Gaining Momentum

By Ketu Desai

The economy is gaining momentum. Third quarter GDP printed 2.8%. The Citigroup economic surprise index has moved into positive territory, indicating that economic data is beating expectations. The consumer continues to power ahead behind a strong labor market. Initial jobless claims remain near all-time lows. There are over 7 million open jobs. Wages are growing, while household debt payments to disposable income are near all-time lows. Around 40% of homeowners don’t have a mortgage, and the majority of the remaining have positive carry.

High stock and home prices have increased consumer confidence. Americans have more than $35 trillion in home equity, which is up 81% since the end of 2019. Real time measures of consumer spending including, TSA air travel data, credit card data, gasoline demand, hotel occupancy, bank lending, box office weekly grosses, Broadway show attendance, restaurant booking data, freight rates, and truck tonnage all point to continued strength.

This is not just consumer spending; it is fiscal spending and corporate CapEx supporting growth. Less than 30% of the $2.4 trillion from the Infrastructure Bill, Inflation Reduction Act, and CHIPS Act has been spent. AI spending alone will likely hit nearly $1 trillion in the coming years, benefiting a wide range of industries. In short, the consumer, government, and corporations are all in good shape to support the economy.

To further support this, the Fed is easing policy as it cut 50 bps in September and expects to cut twice more this year. They also forecast another 100bps of cuts in 2025 and 50bps in 2026. Ironically, long-rates have actually moved up since the Fed cut rates. The more cuts that occur, inflation risks increase and growth risks are reduced. The result is higher long-term rates. This is exactly what we have seen. Five year breakeven rates (a proxy for forward inflation) have meaningfully moved up since the Fed cut, breaking above 2%.

While the Fed is likely to follow through with these expected cuts this year, if the current momentum continues it is likely that the number of rate cuts we get this cycle will be less than expected. Long rates are likely to continue to move to a level that is more consistent with nominal GDP.

With higher rates and high market multiple, many index level returns will have to come from earnings. Continued multiple expansion at the index level is likely limited. The good news is that strong economic growth will be conducive to earnings growth, expected to grow 15% next year and another 13% in 2026. The sweet spot for investors will be in areas of the market that have a low multiple with earnings growth and that benefit from a higher growth environment. Returns in these areas will not only benefit from earnings growth but multiple expansion.

An area that stands out is financials. Financials are expected to grow earnings 18% in the fourth quarter and are expected to have a long-term growth rate of 14%. They trade at 28% discount to the S&P 500. Banks are in a process of their multiple re-rating. Since the financial crisis, they have had significant capital requirements and restrictions. Basel III endgame will raise capital requirements by 9%, significantly lower than the 19% originally feared.

A positively sloped yield curve means that net interest income (NII) has bottomed out for banks. We are on the verge of capital markets and M&A activity restarting after three years. Goldman Sachs said on their earnings call, that they “see significant pent-up demand from our clients,” and their “backlog rose in the third quarter.” Most banks rallied during the earnings season, as credit losses were meaningfully below expectations.

Financials are one of the best performing sectors for the year, despite negative flow. From a technical perspective, financials appear to be breaking out of a multi-year base. The charts show bullish cup-and-handle formations. With positive earnings revisions, low positioning, multiple re-rating, and bullish technicals, financials appear to be taking a leadership role.

Looking forward, the market will focus on US election results, Fed meetings, earnings and economic data.

Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com