Is the Music Slowing Down?

By The Numbers: Atlanta Fed President Bostic said this morning that Moody’s downgrade will raise the interest rate costs for firms that “will cut across financial markets.” His caution is notable, especially with the S&P 500 priced at a lofty 22 times forward earnings. Using a simple pricing model, the S&P 500 should be trading at a 17.5 multiple given the current 9.4% weighted growth rate of companies in the Index, the 4.5% 10-year yield, and the VIX at 22. That equates to the S&P trading at 5000, representing a drop of 15%. Normally, the market goes sideways until the economics of businesses “catch up” to investors’ bullishness. However, with financing and inventory costs likely to depress margins, and anxious consumers, it is a stretch to make sense of the current valuation. The prudent course over the long run may not be to chase markets despite the underlying strength. 

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Finally Great News, But Not For Us

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Soundbite: China is beginning direct investments in Europe to start selling directly to that market. This is what the U.S. needs to revitalize its manufacturing base, but Europe will see the benefits.

The smartphone maker Xiaomi started manufacturing EVs last year, and its top model is already more popular than Tesla’s Model 3 in China. The company is building an EV research center in Munich and plans to produce cars by 2027 at the latest. A number of senior Ferrari and BMW executives have quit to join the effort. Smart EV manufacturer NIO opened a technology center outside of Berlin last year that will work in tandem with its existing facility in Berlin, which was built in 2023. 

Last week, BYD, the largest EV manufacturer in the world, held a signing ceremony with the Hungarian government to set up a factory that will be producing cars before the end of the year and will have the capacity to produce 200,000 units. The Hungarian government is adding about $275 million in infrastructure, with estimates of the BYD investment running above $4 billion. The project is expected to create 2,000 jobs. 

The United States now has the stated goal that tariffs would incentivize our trading partners to invest here to avoid the tariffs. As we wrote last week, we almost need the presence of China, which produces 40% of global manufacturing output. Chinese companies would invest in the U.S. despite concerns about the administration’s policy consistency. Perhaps a part of this rally is discounting such an event, but for now, the only certainty is the party is starting in Europe, not here.

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Ignore at Your Own Risk?

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Soundbite: The University of Michigan’s inflation expectations survey has risen sharply each month this year and sits at disturbing levels, but with the improved trade talks with China, investors are looking at it as yesterday’s news. We advise against fully dismissing the report. Keep an open mind, and look closely at next month’s survey.

Inflation expectations from the University of Michigan’s Consumer Sentiment Survey are white hot. One-year expectations of 7.3% are up 2½ times from year-end 2024 and the highest since the 1970s inflation era. The expected change in prices in the next five years is not normally prone to volatility, but has gone vertical since January, rising from 3.0% to 4.6%. Instead of alarms going off at the Federal Reserve, all is quiet, and investors ignored it.

There are two reasons for looking past this data:

·       Markets are looking at the Geneva trade meeting as a watershed event between China and the U.S., so future reports will see vastly improved inflation expectations, and

·       The New York Federal Reserve’s 5-year inflation expectations data for April, released May 8, is below last year’s reading.

We have written before about the University of Michigan’s sentiment survey’s sampling method as being inferior to the NY Fed’s Survey of Consumer Expectations (SCE). The 5-year inflation expectations being so stable in the SCE explains why members of the Federal Open Market Committee (FOMC) believe that inflation expectations remain anchored.

The uncertainty surrounding the final form of tariffs has diminished, but we are not convinced that tariffs will be seen as a one-time rise in prices, leaving open the possibility that consumers will raise their long-term inflation expectations. The 3-year inflation expectations data in the SCE has been rising each month this year, and we are going to examine the May data closely when it is released on June 9. Importantly, we will see the final Michigan data for May on the 30^th and are eager to see what the preliminary June data looks like when it is released on June 13, a few days before the June 17-18 FOMC meeting. If one month after the Geneva trade talks, there is no drop in the Michigan data, and the 3-year inflation horizon SCE data is higher, then we may see investors begin to worry that persistent inflation will lead to higher interest rates that weigh on stocks. Until then, the consensus is not worried.

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Bill Dudley is Not Popping any Corks

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Soundbite: With the average tariff expected to be 18% versus 2.5% in the first Trump term, the stagflation scenario is still the baseline. The 90-day temporary tariff reduction confirms a Fed on pause until then, and that risks no rate cuts even if unemployment rises. Investors may ignore this because it lies in the future and wait until something negative unfolds before selling.

The worst may not be over for the Federal Reserve, according to former NY Fed President Bill Dudley. He lists the following as supporting his skepticism:

·   The China-U.S. tariff structure may get worse,

·   Firms will still delay purchases, capex, and hiring,

·   The Fed will be slow to move on weaker data, fearing inflation expectations could spike. The FOMC may not have clear data on inflation, growth, or trade until September.

·   If the economy weakens into a recession, the Fed may have to reduce rates quickly down below 2% Fed funds unless it is constrained by inflation expectations.

Assuming tariffs stay where they are after the Geneva discussions, he cites the Yale Budget Lab estimates that the consumer still faces a 17.8% tariff rate. Even after Yale incorporates substitution effects, it is still 16.4%. The Budget Lab forecasts a 0.4% increase in unemployment and a 1.7% increase to inflation. They expect real GDP to fall 0.7% and a permanent drop in real GDP of -0.4% annually.

Dudley is certainly at odds with the current bullish market environment. Bulls can argue that until things change, there is no reason to stop buying.

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What to Look for This Week

(All times D.S.T.)

1. Housing Data: Friday, May 23 at 8:30 a.m. New Home Sales for April. The series has been rising this year and is approaching the 2023 and 2024 peaks. Thursday, May 22 at 10:00 a.m. Existing Home Sales for April. March fell 5.9% 2.4% on an annual basis, the lowest since April 2009, in contrast to a 6% y/y rise in March New Home Sales. Mortgage Bankers Association Purchase Index is out Wednesday, May 21 at 7:00 a.m. and last week it increased to its second highest weekly reading in over a year.

2. Thursday, May 22 at 11:00 a.m. Kansas City Federal Reserve’s Manufacturing Index for May. The series has been in a tight range since 2022, so it is not usually on our radar screen, but we are interested in Prices Received for Finished Products data. It has been rising for six months and spiked dramatically in April.

3. Thursday, May 22 at 7:30 p.m. Japan’s Core Inflation Rate for April. This is an important release because the data is in front of the Bank of Japan’s June 16 monetary policy meeting. Expectations are for keeping rates at 0.5%. but core inflation has been above the BOJ’s 2% target for almost three years, supported by rising wages and March matched January’s high 3.2% reading.

FOMC Voters Speaking:  Thursday, May 22 at 2:00 p.m. New York Federal Reserve President John Williams speaks.

Earnings Note: Four companies that could shed light on the consumer. Tuesday, May 20, Home Depot, and Wednesday, May 21 Lowe’s and Target, all three in the morning before stocks open. Ross Stores report after the close on Thursday May 22.