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- The Federal Reserve (Fed) went from talking tough and acting dovish to talking dovish, setting off an impressive rally in equities and Treasuries.
- Rates markets may be pricing in six rate cuts in 2024, but we suspect equity investors would be selling off if they believed that because it would almost certainly be due to a looming recession.
- Apart from the Fed, equities continue to get a lift from solid earnings and outlooks, and we expect that to continue.
- We expect a gentle rally to continue into yearend.
- Only 13 companies report this week, but they include macro bellwethers such as FedEx, Carnival Corp. (cruises); Nike Inc.; and used car vendor CarMax (KMX).
- The rate-driven rally in interest rate sectors has run its course for now. We move homebuilders (XHB), regional banks (KRE), REITS (XLRE) to marketweight.
- Our favourite long remains the Russell 2000 (ETF IWM).
What We Learned Last Week
‘Tis the season where we make our holiday wishes and look hopefully to the New Year, and things are looking good!
We have been looking for a nice rally into yearend, and got it last week, with the S&P 500 (SPX) up 2.5%, NASDAQ 100 (NDX) up 3.3%, and Russell 2000 (RTY) up 5.6% (Chart 1). RTY has now gained 9.7% in December – well over twice the SPX and NDX.
We have been looking for a gentle rally, largely on the strength of traditional seasonals and a generally good tone in the market. The inflation prints fit that narrative; and we expected the Fed would follow suit with a more or less neutral message. But instead, it delivered a strong tailwind. If Fed Chair Jerome Powell did not outright promise rate cuts, he certainly implied that the Fed would be open to that if inflation eases. Treasuries further amplified the tailwind as the 10Y Treasury yield dropped 30bp after the meeting to 3.91%.
The market is now pricing in three rate cuts by June and six by December. If nothing else, common sense suggests – maybe even dictates – that cuts of that magnitude would almost certainly mean the Fed is taking desperate steps to forestall a looming recession. And we would hardly expect equities to be rallying hard given that outlook.
We are inclined to think investors are not delusional. More likely, most see inflation settling into a stable and gradually declining path while the Fed stands by. Fed funds near 5% is a headwind but it does appear the economy and labour market can continue to cope. As long as the next rate move is likely to be lower, equities are looking at something between a green light and flashing yellow light.
Earnings also continue to support the constructive market tone.
- Costco rallied nearly 3% on a solid beat and upgraded outlook – very impressive for a widely followed large company.
- Steel producer Steel Dynamics Inc. (STLD) jumped 5% on a solid beat and robust order book.
- Home builder Lennar Corp. also posted beats but sold off of all-time highs on a potentially soft gross margin outlook.
AI Vendors Take a Hit – The soft spot in earnings has been Oracle (ORCL) and Adobe (ADBE). We put them on our suggested list back in September based on their ability to capitalize on rising AI investment over the next year. Both sold off sharply post-earnings, ORCL by 12% on a small revenue miss and ADBE by 8% on a softer-than-expected outlook.
We think the AI story remains intact. These are not AI companies, but they are effectively vendors to AI companies. Their products and services are akin to the dry goods merchants who profited off selling picks and shovels to the miners during the California gold rush. That said, these selloffs are an object lesson in the volatility inherent in a hot sector like AI. We view these as developing 2024 stories rather than short-term technical plays. We like to take advantage of lower prices to add to positions.
RTY is a Winner – Our favourite long position remains the Russell 2000, represented by the ETF IWM.
Scale Back Interest-Sensitive Sectors – Homebuilders and regional banks have been among the most interest rate-sensitive sectors in recent months, underperforming through October, then sharply outperforming SPX by about 18% since then (Chart 3).
We were admittedly surprised at the Fed’s dovish stance and did not expect the final Treasury rally to sub-4%. But barring the unlikely event of a collapse in inflation, we think the Treasury rally and rate-driven rally in interest-sensitive sectors is over. Other interest sensitive sectors include REITS (ETF XLRE) and mortgages (ETF MBB).
As we noted last week, we still like these sectors from a fundamental standpoint. But for now, we expect these sectors to perform more in line with SPX.
We like scaling back overweight positions to marketweight.
The Week Ahead
It is another slow week for earnings, with only 13 companies reporting. This is the last batch of earnings to be released in 2023.
This week’s earnings should provide a variety of clues about the evolving macro outlook into the first few months of 2024.
At the top of the list is Micron Technology (MU), which first sounded the alarm about rising commodity semi-conductor chips inventories in June 2022. It has struggled since then to work off inventories and align supply with demand. It further is battling a ban by China on some of its exports. Investors will be focusing on how MU is managing these challenges, as well as any insights on demand outlook for mobile phones, PCs, and other products that rely on commodity chips.
Investors will look to FedEx (FDX) for new signs on whether the so-called ‘freight recession’ remains ongoing or is about to break.
Nike Inc. (NKE) should provide clues on domestic and international demand for upscale athletic gear and sportswear.
People have been willing to spend on cruise holidays throughout 2023 – Carnival Corp.’s (CCL) outlook for 2024 may confirm whether that demand is likely to continue.
CarMax Inc. (KMX) has proved adept at managing through the fraught second-hand auto market and that will likely continue – but how does demand for used autos look at still high rates and high prices?
Key upcoming earnings reports:
- Accenture (ACN).
- FedEx (FDX).
- General Mills Inc. (GIS).
- Micron Technology (MU).
- CarMax (KMX).
- Carnival Corp. (CCL).
- Nike Inc. (NKE).
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.