Ketu Desai
By Ketu Desai
It’s remarkable how in just one month we can have such a significant shift in the narrative. The Fed looks like it is done with rate hikes for this cycle. Multiple times during this hiking cycle, markets have tried to price in the end of hikes and the start of cuts. Each time was premature. For the first time since the start of the hiking cycle, rate cuts now seem realistic. The Fed would lower rates for two reasons – if the economy weakens or if inflation moderates (causing onerous real rates). Both reasons are pointing toward no more rate hikes at minimum, and likely rate cuts next year.
The strength of the employment market was one of the Fed’s strongest arguments for raising rates and keeping them high. Several data points that came out in the last month indicate that the employment market is quickly deteriorating. Initial jobless claims, the most real time measure of the employment market, have been up since mid-October. The number of industries increasing employment has gone from 61 percent to 52 percent in just one month. The unemployment rate has gone up half a percent since April.
The commentary from the latest PMIs said, “businesses cut employment for the first time in almost 3 1/2 years in response to concerns about the outlook. Job shedding has spread beyond the manufacturing sector, as services firms signaled a renewed drop in staff in November as cost savings were sought.” The Citigroup economic surprise index has started to move lower in recent weeks, indicating that economic data is coming in below expectations. Just in November, we have seen important misses on ADP employment, ISM employment, nonfarm payrolls, PMIs, Michigan consumer expectations, new home sales, durable goods orders, retail sales, and many regional Fed PMIs.
The inflation numbers also have moderated. CPI is now down to 3.2 percent, and monthly CPI was zero. PPI (producer prices) shows outright deflation on a monthly basis. Unit labor costs were down last quarter, showing outright deflation. There is more cooling of inflation in the pipeline when market rents and used car prices are factored in. Autos and housing make up over half of the CPI index. The latest Manheim Used Car Index was down 5.3 percent. Oil prices are also down significantly since the end of September. While certain OPEC-plus members are cutting production, non-OPEC members are producing at record levels led by the US with over 13mm bpd.
The global supply chain index hit a record low, which means there is less pressure on businesses to raise prices. We have seen inflation decline meaningfully across the world, which should spread to the US. Walmart’s CEO said on its earnings call, “in the U.S., we may be managing through a period of deflation in the months to come.” Yields have started to reflect this with the 10YR backing off 5 percent. It is likely that the long end remains anchored at higher levels driven by the fiscal deficit, quantitative tightening, and a supply/demand imbalance.
The front-end is likely to move lower as the market adjusts for Fed policy. The result is that the yield curve likely steepens and move back into positive territory in 2024.
The market internals tell the same story. The month showed a clear bifurcation and rotation out of the inflation-oriented sectors and into the deflation-oriented sectors. There was an over 15 percent spread through the last month between technology and energy highlights the rotation. As inflation and rates moderated, for the first time this year, we saw meaningful breadth expansion. Beaten up areas such as small caps, biotech, regional banks, medical devices, industrials, international equities all participated.
A few large cap tech stocks have been responsible for nearly the entire rally this year. As breadth expands there is meaningful upside in all these other beaten-up areas. One that stands out is financials. According to Goldman Sachs, hedge fund positioning in financials is the lowest since they started recording such data. Flows all year have been negative out of financials. Financials are one of the biggest beneficiaries of the yield curve steepening. Their balance sheet and income statement are levered to improvement in the rate environment. They trade at just 10x cash flow, compared to 14.75x for the S&P, over a 40 percent discount.
Despite all the turmoil, financials have grown in both revenue and earnings this year. They are expected to finish 2023 with the second highest revenue growth of any sector. Earnings growth was up 20 percent in the third quarter. The growth is expected to continue in 2024. Capital markets and M&A are not likely to remain this depressed for much longer, which further supports earnings.
The market value of all banks in the S&P 500 is less than 10 percent of the index’s market value, an all-time low. The ratio was previously depressed in the late 1980’s, only for financials to outperform throughout most of the 1990’s. A lot of bad news has been priced into the sector, with very little positioning, any marginal fundamental improvement is likely to drive meaningful returns in the sector.
Looking forward, the market will focus on the Fed meeting, economic data, and geopolitics.
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
