Ketu Desai
By Ketu Desai
The Fed pivoted again. Coming into the year the market expected nothing short of six rate cuts with moderating inflation and growth. With both remaining hot, it has been put into serious question whether we get rate cuts at all. April was the month in which the market adjusted to this new reality. The market now expects just one rate cut this year.
Speeches in April by Chair Powell and other Fed officials have walked back the dovish pivot from December, signaling a higher for longer policy. NY Fed President Williams went as far as to say that he has not ruled out further rate hikes. We could be at an inflection point where the backdrop moves to higher growth, higher rates, and higher inflation. The latest data is increasingly signaling that the economy is likely to remain hot. Real wages are also growing faster than inflation.
Low unemployment with these growing wages means the consumer should continue to power the economy. The consumer is less sensitive to higher rates. Household debt to GDP and household debt service to disposable income are at historically low levels. Only 11% of outstanding household debt carries variable interest rates. We are in the early stages of what is likely to be a lengthy CapEx cycle. PMIs have started to accelerate upwards. This is happening globally. China after a lengthy COVID hangover is finally starting to show signs of recovery. We have witnessed a significant rally across commodities in recent weeks as the global data has improved. The growth backdrop combined with how the math works makes it highly unlikely that inflation gets back to the Fed’s 2% target this year, forcing the Fed to remain more hawkish.
The dominant investment theme is a major CapEx cycle. It is broad and will likely be lengthy. It spans infrastructure, clean energy, manufacturing, and technology. It is funded by fiscal spending from the infrastructure bill, Chips Act, and the Inflation Reduction Act, as well as corporate CapEx, and private capital. At the heart of it is AI. The AI infrastructure buildout is significant, it includes data centers, building semiconductor fabrication plants, and supplying significant energy to power them. Cloud CapEx spending is now tracking up 44% so far this year. Across the economy, CapEx will run approximately $9 trillion, roughly a third of GDP.
The rally from the October lows has been driven by technology. These names have driven the rally for a reason. They had superior earnings growth as the early beneficiary of AI. They were growing earnings north of 30%, while the rest of the market had declining earnings. As the CapEx boom widens to other parts of the economy, this gap will narrow. The rest of the market will have faster earnings growth by the fourth quarter. Many technology names will face a difficult setup. Decelerating growth with a high multiple.
This will make technology much more of a stock-pickers market. Names such as Adobe, Palo Alto Networks, ASML, Taiwan Semiconductor, Netflix, Snowflake, Meta, ServiceNow, Atlassian, IBM all reported strong earnings but saw significant declines in their stock. This will likely continue. Other parts of the market will have a very favorable setup, low valuation with accelerating growth, a catalyst for rotation, particularly to large cap cyclical value stocks.
The Fed Remains on Hold
The bond market failed to protect in the latest equity market drawdown. This has been the case post-pandemic. The TLT (long-bond ETF) is down nearly 50% since the pandemic. The bond market has often been the source of volatility in recent years. Many investors invest 40% of their portfolio in bonds as a hedge and for steady yield. While the yield earned is higher, bond investors have had to put up with more volatility and often price losses which negate the yield they are earning. For instance, TLT is down 10% YTD. It will take nearly 3-years to make that up in yield. The fundamentals for bonds remain challenged. The US funding needs are high, which will result in significant supply. Inflation remains above the Fed’s target. Foreign governments are diversifying Treasury holdings. The Fed remains on hold. In recent weeks, we have started to catch a glimpse of investors looking at other asset classes to hedge their portfolio. Bonds had their biggest monthly drop in allocation since July 2003.
The immediate beneficiary has been commodities, most notably, gold. Gold’s correlation to rates has broken down. Other commodities have also experienced significant rallies in recent weeks including copper, silver, cocoa, and oil. The reality is that hedging will not be as simple as it was during the 40-year bull market in bonds. Instead, it will require more thought and customization for your timeframe, pain tolerance, and what specifically you’re trying to hedge against.
The market will focus on earnings, economic data, and geopolitics in the incoming weeks.
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
