Emerging leadership of Tech + China supports better 2H outlook… more signs inflation cooling

May CPI obvious focus but “half full” gaining incrementally

As many of our clients have remarked recently, every economic data point is really an inflation report. Repeating the obvious logic: trajectory of inflation impacts Fed rate path. Thus, every report is an inflation report.

But as we have discussed previously, there are many emerging signs that economic activity/inflation is potentially slowing faster than expected.

• this week, US mortgage applications plunged to lowest in 22 years.
• for reasons discussed below, this portends a dual hit to home price (negative shock) and possibly 60% drop in mortgage banking employment
• fertilizer prices are down 34% from peak
• there are signs that corn, cattle and wheat prices might be plateauing
• in the meantime, the global supply chain strains seem to be easing
• this points to possible accelerated declines in goods pricing
• of course, oil remains elevated, but oil is almost becoming a barometer for the Russia-Ukraine war and as long as hostilities escalate, oil is higher
• but this is somewhat binary — cessation of hostilities likely dramatically impacts inflation perceptions

All in all, this argues that the “half-full” view regarding both Fed trajectory and equity markets is gaining credence. That is, the 20% decline already has discounted a “soft landing” or “growth scare” and only a “hard landing” would justify further downside. In other words, we stick with our view that stocks strengthen in 2H and even revisit prior highs.

GREEN SHOOTS: Nasdaq 100 and China are beginning to outperform the broader market

And possible signs of “green shoots” are the emerging outperformances of both Nasdaq 100 and China equities:

• Nasdaq 100 peaked (vs S&P 500) in November 2021 and recently showing signs of a bounce
• China (CSI 300) has been quietly outperforming since March 2022
• Both indices would not perform well if inflation risks are rising
• Nor would these outperform if the global economy was headed for a “hard landing”
• So, for now, we see this as “green shoots” and positive for risk assets
• And affirms that we see large-cap Tech leading in 2H 2022

May CPI is important, but not necessarily decisive

May CPI is reported Friday am (6/10) at 8:30am ET and equally important is the U Mich Consumer 1-yr expected inflation. And the key figures are highlighted below.

• our clients have told us their focus will be on the services components of CPI
• they expect goods pricing to be easing

Travel and Hotels have seen the biggest surge in inflation

Our data science team highlights “revenge travel’s” distorted impact on services CPI. The April surge (already reported) shows >20% gains for hotels and airlines:

• May CPI should show this trend to continue
• markets seem to be bracing for further surges as equities were weak into Friday

Inflation surprise risks are abating in the US, even as China comes online

Broadly speaking, inflation risks in the US are diminishing to an extent. As shown below, the Citi Inflation Surprise index (only updated monthly) shows diminishing surprises for the US.

• inflation surprises are rising in Eurozone and EM
• and China
• but diminishing in the US

…Mortgage applications down 68% from 2021 peak

As cost of money has risen (“mortgage rates”), mortgage applications have fallen sharply and now the lowest level in 22 years.

Looking at the 4-week sum, applications are now down 68% from levels seen in 2021. That is a huge decline and for reasons discussed below, suggests downturns in:

• US home prices likely to fall = wealth effect is what Fed is targeting
• Mortgage employment likely to fall sharply = weakening labor market is what Fed is targeting

Home prices are likely to weaken from here (thanks for flagging this Mark Newton). As shown:

• mortgage application activity leads
• home price change by roughly 12 months
• downturn in applications portends a sharp fall in home prices
• Fed tight policy is targeted to impact asset prices like housing
• thus, weaker home prices is an outcome the Fed is looking for

The Fed doesn’t want every stock to fall, but they want to tighten financial conditions

Investors tell us they don’t want to “fight the Fed” and as long as the Fed is tight, they will not touch equities. This is intuitively sound, but here are some issues with this thinking:

• The Fed is fighting inflation, and probably has White House consent to drive a recession, if this is needed
• Inflation, however, could cool faster than Fed and markets anticipate = dovish turn
• The Fed is trying to tighten financial conditions broadly — stocks, housing, cost of money, etc.
• The Fed is not targeting specific stocks — ie, FAANG doesn’t need to keep getting pummeled
• Why doesn’t Fed just short oil futures and tank commodity speculators if they were being specific

In other words, this current Fed policy stance doesn’t means stocks have to keep falling. There is simply no way for the Fed to titrate and create equilibrium in stock prices this way. In fact, looking at scenarios below:

• In our view, markets are focused on the “left tail” risks of Hard landing, recession
• Our base case is that US is facing a “growth scare” and means 20% decline fully discounted this
• FAANG valuations are attractive and we favor OW FAANG/Tech here

Spectrum of Economic outcomes for markets in 2022

Labor shortage in 2022 is a demand driver for Technology/automation…

Signs of economic slowing are becoming more prevalent, allaying concerns that the economy is so “hot” that the Fed needs to further accelerate rate hikes. But the unknown is how quickly inflationary pressures abate. As our clients know, we believe goods inflation will decline faster than consensus expects, which in turn alleviates the inflationary upside risks.

And in this context, we believe investors need to balance their concerns of downside risk, with the emerging opportunities. Take a step back and think about what are the key structural fractures becoming highly evident in 2022:

• importance of energy and food security — USA best positioned. OW Energy
• need to rejigger supply chains to “friends” or back to USA — USA best positioned
• evidence of labor shortages throughout the world — raises ROI of “automation”
• on this last point, OW Technology. USA best positioned (leader in technology)

Of the above, financial markets have reacted appropriately. That is:

• USA vastly outperformed rest of world — our thesis in 2022
• Energy crushing other sectors — Energy is our top sector pick in 2022

Investors deem Technology “done” but we think Technology demand will accelerate next few years

But why has Technology been gut punched and abandoned by the Street? Investors can cite plenty of reasons to not like Technology:

• valuations became a bubble
• demand pulled forward due to COVID
• supply chains hurt visibility
• FX hurting EPS
• on and on

But we think there are 3 simple reasons to like Technology here:

• Technology demand, in our view, will accelerate as companies seek to offset labor shortage
• Technology valuations are lower than the 2003 trough
• Technology has led off every major bottom, not because of QE or low rates, but because of GARP

May jobs report shows tight jobs market easing in the US…

The key takeaway from the May jobs report, in my view, is that labor markets are, on the margin, easing from extremely tight conditions. Participation rate rose modestly. And the average hourly earnings grew at a slightly lower pace.

• but for businesses, labor market conditions are extremely tight today

Figure: Themes in 2022 – “BEEF”

Per FSInsight

Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500

** Performance is calculated since strategy introduction, 1/10/2019