Southern hospitality

I traveled this week in Virginia, accompanied by two southerners who are among the most gentlemanly of gentleman colleagues my company has to offer. Our advisor hosts and our audiences welcomed us with an easy warmth, to match the 90-degree weather. First stop, Charlottesville, where I spoke at the historic Farmington Country Club, in the octagonal room originally designed by Thomas Jefferson in 1802 for his friend George Divers. Splendid! Next stop, the Jepson Alumni Center at the University of Richmond, its own history dating back to 1915. As for the present day, the equity rally is going strong, with notable momentum from the Technology and Industrials sectors. While second quarter earnings growth in the S&P 500 is expected to be modest (5.6% y/y), forward earnings look to be much stronger. The American Association of Individual Investors survey showed a big leap in investor sentiment, which from a contrary point of view suggests a less bullish market going forward. Still, the mood is not yet euphoric. Short interest on individual Nasdaq stocks is the highest in four years. The S&P 500 is just the briefest of rallies away from all-time highs and July is coming soon—the best month for the market over the past 20 years. Taking October 2022 as the start date, this bull market is about halfway through the typical bull’s duration, up 69% vs the average bull’s eventual rise of 178%. Even as “uncertainty” remains the word of the year, the rally has broadened. And since 1950, it’s the strongest recovery the S&P 500 has seen from a 1.5 standard deviation volatility shock.

The May labor report looked pretty good on the surface, with unemployment remaining a modest 4.2%, but other indicators paint a more concerning picture of the labor market. Nonfarm payroll growth in May was just 1.1% y/y, marking a full year of monthly readings below the “stall speed” of 1.4%. In 2007, we had a run of 11 such slow readings, and that didn’t end well. Furthermore, the number of unemployed workers rose by 9.5% y/y, a level historically associated with recessions. Consumer spending remains strong despite—or perhaps because—sentiment showing many fear renewed inflation. And although inflation has been on the retreat lately, it could spell trouble for consumers if loss of pricing power squeezes margins prompting firms to clamp down on hiring. Cyclical parts of the economy like manufacturing and construction (and temp agencies) are contracting—a dynamic at odds with the narrative of a growing economy. Jobless claims data suggests that the unemployment rate could rise by as much as half a percentage point in the months ahead, while the jobs market has featured low firing but also low hiring. Notably, the New York Fed says that unemployment among recent college graduates rose to 5.8% in Q1, its highest level since 2021. A bad time to be a grad.

If housing is in the doldrums until interest rates come down, capital expenditures are about to boom if the “big, beautiful bill” becomes law. Capex is a much larger component of GDP than is housing, with the potential to add 1% or more to GDP. What’s more, capex delivers strong multiplier effects. Thanks, in part, to immediate expensing, we’ll potentially see a shift from a 21% effective corporate tax rate to 12%. The market would love this. The budget deficit has fallen for three straight months amid signs that tariffs are becoming a significant part of US federal revenue. Dealmaking is likely to pick up with passage of the reconciliation bill, progress on deregulation, and the emergence of clarity on trade. Although IPOs have been light so far this year, merger volume in Q1 was the highest in three years. In the view of economist Ed Yardeni, neither the US dollar nor government bonds face a bear market and yields on 10-year Treasurys should stay near the 4.5% mark for the balance of 2025. With a July 4 target date for passage, the reconciliation bill has plenty of hoops to jump through before it can hope to become law. Some predict extensive negotiations between the House and the Senate in July. Given that the House version passed by just a single vote, the Senate is unlikely to be able to impose extensive changes on the bill. So, with all the goings on in DC, not to mention bubbling geopolitical risks, “uncertainty” is likely to be the word of the summer.

Positives

• Normal would be fine The NFIB small business sentiment index rose 3 points to 98.8 in May, well ahead of the 96.0 expected by consensus, and just above its long-term average of 98. Uncertainty rose a bit, remaining around Covid panic levels, but forward expectations improved 10 points and sales optimism gained 11 points, each after four consecutive months of declines. The post-election euphoria has given way to a more “normal” level of expansion optimism. The percentage of respondents increasing hiring over the next three months remained about average (data back to 1985).
• Consumers chilling a bit on inflation … The University of Michigan’s June index of consumer sentiment increased by 8.3 points to 60.5, well above expectations (53.6) and the first monthly increase since December 2024. Median inflation expectations over the next year fell by 1.5% to 5.1% in June, well below consensus (6.4%), while inflation expectations over the next 5-10 years decreased 0.1% to 4.1%, meeting consensus. Elsewhere, the New York Fed said consumer inflation expectations fell in May for the next one, three and five years ahead, each within or slightly above the 2024 range.
• … And the inflation reports gave them reason to May’s core CPI was much softer than expected, rising 0.1% m/m versus consensus expectations of 0.3%. Headline also surprised at 0.1% versus 0.2% consensus. Sharp deceleration was reflected for all categories except food. Owners’ equivalent rent (OER) increased 0.3%, a downward surprise, and now in line pre-pandemic figures. Headline and core, ex-OER, are now both below 2% y/y. Tariffs, which have doubled year-to-date customs tax collections y/y, have not yet had a noticeable effect on the overall price level. Meanwhile, PPI increased 0.1% in May, versus 0.2%. consensus. The key PPI components that feed into the all-important PCE were softer than expected. Focusing on the coming impact of tariffs—which is what really matters for the Fed rate outlook—PPI core goods inflation was 0.1% lower than in April.  Both CPI and PPI suggest that May's PCE inflation rate might have finally dropped to the Fed’s target rate of 2.0%.

Negatives

• Builders need some help Construction spending fell for a second consecutive month in April. Overall spending fell by 0.4% m/m in nominal terms and private spending tumbled by 0.7% m/m. High rates continue to contribute to low affordability for housing, reducing single-family construction and limiting the profitability of new multifamily construction. As a result, residential construction spending continues to plummet, down 6.9% in real terms. Meanwhile, fading fiscal stimulus from the CHIPS Act of 2022 and the Inflation Reduction Act coupled with increased uncertainty is likely depressing private nonresidential investment, which was unchanged y/y. The reconciliation bill, once it passes, should provide a jolt to investment due to favorable tax treatment.
• The have-nots need some help The bottom 60% of the income distribution, a cohort that accounts for 40% of spending, has struggled with higher prices for food, rent and other necessities. Tariffs hit them disproportionately because they save little, while most of the new tax benefits will accrue to the top 40% of the income distribution. The cuts to Medicaid and SNAP (food stamps) benefits set to go into effect next year will counteract the lower taxes on overtime and tips for this group. However, they may benefit from the plunge in immigration activity, which should put downward pressure on rents and upward pressure on wages at the lower end of the income distribution.
• Pessimism from yet another corner In successive weeks, both the Organisation for Economic Co-operation and Development and now the World Bank have sharply reduced their US growth forecasts. The World Bank warned that the 2020s are on track for the weakest performance for any decade since the first Apollo moon landing, given trade tensions and policy uncertainty. The development lender lowered its 2025 outlook to 2.3% from 2.7% in January, which would be the weakest in 17 years, outside of the recessions in 2009 (global financial crisis) and 2020 (Covid pandemic). It also warned—based on its current forecasts—that global growth in the first seven years of this decade is on course to average 2.5%, the slowest for any decade since the 1960s.

What Else

Beware “Sneakflation” Bank of America posits that instead of raising prices immediately in response to tariffs, firms might sneak in larger-than-usual annual price increases next year to account for them. And these price hikes might be spread across a variety of products, rather than just the ones that are affected by tariffs. Empirical Research analysis suggests that inflation will certainly rise, but the change looks less problematic than consumers or academics suspect. Many surveys reveal that after years of above-trend inflation, companies are feeling less confident in their ability to pass through rising costs and are expecting that consumers would bear half of a 10% tariff increase within three months.

AI progress ain’t cheap In its 2025 Environmental Sustainability Report, Microsoft disclosed its global electricity use increased 27% y/y to roughly 30,000 gigawatt​-​hours during the 2024 fiscal year. This suggests that the hyperscalers are on a trajectory for their seventh consecutive year of 25%+ electricity demand growth!

You pay what you get for After a historic May rally, the S&P 500 trades at 21 times forward earnings, 35% above its long-term average. However, sector composition has shifted dramatically over the years: 70% of the index was asset-intensive manufacturing sectors in 1980 vs. 20% today. The index has become higher quality, with lower leverage, lower earnings volatility, and higher margins. Bank of America says improving internals and efficiency gains going forward make mean reversion to the long-term average unlikely. The US trades as the most expensive region (40% premium vs. Europe/Asia which trade at 16 times). But the US is half as levered and corporate transparency is best in class, evidenced by significantly lower estimate dispersion on 2025/2026 forecasts. The US is forecast to double the long-term growth potential of Asia and Europe, with lower earnings volatility than Europe. Plus, we’ve got the US dollar as reserve currency, energy independence, unparalleled liquidity and Tech primacy (at least for now).