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On Inflation, Capital Spending & Economic Resilience
Today, Ed and Elias take a deep dive into core inflation, i.e., minus volatile food and energy prices. The Fed’s preferred measure, the core PCED, justifies tightening monetary policy—both the recent September rate hike and presumably future ones provided that underlying inflation remains elevated. … The alternative measure, the core CPI, is structured differently, causing it to diverge from the core PCED in response to price changes in AI-related spending, financial services, and shelter. … The US economy should remain resilient during this tightening cycle, as GDP growth has become increasingly desensitized to interest rates. That’s one reason the recession widely expected in 2022 and 2023 never happened.
US SECTORS CALL: Semiconductors, Utilities & Materials
Stocks opened last week with a big rally. The S&P 500 rose 1.5% on Monday, and the Nasdaq closed at a record high as oil prices and bond yields fell. The reprieve didn't last. The 10-year Treasury yield climbed to 5.17% by Friday's close, its highest level since 2007. The S&P 500 still finished the week up 1.2%, and six of the 11 sectors rose. Information Technology (MW) led with a 3.1% gain, followed by Communication Services (MW) at 2.2% and Health Care (OW) at 1.7% (chart). Utilities (OW>MW) was the weakest performer at -3.2%, followed by Energy (OW) at -3.0% and Financials (OW) at -1.6%. Here's more on the S&P 500 Information Technology, Utilities, and Materials sectors: (1) Information Technology. Monday's rally was led by chip stocks, which jumped on early signs of success for Meta's Muse agent. AMD rose 10% to close above $1 trillion in market value for the first time, and Intel gained 12%. The S&P 500 Semiconductors industry rose 3.6% for the week and is up 6.8% mtd (chart). The CPU makers did the heavy lifting for the industry. Muse does more than answer questions. It runs a browser, calls external tools, and keeps working on tasks in the background. That work needs general-purpose processors alongside AI accelerators. A report that AMD plans a 10% price increase in Q4 helped too. AMD is up 34.0% mtd, while Nvidia is up just 1.9% (chart). Analysts have continued to raise their estimates for companies in the Semiconductors industry index. Their consensus estimates imply collective earnings growth of 113.0% this year and 73.5% in 2027, on revenue growth of 71.6% and 60.7% (chart). The industry's forward profit margin is 51.2%. Investors still pay less for these earnings prospects than they do for prospective earnings in the rest of the market as a whole. The Semiconductors industry index trades at 16.5 times forward earnings against 19.2 for the S&P 500. The industry now accounts for 53.8% of the Information Technology sector's forward earnings, up from 51.9% in August, against 41.2% of its market cap (chart). We maintain our market weight rating on Information Technology. (2) Utilities. Rising bond yields have hit Utilities harder than any other sector. Utilities is down 7.4% ytd, the worst of the 11 sectors. Electric Utilities is down 8.3% ytd, and Independent Power Producers is down 11.2% (chart). Water Utilities is the only industry in the sector still up this year, but by just 0.3%. Earnings and margins are not the problem; valuation is. The sector's forward earnings is up 6.4% ytd, while its forward P/E is down 12.4% ytd (chart). The bears have a case. At 5.17%, the 10-year Treasury yield competes with utility dividends for income investors. Electric Utilities, the sector's largest industry, is 11.7% below its 200-day moving average (chart). Analysts have also trimmed their 2027 earnings growth forecast for the sector to 9.1%. We think the multiple has suffered enough damage. Analysts expect the sector's earnings to grow 11.3% this year, and it trades at 15.5 times forward earnings against 19.2 for the S&P 500 (chart). That discount pays investors to wait out the bond market. We are retaining our overweight rating on Utilities. (3) Materials. President Trump and President Xi met in Washington on Thursday and extended their trade truce by two months, to January 10, 2027. They made no firm new commitments on rare earths. Materials rose 0.3% this week. Copper led the metals industries, up 1.1% (chart). The sector's earnings boom is mostly a 2026 story. Analysts expect Materials earnings to grow 38.7% this year and 11.4% next. The Steel industry shows the drop-off most clearly. Its earnings are forecast to jump 137.4% this year, grow 8.0% in 2027 and fall 6.9% in 2028 (chart). Both 2027 and 2028 estimates have been gradually falling over time. The Copper industry is the exception. Its earnings are forecast to grow 70.3% this year and 38.9% in 2027 (chart). Its revenue growth is expected to accelerate from 14.0% to 20.6%. The copper price rose to $6.70 per pound on Friday, above the $6.57 record we noted on August 9. Gold has not kept pace. The Gold industry fell 1.7% this week. The gold price is $4,286 per ounce, down 1.0% ytd and below our $5,000 year-end target (chart). Analysts have cut the Gold industry's 2026 earnings growth forecast to 36.1% from above 50% earlier this year (chart). The industry still earns a 38.8% forward profit margin and trades at 12.1 times forward earnings. Investors have priced in the forecast 2027 earnings slowdown. The sector's forward earnings is up 22.6% ytd, while its forward P/E is down 9.7% (chart). At 17.0 times forward earnings, Materials trades below the S&P 500's 19.2. We are retaining our overweight rating on Materials.
ECONOMIC WEEK AHEAD: September 28 - October 2
The week ahead is jam-packed with labor market data releases, capped off by September's employment report (Fri). August's PCED and the third estimate of Q2 GDP arrive Wednesday, along with BEA's annual revisions, followed by ISM's M-PMI on Thursday. FedSpeak continues, with Richmond Fed President Tom Barkin, Governor Lisa Cook, Chicago Fed President Austan Goolsbee, Minneapolis Fed President Neel Kashkari, and New York Fed President John Williams among those scheduled to speak. They will likely weigh in on September’s FOMC rate-hike decision and the recent rise in global bond yields. Overseas, the Reserve Bank of Australia will issue the week's only scheduled interest-rate decision. China's official PMIs and flash Eurozone inflation figures are also due out, with European Central Bank President Christine Lagarde making several public appearances. Micron reports earnings on Wednesday. Here’s more: (1) Employment. September's employment report (Fri) is the headliner. Payrolls rose 162,000 in August, lifting the three-month average to 71,300 (chart). Private payrolls accounted for 127,000 of the gain, led by leisure & hospitality (62,000) and goods-producing industries (41,000). We expect a figure close to 100,000 for September. Fed Chair Kevin Warsh said at his September 16 press conference that the unemployment rate, at 4.1% in August, is "basically running consistent with full employment." He added, "I don't believe that we need to do harm to the labor markets to achieve our [inflation] objective." Challenger's September layoff announcements (Thu) follow August's 52,900, still low by historical standards (chart). Layoffs probably remained light last month, according to initial unemployment claims, which held at a four-week average of 203,600 as of September 18. Warsh noted that claims are running at levels consistent with full employment. August's ADP private payrolls rose 38,000, below the 47,000 consensus and July's upwardly revised 46,000. September's ADP report (Wed) may show improvement, with ADP's weekly readings rising for three straight weeks to a four-week average of 20,000, up from a late-July bottom of 8,250 (chart). That pace equates to roughly 85,000 a month. July's JOLTS data showed job openings at 7.3 million, with the share of consumers saying "jobs are plentiful" at 27.0% in August, both consistent with a stable labor market (chart). We expect more of the same in August's JOLTS report (Tue). (2) GDP. The third estimate of Q2 GDP (Wed) follows the second estimate of 1.5% saar, with the GDP price index up 6.4%. It arrives with BEA's annual update, which will revise prior data. The Atlanta Fed's GDPNow model estimated Q3 growth at 5.0% as of September 25, led by an 18.5% jump in business equipment spending (chart). (3) PCED. August's core PCED (Wed) follows July's 3.3% y/y. That was well below August’s 4.6% pace of core PPI final demand for personal consumption (chart). The core CPI was 2.4% in August. Based on the CPI and PPI data for August, Warsh estimated August’s core PCED at about 3.2% y/y and headline PCED at about 3.6% y/y. The Cleveland Fed's Inflation Nowcasting model projects hotter readings of 3.4% and 3.8%, respectively. (The model’s m/m rates are 0.34% and 0.27%.) (4) M-PMI. ISM's M-PMI (Thu) was 54.6 in August, with the NM-PMI at 55.4 (chart). S&P Global's flash M-PMI for September jumped to 57.0 from 53.9, suggesting another strong ISM reading. The flash composite rose to 58.4, the strongest since July 2021. Input costs across goods and services rose at the fastest pace since October 2022. S&P 500 forward earnings continue to rise, increasing 37.2% y/y in September, suggesting more upside for the M-PMI (chart). (5) Earnings. Micron reports fiscal Q4 results (Wed) for the quarter ended in August. Based on analysts’ consensus estimates, they expect revenue of $50.8 billion, up from $11.3 billion a year ago. EPS is expected at $31.45, within management’s guidance range of $30.00-$32.00 and up from $3.03 a year earlier. Yet the stock has fallen 11.1% since peaking after its last quarterly earnings report back in June (chart). Analysts expect Micron's net income margin to widen to 70.7% in fiscal Q4 from 69.6% in Q3. Its forward profit margin has reached 71.6%, well above its 2018 peak around 42% (chart).
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