One of the big stories in markets this year has been the hale performance of Japanese equities, with the benchmark Nikkei 225 index finally clawing back to and surpassing the record high it had set 34 years earlier, at the end of calendar year 1989. Currently the Nikkei is up 13.2 percent for the year – not bad! But that’s 13.2 percent in local currency terms. Unfortunately for investors whose portfolios are calculated in US dollars, the Japanese yen is down around ten percent versus the greenback. So that nice gain on Japanese stocks winds up as a fairly anemic low-single digits return when it shows up on your dollar-denominated quarterly statement.

And it’s not just Japan. Currencies everywhere, across the spectrum of developed and emerging economies, are down against the dollar this year, and that trend has accelerated in recent weeks.

Higher For Longer

The strong dollar is a direct outcome of the market’s long-overdue realization that US interest rates are likely to stay higher for longer, with doubts now growing that the Fed will cut rates at all. “America’s interest rates are unlikely to fall this year” ran a headline in the Economist magazine this week, which sums up the sea change in conventional wisdom about rates from the euphoria that prevailed at the end of last year. Three successive readings of hotter than expected inflation put paid to that short-lived era of good feelings (it also validates what Fed chair Jay Powell said at the post-FOMC meeting press conference in early February about the Fed not yet being convinced by the data that the inflation dragon was slain). Higher interest rates attract more foreign money into dollar-denominated securities.

Not only are US rates likely to stay high relative to other countries; the US economy is also growing faster. This week the IMF raised its estimate for real US GDP growth in 2024 to 2.7 percent, which follows a much stronger than expected growth rate of 3.1 percent last year. Other economies fare less well in the IMF’s reckoning, with Germany expected to grow just 0.2 percent, Great Britain at 0.5 percent and Japan at 0.9 percent. Put together, the combination of higher interest rates and a stronger economy is amplifying concerns among policymakers elsewhere in the world that their currencies have further to fall.

Remembering 1997

These concerns came to light this week as the mandarins of monetary policy gathered in Washington for the Spring Meetings of the World Bank and IMF. In a rare joint statement, the finance ministers of Japan and South Korea joined US Treasury Secretary Janet Yellen to express “serious concerns” about the recent sharp falls in their respective currencies, the yen and the won, against the dollar. That statement provided at least a bit of relief in currency markets, as Asian currencies gained a little ground. For the finance ministers the concerns are well-founded. In the summer of 1997 a sudden and sharp devaluation hit Asian markets from South Korea to Thailand, Malaysia and Indonesia. Portfolio managers had poured billions into these “Asian tiger” markets earlier in the decade, but fears that the economies had gotten too far ahead of themselves sparked a panicked rush for the exits and a period of painful adjustment for the countries in question.

To be sure, we do not foresee a repeat of the 1997 crisis. Central banks are much better-positioned today in their foreign exchange reserves than they were back then. And there are benefits to a weaker currency for countries with a high reliance on exports for growth, which includes much of the Asia Pacific region. But instability can beget more instability, which is why Yellen and her Japanese and Korean counterparts took pains to issue that joint declaration in support of restoring currency stability. We will see in the days ahead what the central banks will do if jawboning on the sidelines of an international conference does not stop the selling.

With all due respect to T.S. Eliot, April is not necessarily the cruelest month – but so far it has not been particularly upbeat either, as far as US equities are concerned. The S&P 500 established its last record high on the last Thursday in March, right before the long Easter weekend. Since then, stocks have bounced around – with a bit more volatility than we’ve been used to seeing lately – in a mostly directionless manner.

As usual, there are quite a opinions out there as to what it all means – is this a pause before a long downward spiral, thanks to peaking valuations, persistent inflation and interest rates staying higher for longer? Or is it a pause before the next rally, driven by stronger than expected corporate earnings, an indefatigable labor market and resilient consumer spending? Or are we going to drift, Flying Dutchman style, in a manner reminiscent of 2015, when the S&P 500 started the year at 2057, bounced all over the place and ended at 2043, effectively a year-on-year change of zero percent?

To Pause Is Normal

It goes without saying that there are plenty of unknowns that lie between here and the end of December, so making a long-term prognostication at this point is silly (just witness all the major securities firms already revising the year-end predictions for the S&P 500 they made on January 2). But it is not necessarily surprising that the market finds itself in a bit of a non-directional corridor. Just consider the market’s progress since October last year. From October 27, the lowest point of the fourth quarter, the index gained 27.6 percent to its most recent record close on March 28. That’s a hefty advance, and it is to be expected that a bit of profit-taking and hitting the pause button has ensued.

Moreover, there are good reasons to take into consideration both the optimistic take of a still-strong economy and commensurately robust corporate earnings, and the pessimistic view of sticky inflation and higher interest rates (relative to the bond market’s earlier unrealistic expectations). Both outlooks have evidence to support their case; most recently, the pessimists got a solid data point in hand with a Consumer Price Index report showing March prices rising more than expected. That sent stock prices sharply lower on Wednesday. The effect was relatively short-lived, though, as Thursday brought a cooler than expected report on wholesale prices and a subsequent reversal of most of the prior day’s losses in the stock market.

Taking Things In Stride

We actually think the market has taken recent developments relatively well, considering the major repricing of expectations that has been going on in the bond market. We talked about this last week, with the expectations for six interest rate cuts running into the harsh wall of reality to the extent that the bond market is now pricing in somewhere between one and two cuts in 2024. Changes in interest rates are a key driver of equity valuations as rising rates lower the present value of expected future cash flows. Those lower present values, in turn, magnify already-high price-to-earnings ratios and fuel concerns that the market is in bubble territory. Given the substantial change in interest rate expectations, it is perhaps a good sign that share prices are only a bit off their end of March highs.

The Q1 earnings season is officially underway as of today, with a handful of big banks leading the way (traders don’t seem particularly happy with the first batch of bank earnings, having expected/hoped that they might have raised forward guidance on net interest margins in light of expected higher interest rates). We will be looking for signs of upward or downward revisions in sentiment about macro uncertainty as management teams speak with analysts over the coming weeks. For now, we’ll stick with our assessment that the current pause is not the tipping point of a protracted downward trend, but we will have to see what the data tell us in the weeks ahead.

Let’s just say that it has not been a great time in recent weeks for the Six Cut Crowd. You remember these folks, the ones who took the Fed’s three rate cut scenario at last December’s FOMC meeting and promptly doubled that scenario. Not three, no, no, no, but six rate cuts in 2024! That seemingly (to us, anyway) outlandish view fully priced itself into the bond market and pushed yields down as the year came to an end. The 10-year Treasury yield, which had briefly touched five percent in October, ended the year around 3.8 percent. Equity investors got a nice little rally in stocks thanks in large part to those lower yields.

The problem we had back then with the six cut scenario was threefold. First, the Fed itself was making no such prognostication, saying (as it had been saying for months before then) that there was much more to be done before declaring victory over inflation. Second, the economy was running strong. Real GDP growth of 3.1 percent, which is where it finished in 2023, is well above the Fed’s own long-term growth estimate of 1.8 percent. And, third, the idea of a studiously apolitical Fed knocking down rates six times in an election year seemed like a complete non-starter.

Still Growing After All This Time

That was then. What has happened since then? Well, the economy is still growing. As diligently as everyone is looking for signs of a consumer slowdown, the numbers keep telling us that household spending continues apace. The labor market is not showing signs of slowing. Today’s report from the Bureau of Labor Statistics showed payroll gains of 303,000 in March, significantly higher than the 205,000 predicted by economists. Yes, jobs numbers are a lagging, not a leading indicator. But the average number of payroll gains for the last four BLS reports is 279,000, along with an unemployment rate that has not varied from a range of 3.7 to 3.9 percent since last August. As for GDP growth, the numbers for Q1 will come out in a couple weeks, but the most recent median forecast by the Blue Chip Economic Indicators consortium of economists is 2.0 percent, and the Atlanta Fed’s GDPNow forecast is 2.5 percent.

Crude Observations

There is another curve ball messing up the rate cut outlook, and that is the recent surge in oil prices. Now, as we have discussed many times in these pages, changes in the price of oil and other energy commodities do not factor directly into the Fed’s deliberations on inflation; the volatile categories of energy and food are stripped out so as to focus on the less volatile “core” categories of goods and services. But that hardly means that the impact of higher energy prices goes unobserved. After all, energy commodities are a key input into the manufacturing of those other products that do figure into core inflation, as well as transportation costs for the performance of services and so forth. West Texas Intermediate crude oil is up more than 21 percent so far this year, and that will probably not come as a surprise to you if you have been driving past your local neighborhood filling stations recently.

The March Consumer Price Index report will come out next Wednesday. Economists are expecting to see a core CPI reading of 3.7 percent year-on-year, based on an assumption that the month-to-month change in March will be 0.3 percent. Headline CPI, which includes the volatile food and energy categories, is expected to bump up to 3.4 percent from the previous 3.2 percent reading, mostly due to those increases in energy commodities. If the numbers come in hotter than forecast – as they did for both the January and February reports – the chances of a first rate cut in May or June will likely diminish accordingly. At that point the calendar gets tricky. We think it likely that the period from Labor Day to November 5 will be effectively a blackout period as the Fed will seek to keep monetary policy out of the election.

One And Done?

Will there in fact be any rate cuts at all? Raphael Bostic, the head of the Atlanta Fed, opined recently that he thinks there will only be one, and that would come after the election. Bostic is an outlier among FOMC members, the majority of whom still think a two or three rate cut scenario is most likely. But the numbers we’re seeing today – oil prices, economic growth, jobs and consumer spending – don’t paint a rosy picture for those still hoping for a rate cut pony out back. One rate cut may be lowballing things. But six? That’s right out.

A few weeks ago we used this space to write about China and India, the two largest countries in the world by population that both figure prominently into the global economy. If you recall from our commentary that week, India’s stock market has been going gangbusters while China’s has brought nothing but disappointment to those looking for a portfolio win from there. Not surprisingly, therefore, there has been a good deal of chatter among market pundits recently encouraging investors to get on board the India train. It’s easy to tout the benefits of a trade when that trade is enjoying a hot streak of outperformance. It’s something else entirely to back a long shot. And make no mistake, the investment case for China today is a long shot. It’s not something we are prepared to commit any serious money to today. But there is a case to be made – and to be followed closely, if not necessarily acted on yet.

In Need of Something New

The main problem China’s economy faces today is that its primary engine of growth for the past 30-plus years is in dire straits. Property and infrastructure investment, in fact, has been the single most important driver of economic performance throughout the entirety of the country’s development following the death of Mao Zedong in 1976. But in the past three years this sector has completely unraveled, with the failures of several of the largest property developers and, consequently, a sharp retrenchment in housing starts and other relevant measures of health. The saga of Evergrande, one of those failed property developers, played out like a bad soap opera for three years until a Hong Kong court finally enforced a liquidation on what remained of the bankrupt company back in January. A general rule of thumb is that the property and investment sector contributes about a third of China’s total GDP. So if this sector is going into reverse, what new thing is going to enable Beijing to meet its commitment to growing the economy by at least five percent every year?

Clean High Tech Manufacturing

The answer, made abundantly clear in a state of the nation report Prime Minister Li Qiang gave earlier this month and since repeated incessantly in the Chinese press, is high tech manufacturing, with a deep focus on clean energy. On one level this makes a great deal of sense. China already leads the world in some important green technology segments including solar panels, batteries and electric vehicles. Late last year the country’s largest EV manufacturer, BYD, surpassed Tesla as the world’s leading producer of fully electric cars and trucks. This year, the share of China-made EVs in the European market is expected to surpass 25 percent, unless the EU slaps some hefty tariffs on imports. China also is way ahead of the rest of the world in the extraction and refining of most of the key raw materials needed for clean energy manufacturing. As the world tries to move away from dependence on fossil fuels, China stands to be the country setting the pace and reaping the lion’s share of the benefits.

But Where Is The Consumer?

That’s a big part of the investment case. But the case has some big risks, as well. For a start, the obsessive focus on manufacturing as the growth engine does not deal much at all with another big problem in China’s economy – the lack of a vibrant consumer sector. Household consumption contributes less than 40 percent towards China’s total GDP. The comparable figure in the US is close to 70 percent, and it is around 55 percent in the EU. Back in the middle of the 2010s Beijing’s economic authorities tried to orchestrate a rebalancing of the economy away from property and infrastructure towards household consumption. But a sharp currency devaluation and subsequent economic slowdown in 2015 brought that plan to halt, and Beijing went right back to the old standby of property. There’s a trajectory from that decision to the failures of Evergrande and its ilk more recently. It is far from certain that China can achieve a sustainable growth story on the back of high tech manufacturing alone, without the help of a strong consumer sector.

The second big risk is geopolitical. China may well continue to lead the world in all things clean tech, but it won’t matter much if other markets around the world put up massive barriers to Chinese imports. There is a good reason why Xi Jinping dragooned a bunch of US CEOs, in Beijing this week for an annual business conference, into a heavily publicized meeting in the Great Hall of the People to tell them not to give up on the very wonderful opportunities that China’s future will offer them. Xi knows that US political opinion is not working in China’s favor, and he will need all the help he can get from the titans of the private sector to counter the high tariffs and other barriers contemplated by current and future administrations in Washington.

So there it is. As with any investment decision there are risks and opportunities. We continue to believe that the risks outweigh the upside, but we also believe that the opportunity demands continued study.

No, Jay Powell did not do a happy dance at the post-FOMC press conference, but the Fed chair was feeling good on Wednesday and it showed. And why not? The big takeaway from the much-anticipated “dot plot” – the Summary Economic Projections representing Committee members’ best guesses about the economy and interest rates – was the upward revision in growth expectations. After growing 3.2 percent in the fourth quarter last year (and 3.1 percent for 2023 overall), the median FOMC projection for 2024 real GDP growth is 2.1 percent, up substantially from the 1.4 percent median estimate in the last set of SEP numbers last December. And yes, with that higher growth estimate came expectations of somewhat stickier inflation, with the core PCE now projected to be 2.6 percent this year, compared to the December ’23 estimate of 2.4 percent. On that point, though, Powell’s customarily tight-lipped countenance nearly broke out into a smile as he pronounced that “we will get inflation back to 2.0 percent, we will absolutely get there.” Mic drop.

Breaking the Doom Cycle

Powell is a student of history, and knowing the history of Fed monetary tightening cycles past is what gives the Fed chair just cause for a bit of joyfulness. Consider the story told in the chart below, of all the monetary cycles since 1970.

Those grey columns you see in the chart represent periods of US recession. Almost every major tightening cycle since 1970 has ended in recession, including the sharp downturns of 1973 and 1980, and the Great Recession of 2008. This chart explains why the conventional wisdom among economists at the beginning of 2023 was so uniformly of the view that a recession was on the horizon. But this time, or so it appears for now anyway, is different. In fact, while Fed officials are now increasingly comfortable using the term “soft landing” to describe the end of the 2022-23 tightening cycle, the phrase heard more frequently on the Street now is “no landing” – as in, not even a slowdown. We’re not sure that the Street is any more on target about this than they have been with their interest rate cut fantasies of late, but we will concede that the data pointing to a marked slowdown in the economy have not shown up yet in any meaningful way (although a recent upward trend in credit card and auto loan delinquencies may be a sign of things to come).

About Those Rate Cuts

What had traders waiting with breathless anticipation more than anything else, of course, was to see whether the Committee members’ estimates last December for three 2024 rate cuts were still intact. They were (and markets reacted accordingly), with a few individual dots moving up but the median staying put at three cuts. The first of these could, plausibly, happen in May although we think the June meeting, which will coincide with the next batch of SEP numbers, would be more likely. We could potentially see another rate cut in July, then a self-imposed blackout period ahead of the November presidential election with that third cut happening in December. This is nothing more than an opinion on our part so please don’t take it to heart – and plenty could change between now and then.

It’s also worth noting, though, that rate cut estimates for 2025 and 2026 tightened up a bit, such that according to the FOMC median projection, the Fed funds rate will stay elevated and not fall below 3.0 percent until after 2026. If you look at the Fed funds history on the above chart, this scenario would most closely resemble that of the mid-1990s, after the rate hike that began in 1994 and then stayed elevated until the dot-com crash of 2000 led to a recession in 2001.

In fact, that 1994 rate hike, while not nearly as steep as the 2022-23 cycle, is the one glaring exception to the hard landing events of other periods. What followed, as we all know, was a period of sustained economic strength, organic growth and the lagged effect of a productivity boost from earlier technological innovations. Jay Powell knows that history doesn’t repeat itself, but he is surely hoping for a very strong rhyme this time around.

We always arrive at work on an Inflation Day with a certain amount of uncertainty hovering over us. When the CPI or the PCE report – the two main indicators of US consumer price trends – comes out at 8:30 a.m. it has the potential to sharply shift market sentiment away from whatever direction it was moving in. When the numbers come in hotter than expected, that sentiment can turn sour very quickly. Not so for the hot numbers that came out this week. The Consumer Price Index report for February came out on Tuesday and showed inflation advancing faster than economists had expected. The core CPI number (i.e., excluding the volatile categories of food and energy prices) in particular looked worrisome. The month-on-month increase of 0.4 percent was above estimates and roughly double our own metric for a “good” monthly number being a gain of 0.2 percent or less. That monthly number translates to a year-on-year consumer price gain of 3.8 percent, still stubbornly ahead of the 2.0 percent target the Fed has been trying to engineer with its rate policy.

Supercore is the New Core

So, what could be in store for markets once Tuesday trading got underway? Stocks down and bond yields up? Haha, no, that would be far too rational! Au contraire, stocks had themselves a nice little gain of more than one percent, while the 10-year Treasury did move up a bit but stayed within recent trading ranges without much drama. The dynamic seemed to be more of what we talked about in our commentary last week, with the glass half full crowd winning the day more often than not.

The positive theme investors latched onto on Tuesday was “supercore.” This is yet another way of dissecting inflation down to its supposedly least volatile categories, this time by stripping housing costs out of the calculation for services prices. In January this “supercore” number was a very hot 0.87 percent, but in February it slowed to 0.47 percent. Still higher than we would like to see, but what the collective wisdom of the market decided it saw was the trend moving in the right direction. This week saw a record flow of funds into the US equity market — $56 billion, eclipsing the previous weekly record of $53 billion set in March of 2021.

Flowing Into What?

Where is all that new money going? Well, this week saw a big move into the old theme of tech stocks, with the usual suspects atop the Big Tech pile getting a midweek boost. But there is a decided lack of consensus about overall directional moves these days. Over the past month or so the mega-caps have lost some ground to out of favor sectors. The S&P 500 Equal Weight Index, a measure that takes away the distorting effect of contribution to the index from companies with outsize market capitalizations, has outperformed the benchmark (market cap-weighted) S&P 500 for the past month, reversing a longstanding period of underperformance (for the last twelve months, the equal weight index has lagged the benchmark by some sixteen percent).

That may or may not be indicative of anything sustainable – we have seen plenty of false dawns for value stocks and other overlooked sectors of the market in the recent past. But it’s worth paying attention to. While all of this has been going on in the equity market, bond traders have been quietly lowering their (previously outlandish) expectations for Fed rate cuts. All else being equal, higher rates tend to have a more punishing effect on the growthier sections of the stock market. Next week, all eyes will be on the Fed and the March FOMC meeting, which will include an updated set of Summary Economic Projections and thus the latest thinking by the Committee members themselves about where the Fed funds rater is likely to be by year-end. We’ll see what they have to say. Lots to process, and no easy answers.

The US equity market has been at one of those junctures recently that could go one of two ways. Glass half empty, or glass half full? Happily for those of us who like to see the stock prices trending in the upward direction, the glass half full crowd seems to be winning the day. The central point of contention has been thus: can Mr. Market overcome his bitter disappointment at once again being wrong, so very wrong, about how many interest rate cuts are in store for 2024, and learn to love the idea of a strong economy?

Well, the market is up this week on a string of upbeat numbers for the economy: a Purchasing Managers Index (PMI) report on Tuesday showing a healthy and better than expected composite expansion, followed by a final revision of Q1 productivity growth that was well ahead of economists’ estimates, and finally today’s jobs report from the Bureau of Labor Statistics clocking in with nonfarm payroll gains of 275,000 versus a forecast of 200,000 (the unemployment rate did tick up to 3.9 percent, though, and the blockbuster January payroll numbers were revised down to 229,000). At least for the time being, good news for the economy does seem to be good news for the market. But will it last?

The Fed’s Tough Love

The standard mantra for market pundits singularly focused on the direction of interest rates is “good news is bad news” – because when the economy is running strong, the Fed has less urgent need to start swinging the axe and cutting rates. At the beginning of this year, for reasons we continue to not understand at all, the market had priced in six interest rate cuts for 2024. This, despite the Fed’s own summary projections of just three cuts in the December FOMC materials, this despite the apparent lack of a brewing recession and this despite the fact that cutting rates six times in a presidential election year would drag a politics-abhorring Fed into the toxic mess of electoral finger pointing.

This week the Fed was all over the airwaves reminding everyone that, no, not six nor five nor perhaps even three rate cuts were in store. Regional Fed chiefs from Atlanta and Minneapolis opined that two, maybe one would be sufficient, sometime later in the year. Fed chair Powell, who had the very unenviable task of spending the better part of two days briefing members of Congress about matters financial, reiterated what he had said at the FOMC press conference a few weeks ago: don’t expect a rate cut in March, and don’t get out over your skis about what might be coming later (as if the bond market, especially, could restrain itself).

All That’s Left Is Growth

So there will be no rate cut pony out back. We will admit to being pleasantly surprised at how calmly the market is adjusting to this new reality (new, that is, for the six rate cut crowd – but an old reality for anyone who was not partaking of the market’s rate cut Kool-Aid last December). All that’s left to do is to be cheerful about the good growth numbers. Today’s jobs report marks the 39^th straight month of job gains, and also the longest stretch for a sub-four percent unemployment rate in decades. Productivity – the only plausible source of long-term economic growth – is higher than it has been anytime since the turn of the century. The Fed appears to have engineered a dramatic increase in interest rates without sending the economy into recession. So yes – sometimes good news really can be good news.

If you are a long-term reader of our weekly commentaries and our annual outlooks you are no doubt familiar with our thoughts about cryptocurrencies. If you are new to our writings, then here is a short summary: at this point in the 16-odd year of this asset class, it exists essentially as speculation for speculation’s sake, with a real-world use case limited to underworld transactions on the dark web. Oh, and as a way for El Salvador’s autocratic president to style himself as the “world’s coolest dictator.” All of which is to say, we do not consider bitcoin and its ilk as suitable additions to the portfolios we construct around the long-term financial goals and attendant risk considerations of our clients.

Plus Ça Change

That’s not to say that we don’t get asked about crypto – we do, quite often, especially in times like the present when the speculative spirits are once again running high and bidding up prices to close in on record high levels. Here’s a picture of bitcoin, the granddaddy of crypto, from the last wave of euphoria in 2021 to the despairing pits of 2022 and back again.

That’s a whole lot of movement, suggesting that some fundamental changes must have happened with the asset – right? Anyone? Bueller? In fact, nothing much in a fundamental sense has changed at all. Other than the people who attend those over the top conferences where the high priests of crypto gather to spread their gospels, nobody really has a use for blockchain currencies in their daily lives. Thanks to other digital technologies like contactless payment systems, paying for things has never been easier. Tap, swipe, hover, whatever – but none of that involves cryptocurrencies, which are in fact quite clunky when one tries to apply them in a typical transactional setting.

Nor do they have any real function as a store of value, because there is no tangible basis for the value. Bitcoin afficionados will prattle on endlessly about its “scarcity value,” deriving from the fact that only a limited amount of that particular currency will ever get produced, but that ignores the existence of literally thousands of other blockchain “currencies” that, in a world where they actually mattered, would be fungible with each other. The difference between bitcoin and Ethereum and dogecoin and all the rest is hardly the same thing as the difference between gold, silver, platinum, copper and natural gas – commodities that actually have uses in the real world.

Number Go Up

So what explains those seismic shifts, and especially the apparent stampeding of the bulls that is going on now in crypto markets? Last year, author Zeke Faux coined a phrase that became the title of his book, a bestseller among the crop of 2023 business reads: “Number Go Up.” That phrase pretty much explains it: how a bunch of digital ones and zeros with no demonstrable value suddenly turned into trillions of actual dollars. A group of people – not so much large in number as outsize in tech-world influence – simply wanted the number to go up and hyped the living daylight out of things until it did. Remember those Super Bowl ads in 2022 with A-list celebrities pumping up cryptocurrencies and their misbegotten stepchildren of the cultural milieu, non-fungible transactions (NFTs)? But then interest rates went up, and the pumpers did what pumpers normally do and dumped, and the crypto crash was on.

The subtitle of Zeke Faux’s book was “Inside Crypto’s Wild Rise and Staggering Fall.” Now, of course, he will have to update that subtitle to “…and Wild Reincarnation From the Ashes.” Although, as we noted above, nothing fundamental has changed in regard to the properties of blockchain currencies, a recent SEC regulation permitting bitcoin ETFs has made it easier for the average Dick and Jane to trade them (i.e., take a punt on them). The FOMO-meter, the only thing that truly matters in driving the price for crypto, is back in fifth gear. Now it’s just a question of waiting for whatever comes along that will send the animal spirits into reverse again.

So what do we say when the question comes up about whether we will ever change our views about the appropriateness of cryptocurrencies as an asset class for long-term portfolios? We approach any asset with an open mind, we will say, and if something ever comes along to convince us otherwise, we will be happy to change our tune. There’s no ideological animosity here, just an unbiased accounting of pros and cons. Until that compelling case comes along, though, we will leave bitcoin and its ilk to those who enjoy speculation for its own sake.

The Agony and the Ecstasy, one could say. Irving Stone’s famous 1961 novel may have been about the life of Michelangelo and his tortuous experiences while painting the Sistine Chapel, but the phrase easily lends itself to this week’s journey from darkness to light in the US stock market. As we wait for trading to get underway on this Friday morning, all appears well once again, thanks largely to the doings of one company and its continued ability to outdo the ever-higher expectations set by the market.

Hedgies Caught Out

Nvidia, the company that appears to have a dominant position in the market for the semiconductor chips that power all things AI, reported its fourth-quarter earnings after the market close on Wednesday. Heading into that report the market had been in something of a funk. Expectations for Nvidia were sky-high; after all, the company’s stock had risen by more than 200 percent in the past twelve months, and its quarterly sales and earnings numbers within that time had blown the doors off analyst estimates. The AI mania of which Nvidia was arguably the central asset of focus had carried the rest of the market with it, led by seven companies that came to be known as the Magnificent Seven.

Surely it was time for a recalibration, thought the collective wisdom. Nvidia’s stock traded down around nine percent in the three days before its Wednesday aftermarket report. Hedge funds, those incandescently brilliant operators who charge two percent plus a cut of profits for the privilege of riding along in the wake of their shining genius, were collective sellers of Magnificent Seven stocks for five of the six trading days through Wednesday’s close. Meanwhile, the release of minutes from the last FOMC meeting last month appeared to reaffirm the central bank’s intention to sit pat for the time being and not cut rates, lending another minor key note to the already dour tone of the market.

Seemingly Bottomless Demand

Then the numbers came out, and boy did that sentiment do a U-turn. There seems to be almost no end to the demand for what Nvidia sells, which is a graphic processing unit (GPU) platform providing the capability to employ generative artificial intelligence at scale. Data centers, who represent Nvidia’s largest customer base in this segment, bought more than $18 billion worth of these products in the fourth quarter, topping off a year in which sales for this segment grew more than 400 percent. Profit margins were also higher, and forward guidance (one of the biggest concerns among analysts heading into the earnings report) also beat expectations.

The ensuing market rally on Wednesday didn’t just limit itself to US tech stocks, though most of those did fine, especially any that can make a plausible claim to having a good AI story to tell. On Thursday the Japanese Nikkei 225 stock index surged past 39,000 to close at its highest level ever – fully 34 years after its previous record close! The bullish sentiment in the Japanese market, which includes a handful of world-class semiconductor names, traced directly back to that Nvidia earnings report. Softbank, a Japanese firm with a venture capital arm that has had more than its share of troubles in recent years, was a particular beneficiary of the latest iteration of “AI saves the day.”

All was well that ended well, except for all those smart-money funds that sold out of Nvidia and the other AI leaders before Wednesday evening.

Seven, Six, Five or Four?

On its earnings call Nvidia described the current market for GenAI as being at a “tipping point” – a phrase normally interpreted as a moment when a trend moves from linear to geometric expansion. That may or may not be the case, but for the moment, anyway, there does not appear to be any indication that demand for the infrastructure needed to run AI applications at scale is going to diminish.

That being said, it is probably time to revisit that “Magnificent Seven” moniker. The group of companies that drove the market in 2023 has diverged somewhat in 2024, for a variety of reasons. At the moment, only four of the companies are actually ahead of the S&P 500 for the year to date.

Tesla, in particular, has been having a bad time of things, as whatever story it can tell about AI in its value proposition has been overshadowed by the specter of competition from electric vehicle manufacturing in China. Apple has struggled somewhat as well, also in part due to competition eating into its sales in China, one of its most important markets. In fact, only Nvidia and Meta (Facebook), which also had a blockbuster earnings report a few weeks back, are notable outperformers.

In our annual outlook last month we noted that 2024 may be the year when the general halo around AI breaks down into a more sober scrutiny of which companies actually are profiting from it and which ones don’t really have a compelling core use case. That may be starting to happen. For the moment, though, it seems the market will continue to swim along with the established market leaders – as long as they can continue to pull those sales and earnings rabbits out of the hat.

Spare a thought, if you will, for the poor bond market. The fixed income crowd lives and breathes for the certainty of where interest rates are headed, only to be forever buffeted by the crosswinds of conflicting economic data that tear apart the certitude of any directional trends. This week was particularly trying, and most of all for the masses tethered to the “6 in ’24” narrative proclaiming six Fed funds rate cuts in 2024, a narrative which, outside the seemingly impenetrable insular bubble of bond traders and their media boosters, does not exist and has not existed. The culprits this week: two hotter-than-expected inflation reports on the one hand, and a colder-than-predicted number for retail sales on the other.

Inflation Surprise #1

A word about this week’s Consumer Price Index (CPI) report before we delve into the details: the Fed gives more weight in its deliberations to the Personal Consumption Expenditures (PCE) index than to the CPI number, and as we reported a few weeks ago, the most recent PCE was  quite cheery – the index showed a gain of 0.17 percent in December, translating to a 2.9 percent year-on-year growth rate and continuing a steady downward trend over the past half year or so. So that’s good.

But the CPI also matters, and this week it showed some unwelcome trends both at the headline and the core (ex-food and energy) levels. Food prices were up by 0.4 percent in January, representing the highest monthly gain since June, shelter was up 0.6 percent, and services not related to energy (i.e., most of the services that make up our daily lives like visits to the hairdresser or the nail salon) were up 0.7 percent. To put that another way, many of the categories that make up typical household budgets saw price gains in January well above recent trends. That led to an overall year-on-year gain of 3.1 percent for headline CPI and 3.7 percent for core CPI. Once again, the bond market got a bracing dose of cold water thrown on its rate cut plans, as anything suggestive of higher inflation strenuously complicates any plans by the Fed for a near-term rate cut (and Powell had already signaled at last week’s FOMC meeting that such a cut was very unlikely to be on the table when the Committee meets next in March).

Retail Sales: Bad News Is Good News

Then came the reprieve. A retail sales print on Thursday showed a sharp reversal in January that may be the first clear sign of a slowdown in consumer spending (although, to be fair, it may also have more to do with several severe weather incidents last month than with a more sustained directional movement). Retail sales in January declined by -0.8 percent. The so-called Control Group number, which strips out a few volatile categories and is the retail sales figure that flows into Gross Domestic Product calculations, was down a half percent when it was expected to gain a half percent – a one percent deviation from expectations. That’s bad news if you want to see stronger growth, but it’s good news if (like bond traders) the only thing in life that matters is the Fed cutting interest rates. Predictably, yields in Treasury securities came down and offset some of the rise from the Tuesday inflation report.

Inflation Surprise #2

Alas, the bond market’s reprieve was but a passing moment. On Friday another inflation report came out, this time the Producer Price Index that measures changes in wholesale prices (i.e., stuff going on upstream from consumer-facing activity). Normally the PPI doesn’t get anywhere near the attention the CPI and other consumer figures garner, but this time it was a dead weight on market sentiment. Core PPI in particular deviated significantly from expectations, with a month-on-month gain of 0.5 percent versus expectations of just 0.15 percent (and coming on the heels of the previous month when it actually fell by -0.1 percent. As a result, the 10-year Treasury is back at its highest level since last November (though still well shy of the 5.0 percent peak reached last October).

What to make of all this? Well, from our standpoint it goes along with the message we repeat to our clients on a regular basis: the short term is unknowable, so don’t try to profit from outguessing where interest rates, or stock prices, or barrels of Brent crude oil, are going to be tomorrow or next week. We remain puzzled by why the bond market has consistently tried to outrun the Fed and make up its own bedtime stories about rate cut unicorns. But rather than thinking we know any better, we continue to move incrementally and deliberately in the context of the overall structural likelihood of peak rates and a gradual – subject to those many macroeconomic crosswinds – reduction towards the natural interest rate (which is not easy to pinpoint but is almost certainly lower than where rates are now). And we don’t try to read too much one way or another into any single piece of information. One data point does not a trend make.