The market has had another week of indecision, trying to make up its mind whether to cheer another blowout earnings quarter by Nvidia, the darling of one-day options punters, or worry itself into a corner over comments by Fed officials speculating about possible rate hikes if inflation fails to come down more. Maybe this day-to-day uncertainty explains why, according to a recent poll, half the country is convinced the US stock market is actually down for the year to date (it is in fact up more than ten percent for the year thus far and 27 percent since last October, but what does actual reality matter if some bewitching Tik Tok influencer tell you otherwise? That same poll has a near-majority of our fine and informed citizens believing that the unemployment rate is at a 50-year high, which would have it at 15 percent as opposed to the 3.9 percent level currently prevailing here on Earth One).

Businesses Navigate the Slowdown

In all fairness, there is a lot of conflicting macroeconomic data out there to process. By one important metric, though, we should be finding more reason to be upbeat than nervous. With the first quarter earnings season winding down, the financial performance of US businesses has more than met analysts’ expectations. And no, it’s not just Nvidia and other beneficiaries of the market’s infatuation with AI. Earnings per share for the S&P 500 grew at a six percent rate for the quarter, with 96.2 percent of companies having reported. That is higher than the 5.3 percent growth rate projected by those same analysts back in January. And the outlook for the full year has also gone up slightly, with earnings expected to have grown by 11 percent when December 31 comes around.

This week a handful of retailers gave a jolt of confidence to investors worried about the impact of a consumer slowdown. TJX, Ross Stores, Macy’s, Ralph Lauren and Deckers were among the companies that demonstrated resilience amid increasing signs of pocketbook-conscious households. TJX, for one, saw a three percent increase in comparable store sales for the first quarter, at the high end of its prior guidance, and raised its outlook for sales and pretax profit margins for the remainder of the year. This was particularly welcome news as it came on the heels of a disappointing report earlier by Target, which announced that it would be cutting prices on around 5,000 popular items in its stores to increase sales (would seeing lower prices at Target convince the American public that inflation is actually not increasing at a record pace, as most of them seem to believe, or is that asking too much?).

Valuations in Check

Sales and earnings are, of course, important not only as a measure of economic health but as a check on valuations. Currently, the forward price-earnings (P/E) ratio of the S&P 500 is 20.8. That is not cheap, but it is not as expensive as the market was near the end of its last major rally in late 2021. Higher earnings growth – the “E” of the P/E ratio – has kept valuations from moving into bubble territory. We will see in July whether this optimism carries into the second quarter earnings season, but for now the takeaway is that companies are doing better in an uncertain environment than many observers thought they would a few months ago.

Oh, and a final call-out to the 56 percent of Americans in that earlier-cited poll who believe that we are currently in a recession: No, we’re not.

When the first quarter Gross Domestic Product (GDP) numbers came out a few weeks ago, we were among the many observers who noted that the lower-than-expected growth rate (1.6 percent real quarter-on-quarter growth, annualized) was actually not all that bad, with both consumer spending and private business investment – arguably the economy’s two most important growth drivers – sustaining their recent healthy trends.

Well, that view (which among others was offered by Fed chair Jay Powell at the most recent Federal Open Market Committee meeting) may have been correct, but in hindsight it also seems like it was the opening act for what has since been a stream of underwhelming macro performance numbers. Consumer confidence for April came in well below economists’ expectations (both the Conference Board and the Michigan sentiment indexes). Regional and national metrics from the Purchasing Managers Index (PMI) and Institute for Supply Management (ISM) showed manufacturing activity moving into contraction territory. First quarter productivity (the most important measure of the economy’s long-term growth potential) came in lighter than expected. The monthly jobs report published by the Bureau of Labor Statistics showed a slowdown in new hiring and a small uptick in the unemployment rate. April retail sales slowed considerably, and the measure that feeds directly into GDP was negative.

Goldilocks Ascendant

One data point does not a trend make, but that’s a whole lot more than one data point. Now, it should not have escaped your attention that while all this soft economic data has been trickling in, the stock market has been quietly climbing back from its April pullback. The S&P 500, Nasdaq Composite and Dow Jones Industrial Average are all right around their record highs, while bond yields have settled into a fairly tight range with the 10-year Treasury hovering somewhere a bit north or south of 4.4 percent on any given day.

This is – or at least this seems to be by just about every measure we see – what an actual “soft landing” looks like. Not too hot, not too cold, but just right, like the Three Bears in the story. The market loves itself a Goldilocks economy, where modest growth is paired with declining inflation and, of course, a better likelihood of interest rate cuts. The other big economic news this week was, of course, the April Consumer Price Index, which arrived almost exactly in line with economists’ expectations. The core CPI rate of 3.6 percent year-on-year is the lowest in three years, with the current forecast for May core CPI coming down to 3.5 percent. With the chance of a Fed funds rate cut in June now all but off the table, investors are looking ahead to September as a more likely occurrence than the prevailing wisdom had it just a couple weeks ago.

We’ll see if this trend continues – there is another batch of PMI reports due to come out next week, followed by another consumer confidence reading and then the Personal Consumption Expenditures (PCE) inflation report before the end of the month. The next BLS jobs report will come out on June 7, and that will tee up the next FOMC meeting (which happens on the same day as the May CPI report gets published). Conditions could change. For now, though, Goldilocks rules and markets are fine with that.

There is a genuinely strange phenomenon that has taken place in the global equity market over what is by now a very long time period. Consider the chart below. It shows the relative performance of five equity asset classes – US large cap growth, US large cap value, US small cap growth, non-US developed and non-US emerging markets – over four different time periods. Thirty years, ten years, five years and one year. Here is the strangeness: the performance ranking in each and every one of these time periods is nearly the same. Growth, value, small cap, international developed and international emerging (with large cap value and small caps being a bit of a toss-up). Different span of time, same order. Each and every time.

Diversification, Risk and Return

As investment managers, this situation presents a challenge. We have to look at it from several different perspectives. First of all, there is the principle of diversification. One of the cardinal tenets of investment management is that nothing stays the same forever; mean reversion will at some point bring the high flyers down to earth, and when that happens you want to have other positions in your portfolio that offer some cushion. Diversification offers – or should offer – that kind of protection.

That’s all well and good, but there is also something about the performance pattern in the above chart that challenges basic financial theories about diversification, risk and return. Open up any textbook about investment management written any time in the last, say, sixty years, and you will encounter something called the “risk frontier.” This is a linear-ish progression of assets from the safest to the riskiest – from cash under the mattress to, say, investing in early-stage venture capital. The line is supposed to be upward sloping, meaning that as the risk properties of an asset increase, the expected return on that asset over a suitably long period of time should also increase. More risk, more return. As an old Ukrainian saying goes, if you don’t take the risk, you don’t drink the Champagne.

But what is a suitably long period of time? Thirty years? Look at the thirty-year performance chart in the upper left quadrant. The two worst-performing asset classes by far are also the two riskiest (measured by standard deviation) – international developed and (especially) emerging markets. High risk, low return is not something any rational investor would choose. And the very close performance results between US large cap value and US small cap would look very different on a risk-adjusted basis, with large cap value being considerably less risky over time than small cap. Higher risk, same return is also not a great selling point.

The Economic Context

Returns in financial markets, of course, don’t happen for no reason at all. The global economy has changed in many ways over the past thirty years. Take US large cap growth, the runaway outperformer over this time. There are really three stories here: the rise of the Internet economy in the mid-late 1990s, followed by the tech stock crash in the early 2000s, and then the rise of Big Tech to a position of economic dominance from the 2010s and particularly in the past decade or so. Tech isn’t even really an isolated industry sector any more – the intellectual property of technology leaders infuses everything from carmakers to insurance companies to consumer retailers. Small wonder that these repositories of valuable IP, most of which live in the large cap growth segment of the market, have done so well.

At the same time the US economy overall has outperformed those of other developed countries, while emerging markets has really been the story of an increasingly troubled China, a few bright growth prospects in South Asia and Asia-Pacific, and mostly disappointing growth stories elsewhere. The investment thesis for emerging markets back at the turn of the twenty-first century was the belief that they would contribute an increasing share of global growth and catch up over time to the per-capita income levels of Europe, North America and Japan. That thesis has not stood the test of time very well, at least so far.

Nothing Stays The Same Forever

When you look at the magnitude of the performance gap between US large cap growth and everything else over these different time periods, a certain part of your brain has to be telling you that this is not likely to stay the same indefinitely. Right? Going back to that diversification template, this too will pass – and when it does, you want to be prepared. If you think that the history of the past thirty years is going to repeat itself over the next thirty years, well, you would just park all your long-equity capital into large cap growth and leave it there. But history doesn’t repeat, and the economy is likely to change in unpredictable ways as time unfolds. Neither we nor anyone else knows when that will be, or what the impact on different asset classes will be – but the change will come. Be prepared, keep your eyes wide open, and always challenge yourself.

Love the Fed? That may be too strong a sentiment. But at the very least, the bond market is channeling its inner Dude (as in “The Big Lebowski”) and abiding the Fed. The market had already priced itself out of the multiple rate cut fantasy with which it started the year when the FOMC sat down this week to deliberate for two days on an outcome it had telegraphed well in advance. No change in rates today, no change in rates tomorrow, and we’ll just have to see what happens after that. Market pundits observing the event could come up with all manner of contests betting on how many times the phrase “data-driven” would proceed from Jay Powell’s lips. In his customarily clear and unambiguous way, Powell said that there is more work to be done on inflation, that growth continues to be strong, that stagflation (as we discussed in our commentary last week) is not something the Fed is unduly worried about today, and that the Committee will make decisions on the Fed funds rate without regard for extraneous political considerations as the November election approaches (points again for “data-driven”). The market abides.

Two, One or None

The chart below shows how the market has adjusted to the realities of the Fed’s world from the overly enthusiastic response to last December’s FOMC meeting to this week’s confab. The dotted crimson lines on the chart show where the upper bound of the Fed funds rate would be with two rate cuts in 2024 and with six rate cuts in 2024.

Right now, Fed funds futures markets are pricing in two rate cuts, with the likely timing now pushed back to the second half of the year – July at the earliest, but more likely September for a first cut (note here again the importance of Powell’s response to a question at the Wednesday press conference about rate cuts and election optics – data-driven trumps political expediency). There are only three more months of inflation data to digest before the July 31 meeting, which may not supply enough data for a rate decision even if they come in less hot than the three reports thus far this year. At the next FOMC meeting, which ends on June 12, we will get to see whether the “dot plot” – the Summary Economic Projections reflecting Committee members’ best guesses about rates – has changed from the March numbers that still showed a median expectation for three rate cuts this year. More likely than not, that expectation will have shifted.

What About Growth?

The other side of the equation is growth. On Wednesday Powell strongly downplayed the possibility of a slide into 1970s-style stagflation. He noted that the lower than expected real GDP growth of 1.6 percent in the first quarter did not reflect a meaningful shift in the recent strong trends of household spending and private business investment, with most of the deceleration having to do with changes in business inventory spending. The Fed’s base case view continues to be that growth will maintain a steady pace while inflation gradually –but eventually – gets back to the two percent target.

That being said, a couple other macro data points this week merit some attention. The March Consumer Confidence report came out earlier this week showing a decline from 103.1 in February to 97.0 in March. Economists had expected the number to rise to 104.0 in March. This morning, the Bureau of Labor Statistics reported payroll gains of 175,000 for March versus a forecast of 235,000, along with a slight uptick in the unemployment rate from 3.8 to 3.9 percent. This is not a bad jobs report per se, but it could suggest that the recently hot labor market is starting to cool off.

To be clear, our base case is more in line with the Fed’s view that stagflation is an outlier scenario; nonetheless, we need to pay attention to any signs of a potentially cooling economy. The message from both the bond market and the stock market this week reflects satisfaction, more or less, with how the Fed is threading the needle between inflation and growth. A few data points in the wrong direction could change things quickly, however.

When inflation began rising three years ago, eventually reaching levels not seen in a couple generations, the chatter among market personalities was full of oldspeak calling up the 1970s. Among the words and portmanteaux dusted off for re-use was stagflation, last observed in the wild in the days when Carter administration staffers danced under the disco ball at Studio 54. With the Consumer Price Index touching nine percent in the summer of 2022, fears of a combination of higher inflation and tepid growth mounted. Then inflation started coming down steadily and growth kept on, well, growing, and talk of stagflation subsided, packed back into the old steamer trunks alongside bell bottoms and lava lamps.

Thursday Troubles

Until Thursday of this week, that is, when a Bureau of Economic Analysis report on US economic growth in the first quarter delivered two unwelcome pieces of news. Growth, as measured by Gross Domestic Product, came in at an inflation-adjusted 1.6 percent (quarter on quarter, annualized), well below economists’ consensus estimates. The deceleration follows a stronger than expected gain of 3.1 percent in 2023. It wasn’t really a bad result – the main drivers of the deceleration were reduced business inventory investments, weaker exports relative to imports and a reduction in durable goods spending (e.g. on automobiles). Lower inventory spending, probably the main factor causing the headline growth number to come in below forecast, is in part a reflection of more normalized supply chain flows and in part an outcome of cautionary planning among manufacturers in projecting near-term demand trends.

But the growth number is not what caused some consternation in financial markets on Thursday morning; it was another number in the BEA report that showed price trends for personal consumption for the first quarter. The Personal Consumption Expenditures price index is the BEA’s main inflation metric (the Consumer Price Index, the metric more familiar to most Americans, is put out by the Bureau of Labor Statistics). That number came in hot, with the core (ex-food and energy) PCE showing a 3.7 percent appreciation for the quarter as compared to the consensus forecast of 3.4 percent, and seemingly the latest in a growing series of data points suggesting that inflation is stuck on a plateau above where the Fed (and most of the rest of us) would like it to be. Stock indexes tumbled and bond yields shot up. “Stagflation” made the rounds as financial news jockeys kibbitzed about the events of the day.

Not So Hot, After All

The market’s malaise (to use another 1970s-era buzzword) was relatively brief and restrained, with both stock prices and yields well off their worst levels by the end of the day. That hot PCE price index number, remember, was for the entire first quarter, and we already know that at least the first two months of the year saw higher inflation relative to the trend late last year. The bigger question for inflation was whether that trend was going to be continuing on a month by month basis. The PCE was hot for the quarter, but what about for just the month of March?

Fortunately, we did not have to wait very long to find out. The BEA published the March Personal Income and Outlays report this morning, which contains among other items of interest the PCE price index for March. That showed a month on month gain of 0.3 percent, which translates to a 2.8 percent year-on-year increase and, importantly, is basically in line with what was forecasted. We’d still like to see that number be a bit lower; month-on-month increases of 0.1 or 0.2 percent would give the Fed more confidence that inflation is moving towards its target level. But nothing in the March PCE report gives a strong indication that inflation might be moving in a way that would require the central bank to consider another rate increase (which is something that was being talked about in bond market circles earlier in the week).

There is still much that remains to be seen about how the economy is going to fare in 2024. For now, at least, we are not inclined to see the specter of stagflation as a meaningful cause for concern.

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.