US economics, inflation, and the Fed
The markets received good news on the inflation front. After the February Consumer Price Index (CPI) came in cooler than expected, the Labor Department’s companion report on producer prices showed an even sharper decline in the pace of price growth at the wholesale level. While the Producer Price Index (PPI) was unchanged last month after climbing 0.4% in January, the core PPI, which excludes the energy and food components, was up just 0.2%, coming in below forecast.
The Fed held the federal funds rate steady at its March monetary policy meeting. Although inflation eased a bit in February, the central bank is not in a rush to cut the benchmark short-term interest rate again. According to Value Line, the Fed prefers to take a wait and see approach with monetary policy, as it assesses the impact of the Trump Administration’s tariffs on consumer and producer prices and the overall pace of economic growth stateside.
As Professor Siegel puts it: “The key question now becomes how much of the Fed’s downward GDP (Gross Domestic Product) revision — from 2.1% to 1.7% — is temporary. A softer first quarter seems likely, with real growth tracking just 1 to 1.5%, well below prior projections. Yet Powell pointed to non-economic factors weighing on the numbers, including a steep drop in immigration that’s reducing labor supply and cushioning the unemployment rate. The immigration slowdown may also explain why unemployment projections for 2024 and beyond remain relatively flat, even as GDP expectations decline.”
The uncertain fiscal policy may be taking a toll on the U.S. consumer sector. Shoppers are worried that the tariffs placed on imports will drive prices higher in the months ahead. On point, the University of Michigan’s preliminary Consumer Sentiment Survey plunged to 57.7 this month, down double digits from the February figure and the lowest reading since November of 2022. The Commerce Department reported that retail sales, after falling 1.2% in January, rose just 0.2% last month, which was well below the consensus forecast of 0.6%. If consumer spending were to weaken, that would put some negative pressure on the pace of the nation’s GDP growth.
Global economy
Early this month JP Morgan raised its assessment of the probability of a 2025 US/global recession to 40%. This shift only partly reflects an anticipated larger global growth drag from US trade policy. Model estimates based on the bank’s revised expectation of tariffs to be announced by early April — which will likely move the effective US tariff rate above 10% — center around a 0.5% drag on 2025 US and global GDP. JP Morgan believes that even after accounting for likely retaliatory actions, this drag is not large enough to threaten an expansion that stands on fundamentally solid ground.
Of concern, however, is that three related impulses magnify the size of this drag. First and foremost, a large negative business sentiment shock could take hold as Trump administration actions and rhetoric flips the switch on the widely held view that it will maintain a business-supportive policy stance. Second, key sectors of the North American economy could face disruption as US policy moves aggressively to restrict trade and immigration. Finally, prospects for preemptive Fed policy to cushion these magnifying effects are constrained as US inflation expectations move higher.
JP Morgan assesses recession risk as elevated but neither activity nor sentiment readings point to an imminent break. The US economy is moderating from its 2.9% GDP gain over the past two years as support from immigration and government spending wanes. But the sharp current quarter downshift largely reflects an unwind of the 13% consumer durable spending spike in the second half of 2024 and a current quarter import surge. Looking through these volatile swings, solid gains in hiring and indications of a pickup in business spending on capex and inventories suggest underlying growth tracking around 2%.
The surge in US imports depressing US growth is boosting activity elsewhere. Global Industrial Production rose at a 3.8% annual rate in the three months through January and early February readings look strong. The recent surge in Asian exports is striking and indicates an anticipated front-loaded lift in global goods activity in advance of prospective tariffs. An upward revision to current quarter China GDP growth offsets recent US downgrade. JP Morgan sees the risk to its forecast for a solid 2.6% current quarter global GDP gain as skewed modestly to the upside.
Stock market rotation
Starting in February the leadership in the stock market shifted from Growth and Magnificent Seven to more Value and Quality stocks. While valuations of mega caps don’t seem too far stretched by historic standards, the broader market outperformance is a healthy sign of a more sustainable albeit probably more subdued growth.
In their recent paper “The AI Boom vs. the Dot-Com Bubble: Have We Seen This Movie Before?” Research Affiliates explains that narrative-driven markets can always create asymmetric risks, and while history tends to rhyme rather than repeat, the similarities between the turn-of-the-millennium dot-com bubble and today’s AI exuberance are too obvious to ignore. The authors state: “Powerful stories drive returns and propel bull and bear markets alike. They have an undeniable and often era-defining allure. The dot-com bubble, the COVID-induced value crash, and the recent AI-fueled bull market all demonstrate their power and appeal. The good news is that these stories are often largely true, which is why people believe them. The bad news is that by the time they fully take hold, their value may already be captured, if not exaggerated, by current share prices. As a result, these narratives are useless unless investors identify where they are wrong or where they have asymmetric risks.”
The authors highlight the importance of establishing an investment philosophy, which doesn’t necessarily deny the opportunity presented by AI and other breakthroughs. The philosophy should be based on establishing portfolios driven by companies’ fundamentals and their economic footprint. That way, we could have all the mega players in the portfolio, but their weight might be different from a passive index and reflect the strength of companies’ fundamentals rather than their market cap. That is exactly the way we at Signet manages our active portfolios and makes tactical shifts in asset allocations.
The following exerts from the paper provides more color to the argument:
“The internet will change everything. That was the story of the dot-com bubble: The “information superhighway” would revolutionize how we work, communicate, socialize, and inform ourselves. It was all true. Yet the 10 most valuable tech stocks in 2000 underperformed the S&P 500 for the next 15 years. Why? Because the narrative missed two important nuances: It assumed that early dominance meant enduring dominance, and it overestimated the pace of change.
In the dot-com era, as in all others, disrupters were disrupted. The smartphone pioneer Palm, Inc., for example, was more valuable than General Motors in early 2000. By 2003, however, it had been overtaken by BlackBerry, which achieved its peak 20% share of the global smartphone market in 2009. BlackBerry’s reign was also short-lived. Apple launched the iPhone in 2007 and surpassed BlackBerry three years later. By 2013, BlackBerry accounted for less than 1% of the smartphone market and less than 0.1% by 2016. Technological disruption is unforgiving, and amid intense innovation and competition, industry leaders can be quickly dethroned.
The narrative of the 2020 pandemic value crash was an extension of the dot-com story. COVID-19-related lockdowns meant that internet technology would finally come to dominate communication and commerce. Value players, particularly in “in-person” industries, would face sweeping bankruptcies as the world adapted to the pandemic. It was all wrong. The stimulus blowout, among other factors, forestalled business failures and primed the pump of pent-up demand that would revive the restaurant and travel sectors. Value companies fared just fine, for the most part, even as value stocks took a drubbing.
The story of the AI-fueled growth market of 2023 and 2024 closely echoes that of the dot-com bubble. Like internet technology, AI will transform the world. It will anticipate our needs and wants, conduct our research, and predict the future better than any of us mere mortals. It will also displace millions of highly skilled workers. The leaders of AI today will be the leaders of tomorrow because they are creating that tomorrow. The transition will be astonishingly swift, with AI surpassing the intelligence of Nobel laureates by 2026 and the combined knowledge of all of humanity by 2027.
This AI narrative, like its dot-com predecessor, may be largely correct. Anyone who has tinkered with ChatGPT knows that user-friendly AI is transformational. But as with all technological innovation, the pace of human adoption may be slower than the visionaries predict. Modern-day Luddites and digital immigrants will delay the inevitable embrace of these new innovations. Some early leaders may lose their edge amid the fierce competition or even disappear altogether.
Like the internet highflyers of 2000, today’s AI darlings must exceed already lofty expectations to beat the market in the years ahead. If cracks form in the narrative — if the fundamentals fail to keep pace with investors’ fanciful projections — the broader story may begin to crumble and even collapse completely. This can cause sharp market downturns, outsized investor losses, and a cascading effect that turns bull markets into bears.
When markets buy into a narrative, pricing in the best possible outcomes and ignoring the potential challenges, asymmetric risks develop. We love asymmetric risks. For instance, what if AI, like the internet, takes a decade or two to embed itself into the economy? And what if today’s AI leaders are themselves displaced? High-margin businesses attract competition. This costs the top players market share and erodes their pricing power and profit margins…”
To conclude, we are big believers in technology in general and in AI in particular. We embrace all the new opportunities with great enthusiasm and optimism, but at the same time as prudent investors who know and respect repeating history, we keep our portfolios well exposed to the promising themes and to a lesser degree to individual names to capture the full power of the markets!
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: WSJ.com, Jeremy Siegel, Ph.D. (Jeremysiegel.com), Goldman Sachs, J.P. Morgan, Empirical Research Partners, Value Line, BlackRock, Ned Davis Research, First Trust, Citi research, HSBC, and Nuveen.
IMPORTANT DISCLOSURE
Past performance may not be indicative of future results.
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