Sticky Inflation Complicates Things For The Fed And For Investors
Sticky Inflation Complicates Things For The Fed And For Investors
1Q24 US GDP brings unpleasant inflation surprise
The results from the first quarter GDP in the US did not bring a soothing confirmation of a soft landing scenario that the market has been so insistently pricing in since last December. Real growth of the economy dropped to just 1.6% yoy; the main growth driver as of late – personal spending – expanded at a slower than expected 2.5% rate. A slowdown is evident, but it is too early to know for sure how deep it will be.
The real showstopper in the numbers, however, was the underlying inflation coming at 3.7% yoy – higher than expected and accelerating from the previous quarter. So, we have relatively lower real GDP growth and relatively higher inflation inside the nominal GDP number, which is not a good trend. There was a sigh of relief when the core personal consumption expenditures (PCE) indicator for March came at 0.32% mom and 2.8% yoy, but this is still higher than where it should be. Some analysts were quick to point out that because of base effects, the yoy PCE number is unlikely to come much lower from this level for the rest of the year. The data overall presented an unpleasant surprise, and they complicate things further both for the Fed, and for investors.
That inflation is proving sticky and rates are on the rise again is not surprising to us. We wrote about this in our 4Q23 and 1Q24 outlook and strategy pieces. There are many factors at play here, both structural (long-term) and cyclical (relatively short-term). With the risk of repeating ourselves, we would just like to point at the extremely high federal government deficit, on its way to reach more than 5.0% of GDP again this year. This kind of fiscal stimulus when the unemployment rate is at record low would have been unthinkable to the economic orthodoxy crowd a few years ago. Yet here we are. With growth boosted by the fiscal engine, high real interest rates are needed to cool the private sector and keep inflation in check.
Interest rates – higher for longer (like a broken record)
With such an inflation result at hand it’s even less likely that the Federal Reserve will be in a rush to cut rates any time soon. In fact, we may not see any rate cuts this year unless the CPI readings start declining rapidly toward the 2.0% target. Further, the fiscal deficit requires funding and we have seen sizeable auctions of Treasuries at different maturity points over the past week. That dynamic should also tend to push yields higher. Bond yields as a result continued their march higher to reach 4.70% for the 10-year Treasury. This is now almost a full percent higher than the yield at the turn of the year.
As a result, our fixed-income recommendation remains to be short duration and to stick with higher-quality issuers. Credit spreads are too tight and they do not price in a worsening economic scenario yet.
Whether this rise in bond yields will put renewed pressure on the smaller US banks is yet to be seen. When it comes to bank reserves, there is still a huge disparity between smaller and larger banks. The large banks are doing OK. The small banks are at various levels of reserve deficiency. We hope that we don’t see a repeat of last year’s mini-banking crisis, but as the old saying goes, hope is not an investment strategy. So we’ll avoid for now exposure to US small caps particularly on a wholesale basis through an index fund or an index ETF.
What will matter more for equities – interest rates or earnings?
Until very recently, the stock market was rather blasé about the above interest rate dynamics, being sedated by the rate-cuts expectations anesthesia. But as the first quarter results started to seriously roll in this week, and with the “help” of the 1Q GDP numbers, reality seems to be slowly setting in.
Many stocks delivered stellar 1Q results at the bottom line, but the guidance and the outlook came softer than expectations, and that has been causing large negative moves in the share prices. And vice versa, where expectations were low, even in-line results were rewarded. A few examples of some bell-weather stocks that fall in the first category include Caterpillar (big yellow machines) and Harley-Davidson (the ultimate discretionary purchase). They both beat expectations, but shares were down on weak outlook and order books.
What does that all mean? Simply put, it means that so far this year investors bought equities mostly on hopes and expectations of sizeable rate cuts. Many stocks rallied purely on P/E multiples expansion; when earnings or the outlook disappointed, multiples deflated. But the stocks that did not benefit from this P/E multiples exuberance and showed solid results did fine. So, if the market is going to price the rate cuts fully or almost fully out of the picture for this year, then our suspicion is that there could be more air to come out as multiples normalize. One has to be selective in this environment and stock pickers will have a chance to shine.
It seems to us also that the stocks exposed to discretionary consumer spending (Harley Davidson) or industrial capex cycles (Caterpillar) are starting to experience weaker operating environment. Not a surprise – the US consumers have all but spent their excess savings from the COVID times and have been raking up credit card at ever high interest rates. Some businesses are also taking a second look at their order books and funding costs and are feeling the need to pump the brakes. On the other hand, technology and health care related stocks seem to have fared better.
This takes us to the topic of earnings. So far earnings growth has not been questioned by the market due to the soft-landing expectations. The key to watch now is how earnings expectations for the full year 2024 will fare after the earnings season is over. If we see downward revisions to earnings, our guess is that share prices will reflect this rather promptly.
We wrote in our previous strategy and outlook piece that it might be wise to wait for a pullback in order to put new money to work in US equities. It seems that patience will be rewarded indeed and we may see better buying opportunities in the not-too-distant future.
What about international equities? The combination of loose fiscal/tight monetary policy in the US will continue to support strong dollar in our view. High US real rates and strong dollar exchange rate have not been supportive of non-US equities, particularly emerging market (EM) ones. Suffice it to mention slowing global growth, rising funding costs and depreciating (emerging) currencies as some of the few reasons behind this dynamic. We would stay away from EM equities and be underweight developed markets (DM) non-US. However, we should note that the ECB may be ahead of the Fed in its rate-cutting cycle. If and when this materializes, European equities may receive a booster shot in the arm. Stay tuned.
Mihail Dobrinov, CFA April 26, 2024
Trimon Capital
Disclaimer: The information provided in this financial presentation or investment-related material is for informational purposes only and does not constitute financial, investment, or legal advice. Investing in financial markets involves risks, including the potential loss of principal. Past performance is not indicative of future results. The content presented here is based on sources believed to be reliable, but we cannot guarantee its accuracy, completeness, or suitability for any particular purpose. Any investment decisions made based on the information in this presentation are solely at the discretion of the individual investor. We do not endorse or recommend any specific investment product, strategy, or service. Investors should conduct their own research and seek the advice of a qualified financial advisor before making any investment decisions. We disclaim any liability for any loss or damage arising from reliance on the information provided in this presentation.
