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All About The Fed, The Economy & Inflation
In a scant three months, FOMC members moved from a unanimous hold to a unanimous hike, raising the federal funds rate by 25bps and suggesting more of the same to come. President Trump, preferring rates be slashed, blamed everyone on the FOMC except Fed Chair Kevin Warsh. Today, Ed and Elias examine what motivated the September decision and Warsh’s role in it. He had argued all summer that conditions were ripe for a rate hike: The economy was resilient, with a full-employment labor market and financial conditions not restrictive, while inflation was a problem. By September, the Committee at large concurred. … We expect one or two more rate hikes this year. … Also: Dr Ed reviews “The Whisper Man” (+).
US SECTORS CALL: Financials, Communication Services & Industrials
Two shocks hit the stock market last week. On Monday, the heads of the major AI labs called for slowing the development of frontier models, and chip stocks sold off hard. On Wednesday, the FOMC raised the federal funds rate by 25bps to 3.75%-4.00%, the first hike since July 2023, and the updated Dot Plot points to one more this year. The S&P 500 fell 0.1%, with eight of the 11 sectors declining. The Health Care sector (OW) rose 1.8%, and Communication Services (MW) was close behind at 1.2%. Utilities (OW) fell the most, down 3.0%, while Financials (OW) and Real Estate (UW) both fell 2.3%. Let's take a closer look at Financials, Communication Services, and Industrials: (1) Financials. Financials was the second-worst performer this week, but the Fed wasn't the main reason. On Monday, Bank of America CEO Brian Moynihan told the Barclays Global Financial Services Conference that Q3 investment banking fees will come in between $1.6 billion and $1.8 billion, down from $2.0 billion a year earlier. Moynihan cited Dealogic data showing investment banking fees across the market down about 10%. The IPO window has not helped, with OpenAI ruling out a 2026 listing. Bank of America fell 5.1%, and the group fell with it. Investment Banking & Brokerage declined 4.4% this week, the second-worst industry in the sector, while Regional Banks fell 4.8% and Diversified Banks fell 4.0% (chart). Analysts also expect the deal boom to fade. They just put it a year out. Their consensus estimates represent earnings growth for Investment Banking & Brokerage companies of 30.7% this year but just 9.7% in 2027 (chart). Moynihan says the fade is happening now. None of that has dented the fundamentals. Forward earnings is up 12.5% ytd, but the price is up just 1.8% because the forward P/E is down 9.5% (chart). The Financials sector’s companies collectively trade at 14.7 times forward earnings versus 18.9 for the S&P 500, a discount the sector has carried since 2010 (chart). The sector's forward profit margin is at a record 22.1%. We are retaining our overweight rating on Financials. (2) Communication Services. Within Communication Services, up 1.2% this week, Interactive Media Services did the work, rising 2.9% (chart). Monday's selloff ran on fears that a slower AI LLM training race means less demand for compute, as the SOXX gave back 5.5%. Nevertheless, there is a large backlog in the demand for compute as measured by remaining performance obligations of the hyperscalers (chart). Alphabet and Meta account for 78.4% of the sector's market capitalization and 70.0% of its forward earnings. Interactive Media has a 29.4% forward profit margin versus 21.7% for Communication Services as a whole, and analysts expect earnings to grow 73.0% this year versus 55.9% for the sector (chart). The sector trades at a forward P/E of 18.4 even though analysts collectively expect an earnings decline in 2027 of 11.3% (chart). Google and Meta represent 70% of the sector’s earnings and the entire growth story. Remove them, and the fundamentals do not support the multiple. We are retaining our market-weight rating on Communication Services. (3) Industrials. Industrials is down 3.1% mtd and still up 9.2% ytd. Last week's selloff hit its best performers. Construction Machinery & Heavy Trucks and Rail Transportation lead the sector ytd at 29.7% and 20.2%, and last week they were the sector's two worst industries, down 2.1% and 2.4% (chart). Construction Machinery's 2026 earnings forecast has doubled to 40.1% from 18% in January. A pause in frontier AI model training does not cancel orders already placed. Rail revenue growth for 2026 has jumped to 8.8% from 2.9% in March. We flagged the sector’s valuation risk in April, and it has resolved in our favor. The sector's forward P/E was 25.5 back then versus 20.9 for the broader S&P 500 index. It is now 22.4 against 18.9 (chart). Electrical Components has been devalued, with its forward P/E dropping from 28.7 to 24.4, even as its forward profit margin has risen to 18.2%. Industrials still trades at a premium to the S&P 500 multiple on slower earnings growth expectations. The analysts’ consensus for long-term earnings growth is 18.0% compared with 26.6% for the S&P 500. We are retaining our overweight rating on Industrials.
GLOBAL MARKET CALL: Stocks Weathering Storm In Bonds
Central banks in the US, Europe, and Japan all raised their policy rates over the last two weeks. Bond yields are rising nearly everywhere. Neither development has broken the global stock bull market, as earnings forecasts keep getting marked up. The Stay Home and Go Global investment strategies have been tracking each other fairly closely in recent months, with limited dispersion between the two. The divergence instead has been across individual markets. Here's more: I. Stay Home vs Go Global The ratios of the US MSCI to the All Country World (ACW) ex-US MSCI in dollars and in local currencies remain on downtrends relative to their early-2025 highs (charts). However, they have been relatively flat so far this year. The major stock market index performances show the same. The US MSCI is up 11.7% ytd in dollars versus 12.9% for the ACW ex-US MSCI (chart). Among country MSCIs, Brazil leads the mtd rankings at 3.6% in dollar terms, with Taiwan at 2.8% and South Korea at 1.0% (chart). The US is down 0.5%, ahead of the ACW ex-US at -2.0%. Germany and Switzerland trail at -6.0% and -5.0%. II. Earnings & Valuation Consensus EPS estimates outside the US are getting revised up across the board. The ACW ex-US MSCI's 2026 consensus earnings growth estimate is now 38.2%, up from 13.3% at the start of the year (chart). The 2027 estimate is 15.7%. South Korea leads at 335.6% for 2026, with the emerging markets aggregate at 74.6%. The US MSCI trades at a 19.4 forward P/E versus 12.6 for the ACW ex-US, 15.6 for Japan, 14.2 for the European Monetary Union (EMU), 9.7 for Emerging Markets, and 5.0 for South Korea (chart). Korea is at a 14.4-point discount to the US. Profit margins explain the US valuation premium. The US MSCI's forward profit margin is 16.6% versus 13.4% for Emerging Markets, 12.6% for ACW ex-US, 10.5% for the EMU, and 10.1% for Japan (chart). Every one of them has been rising. III. Global Bonds Yields are still climbing, and equities seem to be reading it as a sign of economic growth, alongside other less bullish developments such as higher-for-longer bond yields and fiscal excesses. The UK's 10-year government bond yield is 5.30%, the US's is 5.01%, France's is 4.57%, Germany's is 3.52%, and Japan's is 2.98% (chart). The US is at the top of the 4.00%-5.00% range we call the "old normal." China remains the exception, at 1.72% and still drifting lower. Its bond market continues to reflect deflation expectations while all others reflect the opposite. IV. Japan The Bank of Japan (BOJ) raised its policy rate by 25bps to 1.25% on Friday, the highest since 1995 (chart). The yen weakened on the decision, largely due to two dissents by board members appointed by Prime Minister Sanae Takaichi. Governor Kazuo Ueda said monetary policy has entered a new stage and declined to rule out more consecutive rate increases and larger rate increases. The inflation data explain the caution. Headline CPI was 1.9% y/y in August, with the core rate at 2.0%, while the PPI was 7.6% (chart). The BOJ is tightening in response to a cost shock, not a demand boom. Japanese rates have moved regardless. The 2-year government bond yield is 1.84%, well above the 1.25% policy rate, and the markets expect the policy rate to reach as high as 2.00% by the end of 2027 (chart). Meanwhile, Topix Banks closed near recent record highs (chart). Both have gone nearly vertical over the past two years. The Financials sector is up 38.9% ytd in the Japan MSCI, second only to Information Technology at 44.3% (chart). V. Gold Gold has been weak recently as major central banks have been raising policy rates (chart). However, it found support at an uptrend line that started in 2023. We are still targeting $5,000 by the end of this year.
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