Handoff

1480 words – a 4 minute read.

We know football season is over so no, today’s title is NOT football related.  We did note however, that Chief’s HC Andy Reid used motion to create the Super Bowl winning TD, the same motion we wrote about in: Lean into Complexity two months ago.  Rather, today’s title reflects a critical handoff in risk markets from Fed rate cut hope dependency to forward looking economic & earnings growth driven upside.

This suggests a certain amount of maturity in the current risk rally, a successful transition from the lower rates are needed to push stocks higher thesis to the beginnings of an embrace of our early cycle, economic recovery thesis complete with double digit SPY EPS forecasts for both 2024 & 2025 (macro surprise #4 in our 4 for 24 macro surprises).

We have receipts & note that at 4.32% on the 10 yr. UST bond its back to where it stood in November while the S&P is up roughly 20% from its November lows & ACWI is up 17%. 2023’s stage one of the current bull market was driven primarily by multiple expansion, a very typical process. Today, we are in handoff mode to stage 2, earnings driven market expansion.

The DM ex US equity markets provide several real time examples. Yesterday, Japan reported negative GDP growth in Q4 for the 2nd Q in a row while the EU reported 2023 GDP growth of 0.1%, essentially stagnation. Here is the tell: the main Japan ETF, EWJ, hit a new 52 week high yesterday while the Nikkei creeps ever closer to a new nominal ATH, something not seen in 30 + years!

The same holds true for Europe; we wrote last week about our Magnificent 6, Europe’s growth leaders that include tech, health and luxury names all wrapped up in the EAFE Growth ETF (EFG)  we recently added to our Global Multi Asset (GMA) model. Well, the same day the EU reported that weak GDP report & amidst a weak Q4 EU earnings season, EFG also hit a new 52 week high.

We are not alone; GS just came out with an EU based grouping of internationally exposed quality growth compounders it calls GRANOLAS complete with a chart showing that since Jan 2021, these stocks has performed in line with the US’s  Magnificent 7.

As we never tire of saying, markets are forward looking. Q4 lies in the past & thus is not very meaningful, especially at today’s cycle turn. The turn from rate hikes to rate cuts, from monetary to fiscal policy, from recession fears to early cycle recovery is powerful. Eliminating the inconsistency in market views between the weak economy 7 rate cuts would suggest and the solid growth outlook suggested by 10% 2024 EPS projections is also very positive. To eliminate that inconsistency with only the mildest of one day pullbacks is a clear sign of market strength.

In last Friday’s Musings, we noted the coincident breakdown of TLT, the long duration UST ETF with the breakout of GSG, the GS Commodity index ETF. This is exactly what one would expect if the market thought growth would pick up – duration weakness & commodity strength. Good economic news is once again good news for stocks. Thus, our OW equity/commodities and UW FI allocation.

The NY Fed reports that: “The share of Americans who think their financial situation will be better in a year rose to its highest level since March 2020, when the pandemic hit.” Axios notes growing CEO level confidence: “32% of the 138 Fortune 500 CEOs surveyed in January said general economic conditions are better compared with six months ago — up from 18% in the last quarter of 2023”. This is usually a good sign for buybacks or cap ex or perhaps even both.

The day to day US data releases can make one dizzy; from higher than expected January CPI pushing rates up and stocks down for all of a day followed by weaker than expected retail sales which is quickly followed in turn by stronger than expected PPI data. We focus on the trend that suggests the rise in productivity and the fall in nominal wage growth in recent quarters has brought the balance of inflation much more into line with a structural 2% inflation rate while today’s Atlanta Fed Q1 GDP Nowcast at 2.9% suggests robust growth.

Such data swings can lead to risk repricing especially after the 20% run we have had; pullbacks and pauses,  data generated or otherwise, make perfect sense. Blue Chip Daily ran the data to note that 3% pullbacks are a normal feature of every market, in fact, the S&P averages roughly 7 such pullbacks pa. A larger 5% pullback is also a feature, not a bug, of every market – over the past 100 years, these tend to occur roughly 3xpa.

The question is what does one do with such. We would use such pullbacks to add and build positions in the sectors best reflecting the US cyclical recovery we see taking shape with XLK, XLI, IYT, XHB, SMH etc. all leading the way. Blue Chip also addresses the concentrated market question, highlighting that both the equal weighted S&P and equal weighted Nasdaq 100 have broken out to new ATHs. Outside the US, we would look to add to EM debt and equity coupled with commodities.

Another way of thinking about this was highlighted by FinTwit this past week, reporting that US equity averages a bear market roughly once every 4 years & noting that we have had 2 bears in the past three years. This lines up with our return to stability thesis (macro surprise #3) we first articulated last October.  We note that the Fed now has lots of room to cut rates should it need to do so. We have successfully lifted off the zero bound with very limited economic and financial market fall out. One reason why stocks have been comfortable with the rate back up is its view (we believe correctly) that there is a V high bar to further Fed rate hikes.

We continue to focus forward, on the trend of BTE economic & earnings growth and note that US Q4 EPS to date are running 8% above yr. ago levels vs Jan 1st forecast of 5%. We remain much less concerned about how many Fed cuts will take place and when as we wrote in: March or May – Who Cares; our thoughts haven’t changed a bit.

We would gladly trade fewer rate cuts for a more robust economy with solid EPS growth and believe that’s what we are getting. As noted above investors are fine with that trade, pushing out rate cuts and reducing the total number expected – now 4-5 vs 6-7 a month back (Marc Chandler notes that post January’s weak retail sales report, a May rate cut is now a 45% probability, down from 75% a week or so ago and a near certainty a month ago). The total rate cuts expected in the cycle has shrunk by roughly 60 bps from close to 170 at YE 2023 to roughly 100 bp in cuts today.

 Given our growth view, we have been in the 3-4 rate cut camp for some time and believe that reducing rate cuts to 3-4 starting in June or July while raising GDP forecasts to reflect a more solid recovery is bullish as we wrote last week in: Wall Streets’ Failure of Imagination.

Before we close with a few words on China here is this week’s early cycle data point from the WSJ: “1.86 Million Projected container imports into major U.S. ports in February, in 20-foot equivalent units, up 2.8% from January’s estimated imports and 20.4% ahead of February 2023, according to the Global Port Tracker.”

We note that Chinese equity had a decent week even with China closed for Lunar New Year. KWEB is up 10% or so from its 2/02/24 low as US investors position for more proactive Govt policies post holiday while the early read on those New Year celebrations suggest positive stirrings in confidence and hence consumption (travel, dining etc. up big Y/Y).

For all the angst re China confidence and consumer, its worth noting real retail sales are running roughly 6% above year ago levels while January auto sales rose close to 60% Y/Y to over 2M units sold (dwarfs US auto market with 1.3M units sold per month). New energy (plug in and hybrid units) units sold rose 100% Y/Y as China continues to dominate the clean energy universe.

China has all the makings that made the US equity market so compelling last November: favorable seasonality, horrible sentiment, very light positioning and strong technical support. Given Chinese equity has gone south while the US market has gone north some mean reversion alone suggests a good risk reward opportunity.