Fiscal on Fire
The '95 analog revisited, fundamental earnings momentum, fiscal boom, the Fed's balance sheet and malinvestment, record low implied correlation
Party Like it’s 1995
Integral to our bullish ‘23 outlook was the ‘95 analog. From the peak in the aggressive rate hike cycle in November ‘94 the S&P 500 went on a tear that didn’t lose momentum until the Fed cut the policy rate 25bp in early July. It then consolidated for two months before resuming the uptrend as a tech-driven investment boom was in its early stages. As Mark Twain reportedly said, history rhymes, it doesn’t repeat, and there is one key difference with the current cycle, namely the depth of the yield curve inversion and its impact on small banks, businesses, and the massive, growing pile of government debt. This is a subtle but important difference for asset allocators: 10-year Treasuries began the rate hike cycle near 5.5%, peaked at 8% in November ‘94, and finished ‘95 back at 5.5%. Returning to the starting point for Treasuries this cycle is a very low probability outcome. With the first quarter in the books, the 10% rally in the S&P 500, led by communication services, energy, tech and financials in that order, following a similarly strong 4Q23, looks a lot like ‘95 with a couple of important exceptions attributable to the deeply inverted yield curve. The Russell 2000 index did not lag in the first leg of the ‘95 rally, and Treasury returns were positive, but in 1Q24 small caps lagged large caps by 5% and the Bloomberg Treasury Index total return was -1%.
Our outlook for ‘24 was bullish, but not for 1Q when our base case was a growth scare driven by the labor market that would cause a modest equity market correction. Our second most likely outcome was a resumption of yield curve bear steepening. We got a version of the latter scenario, but the velocity of the move was not sufficient to offset the recovery in earnings from the 4Q22-2Q23 shallow earnings recession, consequently equities looked right through negative fixed income returns. Earnings estimates increased, earnings estimates momentum (net revisions) ground higher, margins increased and deflated (real) sales per employee increased sharply, implying productivity is on the rise. Whether the surge in productivity turns out to be a one-time level shift as Fed Governor Waller suggested during his Economics Club of NY speech we attended (virtually) Wednesday night, or our accelerated technology innovation adoption that began pre-pandemic thesis is correct, it looks to us like margins will likely continue to move higher in the near term. As we have long maintained, going back to our days as the head of equity strategy at Barclays Capital, the rate of change of earnings estimates drives the market multiple. It is going to take a significant weakening of aggregate demand to derail the underlying fundamental earnings momentum.
In this week’s note we will review gross domestic income and the recovery in the corporate contribution, strong fiscal spending and the impact on physical plant investment, as well as the outlook for the Fed’s balance sheet. Next week, following Tuesday’s Job Openings and Labor Turnover Survey we will release an employment report preview. That report is critical for our Quadrilemma thesis, because while equity investors are sanguine about the timing of the Fed beginning to normalize policy, with the Treasury changing their issuance mix from bills to coupons, another significant, high velocity bear steepener is possible, if not probable, if the labor market data doesn’t soften and inflation doesn’t cool.