Does the Fed Really Need to Ease?

Does the Fed Really Need to Ease?

May 29, 2024

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Last week was an interesting week. Major market indexes continued to grind and chop higher last week before running into a pothole on Thursday as the NASDAQ Composite reversed badly on heavy volume but was still able to hold 10-dma support. It seemed that the culprit was Nvidia, whose earnings last Wednesday evening sparked an early rally. This rally reversed in bearish fashion Thursday, but continued upside as NVDA shares provided the impetus for a rebound rally on Friday. In the process the NASDAQ posted a new all-time closing high on light volume ahead of the long three-day Memorial Day Weekend holiday. I found the message that was relayed by Nvidia’s chairman really quite interesting. On the surface the economic indicators have been continuing with the consistent message that corporate earnings, unemployment, wages, CPI and PPI continue to say that the Fed is still to play both halves of the middle as far as interest rates are concerned. They would prefer to ease them to make borrowers happy, but they can't for fear that this would stoke the flame of inflation and possibly reignite higher rates for longer. Here is how the inflation picture has progressed:

And from an analyst at Bankrate, "The Federal Reserve has indicated that it's done raising interest rates for this economic cycle, and while rates may remain 'higher for longer,' investors expect that the only place for them to move is lower. This expectation is helping put a floor under the market — what experts call the 'Fed put' — and even just the anticipation of lower rates helps buoy stocks. “To achieve the Fed's 2% mandate on inflation, it would likely require a recession and a bear market, particularly in the housing sector. But this is an election year, so there is an incentive to prevent this from happening. Further rate hikes could also cause more bank collapses, similar to the Silicon Valley Bank incident last year, potentially trigger a commercial real estate collapse which is in a bubble and make it increasingly difficult for the US to service its growing debt. The University of Michigan’s latest survey showed consumers' expectations for inflation in the year ahead ticked higher in May from 3.2% to 3.5%, both numbers well above the Fed’s 2% target. But markets climb a wall of worry even with the concerns about interest rates and inflation.

But I want to focus a bit more on Nvidia. Jensen Huang, the CEO said in his post earnings comments that the company would have delivered far more chips if they could have been made faster, but production was sort of maxed out. It appears that most major companies- of all types, across the world are demanding these chips for fear of missing the AI boom. I believe that the deflationary effects of these highly sophisticated chips are affecting the entire food chain. Orders are more timely. Inventories are not needing to be quite as robust. Labor can be deployed far more effectively. Waste can be minimized. Basically, every aspect of any product or service becomes more profitable and therefore margins expand, profits expand, and volume doesn't need to expand. This will eventually reach critical mass, but it hasn't happened yet. 

I keep focusing on the NASDAQ as it is still the leader in the growth race of the equity markets. The pre-Memorial Day rally in the index was thrown a curve ball on Thursday as traders were trying to solve the riddle of inflationary growth coupled with deflationary efficiencies as I have mentioned above. Here is a picture of the NASDAQ. Notice the stubbing of its toe on Thursday (but not enough to imply a true directional change) but only to reverse and continue the trend on Friday. 

As this index grinds and churns higher, breadth as measured by the NASDAQ Advance-Decline Line shows that the rally has remained relatively narrow. In a robust breakout to new, all-time highs, we might expect to see breadth at least pushing sharply higher, but the NASDAQ's breakout to new highs this past week was accompanied by steadily declining breadth. I bring this up because breadth seems to be bantered around by many market commentators as an indicator of strength, or in this case a lack of strength. This may be a cautionary sign unless breadth is able to pick up again as it potentially plays catch up to the indexes. In the past weeks I have been discussing how the Russell 2000 index (smaller companies) needed to begin to join the party or a lack of confirmation across company sizes could cause the broad indexes to decline. What is important is that the smaller companies don't need to lead bigger companies, but their index does need to participate. This has been happening and after the small breather index prices took in late April, things seem to be clicking back in gear. 

All of these things seem to be happening at just the right time in the presidential election cycle, as June has historically been the sort of kick off month into the final election period. This seems to be confirmed by this past weekend's interviewee in Barrons, Solita Marcelli. Ms. Marcelli, CIO of UBS Global Wealth Management arm, was asked an important question, "What did you learn from the latest earnings season?" Ms. Marcelli said that results were strong, and guidance was encouraging. "With companies revising expectations higher. The artificial intelligence story is intact. AI had capacity constraints which means they could have been even stronger." She believes the consumer is still strong, with the best view coming from credit card data and banks. She saw some weakness on the low end, but companies with strong brands have been able to push on higher prices. She went on to say that she now expects S&P 500 earnings to grow 11% this year, and cautiously projected 6% in 2025. With this level of earnings growth, the Fed can hardly ease rates!

She expects a soft landing (no recession), and GDP to come in a quite manageable 2% this year.  She also points out that there are more job openings than there are employees available. This brings me back to my comments at the beginning of this note. The Fed can hardly ease if we have full employment, stable wage growth, manageable GDP growth and robust earnings growth. And at the same time, investors of all sizes can earn around 5% on short-term paper. Given the still full coffers of cash out there, the flow of available investable capital could really only be negatively affected, psychologically, by some type of black swan event. 

As June begins at the end of this week, I want to share a chart from Thomas Lee of FundStrat. As you can plainly see, when markets have acted as they have this year, June has had a 100% success rate at a positive outcome. Of course, past performance is no guarantee, but I do like to deal in high probabilities!

Should the economy remain not too hot nor cold, rates higher for longer could help major stock averages continue their uptrends in anticipation of a rate cut and due to the ongoing stealth Quantitative Easing. Should the economy run too hot, a rate hike would be damaging to markets. Should the economy run too cold, rate cuts could also be damaging to markets as it could mean the Fed was behind the curve so have to now step in aggressively as has happened in some prior cycles such as in 2001 and 2008. Hence the reason for this week’s title. It is continuing to be evident that the Fed can pretty much let the markets live and breath unless a black swan is born or there is some shock either positive or negative to the economy.

Please let us know if you have any questions that we can address we will be more than happy to answer them. We hope you had a terrific Memorial Day and that you are gearing up properly for a wonderful July 4th celebration as well. 

- Ken South, Newport Beach Financial Advisor


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