Every correction needs a catalyst

What could be that catalyst? Catalyst #1: sticky inflation. How about that March CPI report! But there’s more. We’ve seen rallies lately in numerous commodities—notably oil and gold, but also some industrial metals. Furthermore, with bitcoin up and equities up as well, it seems a reflation trade is on, which prompts the worry that the Fed won’t find it easy to cut rates. With unemployment low and inflation recalcitrant, some investors have come to wonder whether the neutral fed funds rate might be higher than the Fed thinks. Renaissance Macro suggests that “r-star” might be a point higher than the 2.6% currently supposed. If so, the fed funds rate is not going down to 3% in 2026 as per Fed projections. So far in 2024, CPI is running at 4.6%, and y/y inflation comparables are about to become less benign—uh oh. To some extent, the elevated rate is a function of shelter, one of the stickiest inflation components. On an ex-shelter basis, headline CPI was 2.3% y/y in March. That’s encouraging, but services inflation is on a tear lately; CPI services less rent of shelter has gone from 2.8% y/y in September to 4.8% in March. Then there’s the election-year factor. Taxes are coming due, and this will give the Treasury a “$1 trillion cash bazooka” (Strategas’ words) to spend between now and November. That said, ISI notes most leading inflation indicators are soft, suggesting that help may be on the way.  For one thing, the quits rate has gone down, although the labor market (stickiest inflation component #2) may still be too tight. Importantly for the Fed: 1, 3, and 5-year inflation expectations remain anchored around 2.5%. Not an ideal correction catalyst, inflation remains elevated, and with low unemployment, it’s hard to see the Fed’s doves outweighing the hawks.

Catalyst #2: Q1 earnings season. Knock on wood, indications are mostly solid, with overall growth expected to be 5%. Communication Services and Information Technology are set to lead the charge but, interestingly, Utilities is projected to see 18% growth. Wolfe foresees strong earnings in the quarter ahead due to strength in the economy. Strategas sees 2024 EPS for the S&P 500 advancing about 10.5% above 2023, with 2025 adding a further 13%. (A possible upside surprise this year? Energy.) Because we had an earnings recession in 2023, this year’s earnings benefit from comparison to a weak base. Furthermore, profit margins are expanding. 2025 upside catalysts: Inventories stand in need of replenishment, the manufacturing sector is rebounding and tech capex is booming. Government largesse in the form of three massive stimulus programs has unleashed a construction spending boom. $500 billion of federal funds will be boosted by state government funding as well as private capital to attract foreign and domestic manufacturers. And the consumer is shifting back to buying goods. Speaking of which, correction catalyst #3 would be rising unemployment, but strong earnings growth suggests no such thing.

So where’s that correction everybody expects? As of this writing, the S&P is just 2% off its record high of 5,264. Strategas says the technicals look pretty good. Making no progress for the last month, you could say the market is tired. Still, liquidity is more plentiful than one might think. It’s true that M2 continues to contract y/y, but the U.S. monetary base (which made a significant low in October 2022 along with the S&P 500) is up 10.8% on the year. Leuthold points out that it’s not the size of this rally that’s so rare, up 30% in half a year’s time. What’s strange is that it began a year or so after the yield curve inverted, with valuations already a bit rich and unemployment low. The silver lining—one of the most pronounced short-term wealth effects in history. Fundstrat thinks that as long as Technology and Financials hold up vs. the S&P, the recent turmoil in the markets will end by going higher. (Tough start to both sectors, as earnings season has commenced.) Wolfe asserts its bullish stance in the face of such downward pressures because overall earnings look solid and Fed Chair Powell seems keen to cut rates this year. And this can’t happen a moment too soon for small-cap companies. The small-cap negative preannouncement earnings ratio is at a multi-year high. Small business confidence is clearly in recession territory, in stark contrast to big business sentiment and real GDP growth. The last time we saw such a NFIB/GDP bifurcation was in the late 1970s, when inflation was also squeezing small businesses. This is a nagging concern, prime fodder for a correction.

Positives

• Producer inflation The Producer Price Index came in better than expected, with headline PPI rising 0.2% in March, a 2.1% year-over-year gain. Core PPI (ex-food, energy and trade) also rose 0.2%, resulting in a 2.4% gain on the year. Retailers’ gross profit margins rose by 0.3% in March.  
• European inflation Euro zone CPI has dropped to 2.4% in March, with core inflation down to 2.9%. The ECB’s 2% target is now in sight. Coupled with the Bank Lending Survey showing unexpectedly weak demand in Q1, rate cuts in Europe are likely before those in the U.S.
• A busy Pacific Exports from Taiwan jumped to 18.9% growth y/y (vs. 7.5% expected). Exports are now 25% above 2023 lows, while still 11% below 2022 levels. The U.S. was an especially favorable market, with AI an area of strength for Taiwan’s chipmakers.

Negatives

• Small businesses are hurting The NFIB’s Small Business Optimism Index fell to its lowest level in 11 years, its 27th straight month below the long-term average. Just 11% of firms plan to hire, and 37% are unable to fill job openings. 8% of firms cited poor sales as their single biggest problem—a fresh high; historically, this has meant an increase in unemployment was around the corner.
• American inflation The CPI in March rose 0.4%, increasing to 3.5% year-over-year. Taken together, data in the CPI and PPI reports imply a core PCE on April 26 of 0.25%, or a 3% annual rate and only a hair above the 0.21% increase or 2.5% annual rate that the Fed seems to want before it cuts.
• The consumer and inflation The University of Michigan Consumer Sentiment survey slipped more than expected in preliminary April readings. Also, consumer expectations of inflation one year out increased to 3.1%. In the New York Fed’s consumer survey, inflation expectations one year hence came in at 3.0%.

What Else

Gold in Asia Surely the rally in gold is a sign of runaway U.S. inflation? Not so fast, Gavekal says. Demand for gold right now is coming from Asia, not nervous Americans looking for a hedge against currency devaluation. Central banks (led by China) are buying gold, but they have retail counterparts. Chinese personal investors, burned by the housing and equity markets, are contributing to the current gold boom.

Big immigration After the reopening from Covid, 64% of new foreign-born adults have found employment vs. 60% of new native-born adults. With the native-born population shrinking, the majority of employment growth lately in the U.S. comes from people born in other countries. U.S. births peaked in 2007 at 4.3 million, falling to 3.6 million last year.  

How is that possible? There are sometimes said to be more moves in the game of chess than there are atoms in the universe. That’s not entirely right, since a bit more than half of those chess moves are not legal moves. The game of Go, however, does indeed have more possible moves than the universe has atoms.