by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are giving back gains after a surprisingly strong jobs report. In college athletics news, Caitlin Clark, the Iowa star, secured her second straight Player of the Year award. Today’s Comment discusses why the Fed’s tolerance for inflation might be higher than investors anticipate, analyzes the surprising strength of US banks following the one-year mark of the Silicon Valley Bank collapse, and delves into the resilience of European equities despite a stagnant European economy. As usual, our report includes a roundup of international and domestic economic releases.

Not 2%, But Close Enough: The S&P 500 trimmed gains after a Fed president downplayed rate cuts, but signs suggest a Fed policy shift might still be coming.

• The Federal Reserve’s monetary policy stance is in flux. In a recent LinkedIn event, Neel Kashkari, president of the Minneapolis Fed, admitted his prior projection of two rate cuts in 2024 might need to be revised. Wary of inflation proving more persistent than anticipated, Kashkari signaled a possibility that the Fed may not cut rates at all this year. This shift follows hotter-than-expected inflation data in January and February, impacting both consumer and producer prices. However, Loretta Mester, president of the Cleveland Fed, remains optimistic, believing inflation will cool enough to allow for a rate cut as planned.
• The threshold for a rate cut may be lower than most investors realize. The latest FOMC projections showed that the committee expects three rate cuts and inflation to fall to 2.5% by year-end. This suggests policymakers may be comfortable with a slower-than-expected pace of inflation reduction as long as the progress is consistent. Even so, the conflicting inflation data may complicate their decision. In February, the Consumer Price Index (CPI), a common inflation gauge, rose 3.8% from the prior year, while the Fed’s preferred measure, the Personal Consumption Expenditures (PCE) price index, currently sits at 2.8%.

• The timing of any policy easing could hinge on which inflation indicator policymakers prioritize, or even if they consider both. Despite policymakers preferring to use core PCE as their tool to evaluate inflation, they have been known to react to changes in core CPI. This is evident in their recent references to persistent inflation, primarily based on the month-to-month change in the CPI data in March, which overshadowed a noticeable deceleration in core PCE. If they prioritize the CPI, they might hold rates for longer than expected. Conversely, if they focus on the PCE price index, they could be open to a rate cut as early as June.

Slow Moving Train: More than a year after the Silicon Valley Bank collapse, the financial system shows signs of recovery, though some skepticism lingers around regional banks.

• This week, Federal Reserve Vice Chair of Supervision Michael Barr sought to reassure the public about the financial system’s health, while acknowledging potential risks in commercial real estate. At a National Community Reinvestment Coalition event, he declared banks to be “sound” and “resilient,” highlighting improved liquidity. However, he balanced this optimism by acknowledging “pockets of risk” due to firms holding “significant unrealized losses” on their books and having a high concentration of commercial real estate. Instead of an immediate crisis, Barr likened the situation to a “slow-moving train” with potential problems surfacing over several years.
• Despite lingering concerns about the health of the banking system, US banks have surprised analysts with a strong start to 2024. Large-cap bank stocks have surged 11% year-to-date according to a UBS index, significantly outperforming the S&P 500’s gain of just 8.5% over the same period. This robust performance can be attributed to two key factors. First, large banks capitalized on opportunities last year by acquiring struggling but profitable regional banks, which has bolstered their earnings. Second, net interest income has remained healthy due to the Federal Reserve’s decision to keep interest rates elevated.

• Large banks have thrived this year, but regional banks remain a cloud of concern for investors. The KBW regional bank index is currently in negative territory, reflecting investor wariness of smaller banks due to anxieties about their commercial real estate exposure. The recent misstep at New York Community Bank further fueled these apprehensions. Still, it’s important to note that the closure of the Fed’s Bank Term Funding Program hasn’t triggered signs of an imminent regional banking crisis. If this situation continues, it will further add to optimism that the economy may avoid a downturn this year.

Silver Lining in Europe: European equities are showcasing resilience amidst prevailing economic headwinds and Germany’s weakened state.

• The STOXX Europe 600 (SXXP) has soared to new highs in 2024, fueled by a strong performance from large-cap stocks, particularly in banking and car manufacturing. The banking sector has witnessed its best showing in six years, surging 34% year-over-year. This rise is attributed to the banks’ ability to maintain financial health and capitalize on recent interest rate hikes by the European Central Bank (ECB). The recent shift by automakers away from electric vehicles due to perceived slowing demand, though, has also found favor with investors worried about declining profit margins and potentially lower sales.
• Despite a strong stock market performance, the eurozone economy faces ongoing challenges. The region narrowly averted a recession, technically defined as two consecutive quarters of economic decline. Recent data paints a concerning picture, with retail sales dropping 0.5% in February and the March purchasing managers’ index indicating a further contraction in construction activity. Germany, a key eurozone player, appears particularly vulnerable. Its manufacturing sector, a traditional engine of growth, continues to drag. German industrial orders rose a meager 0.2% in February, far below expectations of 0.8%.

• The strong stock market performance may be short-lived if economic conditions continue to deteriorate. Downturns historically lead to credit tightening, making it harder for companies to borrow and potentially hindering their ability to remain profitable. However, the ECB’s planned interest rate cut in June could help ease the situation by making credit more affordable. In the current economic climate of uncertainty, European blue-chip stocks could be a viable option for investors seeking a safe haven. These companies are resilient to major financial fluctuations, while also maintaining relatively attractive valuations compared with their US peers.

Other News: Bank of Japan Governor Kazuo Ueda signaled a possible rate hike in the second half of the year; the comment led the yen to strengthen against the dollar. Argentinian President Javier Milei seemed to retract his commitment to distancing the country from China by indicating that Beijing still wields considerable influence in South America. Treasury Secretary Janet Yellen has underscored the impracticality of the United States severing ties with China, solidifying a persistent trend of simmering tensions between the world’s two largest economies.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equities are off to a great start after initial jobless claims data came in higher than anticipated. In sports news, the St. Louis Cardinals, considered by many to be World Series contenders, kick off their home opener today. Today’s Comment explores three key market concerns: the impact of future policy rate uncertainty on market jitters, how the AI rally might diverge from the dotcom bubble, and whether Swiss inflation data offers clues about global inflation trends. As usual, our report includes a summary of domestic and international data releases.

Shifting Sands: The Fed’s uncertainty about inflation’s trajectory is muddying the policy path, prompting markets to reassess their interest rate forecasts.

• Fed Chair Jerome Powell reiterated the importance of patience in considering rate cuts for the Federal Reserve. Speaking at a panel discussion at Stanford University, Powell highlighted the significant influence of supply-side factors in curbing inflation since the onset of the pandemic. While he avoided giving a specific rate forecast, he indicated the latest data hasn’t “materially changed” the Fed’s view on inflation. This aligns with San Francisco Fed President Mary Daly, who still favors three rate cuts this year. In contrast, Raphael Bostic has reduced his forecast from two cuts to one.
• Conflicting economic data is further muddying the Federal Reserve’s decision on interest rates. The Institute for Supply Management’s (ISM) latest manufacturing PMI shows prices paid have surged to their highest levels since 2022, indicating persistent inflation. However, the non-manufacturing PMI shows service sector prices at a four-year low, suggesting a potential easing of price pressures in that sector. This surge in manufacturing prices likely reflects rising commodity costs, while the low service-sector prices could signal easing wage pressures, which aligns with the decline in the non-manufacturing employment component. The negative response to manufacturing data and positive reception of service data highlights the market’s current volatility.

• The ISM report, though not directly influencing policymakers, exposes the market’s hair-trigger sensitivity to economic data, as evidenced by contrasting reactions. Uncertainty regarding rate cuts will hang in the air until the Fed’s June meeting, where their updated economic projections will shed light on their path forward. Committee members, especially the hawkish ones, are paying attention to payroll data. A significant drop in March or April jobs could trigger a dovish pivot towards rate cuts this summer. Conversely, persistently strong job reports could lead to a reduction, or even a complete halt, in planned rate cuts for the year.

Tech Moves: Soaring valuations prompt tech companies to seek new income sources to satisfy their investors.

• Tech giants like Google are exploring premium features on select products behind paywalls, creating new revenue streams. This could fund continued development of these enhancements while maintaining their free, ad-supported core offerings. Meanwhile, Apple’s foray into home robotics signals a potential pivot away from their electric vehicle project. These moves, though not finalized, highlight the growing pressure on tech companies, particularly the Magnificent Seven (M7), to diversify income and justify high valuations in a changing market. The recent drop in Tesla stock following weak deliveries exemplifies how investor sentiment can quickly turn after negative news.
• The recent surge in the M7’s stock prices evokes comparisons to the dotcom boom of the late 1990s. However, a crucial distinction lies in the companies’ financial health. The dotcom bubble was fueled by speculation on unprofitable startups with minimal revenue and high debt. In stark contrast, the M7 are established powerhouses generating substantial profits. Their impressive free cash flow of $309.2 billion in 2023, a staggering $100 billion increase year-over-year, demonstrates their financial strength. This massive cash cushion positions them as far more resilient than the fragile dotcom companies, providing a buffer during periods of economic uncertainty.

• While there’s confidence that the large-cap rally will spread to other sectors, the M7’s future path remains uncertain. The upcoming Q1 2024 earnings season will be critical, potentially shaping the rally’s direction as it reveals these mega-caps’ abilities to maintain profitability. However, unlike the dotcom bubble, the size and scale of the M7 provide a buffer. Even if the AI boom weakens, these companies have the resources to explore alternative revenue streams, fostering a more resilient position. This doesn’t necessarily guarantee a complete avoidance of a correction, but investors should be prepared for a more measured market response compared to the dramatic downturns of the dotcom era.

The Swiss’s Dovish Surprise:  March’s lower-than-anticipated inflation data supports the central bank’s decision and raises the possibility of additional stimulus measures.

• Swiss consumer prices have risen just 1% since March 2023, falling short of expectations for a 1.3% increase. This comes on the heels of the Swiss National Bank’s (SNB) decision in March to cut borrowing costs, marking the first such move by a G-10 central bank since November 2020. The SNB’s pivot aimed to curb the Swiss franc’s appreciation against the dollar. A recent study suggests the SNB would require an additional $30 billion alongside a commitment to keeping interest rates low for the next three years to prevent a mere 1.1% appreciation of the Swiss franc’s real effective exchange rate.
• Although a single month’s data shouldn’t be over-emphasized, recent CPI figures offer early signs of potential global inflation moderation. For instance, preliminary data from the eurozone shows core inflation dipping below 3.0% for the first time since March 2022. Similarly, both Japan and Canada have experienced a notable slowdown in inflation over the past several months. If this trend continues throughout the developed world, it is possible that the central banks will likely follow through on plans to reduce their policy rates this year.

• Slower economic growth in some countries is tempering inflation, but rising commodity prices threaten this progress. The robust US economy, with strong wage growth and a tight labor market, might prompt the Federal Reserve to maintain its current stance before easing monetary policy. This could lead to a stronger dollar as the interest rate differential between the US and other countries widens. Consequently, import-dependent nations may face challenges due to higher costs for dollar-denominated goods. This divergence in monetary policy could dampen global interest rate reductions, potentially falling short of market expectations.

Other News: Germany is undertaking military reforms in response to a perceived increase in global hostility. An Israeli cabinet member’s call for early elections highlights the current political instability in Israel.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with new signs that global consumer demand for electric vehicles isn’t growing as fast as previously thought, with major implications for the global economy and policymakers. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including news of a major earthquake in Taiwan and the latest statement from a Federal Reserve policymaker pointing to US interest rates remaining “higher for longer.”

Global Electric Vehicle Market:  Adding to the evidence that global demand for electric vehicles is slowing sharply, EV giant Tesla yesterday stated that its first-quarter deliveries were down much more sharply than expected. The company said it delivered just 386,310 vehicles in January through March, down 8.5% from the same period one year earlier and far below the anticipated rate of about 457,000.

• Even though top Chinese EV makers reported even steeper delivery declines, leaving Tesla as the world’s top seller, the news nevertheless pushed Tesla’s stock price 4.9% lower for the day, leaving it down about 33% for the year-to-date.
• If the delivery shortfalls really do reflect a saturated market or waning demand, it suggests there will be an even greater profit bloodbath as China’s excess capacity leads it to try to dump even more vehicles on the world market.

Taiwan: An earthquake with a magnitude of 7.4 struck the country’s east coast this morning, killing at least nine people and damaging infrastructure and buildings. Of course, a key question for the global economy is the fate of Taiwan Semiconductor Manufacturing Company’s fabs on the island, which produce most of the world’s advanced computer chips. The firm said damage to its plants has been minimal and workers are already returning to their jobs, but the quake will nevertheless refocus attention on the security of chip supply chains.

European Union-China: Just weeks after signaling the EU wouldn’t intervene to help European solar panel makers survive the onslaught of cheap Chinese imports, the European Commission today announced it will investigate whether two Chinese producers are using state subsidies to engage in unfair competition. The probe will utilize a new anti-subsidy law passed by the EU last July. The about-face on solar panels illustrates how political winds are increasingly forcing Western governments to take a tough stand against Chinese military and economic threats.

Eurozone: The March consumer price index was up just 2.4% from the same month one year earlier, coming in a bit better than expected and slowing from the rise of 2.6% in the year to February. The slowdown in inflation mostly stemmed from weaker price growth for food, energy, and other goods, while service inflation remained steady. Despite the sticky service inflation, the figure is likely to increase expectations that the European Central Bank can cut its benchmark interest rate in June.

• With the US’s healthy economic growth and sticky overall price inflation increasingly convincing investors that the Fed will move only slowly in cutting its benchmark interest rate, the prospect of near-term rate cuts by the ECB has been weighing on the euro.
• Even though the EUR is slightly higher today, trading at 1.0783 per dollar, it is still down some 2.5% against the greenback for the year-to-date.

US-China Diplomacy:  Yesterday, during their first phone call in two years, President Biden and President Xi reportedly had a “candid” and “constructive” conversation about a range of issues between the two countries. However, Xi warned Biden that China “will not sit idly by” if the US continues what he called efforts to suppress Chinese economic and technological development. In turn, Biden said he will keep taking what he called limited steps necessary to ensure US national security.

• While it’s probably good that Biden and Xi are talking again, the tit-for-tat exchange on economic and technological relations should serve as a reminder that tensions look set to continue spiraling.
• The US-China relationship continues to show signs of being a “Thucydides Trap,” where the reigning hegemon (i.e., the US) faces a rising power (i.e., China). Some foreign affairs scholars, such as Harvard professor Graham Allison, argue that to avoid war in such a situation, the US should accommodate China’s rise. However, both Democrats and Republicans in Washington continue to show signs that they’re willing to stand up to China in an effort to preserve the US’s dominance in geopolitics and the global economy.

US-China Capital Flows: Reflecting the bipartisan effort to rein in China, Democratic and Republican lawmakers in the House of Representatives have introduced a bill that would bar index funds from investing in Chinese companies. According to the bill’s sponsors, the proposed No China in Index Funds Act is justified because index funds do not research the firms they hold and therefore can’t uncover the unique risks inherent with Chinese companies.

• The bill was introduced by Rep. Brad Sherman, a Democrat from California, and Rep. Victoria Spartz, a Republican from Indiana.
• Sherman and Spartz have also introduced a number of other anti-China bills that would “end tax breaks for Chinese equities, restrict sanctioned Chinese companies’ access to US capital markets, increase transparency on risks to American corporations, and reduce exposure to these risks for retail investors and other Americans saving for retirement,” according to a statement from the lawmakers.

US Monetary Policy: In a speech yesterday, Cleveland FRB President Mester said the continued fundamental strength in the US economy has convinced her that interest rates will settle at a higher level than she previously thought, even after the Fed finishes its impending rate-cutting cycle. Over the long term, Mester said she now expects the benchmark fed funds rate to settle in a range of 2.5% to 3.0%, rather than the flat 2.5% she assumed previously.

• Mester’s view of higher future interest rates is consistent with our view that geopolitical tensions and structural changes in the global economy will lead to increased inflation and interest rates going forward. In our view, inflation and interest rates are also likely to be more volatile.
• Separately, Mester also poured cold water on the idea of any rate cut at the Fed’s policymaking meeting in May. She hinted that a cut was still possible at the June meeting, but only if in-coming inflation data clearly supports it.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with increasing geopolitical tensions after an apparent Israeli airstrike killed senior Iranian military commanders in Damascus, Syria. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including a growing likelihood that the Japanese government will intervene in the currency markets to support the weakening yen, and new signs that investors are giving up on the likelihood of a Federal Reserve interest-rate cut in June.

Israel-Hamas-Syria-Iran:  In an indication that Israel’s war against Hamas in the Gaza Strip threatens again to escalate, the Syrian government yesterday claimed Israel was behind a missile strike on an Iranian diplomatic post in Damascus. The strike reportedly killed several high-level Iranian military leaders. It also marked at least the fourth Israeli strike on Iranian military forces in Syria this year, potentially aimed at provoking Iranian proxy forces in the area to fight back so that they can be targeted. The risk is that such an incident could draw Iran directly into the conflict.

• Separately, an Israeli airstrike has killed seven workers from World Central Kitchen, the aid group established by celebrity chef José Andrés that first rose to fame by providing food aid to Ukrainians displaced by the Russian invasion of their country. After the UN, World Central Kitchen is reportedly the largest food-aid group operating in Gaza.
• Israel today claimed the airstrike was unintentional, but the killing of aid workers is likely to further undermine global support for Israel’s attacks on Hamas in Gaza.

Russia-Ukraine War:  Britain’s defense intelligence agency has issued a dire warning that a key Ukrainian defensive line west of Avdiivka is beginning to collapse as Russia pours new troops, equipment, and munitions into the area. The report suggests that Russian forces may be starting to build sufficient momentum to overcome Ukrainian resistance, especially now that Kyiv’s forces are facing severe resource constraints.

• Any additional Russian momentum will likely cause greater angst in Western European capitals regarding future threats from President Putin.
• In turn, that could spur additional European aid to Ukraine and even more commitment to boost European defense spending.

United Kingdom:  S&P Global said its March purchasing managers’ index for manufacturing rose to a seasonally adjusted 50.3, beating both the flash estimate of 49.9 and the February reading of 47.5. Like most major PMIs, this one is designed so that readings over 50 indicate expanding activity. With the rise in March, the index suggests Britain’s factory sector is now growing again for the first time since July 2022.

Japan:  Finance Minister Suzuki warned today that he is watching trends in the currency market with a “high sense of urgency” and that his ministry would address any “excessive movements” in the yen (JPY). That marks the latest in a string of government warnings that it might intervene in the market to keep the yen from weakening further.

• Despite the Bank of Japan’s recent move away from negative interest rates, investors have been dumping the yen on concerns that the central bank doesn’t intend to keep hiking rates. In contrast, investors increasingly think that continued good economic growth in the US may prompt the Federal Reserve to slow or even abandon its plan to start cutting its current high interest rates.
• So far this morning, the yen is trading essentially flat at 151.65 per dollar ($0.0066), its weakest level in approximately 34 years and is down 7.1% for the year-to-date.

US Monetary Policy:  Against the backdrop of strong US economic data and signs of sticky price inflation, investors continue to ratchet down their expectations for interest rate cuts from the Fed. In a little-noticed development, trading in interest-rate derivatives now indicates only a 56.8% chance that the policymakers will implement their first rate cut at their policy meeting in June; trading suggests there is a 49.1% chance that they will keep the benchmark fed funds rate unchanged until at least their July meeting.

US Stock Market Regulation:  In an exclusive report by the Wall Street Journal today, US regulators are examining whether big money managers such as BlackRock and Vanguard are truly acting passively when their index funds amass more than 10% of the shares in major banks. To date, the regulators have exempted the index providers from some rules that treat investors as active when they surpass 10% ownership. The new probe reflects bipartisan concern that the index funds are using their big ownership stakes to push ideological causes, from climate-change policies to pay equity.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with yet another warning from a top European leader of a potential war with Russia. We next review a wide range of other international and US developments with the potential to affect the financial markets today, including several key economic reports out of Asia and various notes on the US economy and markets.

European Union:  In an interview last week, Polish Prime Minister Donald Tusk became the latest high-level EU official to warn of an impending war in Europe. According to Tusk, “I know it sounds devastating, especially to people of the younger generation, but we have to mentally get used to a new era. We are in a pre-war era. I don’t exaggerate. This is becoming more and more apparent every day.” In his interview, Tusk said it is essential for the EU to stand by Ukraine and make sure it is not overrun by Russia’s invasion forces.

Turkey:  In local elections yesterday, incumbent Istanbul Mayor Ekrem İmamoğlu, one of President Erdoğan’s top critics, appears on track to win reelection with about 50.8% of the vote.  Opposition candidates also look set to win in other major urban areas, potentially setting up a major embarrassment for Erdoğan and his conservative Islamist political party.

Japan:  The Bank of Japan said its “Tankan” index of optimism among large manufacturers fell to 11 in the first quarter, slightly beating expectations but still coming in weaker than the reading of 13 in the fourth quarter. The index is designed so that positive readings point to more manufacturers seeing positive business conditions rather than seeing negative conditions. Even though the decline in the first quarter was the first since the beginning of 2023, the positive reading therefore still suggests Japan’s factory sector is in good condition.

South Korea:  The country’s exports, a bellwether for global trade, showed a total value of $56.56 billion in March, up 3.1% from the same month one year earlier. The increase was a bit weaker than expected, and it marked a slowdown from the 4.8% rise in the year to February. Nevertheless, South Korean exports have now risen on a year-over-year basis for six straight months, suggesting that global economic activity is picking up after some softness in 2023.

• According to the data, exports to the US were up a healthy 12.0% in the year to March, reflecting the country’s continued strong economic performance.
• In contrast, exports to China were up just 0.4%, reflecting that country’s continued lethargy as it faces a slew of structural economic headwinds.

China:  The government’s official March purchasing managers’ index for manufacturing rose to a seasonally adjusted 50.8, beating expectations and marking a sharp improvement from the reading of 49.1 in February. Like most major PMIs, the official Chinese index is designed so that readings over 50 indicate expanding activity. The March reading therefore suggests that China’s factory sector is now growing again after five straight months of contraction, despite the weakness suggested by China’s lessening demand for South Korean products.

• The rebound in Chinese manufacturing may seem like a positive for the global economy and financial markets, but that isn’t necessarily the case.
• We note that the rise in the manufacturing PMI came in part from a surge in new export orders, which is consistent with the idea that Beijing is trying to re-accelerate its economy by dumping electric vehicles, batteries, solar panels, and other products on world markets. Such dumping threatens to decimate key industries throughout the developed countries.

US Monetary Policy:  After Friday’s personal income and spending report showed the Fed’s preferred measure of consumer price inflation remained above target, Chair Powell took a sanguine attitude, stating at an event in San Francisco that he still expects price pressures to keep easing, even if the road to 2.0% inflation will be “bumpy.” Nevertheless, Powell also warned that the Fed would take its time in cutting interest rates if price pressures prove sticky.

• In Friday’s report, February personal income rose by a seasonally adjusted 0.3%, slowing from a gain of 1.0% in January. Nevertheless, despite the slowdown in income growth, February personal consumption expenditures (PCE) jumped 0.8%, accelerating from their rise of 0.2% in the previous month. On a year-over-year basis, personal income in February was up 4.6%, while PCE was up 4.9%.
• Excluding the volatile food and energy components, the February core PCE price index was up 2.8% year-over-year, after two straight months in which it increased an annual 2.9%.

US Bond Market:  New data shows corporate bond issuance has already hit $606 billion so far in 2024, up about 40% from the same period last year and the highest year-to-date total since at least 1990. Reports suggest companies are rushing to market in part to take advantage of today’s low corporate yield spreads over Treasury obligations, but they may also be trying to get ahead of any potential volatility in the marketplace as the November elections draw closer. Trading in VIX futures also points to investors betting on election-driven market volatility.

US Labor Market:  According to the Wall Street Journal, new high school graduates and other members of Generation Z are increasingly eschewing college in favor of training in trades such as welding and plumbing. The report says the number of students enrolled in vocational-focused community colleges rose 16% last year to a record high. The number in construction-trades programs alone jumped 23%. The figures are consistent with our view that US reindustrialization and today’s labor shortages will help broaden the workforce going forward.

US Artificial Intelligence Industry:  Technology giant Microsoft and OpenAI are planning to jointly build a specialized data center costing up to $100 billion to boost OpenAI’s computing capacity for artificial intelligence. The data center would house a supercomputer called StarGate with millions of specialized AI processors. In return for funding the project, Microsoft would have exclusive rights to use the resulting AI systems. The project illustrates how much investment could be needed to build out AI systems in the US going forward.

• A separate report today says big AI firms will soon run out of the high-quality internet text needed to train their large language models. As a result, they may have to shift toward using synthetic text derived from videos, proprietary data, or other sources.
• The report may also help explain China’s extensive hacking of large US databases and its promotion of social media tools like TikTok, which could vacuum up immense amounts of user data. If even the internet isn’t big enough to feed modern AI models, Beijing may be surreptitiously gathering immense amounts of private data from US citizens to aid its influence campaigns and espionage efforts.

US Agriculture Industry:  After years of concern about falling honey-bee populations, new data from the Department of Agriculture suggests bee colonies are making a strong comeback. For example, the data shows that more than one million new bee colonies have popped up around the US since 2007, making them the fastest-growing type of livestock in the country.

• The rise may in part reflect inflation, since the Agriculture Department only counts bee colonies producing at least $1,000 of revenue each year.
• Nevertheless, the strong rise in counted bee colonies suggests populations are indeed rising, allaying concerns that global warming, invasive species, and other challenges are reducing the population of bees that are so critical to pollination and food production. The new data is therefore creating a buzz among environmentalists. (Sorry)

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Note to readers: the Daily Comment will not be published tomorrow due to the Good Friday holiday.

Good morning! While equities are showing a muted reaction to the revised GDP figures, we are celebrating the start of the MLB season. Today’s Comment dives into the rationale behind why investors shouldn’t overlook large-cap stocks. Additionally, we explore how central bank caution has supported the dollar, while shedding light on the factors contributing to the remarkable ascent of the Mexican peso, which has emerged as one of the top-performing currencies globally. As usual, the report includes a summary of domestic and international data releases.

Not Like the Rest: Hopes for Fed rate cuts and the froth in AI stocks fueled risk-on sentiment in Q1; however, this may not carry over into next quarter.

• Fueled by AI optimism and dovish monetary policy expectations, the S&P 500 surged 10% in Q1, its fastest year-to-date rise since 2019. Policymakers’ promises of rate cuts and tech companies’ defiance of expectations fueled this growth. However, recent headwinds threaten to stall this momentum. Fed officials, like Governor Christopher Waller, have grown cautious, downplaying the possibility of imminent cuts due to strong economic data. Additionally, concerns mount that tech valuations are stretched, potentially jeopardizing their outperformance streak. These mounting doubts raise the specter of whether these trends will be able to hold going into the next quarter.
• The market may experience volatility in the next quarter due to a confluence of factors. The Federal Reserve’s monetary policy decisions will be heavily influenced by upcoming employment data. Another strong payroll report, if it exceeds expectations like the recent ones, could lead policymakers to reevaluate their plan for interest rate cuts, potentially reducing the anticipated number to just two for the year. Additionally, investor sentiment is shifting as they look beyond the Magnificent Seven (M7) stocks, whose valuations are reaching expensive territory, and seek safer alternatives.

• The narrow leadership in the market’s 2024 rise suggests a Q2 pullback in momentum is more probable than a correction, absent a significant macroeconomic shock. That said, investors may be able to find value in large-cap companies outside the M7. Excluding those large-cap companies, the index has a P/E ratio of just under 19, which is right in line with historical averages. Given their size, those large-cap firms are relatively well-positioned to absorb changes in Fed policy compared to their mid- and small-cap counterparts and would likely benefit if the Fed follows through on its easing plans.

The Dollar Is Back! The greenback has roared to its strongest quarter in two years, as a shift in market expectations for central bank policy bolstered the dollar’s value.

• The US dollar has surged 2.7% in Q1, according to the Bloomberg Dollar Spot Index, fueled by a shift in central bank policy expectations. Markets initially anticipated interest rates converging globally, but recent pronouncements suggest a slower pace of easing. Echoing the Fed’s cautious stance, central bankers worldwide signaled a more measured approach. Bank of England Monetary Policy Committee member Jonathan Haskel indicated that the UK is a long way off from cutting rates, while ECB President Lagarde remained noncommittal on future policy easing after the ECB’s expected June cut. Meanwhile, the Bank of Japan distanced itself from any tightening bias.
• Central banks’ shift away from aggressive rate cuts has resonated with the market. Investors have adjusted their forecasts upward, anticipating a slower pace of rate reductions and a higher interest rate environment over the next three years. This hawkish tilt is particularly pronounced in 2025 projections, with US rates revised up by 70 bps and the UK seeing a 55-bps increase. These revisions suggest the market isn’t convinced that central banks in Europe and the UK will take drastic measures to cut rates independent of the Federal Reserve’s actions, despite economic weakness in those countries.

• The Fed’s aggressive rate cuts, which have historically started from higher points, often result in a lower terminal rate compared to other central banks. Even if the Fed cuts this year, whether before July or after the election, the dollar’s weakness would likely be temporary. However, the current combination of a strong dollar and high interest rates creates tighter global financial conditions than investors may have anticipated for 2024. This could potentially dampen global growth and make US equities more attractive relative to foreign markets.

The Super Peso: The Mexican peso (MXN) has defied expectations in 2023 by strengthening despite rate cuts and potential US tensions.

• The MXN has emerged as the world’s strongest currency against the dollar this year. Two key factors fueled this stellar performance. First, despite lowering its policy rate this year, Mexico boasts one of the highest interest rates globally, making it attractive for carry-trade investors seeking to profit from interest rate differentials. These investors buy foreign currency (like the dollar) and then invest those funds into a higher-yielding currency (like the peso). Secondly, President Andrés Manuel López Obrador’s (AMLO) plan to reduce government spending has helped curb national debt, bolstering investor confidence in the Mexican economy and its currency.
• Mexico’s strong peso hasn’t shielded its stock market from volatility in 2024. The MSCI Mexico soared nearly 30% in the final two months of 2023, but this year’s performance has been choppy. This uncertainty likely stems from outgoing AMLO’s late-term spending spree, which is expected to push the estimate of public debt as a percentage of GDP from 4.9% to 5.0%. Additionally, his presumed successor, Claudia Sheinbaum, has pledged to cap oil production at 1.8 million barrels per day, a slight decrease that suggests a potential move away from fossil fuels.

• Mexico’s upcoming election looms large over its financial markets. The country’s proximity to the US makes it a magnet for companies seeking North American market access. While AMLO has navigated relations with both US presidential contenders, uncertainty swirls around Claudia Sheinbaum and her ability to maintain these ties. Further complicating matters, tensions with the US are rising as Chinese firms attempt to manufacture electric vehicles in Mexico for the US market, attracting criticism from American lawmakers. Immigration, another perennial issue, adds another layer of complexity. If Sheinbaum is able to successfully avoid US hostilities, Mexican companies could present potential opportunities for investors looking for foreign exposure.

Other News: China’s most senior military leader has urged Asia to take responsibility for managing its own security, indicating that despite the thaw in tensions between the world’s two largest economies, significant geopolitical differences persist. The Russian propaganda machine remains active and potent, raising concerns that Moscow may attempt to influence the upcoming US election.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Equity markets are off to a strong start today. In sports news, the NFL has announced a rule change to its kickoff format, making it similar to the format used by its competitor, the XFL. Today’s Comment dives into the nuanced reasons behind the Bank of Japan’s cautious approach toward significant shifts in monetary policy, explores consumer apprehensions surrounding the upcoming election, and examines the burgeoning AI frenzy making its way across Asia. As usual, we include a round of international and domestic news.

Yen Worries Continue:  The Japanese yen (JPY) weakens as the Bank of Japan indicates it will refrain from additional interest rate hikes, despite inflation exceeding its 2% target.

• The Bank of Japan threatened currency intervention to halt speculation, driving down the JPY. Earlier today, the currency plunged to a 34-year low of 151.97 per dollar, alarming policymakers. This sharp depreciation follows the central bank’s recent decision to end negative interest rates and to signal a pause in further tightening. However, Governor Kazuo Ueda’s dovish stance — suggesting the BOJ won’t raise rates aggressively until inflation expectations reach 2% — has spooked investors. Consequently, they’re dumping yen holdings in anticipation of other central banks, like the Federal Reserve and the European Central Bank, maintaining higher rates for a longer period than the market anticipated at the start of the year.
• Recent inflation data strengthens the Bank of Japan’s case for maintaining its dovish stance. Headline inflation rose 2.8% year-over-year, but this increase hasn’t translated to core inflation. The core index has remained flat since October 2023, suggesting underlying inflationary pressures are subdued. Furthermore, core inflation shows signs of further moderation, rising at an annualized pace of only 2.1% over the past five months, significantly lower than the 3.3% annual change observed in February. The setback in inflation has likely led policymakers to question whether the country has truly turned a corner in its fight against deflation.

• In a shift from past policy, central banks, including the Bank of Japan, are prioritizing a cautious approach to monetary policy. Their primary concern is to avoid triggering unintended economic downturns that would necessitate future policy reversals. This cautious stance extends even to central banks who have traditionally been seen as more hawkish, as evidenced by similar concerns about interest rate adjustments voiced by members of the European Central Bank and the Federal Reserve. This cautious approach by central banks is likely to keep the interest rate differential between the US and its peers stable or even widen it, potentially strengthening the dollar.

Election Concerns: Anxiety is rising among American households about the country’s direction, fueled in part by the potential for a rematch between President Biden and his predecessor, Donald Trump.

• Recent surveys paint a complex picture of consumer sentiment. While headline figures from the Conference Board and the University of Michigan suggest stability, a closer look reveals a growing unease about the future. This is evidenced by a decline in consumer expectations in the Conference Board’s March survey, with the six-month outlook dropping to its lowest point in six months (73.8, down from 76.3). The University of Michigan Sentiment Index echoes this trend, dipping slightly from 75.2 to 74.6. Notably, this weakening confidence emerges despite positive signs in the labor market and significant progress on inflation reduction from its highs in 2022.
• The forthcoming election appears to be a significant factor in the growing disparity between consumer sentiment and favorable economic indicators. According to the latest findings from the University of Michigan, the survey shows a downturn in sentiment among independent voters, while partisan optimism is on the rise among the two major parties. The Conference Board’s observations underscore a rising trend of write-in responses concerning the political climate. This coincides with a noticeable generational divergence among respondents. Individuals under 55 exhibit a considerable decline in enthusiasm, while those aged 55 and above demonstrate greater optimism.

• While the election may influence consumer sentiment, it likely won’t significantly impact short-term spending. This disconnect suggests voters perceive that neither candidate is offering solutions to improve daily living standards. A deeper reason could be the growing acceptance of a new economic reality: Low borrowing costs are likely gone. Tighter monetary policy and ballooning deficits are expected to keep long-term interest rates above 4% for the foreseeable future. This shift may force consumers who missed the window of easy credit to increase savings to maintain their desired financial stability. In the long run, this could stifle economic growth as households tighten their belts and reduce spending in order to adapt to the shifting economic landscape.

Emerging Tech: With tech stock valuations reaching lofty heights, investors are increasingly turning their attention to Asian countries to capitalize on the burgeoning growth in artificial intelligence (AI).

• US tech giants Meta, Nvidia, Microsoft, and Amazon have been driving the S&P 500’s returns this year, accounting for 55% of its gains so far. This surge is likely due to the increasing popularity of AI and the corresponding demand for semiconductors, which are crucial components in AI hardware. While some of the excitement may carry over from last year, Nvidia’s strong sales figures in Q4 have bolstered investor confidence that these companies can continue to deliver above-average returns in the future. That said, their high valuations have led investors to begin seeking cheaper alternatives.
• Fueled by the Asian tech boom, India, South Korea, and Taiwan have emerged as attractive destinations for investors seeking to diversify their tech holdings beyond the US. ETF flow data from Bloomberg shows that India is leading the way with $197 million in inflows year-to-date, followed by South Korea at $181 million, and Taiwan at $112 million. These countries are all well-positioned to benefit from the growth of key technologies like AI and semiconductors and are attracting investors seeking exposure to these trends. The rising inflow also reflects a growing investor preference for geographically balanced portfolios, with a focus on countries with strong economic ties to the US or those maintaining neutrality.

• Risk appetite is currently high, likely fueled by market expectations that central banks will begin easing monetary policy within the next six months. While US mega-cap tech stocks have been in the spotlight for years, their dominance seems to be fading. This is evident in the recent broad-based gains across the S&P 500. Investors seeking to capitalize on the AI boom might find opportunities abroad. Foreign AI firms have experienced impressive growth over the past year and currently trade at lower valuations compared to the well-established “Magnificent Seven” US tech giants.

Other News: Protests have broken out in Hungary after Prime Minister Viktor Orbán was implicated in a graft probe. The Bank of England has warned that a boom in private equity may negatively impact the country, elevating the potential for financial mishap. The Congressional Budget Office Director, Phillip Swagel, has warned of a “Liz Truss-style market shock” if the US government does not get its fiscal house in order.

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