By Ketu Desai
The bond market vs. the Fed continues to be the story. The Fed looks to have the early lead. The two-year, a proxy for monetary policy, has repriced, up 65bps in February. The market now expects the Fed Funds rate at 5.4 percent in September. Rate cuts are being priced out of the market. The catalyst has been stronger than expected economic data. The strength is coming from the employment market and the consumer. The employment market remains remarkably strong, with initial jobless claims near record lows. The strength of the labor market combined with savings from the pandemic have fueled the consumer.
January retail sales came in at 3 percent. Bank of America card data shows spending up 5.1 percent in January up from 2.2 percent in December. Part of the strength in the consumer is that real wages are increasing. Inflation is coming down, while nominal wages are increasing, which increases purchasing power for the consumer. It is not just the consumer that is showing strength, composite PMIs are into expansionary territory, homebuilder sentiment has improved, and manufacturing production is now growing after declining in December. The strength is global in nature. European composite PMIs are now into expansionary territory and the Citigroup economic surprise index is solidly positive. Chinese growth could be the wild card for global growth. The early read is positive, Chinese PMI is now into expansionary territory. The Chinese central bank ramped up liquidity injections in February. At the same time, the Chinese consumer with three years of pent-up demand and $1.2 trillion in excess savings has started to spend, most notably on travel. The website Trip.com says that travel bookings are up 640 percent from last year. Chinese road congestion is now above 2019 levels.
It remains unclear whether the recent strength in data is a head fake (driven by seasonal adjustments, warm weather, and cost of living adjustment for social security) or not. Monetary policy works with “long and variable lags.” If the strength continues, the Fed will likely have to tighten more than is currently priced in. Energy prices are a key variable. Oil has come in from nearly $130 to the high $70s and natural gas has fallen from nearly $10 to the mid-$2s. Energy prices have helped bring inflation numbers down. Lower energy prices also have helped the consumer feel more confident and allow for more discretionary spending. IEA forecasts that oil demand will hit new records this year, with demand outpacing supply. How the Chinese reopening goes and if and how much Russian oil comes off the market are key variables for energy prices. Higher energy prices mean that inflation fears will come back, and that rates will be higher for longer.
The rally thus far this year has been dominated by tech and growth stocks. High multiple, unprofitable tech has performed particularly well this year. Defensive and value stocks have underperformed this year. The driver for these moves is largely attributed to positioning. About $300bn of short covering has occurred. Part of the move is also a view that the Fed is almost done and will cut rates later in the year. The recent economic strength makes that unlikely right now. The fundamentals have not improved much for tech stocks, despite the massive rally. Growth for many tech names is still challenged. Apple’s revenue fell 5 percent in the quarter. Meta’s revenue fell 4 percent—and its guidance implies a 2 percent drop for the current quarter. Alphabet had a 1 percent gain, but ad revenue was off 4 percent, including an 8 percent decline for YouTube. Microsoft managed a 2 percent sales rise. You are paying an average of 32.9x for combined revenue growth at the five tech giants of just 1 percent. Slow growth with high multiples means that it is unlikely that there is continued leadership from tech. The risk / reward is particularly unfavorable if the Fed has to continue to raise rates. While the YTD rally in tech is nice, it might be an opportunity to take some profit.
Looking forward, the market will continue to focus on the economic data, the Fed meeting, and the latest in geopolitics.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. firstname.lastname@example.org