THE DAILY EDGE: 1 April 2024

Note: I will be travelling in Asia until April 24. Limited equipment and different time zones will limit the frequency and depth of my postings.

Powell Reiterates Fed Doesn’t Need to Be In Hurry to Cut Rates It won’t be appropriate to cut rates until the Fed is confident inflation is on track toward the 2% goal.

“The fact that the US economy is growing at such a solid pace, the fact that the labor market is still very, very strong, gives us the chance to just be a little more confident about inflation coming down before we take the important step of cutting rates,” Powell said Friday at an event at the San Francisco Fed. (…)

The core personal consumption expenditures price index — which excludes volatile food and energy costs — rose 0.3% in February after climbing 0.5% in the previous month, marking its biggest back-to-back gain in a year. The measure is up 2.8% from a year earlier, still above the Fed’s 2% target.

“It’s good to see something coming in in line with expectations,” Powell said of the data, adding that the latest readings aren’t as good as what policymakers saw last year. “February is lower but it’s not as low as most of the good readings we got in the second half of last year; but it’s definitely more along the lines of what we want to see.”

Powell said officials expect inflation to continue falling on a “sometimes bumpy path,” echoing remarks he made following the Fed’s last policy meeting earlier this month. (…)

The Fed chief said Friday he doesn’t see the possibility of a recession as elevated at this time. Still, he reiterated that an unexpected weakening in the labor market could warrant a policy response from Fed officials. (…)

That’s another confirmation that inflation is now on the back seat, behind employment as Powell said after the last FOMC: “We’re strongly committed to bringing inflation down to 2% over time,” Powell said. “But we stress, over time.”

He was pleased by the “in-line” inflation numbers but he must have been surprised by many other numbers in last Friday’s report:

• Wages and salaries jumped 0.8% in February (the largest one-month gain since January 2023) for a +0.55% average (+6.7% a.r.) in the last 2 months vs +0.33% (+4.1% a.r.) in Q4’23. Same data for total compensation of employees (labor income).
• Consumption expenditures followed, up 0.8% in February (the biggest jump in over a year and a half) and +0.5% on average in the last 2 months after +0.4% on average in Q4’23. Demand is not slowing, is it?
• Expenditures on services rose 0.9% after +1.0% in January (the biggest monthly jumps since mid-2021). The Q4’23 average growth rate was 0.6%. In real terms, services rose 0.6% in February and +5.5% a.r. in the last 2 months vs +4.0% a.r. in Q4’23 and 2.0% a.r. in Q3’23.

The “refreshingly in-line” inflation number was really the result of 2 other, also surprising, numbers:

• Goods prices jumped 0.5% in February after 4 consecutive negative months. Some of that was because of higher energy prices but food prices only rose 0.1%. Durables prices rose 0.2% like in January after 6 consecutive declines.
• Services inflation was somewhat muted at +0.3% after +0.6% in January. But last 2 months: +5.5% a.r. following +3.5% in the second half of 2023.

Just a bump?

Data: Bureau of Economic Analysis; Chart: Axios Visuals

The inflation rate for services less housing, or super-core inflation came in at 3.3% year-over-year, but the three-month annualized rate of 4.5% points to a problematic rise in service sector pricing. While financial markets may take some comfort in the annual rate of the core PCE deflator coming in at 2.8% with a slightly smaller-than-expected monthly rise of 0.3% in February, service prices are no longer cooling as they were a few months ago. (Wells Fargo)

Source: U.S. Department of Commerce and Wells Fargo Economics

And BTW, rental income jumped another 1.6% MoM in February after +1.4% in January and +0.5% on average in the second half of 2023. Somebody’s income is somebody else’s expense. The long, long, long-awaited slowdown in rents remains elusive.

In fact, Zillow reports that “new rents” rose 0.41% in February, in line with the previous 4 months and well above the 2023 average of +0.28%.

Many pundits highlight the fact that real disposable income has been flat since November, eventually curbing demand.

But labor income keeps rising strongly and the wealth (d)effect is alive and well:

S&P 500 Market Cap Is Up $10.9 Trillion Since the Fed Pivot

The S&P 500 is up 25% since the November FOMC meeting. That is a $10.9 trillion increase in the market cap of the S&P 500 in five months.

Similarly, with lower rates and tighter credit spreads, the market cap of the US bond market is up $2.6 trillion. That’s a total increase in wealth since the Fed pivot of $13.5 trillion. For comparison, US consumer spending in 2023 was $19 trillion.

Combined with higher home prices and higher bitcoin prices, the bottom line is that the wealth gain experienced for US households since the Fed pivot is at least 70% of consumer spending, and this is going to be a strong tailwind for private consumption over the coming quarters. (Torsten Slok, Apollo chief economist)

• The typical homeowner who has owned a home for the last 4 years just received a $208K boost in net worth as home prices have exploded at an unprecedented rate. Homeowners hold $31.8 trillion in home equity, a staggering increase from just under $15 trillion in home equity at the prior housing cycle peak in 2006. (John Burns)

• Dan Suzuki, deputy chief investment officer at Richard Bernstein Advisors:

It’s a pretty mixed report, so I wouldn’t expect it to meaningfully shift the narrative on inflation or the Fed. The story remains that the steady moderation of inflation has stalled above where the Fed wants it to be, and if growth continues to gain momentum, or even just stays as strong as it’s been, there’s a real risk that inflation heads higher. That would lead us down the path toward no Fed cuts and potentially even a hike.

• 32% of small businesses expect to raise prices over the coming months, the highest share since 2022. Historically, this data point is a strong leading indicator of overall inflation. Data pointing to a potential reacceleration in inflation will surely spook Fed members, supporting the case for keeping rates higher for longer. (John Burns)

• The Fed and most everybody else take food inflation out of the equation but this chart from Tavi Costa (via John Mauldin) suggests that we should beware:

Source: Tavi Costa

• Gavekal:

(…) In short, over the past two months the case for Federal Reserve rate cuts has taken on some serious water. This leaves investors with an important question. What will the Fed do next? Will it try to get ahead of the curve and beat back the expectations of imminent rate cuts that it raised in December? Or will the Fed deliver on the promise of rate cuts, even though the macro backdrop is no longer so supportive of easier policy?

One added complication is the calendar. The Fed will be loath to start a new rate cut cycle in July, smack in between the Republican and Democratic conventions. It will also be loath to start a new cutting cycle in late October, days before the US presidential election. This means that the obvious times for the Fed to start a new rate cut cycle are either in June or in December (unless a Lehman-style or Covid-type crisis forces its hand). (…)

Against all the possible reasons to cut, the main reason Fed policymakers might want to sit on their hands is that Powell has made it clear he does not want to be remembered as another Arthur Burns. That’s basically it: the fear of being remembered as Arthur Burns versus the fear of no longer getting invited to D.C. dinner parties.

But Mr.Powell has not been very subtle lately stressing that the 2% inflation target is “over time” along a “bumpy road”, acknowledging an economy growing at “such a solid pace” and a “labor market [that] is still very, very strong”.

Demand for goods remains well above trend while demand for services is back on trend…

… and rising faster than service-sector employment:

Curiously, the unemployment rate in service occupations rose from a near all-time low of 4.1% in September 2023 to 5.1% in February. This in spite of service wages having risen 23% since 2019 vs 16.7% for all private employees.

Productivity is clearly welcome!

One month ago:

• “at some point, I think it will be appropriate to pull back on restrictive monetary policy, likely later this year.” (NY Fed’s John Williams)
• “if inflation expectations. . . continue to move down then I think we’re in a good spot where we could consider an easing of the restrictive level that we’re in.” (Cleveland Fed’s Loretta Mester)
• “the question is, how long to remain this restrictive?” (Chicago Fed’s Austan Goolsbee)

This restrictive? Interest rates going from 0% to 5.5% in 18 months have not bothered consumers nor the whole economy much, have they?

This questioning is clearly helping boost the wealth (d)effect.

Helping?

BTW, National Bank Financial held its Annual Canadian Financial Services Conference last week. Here`s what some bank executives said about the impact the Canadian monetary policy is having on the admittedly more leveraged and interest-sensitive Canadian consumers:

• Customers and delinquencies are holding up despite higher interest
  rates. (BNS)
• Clients remain resilient despite facing challenges such as higher rates and
  inflation. CM expects some credit migration but sees no signs of systematic issues in its
  portfolios. (CIBC).
• Mortgages. Customers are absorbing higher payments, with no major
  impact to delinquency trends. (National Bank)
• Commercial. Delinquencies and impairments are still below pre-pandemic
  levels, on a path towards normalization. (National Bank)

A Hollywood Ending for Fourth Quarter GDP

In its latest revision to fourth quarter GDP, the Commerce Department flagged growth during the period at 3.4%, which is a faster clip than previous estimates. With the benefit of even more hindsight, consumer spending is now pegged at an annualized growth rate of 3.3% up from just 3.0% previously. What drove the adjustment higher was a better finish than expected for services outlays.

While it may be encouraging to see sustained consumer spending growth in this sector, the staying power could be problematic for the Fed should the sustained demand there prevent a cooling in service prices.

Structures spending jumped to 3.7% from 2.4% in the prior estimate on upward revisions to private nonresidential construction spending. One theme we’ve highlighted is how a boom in manufacturing construction has scope to lift future output capacity. In the meantime it can be supportive to topline growth through stronger structures investment. (…)

  

The new data in this release come on the income side of the National Income & Product Accounts (NIPA) and show a slightly brighter picture of the economy at the end of last year than implied by the GDP estimates. The output and income side of GDP accounting should in theory be equivalent as the creation of output generates an equal amount of income, but in reality the two differ due to statistical discrepancies and data omissions.

Real gross domestic income (GDI) rose at an annualized rate of 4.8% in Q4, indicating a stronger pace of growth to end the year. As seen in the nearby chart, this outturn has led the recent unusually wide gap between the annual growth rates of GDP and GDI to narrow. We expect the two measures to converge further in subsequent data releases.

The largest component of GDI is employee compensation, which was revised a touch lower in this updated release. It was still up at a 4.5% annualized rate during the quarter, consistent with solid income growth that has helped sustain consumer spending.

The new piece of income data in this release is economy-wide corporate profits. Pre-tax profits were stronger than we had anticipated, rising 4.1% (not annualized) during the quarter, or by $105 billion. This marks the largest quarterly gain since the second quarter of 2022 and leaves profits about 5% above where they stood at the end of last year.

Most of the year-end profit strength was concentrated in domestic industries specifically, where profits rose $142 billion in Q4. Foreign profits, or remittances from foreign subsidiaries less remittances of American subsidiaries to foreign parents, fell by $8.9 billion. (…)

Broad measures of profit margins remain elevated suggesting businesses have been able to offset higher input costs of material and labor by increased sales. (…)

HOUSING

GS: “Existing home sales increased by 9.5% to a seasonally adjusted annualized rate of 4.38 million units in the February report, significantly above expectations.”

7% rates are keeping the housing market in check.

• Mortgage rates remain stubbornly high at 7% as the economy stays strong and the Fed hesitates to cut interest rates.
• Resale inventory is inching higher as the lock-in effect (when homeowners are “locked in” and unwilling to give up their sub-6% mortgage rates) slowly loosens.
• Demand is sluggish for this time of year as affordability issues persist.
• Builders still have the edge, but rising resale inventory could erode their advantage.

The inventory of existing homes for sale, while still near historic lows, has grown +2% since this time last year. The housing market is well past the peak lock-in days of early 2022, when 92% of borrowers had a rate below 6%.

As of 3Q23 (our most recent data), the share of borrowers with rates below 6% had fallen to 88%—and the actual number is likely closer to 85% today based on trends. Millions of borrowers are no longer locked in, which will only grow as rates stay high and homes take longer to sell.

Canada GDP Grows Stronger-Than-Expected 0.6% in January Canada’s economy made a solid start to the new year with growth in the first two months tracking well ahead of the BOC’s forecast, reinforcing expectations the central bank will once again stick to the sidelines at its coming policy meeting.

The expansion in January was the strongest in a year, bolstered by a recovery with public sector strikes ending in Quebec and backed by increased activity across many segments of the economy. And a flash estimate suggests the strength carried through to last month thanks to increases in areas ranging from natural resources extraction to manufacturing and finance, Statistics Canada said Thursday.

Although inflation in the country has cooled in recent months and slack is building in the labor market, the rebound in industry growth in 2024 suggests no urgency for the Bank of Canada to begin cutting interest rates and economists continue to expect it to leave its policy rate unchanged at next month’s meeting and possibly through the first half of the year. (…)

Compared with a year earlier, GDP by industry in the first month of the year rose 0.9%.

Preliminary data suggest GDP by industry expanded 0.4% month-over-month in February.

“The economy started 2024 with a bang. Broad-based gains suggest that the economy is faring better than expected despite restrictive monetary policy,” said Arlene Kish, director of Canadian economics at S&P Global Market Intelligence, who only expects the first rate cut in Canada in July. (…)

Economic activity in January was driven by services-producing industries with a rebound in education following the end of public sector strikes in Quebec that had contributed to downwardly-revised 0.1% dip in GDP in December.

Canadian manufacturers also saw a recovery in January, as did utilities with a sudden drop in temperatures mid-month that drove a surge in demand in western parts of Canada. While the Quebec strikes in November and December, which also covered some health care workers in the province ended, Statistics Canada said the start of a strike by some teachers in the province of Saskatchewan tempered some of the education sector’s rebound.

Overall, services-producing industries increased 0.7% on-month and goods-producing industries were up 0.2% in as manufacturing recouped all of the decline seen in December and utilities rebounded with a sudden drop in temperatures mid-month that drove a surge in demand in western parts of Canada. Still, rail transportation was down for a second consecutive month, dented by the winter weather in Western Canada that affected train operators, and oil and gas extraction pulled back after reaching a record high level in December while and mining and quarrying declined after three straight months of growth.

Statistics Canada’s early indications for February suggest activity by utilities faded but only partially offset growth in other areas. The estimate is due to be updated with the release of official GDP data for the month on April 30. (…)

SENTIMENT WATCH

From Callum Thomas:

• Tech stocks have broken out to an all-time high relative to the S&P 500 — not to jinx it, but that looks like the establishment of a new permanently higher plateau for tech stocks!

• US tech stock valuations have now surpassed the 2021 highs in both absolute terms (vs their own history) and relative terms (vs the rest of the market).

• Tech insiders have been selling.

Source: @financialtimes

Citing data firm Verity, the Financial Times relayed Monday that the ratio of insider sellers to buyers in the lynchpin technology sector stands at roughly 13:1 in the quarter to date, a ratio topped only twice in the past decade and comparing to less than 5:1 throughout 2022 as the market endured its post-Covid downshift. (…) “We are also seeing a number of the big names in this space with insider selling that is not typical.”

Indeed, several captains of industry have opted to ring the register since the start of 2024:  Amazon.com founder Jeff Bezos and CEO Andy Jassey have collectively offloaded $30 million in company shares, while Meta CEO Mark Zuckerberg cashed out $135 million worth of stock, Palantir co-founder Peter Thiel parted with $175 million and outgoing Snowflake CEO Frank Slootman hit the bid to the tune of $69.2 million. (FT via ADG)

• The average stock has seen record underperformance — as proxied by the performance of the equal-weighted vs cap-weighted S&P500 (this is another way of saying that the top stocks have been really strong). What’s really interesting though is how when that performance differential indicator gets to extremes like this it has often market a turning point in equal vs cap-weighted relative performance (which comes down to sector/style/size relative performance).

Source:  @sentimentrader

CHINA

From Oaktree Capital:

The current market narrative about the “uninvestability” of China reminds us of a recent comment from our co-chairman Howard Marks: “If you have two piles of assets – one with things that everyone loves, that are priced well and performing well, and the other with assets that everyone dislikes, that have poor price performance and are believed to be troubled – you have to ask yourself where will you find the best opportunities?” The answer is clearly in the latter.

Chinese equities may be at the top of the “disliked and troubled” pile today. They are currently trading at a record-low 8.2x forward estimated earnings, on average, and the gap between U.S. and Chinese technology stocks is the widest it has been in many years.

Moreover, sentiment regarding investment in China is as bad as we’ve ever seen it, with global positioning surveys showing China to be a large consensus underweight.

Counterintuitively, many investors who favored Chinese equities a few years ago when large Chinese companies were often being very aggressive in their use of capital, now consider the same equities to be too risky, even though the companies involved have become much more conservative and the equities themselves have become much less expensive.

Importantly, we think many high-quality Chinese companies are being punished not because of concerns about their fundamentals, but because of broad macro concerns about China. In fact, the fundamentals of many companies are actually improving. For example, net cash positions at the top 15 Chinese companies in the MSCI Emerging Markets Index have risen from negative $19 billion in 2019 to $113 billion in 2023.

In early 2023, few people were negative on China. Its housing problems were barely discussed other than here. The FTSE China H Share Index peaked in early May before sinking 30% while the doom and gloom scenarios moved to the front pages.

China’s problems and challenges are now widely known. What we don’t know is if the worst is near.

FYI, the last time the S&P 500 was at 8.2x forward EPS was in June 1982 (red line):

That said, China remains China…

Yesterday:

• The NBS manufacturing PMI index rose to 50.8 in March from 49.1 in February. The new orders sub-index jumped to 53.0 from 49.0, the output sub-index increased to 52.2 from 49.8, and the employment sub-index inched up to 48.1 from 47.5.
• The new export order sub-index increased sharply to 51.3 in March vs 46.3 in February. The import sub-index also improved to 50.4 in March vs 46.4.
• The input cost sub-index increased to 50.5 from 50.1, while the output prices sub-index fell to 47.4 from 48.1.
• The official non-manufacturing PMI (services and construction sectors) rose to 53.0 in March vs 51.4 in February.

Huawei Bounces Back From U.S. Sanctions as Profit Doubles The results are a stunning comeback for the Chinese tech-giant, years after U.S. export controls cut it off from advanced technology.

The tech giant on Friday said profit rose to 87 billion yuan, or $12 billion, a rise of more than 140% from the same period a year ago. It is the largest jump in profit for the company since it started reporting comparable figures in 2006. Revenue rose 10% to $99 billion.

It said growth was driven by higher sales in its consumer electronics and cloud computing offerings. Last September, Huawei surprised U.S. authorities by releasing a new smartphone, the Mate 60 Pro, with 5G-like capabilities, running on its homegrown chips.

Five years after the U.S. restricted sales of the most powerful chips to Huawei, the telecom equipment and mobile phone maker has shown strong resilience. The company has diversified into new business lines such as cloud computing, enterprise software and automobile systems and retooled its products.

Last year nearly 70% of Huawei’s revenue came from China as its overseas presence shrunk. Five years ago, China formed about 60% of its revenue, while the rest came from Europe and emerging markets. Huawei doesn’t break out U.S. sales figures.

Revenue from its telecommunication equipment and enterprise technology business grew 2%. Sales at its consumer business group, encompassing products such as smartphones, laptops and smart wearables, rose 17%. (…)

Huawei has managed to deliver AI chips that developers say match the capabilities of some of Nvidia’s top processors. Nvidia named Huawei as one of its competitors in its annual report in February.

In 2023, Huawei spent $23 billion on research and development, about 23% of its total revenue.