Fed Minutes Show Unease Over Premature Cuts Only two officials highlighted the risks of keeping rates too high for too long at last month’s policy meeting

(…) “Most participants noted the risks of moving too quickly to ease the stance of policy,” said the minutes of the Jan. 30-31 meeting, released Wednesday with a customary three-week delay. Only two officials pointed to the risks “associated with maintaining an overly restrictive stance for too long.” (…)

Central-bank officials are trying to balance two risks: One is that they move too slowly to ease policy and the economy crumples under the weight of higher interest rates. The other is that they ease too much, too soon, allowing inflation to become entrenched at a level above their 2% goal.

The written account of last month’s meeting showed some officials thought recent improvements in inflation reflected one-off developments. “Nevertheless, they viewed that there had been significant progress recently on inflation returning to the committee’s longer-run goal,” the minutes said. (…)

Officials at last month’s meeting “judged that the policy rate was likely at its peak for this tightening cycle,” the minutes said. (…)

The Fed typically cuts interest rates because economic activity is slowing sharply, but in public comments, officials have turned their attention to scenarios under which they could lower rates even with solid growth. That is because as inflation declines, inflation-adjusted or “real” rates will rise if nominal rates are held steady.

Later today we get the U.S. purchasing managers survey. World Economics’ Sales Managers Survey is as good as it gets.

Source: World Economics

While on surveys, the Business Leaders Survey turned worrisome on wages and prices lately (via Rosenberg Research):

  

But Atlanta Fed’s Business Inflation Expectations Remain Relatively Unchanged at 2.3 Percent

Sales levels and profit margins compared to “normal times” increased, according to the Atlanta Fed’s latest Business Inflation Expectations survey.

In the real world:

Toll Brothers reported a strong orders (+40% YoY). Management indicated that demand is strong, with a marked increase in demand since mid-January.

JB Smith, an apartment developer in the D.C. area: “Leasing levels remained solid throughout the quarter despite some anticipated seasonality typical for the winter months. Across our portfolio, we increased effective rents by 7.0% upon renewal for fourth quarter lease expirations [Q3 was +4.8%] while achieving a 56.0% renewal rate.”

Canada Inflation Cools to 2.9% in January

Consumer prices rose 2.9% in January from a year earlier, following December’s gain of 3.4%, Statistics Canada reported Tuesday. That marked the lowest level since June, and undershot the 3.3% advance economists were expecting.

On a month-over-month basis, the consumer-price index was unchanged in January, after falling 0.3% the month before and compared with the 0.4% increase that was expected. (…)

The deceleration left annual inflation just inside the Bank of Canada’s 1% to 3% target range and was driven by a drop in gasoline prices compared with last year. Excluding gasoline, headline inflation slowed to 3.2% from December’s 3.5%. (…)

The Bank of Canada’s preferred measures of underlying annual inflation made progress in January, with weighted median and trimmed mean CPI rising an average 3.35% last month from a year earlier compared with 3.6% growth in December. (…)

Excluding food and energy costs, the core consumer-price index slipped 0.1% from the previous month and rose 2.7% year-over-year.

On a three-month average annualized basis, CPI-Trim declined to +3.2% in January from +3.8% in December and CPI-Median edged down to +3.3% from +3.5%. On a month-over-month annualized basis, CPI-Trim and CPI-Median decreased respectively to +1.2% (vs. +4.8% in December) and +1.7% (vs. +4.7%). For both measures, January 2024 recorded the slowest monthly inflation rate since 2020.

Eurozone downturn eases as service sector stabilises, but price pressures intensify

The seasonally adjusted HCOB Flash Eurozone Composite PMI Output Index, based on approximately 85% of usual survey responses and compiled by S&P Global, rose from 47.9 in January to 48.9 in February. Although signalling a ninth consecutive month of falling output, February’s decline was the smallest since last June. While the latest reading suggests that the eurozone’s deepest contraction since 2013 (if early pandemic months are excluded) has persisted into 2024, the rate of decline is showing signs of moderating in the first quarter.

Business conditions continued to vary markedly by sector and country across the eurozone, however, underscoring the weakness of manufacturing in particular, which has in turn hit Germany especially hard.

Manufacturing output fell across the eurozone for an eleventh consecutive month in February, the rate of decline accelerating again after the moderation seen in January to register another month of steep contraction. New orders for goods likewise fell sharply by historical standards (albeit the rate of loss cooling slightly for a fourth month running).

In contrast, service sector business activity stabilised in February after six months of continual deterioration, linked to an easing in the rate of decline of new business for a fourth straight month to signal only a marginal drop in demand.

Similarly, while export orders fell for both goods and services, a steepening rate of decline in the manufacturing sector contrasted with a moderation in export losses in the services economy.

By country, output fell especially sharply in Germany, dropping for an eighth successive month and at the fastest rate since last October. A moderating downturn in Germany’s service sector only partially offset a deepening contraction in manufacturing.

Output also contracted in France, but the decline was the smallest recorded since France’s downturn commenced back in June of last year thanks to moderating rates of deterioration for both manufacturing and services sector output.

The rest of the eurozone meanwhile collectively reported growth of output for a second month running, contrasting with the declines seen over the prior five months, enjoying the largest monthly improvement since last May. Faster service sector growth was accompanied by a near stabilisation of manufacturing output.

Employment increased for a second month running in February after two months of decline at the end of 2023. While the overall rise in payroll numbers was only modest, the latest increase was nevertheless the largest since last July. Again, sector divergences were noteworthy. A steepening rate of job losses in the manufacturing sector contrasted with net hiring reaching an eight-month high in the service sector. A marginal drop in employment in Germany was accompanied by a marginal rise in France and a nine-month high rate of job creation in the rest of the region.

Growth of average input costs across producers of goods and providers of services accelerated for a second successive month to reach the highest since last May. Although well below highs seen during the pandemic, the latest rise pushed the rate of increase further above the survey’s pre-pandemic long-run average to signal elevated cost pressures by historical standards.

Service sector input cost inflation rose to a nine-month high and prices fell in manufacturing at the slowest rate for 11 months.

Selling price inflation likewise accelerated, up for a fourth month running in February to also hit the highest since last May. Excluding the price surge seen over the two years to last May, February’s rate of inflation was the highest recorded since January 2018 and well above the survey’s pre-pandemic long-run average.

Although prices charged by manufacturers fell at a slightly increased rate, continuing the disinflationary trend seen for goods over the past ten months, prices levied for services rose at the sharpest rate for nine months, the rate of inflation having now accelerated for four straight months. Excluding the 19-month period to last May, the latest rise in service sector prices was the largest recorded since September 2000.

  

Japan: Private sector activity stagnates

• Flash Composite Output Index, February: 50.3 (January Final: 51.5)
• Flash Services Business Activity Index, February: 52.5 (January Final: 53.1)
• Flash Manufacturing Output Index, February: 45.4 (January Final: 47.7)

The headline au Jibun Bank Flash Japan Manufacturing Purchasing Managers’ Index™ (PMI)® fell from 48.0 in January to 47.2 in February, signalling a ninth consecutive deterioration in operating conditions that was the most marked since August 2020. A steep reduction in new orders led to production shrinking at the fastest rate for a year. In turn, purchasing activity fell sharply while lower capacity pressures led to employment levels falling at the quickest pace since January 2021. Price pressures faced by Japanese manufacturers softened during February, as the rate of input price inflation eased to a seven-month low, which contributed to the softest rise in output charges since June 2021.

The au Jibun Bank Flash Japan Services Business Activity Index posted 52.5 in February, down from 53.1 in January. Despite easing slightly on the month, the latest expansion extended the current sequence of growth to 18 months. Moreover, the rate of growth in new business accelerated during February and was the strongest recorded since last August. Optimism with regards to future activity and indications of capacity pressures nevertheless led to a solid increase in employment that was the most marked for nine months. On prices, inflationary pressures led to a sustained albeit softer increases in both input costs and charges.

  

The Economist in April 2023:

• America’s economic outperformance is a marvel to behold
• The lessons from America’s astonishing economic record

Three quotes:

• America’s dominance of the rich world is startling. Today it accounts for 58% of the G7’s GDP, compared with 40% in 1990. Adjusted for purchasing power, only those in über-rich petrostates and financial hubs enjoy a higher income per person. Average incomes have grown much faster than in western Europe or Japan. Also adjusted for purchasing power, they exceed $50,000 in Mississippi, America’s poorest state—higher than in France.
• Investors who put $100 into the S&P 500 in 1990 would have more than $2,000 today, four times what they would have earned had they invested elsewhere in the rich world.
• On a whole range of measures American dominance remains striking. And relative to its rich-world peers its lead is increasing.

Nearly one year later, American exceptionalism is on everybody’s mind.

Ed Yardeni illustrates how U.S. equities have totally outperformed world markets over the past 15 years, both in local currencies and in dollar terms:

In dollar terms, U.S. MSCI revenues jumped 65% since 2008 while World-ex-US revenues declined 20% (+16% in local currencies).

Since the pandemic, U.S. MSCI: +30% vs World-ex-US: –5% (+5% in local currencies).

These next 2 charts compare U.S. revenues with developed countries-ex-US in dollar (left) and local currencies (right).

  

The Economist again: “The world’s biggest economy is leaving its peers ever further in the dust”.

Trends are not always our friends. After a while, we tend to take them for granted, they become “natural”, ingrained, widely expected. Without a complete understanding of how they happened, we may be surprised when they end and reverse.

This chart from J.P. Morgan Asset Management shows that

over the past 50 years, there have been different regimes of U.S. vs. international outperformance. In other words, outperformance comes in waves. After a long period of U.S. outperformance, it is worth considering whether we may be transitioning to a new wave.

Source: FactSet, MSCI, J.P. Morgan Asset Management

Growth arises from many sources. The American economy benefits from several advantages compared its world competitors. To list a few:

• population growth, including immigration
• education
• productivity, dynamism, flexibility
• innovations
• energy
• dollar

These attributes have long been mainstays of the American economy over time and cycles.

One additional source of growth has emerged since 2008: the U.S. government has significantly intervened in the economy, boosting its expenditures from 21% of GDP to its current 25.5%, doing so with borrowed capital as opposed to higher revenues.

In fact, every economic shock since 1981 was used to substantially boost the U.S. debt leverage, without subsequently restoring the debt ratio. The jump in leverage since the GFC has been nothing short of spectacular: the federal public debt exploded from 62% of GDP in 2007 to 120%, in 15 years!

Among G7 countries, only the U.K. boosted its debt leverage faster than the U.S. since 2010. For the average G7 countries ex-USA, debt to GDP increased by 14 percentage points (+18%). Meanwhile, debt leverage rose by 27 pp or 39% in the USA.

In effect, the U.S. government’s increased spending provided additional revenues to the private sector without any offsetting contribution extracted from corporations or citizens.

The budget space provided by the huge decline in interest rates since the mid-90s was entirely used to raise spending and debt.

As a result, interest expense now represents 15.4% of the government budget, up from 9.2% in 2010.

• The most recent projections from the Congressional Budget Office confirm once again that America’s fiscal outlook is on an unsustainable path — increasingly driven by higher interest costs. Growing debt, in addition to the rise in interest rates over the past couple of years, has significantly increased the cost of federal borrowing. In 2023, interest costs on the national debt totaled $659 billion — surpassing most other components of the federal budget. (Peterson Foundation)
• The debt is growing faster than the economy, so it is unsustainable. It’s time for us to get back to putting a priority on fiscal sustainability. And sooner’s better than later. (Jay Powell at 60-Minutes)

Keep in mind that the CBO projections naively assume that inflation, real growth and real Treasury yields will all average 2% over the forecast horizon.

About one third of Treasurys will be maturing during the next 12 months, very likely with a steep markup on renewals, taking even more budget space, crowding out more discretionary spending.

This means that the federal government is losing considerable leeway to adjust spending to economic needs and its discretionary expenditures are unlikely to provide the same economic impetus as they did since the GFC. The CBO’s baseline (and naive) projections have discretionary expenditures declining in 2024 and 2025 rising very modestly thereafter but actually declining in real terms.

The American stars (and stripes) neatly aligned themselves after the 2008-09 GFC. The federal budget exploded under both Democrat and Republican governments (R.I.P. the Tea Party) while interest rates were brought to zero. Corporate tax rates were drastically cut in 2018.

The pandemic prompted the U.S. government to further boost spending and the Fed to flood the economy with liquidity. Americans merrily spent their pandemic bounty. Meanwhile, broken trade channels and the trade dispute with China are inciting businesses to reshore production, encouraged by significant government subsidies and increased protectionism.

Manufacturing construction doubled (+$110B) since mid-2022, ten times faster than GDP, while manufacturing shipments and new orders stagnated. Actually, manufacturers spent twice more building plants in 2022-23 than during all previous 20 years.

Manufacturing capacity utilization peaked at 80% in April 2022, highest in 22 years, from 76% pre-pandemic. It has since dropped to 76.5% and is likely to get lower as the more recent projects get completed.

Most of this new capacity is not to meet new demand, creating overcapacity, mainly in China, that is now fighting for new orders, likely displacing other production in a deflationary domino effect.

The war in Ukraine also benefitted defense spending in the U.S..

Industrial production in the U.S. defense and space sector has increased 17.5% since Russia launched its full-scale invasion of Ukraine two years ago. Business is coming from European allies trying to build out their military capabilities as well as from the Pentagon, which is both buying new equipment from defense manufacturers and replenishing military stocks depleted by deliveries to Ukraine. (WSJ)

Looking ahead, many important changes are likely:

• Consumer spending will normalize, with increased volatility. Since 1959, the personal savings rate has only been lower than the current 3.7% during the 2005-08 period when Americans splurged on housing, and briefly in 2022, in total only 7% of the time. Before the pandemic, the savings rate ranged between 5.0% and 8.5%.
• Construction spending will also normalize. Since 2010, total construction spending grew 50% faster than GDP, carrying a high economic multiplier.
• Government spending ex-interest expense will measurably slow down.
• The unemployment rate is at a historical low. Employment growth will slow.
• American politics are getting increasingly toxic and inefficient.

Investors are paying top valuations for large cap stocks, clearly extrapolating the past without appreciating that the true American exceptionalism actually is all the exceptional factors that boosted its economy since 2009 and oblivious to the rising risk from its indebtedness as interest rates normalize.

We may well be in a melt-up fueled by Goldilocks sentiment and passive investing mechanically boosting the Magnificent 7 stocks, but the risk/reward ratio has reached a mined no-man’s land area.

J.P. Morgan Asset Management agrees:

Indeed, the stars do seem to be aligning for international to take the baton from the U.S. over the next decade, including: cheaper equity valuations, cheaper currencies and a combination of cyclical and structural investment themes than can help boost long-term returns.

The panel below shows valuation measures for international equity markets. The left-hand side shows the price-to-earnings discount of international vs. U.S. equities. On the right-hand side, we show the difference in dividend yields between international and U.S. stocks.

We can see that international equities are trading at a significant discount right now and that they offer an attractive yield pickup relative to U.S. equities on average.

Ed Yardeni offers these absolute P/E charts:

(MacroMicro)

Another way to contextualize current valuation ratios from JPMAM:

Since 2009, this blog has been discouraging country diversification: in single words, Europe was seen as unmanageable, Japan as unscrutable and China as uninvestable. By comparison, the U.S. was very likable, and mostly reasonably valued.

Nobody knows how long the U.S. will remain such a magnet for capital and what will trigger the change in sentiment. But alternatives are now more interesting, allowing for at least some diversification.

Back in 2009, U.S equities were selling at a discount to the world as the GFC made it “uninvestable” to many (one reader called me a “bloody fool” after I wrote a very bullish post in March 2009). The current premium is the largest ever as the U.S market has become “the only one”.

According to Bank of America’s latest fund manager survey, institutional investors are overweight US stocks, but even more worrisome may be the concentration in smaller investor portfolios. According to a recent Wall Street Journal article citing Vanda Research, the average individual’s stock portfolio has 40% of its value tied up in just three tech stocks! (…)

Eventually, high valuations and unattainable growth expectations lead to disappointments and significant devaluations. The subsequent period of deteriorating fundamentals and weak returns causes the pendulum to swing to opposite extremes.

As a result, periods of significant outperformance tend to be followed by periods of significant underperformance, reversing much of the previously earned extraordinary gains, even for the biggest of secular themes. Positioning and valuation suggest that investors expect the US equity dominance of the past 15 years will last indefinitely, but history seems to suggest otherwise. (…)

When coupled with the prevailing bifurcation of sentiment and record market concentration, the current juncture may offer investors a once-in-a-generation opportunity to rebalance portfolios. Just as in the wake of the Internet bubble, what part of the market you own could mean the difference between another lost decade of returns for crowded and expensive assets or very attractive returns or assets where capital is truly scarce. (RBA)

To be sure, many alternatives carry their own stigmas: the Eurozone is still largely disfunctional and China is still China. But big opportunities generally hide in plain sight, particularly when nobody wants to look.