (which they control) from fifteen-year lows.  A stronger yuan is counter to their economic interest (and policy), where they like to manipulate a weak currency to drive exports.  So, a stronger yuan was intended to signal alignment with Xi's speech (of cooperation/global friendliness).
 
As you can see in the chart, the strengthening of the yuan continued over the next three months, to the tune of about 10% …
 
 
As you can also see in the chart (to the far right), China strengthened the yuan to coincide with Xi's speech at the recent APEC meetings in San Francisco.  
 
What did he say?
 
In the face of tense U.S./China relations, the speech was full of conciliatory and idealistic language.  He said China is "ready to be a partner and friend of the United States."  He called for a peaceful coexistence, cooperation and "mutual respect."  And he promised to "never pursue hegemony or expansion."
 
So, perhaps as a sign of good faith, Xi and the PBOC are strengthening the yuan again (again off of fifteen-year lows). 
 
Also keep in mind (a little backstory), for the decade prior to the Trump presidency, China agreed to slowly allow the yuan to appreciate (against the dollar) in response to tariff threats from Senators Graham and Schumer (yes, Schumer). 
 
They let the yuan climb by an average annual rate of just 6%.  That kept the toothless U.S. tariff threats at bay.  Meanwhile, using the continued weak currency advantage to fuel exports, the Chinese economy grew by four-fold during over that ten-year period.  Enter Trump, and he went forward with tariffs on Chinese goods, penalizing China for unfair trade. 
 
So, while in San Francisco, did Xi and the Biden administration make a deal that includes a stronger yuan and relaxed tariffs? Maybe.
 
For markets, what performed over that stretch in late 2022/early 2023, of a stronger yuan and weaker dollar (from the chart above)?  Chinese stocks (up 12%), Emerging market stocks (up 27%), Copper (up 23%), and gold (up 21%).