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Question For The Fed: Where Is Waldo?
The risks to the Fed’s dual mandate are constantly changing. Its attempt to hit its inflation target is complicated by price pressures beyond the control of interest rates, and its attempt to hit on a federal funds rate that neither over-stimulates nor over-restricts economic growth is complicated by the elusive nature of this neutral rate. Today, Elias and Ed examine the forces with bearing on the Fed’s rate decisions since 2022. They also explain why they believe that the neutral federal funds rate has risen over recent years and the implications for monetary policy looking ahead.
US SECTORS CALL: Tech Wrecked, Health Care & Staples Rally
The S&P 500 fell 2.0% this week, and Information Technology (MW) took the biggest hit. The sector fell 6.4%, the worst of the 11 sectors (chart). The iShares Semiconductor ETF (SOXX) fell 11.8%. Credit worries spread to AI infrastructure. CoreWeave fell 25% last week. Its worst day was Wednesday, when it sank 15% as its bond yields soared. It was the IT sector's second straight losing week. Industrials (OW) also fell for a second week. On a ytd basis, Energy is up 52.7%, the best of the 11 sectors. IT is second at 21.6% (chart). Consumer Staples (UW) and Energy (OW) led the 11 sectors, each up 5.0%. Health Care (OW) rose 3.4%. Every defensive sector gained, with Utilities (MW) up 2.0% and Real Estate (UW) up 1.2%. Health Care and Staples rallied for different reasons. Earnings drove Health Care's gains. Staples' gains have been driven by its multiple. Here's more on Information Technology, Health Care, and Consumer Staples: (1) Information Technology. The tech selloff last week was led by Semiconductor Equipment (down 17.4%) and Communication Equipment (down 13.3%) (chart). IT Consulting & Other Services rose 5.6%, and Technology Hardware slipped only 1.5%. Two weeks ago, Semiconductor Equipment was the best-performing IT industry, up 97.3% ytd. It is now up 51.6%. Its forward P/E has fallen to 27.0 from 31.1. Its earnings outlook hasn't changed. Analysts still expect growth of 35.0% this year and 48.5% next year (chart). Semiconductor Equipment and Communication Equipment are the only IT industries for which analysts expect faster growth next year (chart). The selling hit the expensive industries. Semiconductor Equipment trades at 27.0 times forward earnings and Communication Equipment at 25.2. Semiconductors, the biggest contributor to IT's earnings, trades at a 14.7 multiple, below the S&P 500's 18.9 (chart). That is less than half its June 2024 peak of 35.5. A low multiple can be a warning signal for a cyclical industry. Investors tend to pay the least when earnings are peaking and the most when they bottom. The industry's forward P/E reached 79.1 in February 2009, as earnings collapsed. So far, analysts are still raising their estimates. They expect earnings to grow 114.0% this year and 77.5% next year. As long as estimates keep rising, we see this week's semiconductor selloff as a buying opportunity. We retain our market weight rating on Information Technology. (2) Health Care. Health Care rose 3.4% this week, and every industry gained. Health Care Distributors rose 16.1%. Even Health Care Equipment, down 16.3% ytd, rose 4.4%. Earnings are doing the heavy lifting. In August, forward earnings and the forward P/E contributed about equally to the sector's ytd gain, at 6.6% and 6.3%, respectively. Forward earnings is up 9.2% ytd, while the forward P/E is up only 2.8%. The price index is up 14.1% (chart). The best is ahead. Analysts expect the sector’s earnings to grow 1.6% this year and 22.5% next year. Pharmaceuticals' earnings are forecast to fall 5.2% this year and rise 28.6% next year (chart). Biotech is estimated to grow earnings 46.4% next year after falling 6.2% this year. The large caps are catching up. On September 10, the S&P 500 Health Care index was up 6.7% ytd, against 20.6% for the S&P 600 and 17.2% for the S&P 400. The S&P 500 sector is now up 14.1%, versus 17.8% and 17.3% (chart). The sector trades at 18.9 times forward earnings, equal to the market multiple of 18.9. We retain our overweight rating on Health Care. (3) Consumer Staples. Two weeks ago, we argued that earnings didn't justify Staples' valuation premium. Investors have since paid even more for the sector. Its forward P/E has risen to 22.5 from 20.7 on October 1. That is above both the S&P 500's 18.8 and IT's 19.1 (chart). The multiple is doing the work again. Staples' forward P/E was down 0.3% ytd at the end of September. Two weeks later, it is up 6.5% ytd. Forward earnings is up 4.9% ytd and has barely moved since September (chart). The priciest industry got pricier. Merchandise Retail's forward P/E rose to 33.6 from 31.0 two weeks ago, though its earnings growth is forecast to slow to 7.1% in 2027 (chart). This is a defensive bid, not an earnings story. We retain our underweight rating on Consumer Staples.
ECONOMIC WEEK AHEAD: October 19 - 23
Last week’s inflation reports came in hot. September’s CPI rose 0.6% m/m, lifting headline inflation from 3.4% y/y in August to 3.7%. Core CPI rose 0.3% m/m, taking its y/y rate from 2.4% to 2.6%. Both topped expectations. PPI final demand jumped 1.3% m/m. That pushed its y/y rate to 6.3%, the highest since 2022. Retail sales rose 0.8% m/m, though just 0.2% excluding gas stations. Odds of a 25bps hike at the October 27-28 FOMC meeting fell from 22% before the CPI report to 17%, despite the hot inflation data. Fed Chair Kevin Warsh offered no signal on October's meeting at the IMF and World Bank annual meetings in Bangkok on Friday. “I don’t prejudge meetings,” he said. Odds of a December hike rose. We still expect the Fed to reverse the remaining two of last year’s three 25bps “insurance” cuts. Fed officials are now in their pre-meeting blackout period. This week’s data calendar is light, with earnings season taking center stage. Friday’s flash PMIs are the main US releases. The Fed’s Financial Stability Report and Canada’s federal budget are tentatively due Tuesday. Here’s more: (1) ADP & Unemployment Claims. ADP’s weekly employment reading (Tue) follows a rise in the four-week average to 24,750 for the week ended September 26, the highest since early June and up from a late-July bottom of 8,250 (chart). Initial jobless claims (Thu) follow last week’s 199,000, with the four-week average at 198,500 (chart). Continuing claims fell to 1,710,000 for the week ended October 2, matching their four-week average. The labor market continues to improve. (2) Flash PMIs. S&P Global’s flash M-PMI and NM-PMI for October (Fri) follow September readings of 55.9 and 58.8 (chart). The services prices component is worth watching after ISM’s NM-PMI prices-paid index jumped to 70.7 in September, the highest since July 2022. Flash PMIs for Australia and Japan (Thu) and for the Eurozone, Germany, France, and the UK (Fri) also land this week. September’s M-PMIs were 52.9 for the Eurozone and 52.1 for the UK. (3) Earnings. The earnings reporting season picks up this week. Netflix, GE Aerospace, and Northrop Grumman report on Tuesday. Tesla and Meta, the first of the Magnificent-7 to report, follow on Wednesday along with Lam Research, IBM, and Texas Instruments. Spotify, Bloom Energy, Western Digital, Lockheed Martin, and Blackstone report on Thursday. ASML and TSMC posted record Q3 results last week. ASML’s net sales rose to €11.7 billion from €9.3 billion in Q2, with the gross margin up to 57.5% from 54.0%. TSMC’s revenue jumped 50.9% y/y. Analysts’ consensus estimates imply Q3-2026 operating EPS growth for S&P 500 companies of 24.0% y/y (chart). (4) Global. China’s Q3 GDP (Mon) follows Q2’s 4.3% y/y growth (chart). We expect a moderate pickup in activity. China’s unemployment rate for September is also due, following August’s 5.2% rate. UK CPI (Wed) for September follows August’s 3.1% y/y headline and 2.6% core (chart). Rising energy and input costs point to a further pickup, with the input PPI up 8.2% y/y in Q2. Bank of England Governor Andrew Bailey speaks later that day. UK labor market data (Tue) and PPI (Wed) are also due. Canada’s CPI (Mon) for September follows August’s 3.0% y/y headline and 2.3% core (chart).
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