Thought to ponder…
“Vast emptiness, nothing holy. What is the mind like if it’s not occupied with plans and schemes, and fears that the plans and schemes will fail? What if your unexamined beliefs were to fall away and you were to live without them, and also to live without the thought that you had given anything up?
John Tarrant
Bring Me the Rhinoceros
The View from 30,000 feet
The biggest stories of the week were centered around intensified conflict in the Red Sea drawing the U.S. further into direct engagement, Ukraine stepping up attacks against Russian infrastructure, earnings, the Q4 GDP release, PCE and China’s latest attempts to breath some life into their economy to restore confidence in capital markets. I was commenting to a client late last week that one of the research services we follow posted their top five “Black Swans” for 2024. In the interest of protecting their copywrite, I won’t share them with you but what I will share is that to my surprise, four out of five of them were geopolitical, and one was associated with as downturn outside the U.S. Perhaps even more interesting, is that none of the risks they identified were events that would tip the U.S. into a recession, although - spoiler alert, they expect a recession in the U.S. I’m not convinced. What we know to date is that for the last six months annualized Real GDP has had a 4 handle, and annualized PCE has had a 1 handle. This doesn’t represent a soft-landing, it’s closer to a fairytale. I’m not saying that there won’t be a recession, but what I will say is the most recent data is shifting the probabilities away from a recession. This is good news for the economy but may be bad news for anyone expecting the Fed to embark on an aggressive rate cutting campaign any time soon. As financial markets come to terms with a less accommodative Fed, we should be prepared for some market indigestion. It would likely take a crack in the labor market to bring about something more ominous for the U.S. markets and start to move the probabilities away from a soft / no landing scenario.
Earnings Dashboard Update: All things Magnificent
Breaking down performance in the S&P500 YTD
Inflation Dashboard: More moves in the right direction
The most Frequently Asked Question from clients this week: What could derail the disinflationary story tied to a soft landing?
Focus Point Sector Rotation Update: “The more things change the more they stay the same” - Cinderella
Earnings Dashboard Update: All things Magnificent
Three weeks into earnings season, the results can be characterized as lackluster, at best. The margin of earnings beats are below historical norms and the combined actual and estimated of the remaining Q4 release is now projecting a negative -1.40% loss for Q4. That’s the bad news.
The good news is that this week 106 companies are set to report including some of the powerhouse tech leaders, which is where the earnings leadership is coming from anyway. Consider this, according to Factset estimates:
Six out of seven of the Magnificent 7 are expected to be the top contributors to earnings in Q4. Those six names have an average estimated EPS growth of 53.7%.
Excluding these six companies, the S&P500 earnings growth rate would be projected at -10.5% for Q4.
The four top earnings growers in the Magnificent 7 are expected to have an average Q4 earnings growth rate of 79.7%
The new year starts off like the last year ended – all about the Magnificent 7
Breaking down performance in the S&P500 YTD
Year-to-date the S&P500 has resumed the trends of 2023, with the best two performing sectors being Comm Services and Information Technology. Together these two sectors account for 100% of the gains in the S&P500, with the other nine sectors adding up to approximately zero contribution.
Through Friday’s close the S&P500 was up +2.61%. There were 150 companies within the S&P500 that had gains in excess of +2.61%.
The top 31 companies in the S&P500 account for 100% of the gain in the S&P500.
The average stock in the S&P500 is down -0.9% year-to-date, with the median stock down -0.1%. The Equal Weight S&P500 is down -0.2% on the year. The Russell 2000 is down -2.4% year-to-date.
Tesla, which is down -26.25% for the year, has now dropped out of the top ten largest weights in the S&P500, while Broadcom has moved into the top 10, making the index even more heavily tilted towards Info Tech and Comm Services. In fact, eight out of ten of the largest names are Info Tech or Comm Services with the other two being Berkshire Hathaway and Eli Lilly.
Globally, the concentration isn’t much better with only five out of the 26 countries we follow having a positive year, which incidentally is better than where we closed last week when only three countries were in the green.
Concentrated market (again), with top performing sectors and companies driving gains
Inflation Dashboard: More moves in the right direction
The biggest story on inflation last week was the PCE report, which showed a continued disinflationary trend, supporting the view that the Fed will need to move to a less restrictive stance in the short-term, or real rates will move from a restrictive level to an overly-restrictive level.
The three-month annualized pace of inflation slowed to 1.5%, and the six-month annualized pace of inflation continued at its most recent reading of 1.9%.
Earlier in the week the first reading on Q4 2023 GDP came in at 3.3%, following the Q3 2023 GDP of 4.9%.
The first measure of the Atlanta Fed GDPNow was produced last week indicating that Q1 2024 is growing at a 3.0% pace.
Taken in totality, the economy is currently running at above potential growth, at full-employment, with inflation below the Fed’s targeted range.
Continued signs of normalization in rental markets and supply factors
FAQ: What could derail the disinflationary story tied to a soft landing?
The big picture is that the economy is growing at above potential with inflation over the last six months now below the Fed’s targeted range. In a perfect world, the Fed would gradually turn less restrictive, allowing inflation to flatten out around 2.0%. However, there are some real risks to this glide path:
As the Fed lower rates, financial conditions will ease creating a pick-up in economic activity that is likely to drive inflationary pressures higher.
There are geopolitical factors out of the Fed’s control working against the disinflationary story.
Congestion in the Red Sea due to Houthi attacks is gumming up global supply chains, creating parts shortages and ultimately will drive prices higher if the situation is not resolved soon.
The financial markets have not yet placed a geopolitical risk premium on oil prices due to the turmoil in the Middle East, but we are one missile away from that changing at any moment, and given that fact there are missiles flying, this risk should not be overly discounted.
The Chinese government is becoming more aggressive in their efforts to reflate the economy, even resorting to banning short selling and buying equities in the open markets. Current policies in China probably aren’t enough to create an inflationary wave, but the direction of travel for the
FP Sector Rotation Update: “The more things change the more they stay the same” - Cinderella
The Focus Point Sector Rotation Model is a combined trend following and mean reversion model that utilizes seven factors to analyze daily price data on sectors to determine the strength of upward trends.
Four industry groups are leading the way for the markets in 2024, with the largest gains coming from the big winners of 2023, Info Tech and Comm Services.
Sectors are exhibiting early cycle leadership, with companies that would benefit from lower rates moving higher.
Putting it all together
Last week was the most enlightening week of data for the year, with GDP showing growth above potential, while PCE indicating inflation below the Fed’s target. This should set the stage for the Fed to lower rates. If only it were that simple. The Fed faces a host of challenges related to the decision to lower rates:
Lower rates will ease financial conditions further, creating the potential for inflation to reignite.
There are events happening in the geopolitical theater that the Fed has no control over that could cause another uptick in inflation, such as hostilities in the Middle East and Chinese stimulus.
Market leadership has once again concentrated at the top. The Magnificent 7 is back. Tesla is out, Broadcom is in.
The markets have moved to pricing the rate cut in March as a coin flip and showing less conviction about the pace in the remainder of 2024. Further indigestion is to be expected as the markets adjust expectations.
The larger picture is that inflation continues to fall at a faster pace than expected, the labor market remains strong, which is causing resiliency in demand and corporate profits. It’s hard to be pessimistic with this as the backdrop, but with expectations for S&P500 earnings to grow at 11.6% in 2024, well above historical averages, and six rate cuts priced in versus a Fed that’s broadcasting three cuts, it’s also hard to feel like the markets aren’t priced for perfection.