Ketu Desai
By Ketu Desai
This is a cycle driven by income, not debt growth. Unlike the Great Financial Crisis, which was driven by debt, mostly mortgage debt, this cycle has been driven by low unemployment, strong consumer balance sheets, and wage growth. Unemployment is near 50-year lows, consumer debt to income and savings are at healthy levels, and wages are up near 18 percent since the start of the pandemic. Most consumers have locked in their mortgage at low rates and are generating a positive carry on it.
Only 11 percent of outstanding household debt carries variable interest rates. This is a cycle that is driven by fiscal expansion. There was approximately $5 trillion spent during the pandemic. Some of which is still sitting out there on consumer balance sheets. There is still another nearly $2 trillion that will be put to work from the IRA and Infrastructure bill. This is a cycle driven by supply and demand imbalances.
Initially, the imbalances were in many aspects of the supply chain, most notably semiconductors. Now the focus is on housing. Unlike previous supply and demand imbalances, bringing on housing supply takes a long time and has a far greater multiplier effect on the economy. There are a few implications from this. The economy has a nice cushion with the consumer in good shape and spending coming from the government and housing. With lower debt levels and a significant amount of debt locked in at low rates, the economy is less rate sensitive, meaning that the Fed will have to keep rates higher for longer.
Lastly, many traditional recession indicators such as the yield-curve are less relevant. The yield-curve has been manipulated for years with QE and now QT, with all the fiscal spending there are new supply and demand dynamics, and the inversion could simply be reflecting lower inflation in the future rather than lower growth.
This cycle is unique when it comes to earnings. This is an inflation cycle. Higher inflation means that while real growth may fall, nominal growth will stay positive and growing. Earnings are nominal, meaning that the earnings collapse many have expected hasn’t occurred. This quarter is likely the trough in earnings.
In 2024, earnings are expected to accelerate nearly 13 percent. These estimates have been increasing in recent weeks. An additional tailwind for earnings is the dollar. The dollar took off between 5-7 percent from earnings in 2022. The dollar is down nearly 15 percent since October of last year. A weaker dollar will not only boost earnings, but it will help loosen financial conditions. The dollar from a fundamental perspective seems to have topped. The Fed looks like it is close to the end, while other central banks are likely to be more hawkish. From a technical perspective, the dollar is now below both its declining 50D and 200D moving average. It is making a series of lower highs and lower lows, indicating a down-trend.
The rally off the lows has also been unique. While breadth has expanded recently, the rally has been very top heavy with a few large cap tech names driving the indices. While large cap tech remains an important allocation, it does have less upside than other areas of the market. In certain ways, large-cap tech has become defensive. These companies have the best balance sheets and can finance at the cheapest rates. As investors get more comfortable that the Fed is near the end and earnings and the economy are going to hold up, they will likely start to reduce the significant positioning in these names.
The clear beneficiary will be cyclicals. We started to witness that this month, with energy rallying 8 percent, materials 3.5 percent, and industrials 3 percent. Steel stocks hit their highest level in 12-years. The market internals are sending a message. Cyclicals will benefit from both increased long positioning and short covering. Many single names have double-digit short positioning and are subject to significant short squeezes on marginally good news. Energy looks particularly interesting right now.
It is the cheapest sector in the market, has the highest dividend yield, has among the highest capital return in the market, while generating the most cash. With oil prices rallying, upward earnings revisions seem likely. Long positioning in energy is low, while short positioning is high. It is likely that as the year progresses, we will start to see a significant supply / demand imbalance in oil. An additional tailwind for oil will come from a weaker dollar. From a technical perspective, the energy sector just moved above both its 50D and 200D. It is on the verge of a golden cross and there is a positive divergence in place. Finally, kryptonite for tech is inflation, and energy is probably the best inflation hedge.
Looking forward, the market will focus on the Fed’s Jackson Hole gathering, earnings, and the economic data.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. [email protected]
