US economics, inflation, and the Fed
While Inflation is slowing down, the economic data produces mixed signals. The Consumer Price Index (CPI) increased 2.9% for the 12-month period ended July 31st. This was the first reading below 3% since 2021 and, along with a sharp retreat in the July Producer Price Index (PPI), indicates that the Fed’s most restrictive monetary policy course in four decades is effective. The latest data suggest that the domestic economy is slowing following a solid second-quarter showing. On the one hand, retail sales did advance by an outsized 1.0% in July, far exceeding the consensus forecast. On the other hand, a closer look showed that much of the gain was fueled by the upper (and wealthier) classes, while lower- and middle-income households have cut back on spending according to Value Line. Meantime, industrial production fell more than expected last month, and residential construction, an important contributor to the nation’s gross domestic product (GDP), declined sharply.
The stage appears set for the Federal Reserve to begin reducing the benchmark short-term interest rate at its September Federal Open Market Committee (FOMC) meeting. Consensus expectation is that the central bank will implement a quarter-point cut, despite calls for a half-point reduction from Wall Street. With inflation moving in the Fed’s desired direction, the FOMC may be more concerned about staying “too restrictive for too long” and jeopardizing the possibility of a soft landing for the economy.
Global economy
While making no material changes to growth or inflation projections over the past two months, JP Morgan sees more downside risk to both. There has been a midyear loss of momentum in the Euro area and China amid weakening global manufacturing surveys. US GDP growth is tracking a solid gain pace, but labor demand has softened with hints of slowing labor income gains and rising layoffs.
Although the August flash manufacturing PMI (Purchasing Manager’s Index) continues to show weakness, the all-industry developed markets reading moved higher, due to a broad-based rise in services. However, the Euro area August bounce may reflect a temporary boost from the Olympics and Taylor Swift. Elsewhere the survey points to more sustained strength and JP Morgan nudged higher their second-half 2024 GDP forecasts for the US, UK, and Japan in recent weeks. The bank predicts the US economy to grow by 2.5% and the global economy by 2.6% this year.
Stock market, factors, and economic sectors to dominate
The second-quarter earnings season was a successful one for Corporate America. While a handful of prominent companies missed estimates and/or lowered forecasts, profit growth for S&P 500 companies averaged over 10% for the period. That was good enough to provide support for most stocks that were trading at elevated price-to-earnings multiples entering reporting season according to Value Line.
Moreover, the market widely prices in the Fed starting to cut interest rates in September. Professor Siegel notes:
“As for the market’s response, there was a noticeable tilt towards value, dividend-paying, and smaller-cap stocks after Powell’s talk at Jackson Hole. This trend reflects a broader anticipation of decreasing interest rates, making bonds less attractive to stocks in comparison. It also suggests a potential shift in investor preference from high growth but volatile tech stocks, to more stocks paying good dividends, a realignment that could define the next phase of market behavior.”
While it is tempting to throw all your eggs into the Value and Small baskets, we need to be cautious about overreacting here. Empirical Research Partners note:
“We looked at how the fundamentals and valuations of today’s Tech Leaders compares to their predecessors at the peak of four past tech booms: the Mainframe Era of the late-1960s, the PC Era in the early-1980s, the infamous New Economy Era that peaked in early-2000, and most recently the surge in stay-at-home tech plays early in the Pandemic. Compared to their ancestors, the current crop of Tech Leaders is less extreme in most dimensions.
For example, the capex growth rate of the Tech Leaders this time has been much slower than what we saw for the Leaders in the three years leading up to past tech peaks, and their valuations are far lower. At the four prior tech peaks, the Tech Leaders were priced at an average forward-P/E premium that ranged from 2.4 times the market (in the early-Pandemic surge) to six times (at the peak of the New Economy Era). Today’s reading is 1.8 times. Keep in mind that the free cash flow margins of today’s tech leadership average 21%; at the New Economy peak they were 1.4%.
The rising controversy and big spending in the tech leadership warrants some scrutiny but we don’t think we have the weight of evidence needed to abandon the leadership wholesale. We’ve been taking some profits in our winners, like the semis, but we don’t think the setup favors any abrupt reallocations. The opportunity cost of being out too early is high and the events of the past few weeks have once again illustrated the danger of “overreacting to the tape.”
Judging by Signet’s proprietary Macro Score 1 Year multi-factor subgroup weights (the model shows which factors project to be more important in the next 12 months) we can see that Growth is actually in the driver’s seat and agree with Empirical’s assessment cited above.
On the Sector front, Signet’s proprietary forecast for the following 12 months favors the following:
We maintain our barbell approach (although we narrow it down a bit, over-emphasizing more profitable companies). We believe it makes sense to keep exposure to Large Growers of a GARP nature (pockets of Technology, Communications, and some Discretionary), which is the cohort of Large Growers outperforming their expensive peers. However, we also like cyclicals at attractive valuation levels, and we find it appropriate to maintain a healthy exposure to Financials, Industrials, and Technology. We have become more positive on Real Estate as interest rates are declining. We are underweighted in Utilities. We maintain adequate exposure to Healthcare which worked well in 2022 as a hedge and should do the same in the future.
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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