US Strategy Weekly: Rarefied Air

Recent comments by several Federal Reserve Board governors suggest they agree with our base case that there will be only one rate cut this year, if any. However, in our view, Fed policy is no longer the pivotal factor driving financial markets. At mid-year, the S&P 500 and the Nasdaq Composite indices have been setting a string of new all-time highs based on a consensus view that inflation is falling, interest rates are coming down, earnings are rising, and most importantly, the future of generative AI will provide outsized profits for some companies. As a result, the stock market is moving into rarefied air in terms of valuation, with the trailing 12-month operating PE ratio for the S&P 500 reaching 25 this week. See page 10. This multiple has only been higher in 1999-2000 (dotcom bubble), 2009 (due to collapsing earnings), and 2020 (also due to collapsing earnings).

This week’s market mover is Nvidia Corp. (NVDA – $135.58), up 3.5%, to a valuation of $3.34 trillion, just four months after it bettered the $2 trillion mark and a year after breaching the $1 trillion milestone. It is now ahead of both Microsoft Corp. (MSFT – $446.34) at $3.32 trillion and Apple Inc. (AAPL – $214.29) at $3.29 trillion, after tripling in price over the last year. According to Matthew Bartolini, the head of SPDR Americas Research, the Technology Select Sector SPDR Fund (XLK – $231.41) is set to rebalance and recent calculations showed Nvidia’s weighting increasing to 21% from 6% as of June 14. The stock’s performance over the last three trading sessions is apt to boost this weighting. As our tables on pages 16 and 17 show, the XLK has severely trailed the performance of the S&P 500 technology sector, due in large part to its being underweight in NVDA. We expect NVDA’s upgrade in weighting in the XLK will increase demand for the stock, particularly from money managers also underperforming the indices. This will move the stock price even higher. Momentum begets momentum. Nvidia also completed a 10-for-1 stock split on June 10, a factor that often increases demand for stock.

In terms of the consensus view, it is important to point out that interest rates have come down recently due largely to political uncertainties in the European Union. US treasury securities have become the global safe-haven investment for the moment. The European Parliament elections which took place earlier this month resulted in a major shift toward conservative parties which forced President Macron of France, to call for snap elections on June 30 and July 7. Current polls show Macron losing the election. Moreover, the fiscal situation of both France and Italy threaten the stability of the EU. France’s debt-to-GDP ratio of 111% is similar to Italy’s before the euro crisis in the early 2010’s. The IMF forecasts that Italy’s public debt will reach approximately 140% of GDP in 2024. Countries with debt above 90% of GDP must reduce it by an average of 1% per year according to European Union fiscal rules, although the EU is considering new proposals that could replace or amend these rules. Nevertheless, the EU is in political and fiscal disarray, and this boosted Treasury security prices recently.

The consensus view on inflation may also be on thin ice. Investors celebrated May inflation numbers showing a 0.1% decrease in headline CPI to 3.3% YOY, and a 0.2% decrease in core CPI to 3.4% YOY. However, both indices remain well above the Fed’s target of 2% and it is not just housing that is currently keeping headline inflation above 3%. Food away from home and medical care rose much faster in May than headline CPI and are areas of concern. See page 3.

In terms of inflation coming down, many economists are saying CPI numbers are overstated due to the owners’ equivalent rent (OER) index which lags home prices. However, insurance, and fuels and utility prices are soaring, not just rents. Moreover, OER began to decline 12-18 months after housing prices peaked in 2021. Year-over-year house prices were negative in the first half of 2023, but prices are trending higher once again. This suggests OER could start trending higher later this year. See page 4.

And the main issue for inflation is no longer housing, but services. Rising insurance costs have been a major hurdle for families and more recently prices have been increasing for medical care services and other areas of personal care. Core CPI indices that exclude shelter, food, energy, and medical care, have flattened out in recent months, but are not trending lower, a sign that prices are rising-to-stable in a broad range of areas. See page 5.

Another potential roadblock for the Fed’s target of 2% is the rising price of oil. The year-over-year declines in WTI futures (CLc1 – $81.71) and gasoline futures (RBc1 – $2.50) were factors that helped lower the CPI in 2023, but oil prices are rising once again. WTI futures are up nearly 16% YOY. Some PPI indices, like the PPI for finished goods, rose from 2.0% YOY to 2.4% YOY in May. This uptick is apt to continue. See page 6. Overall, we are not convinced that inflation will be steadily moving lower in the months ahead.

The financial crisis of 2008-2009 appears to have triggered a dovish change in Fed policy. The crisis, which had bad mortgage securities and derivatives at its core, required a long period of easy monetary policy to support the balance sheets of global banks which owned too much of these securities. Prior to 2008, the Fed was willing to quickly hike interest rates and slow the economy. But since the Fed was much slower to increase rates and inflation in this cycle, inflation became endemic and it will be more difficult to suppress, in our opinion. See page 7.

And earnings may not be as robust as the consensus believes since there are signs that the consumer is getting tapped out. Retail sales for May were up 0.1% from April’s level, which was below expectations. Total retail & food services rose 2.3% YOY, were up 2.5% YOY excluding autos, and rose 2.6% YOY excluding autos and gasoline. However, real retail sales fell 0.9% YOY, declining on a year-over-year basis for the 14^th time in the last 19 months. See page 8. As the impact of multiple fiscal stimulus packages begins to fade, the consumer is showing signs of fatigue on the higher income level and actual weakness in the middle-to-lower income level.

This also shows up in consumer sentiment. The main University of Michigan consumer sentiment index for June fell 3.5 points to 65.5, the present conditions index declined 7.1 points to 62.5, and the expectations index was down 1.2 points to 67. 6. All three indices returned to recessionary levels. The Michigan survey showed an 11-point decline in income expectations for consumers, to 67, a reading that brings expectations back to levels seen at the end of 2023. See page 9.

Technical Update The Nasdaq Composite index and the S&P 500, led by big-cap technology stocks, continue to make record highs. The Dow Jones Industrial Average is 3% below its record high of May 17, 2024 and the Russell 2000 index remains 17% below its high of 2442.74 made on November 8, 2021. The Russell is trading below its 50-day and 100-day moving averages this week and the DJIA is trading slightly above its two moving averages. It is a stock market of haves and have-nots, much like previous bubbles. However, as deficits and debt-to-GDP levels increase around the world (US, China, France, Italy) it may be the debt markets that become the real concern in the months ahead.

Gail Dudack

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