Even though investors are no doubt thrilled that the S&P 500 is back at all-time highs, this chart demonstrates why this is actually a dangerous thing. Once again, mega-cap growth and tech is the only game in town. It’s not entirely surprising given that tech tends to do relatively well in late cycle economic growth periods, but the lack of market breadth is concerning for sustainability. We are definitely in the late cycle. Growth is positive but trending slower. Manufacturing is slowing. Cyclicals have completely fallen apart and small-caps are in just as bad of shape. Consistently throughout this cycle, we haven’t seen much beyond traditional large-cap growth/tech sustain any meaningful outperformance. Is that a function of all the government stimulus and liquidity being pumped into the system as opposed to genuine organic growth? It’s entirely possible and it looks like the trend is getting worse as the Fed dials back its balance sheet runoff and prepares to cut rates later this year.
We’re about to get two major market events that could shape the short-term direction of the markets. Wednesday’s inflation report, where forecasts call for 0.3% core inflation and 0.1% headline inflation, is likely to confirm the trends we’ve seen in place over the past year. In particular, core inflation remains sticky and stagnant and immediate relief is still not in sight. With the annual rate moving lower over the past several months, a lot of investors feel that the disinflationary trend is still intact. It isn’t. We’ve got several months of low base effects about to roll off of the 12-month calculation, which means the street is about to see the annual rate rising again. Perhaps that’s the impetus to get investors concerned about the idea that inflation isn’t going away, but even if it doesn’t, this is the thing that’s going to make it really difficult for Powell to be taken seriously if he tries to take a dovish tone this week in his post-meeting commentary.
Speaking of which, the Fed is likely to pivot this week from its earlier forecast of three rate cuts by the end of 2024. As it stands today, the market is pricing in about 1.5 cuts, but Powell has taken a pretty consistently hawkish tone over the past several months. I think he wants to cut rates in order to preserve the soft landing, but knows that he can’t reasonably do it with a core inflation rate trending at 4% annually and not going down. Rate cuts at this point might be too risky, which is why I think the Fed is choosing to loosen instead by slowing balance sheet runoff if it can't do it with rates. This allows liquidity to be preserved in the same and available should the labor market crack, growth slows too quickly or consumers just stop spending. Rate cuts could take 12 months to be felt. Billions of dollars worth of bonds could have a much more immediate impact.
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