Too Defensive

By Ketu Desai

The Fed started to normalize interest rates by cutting 50bps last month. The Fed expects to cut twice more this year by 25bps each. They forecast another 100bps of cuts in 2025 and 50bps in 2026. With inflation heading toward 2%, the risk is skewed toward the labor market. The easing cycle will reduce that risk. For the past 2+ years, the Fed wanted to cool things down. Investors were fighting the Fed and now, Fed put has returned.

The Fed is here to support the labor market, consumers, corporate confidence, credit markets and a strong banking system. We are settling into a normalized environment with 2-2.5% growth and inflation. The yield curve has inflected positive and is steepening. A positive yield curve will normalize banking and likely open up capital markets. The irony is that as growth risks are reduced, long-rates are likely to rise. It seems likely that they will continue to normalize to a level that is roughly near nominal GDP growth.

With the economy normalizing, the Fed easing, and a positive yield curve, investors are positioned too defensively. Money market assets total $6.8 trillion, up more than 50% from the level prior to the pandemic. Investors added $126bn after the Fed cut. The yield on these assets is on its way to being cut in half. The real yield on these assets will move close to zero. Even within equities, positioning is too defensive.

Positioning in sectors such as utilities and consumer staples is elevated. For instance, positioning in utilities is the highest since December 2008, 2.8 standard deviations above its long-term average. Utilities trade at 19.4x earnings for 8% growth. Compare that to communication services trading at 17.4x for 19% growth. Communication services give you exposure to some of the best companies in the world including Alphabet, Meta (Facebook), and Netflix. You can buy Nvidia at 28x earnings for 40% growth. Compare that to buying Colgate for 27x for 9% growth, Costco at 50x for 11% growth, Procter & Gamble at 23x for 7% growth, or Walmart at 29x for 11% growth. Rate cuts are likely to give investors more confidence to step out on the risk curve, driving mean reversion for many defensive sectors and asset classes.

Many infrastructure-related names (certain semiconductors, industrials and materials) have lagged recently. They have underperformed for a number of reasons, including that they were crowded trades (especially in the Yen carry trade), investors were worried about the economy, and investors questioned whether the AI-spending would continue.

There is now more certainty around all of these concerns. Four important events occurred in September that will likely revive trade. The first is the Fed put while left tail risk related to growth has been reduced. This should promote risk-taking in secular growth names. The second is that Microsoft agreed on a deal with Constellation Energy to restart the Three Mile Island nuclear plant. They expect the nuclear reactor to come back online in 2028.

This long-term commitment gave investors comfort in the staying power of AI spending by the hyper-scalers. The third event is significant stimulus measures from the Chinese government. It includes lowering reserve requirements for banks, making loans to market participants to buy stocks, providing capital for share buybacks, providing relief for homebuyers, and direct payments to their citizens. It is difficult to be bearish when the central bank of the two largest economies in the world is easing.

Finally, Micron said that high bandwidth memory chips are sold out for both 2024 and 2025. Micron increased the TAM by 25% for 2025. Bain predicts that the market for AI-related hardware and software is expected to grow between 40% and 55% annually, reaching between $780 billion and $990 billion by 2027. Investors realize they are positioned too defensively and with the magnitude of the events in September, the infrastructure trade will be rebuilt.

Looking forward, the market will focus on the election, third quarter earnings, and the latest 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