February 5, 2024Scroll down
The CIO’s Take:
Last week’s calendar was absolutely packed, with the height of earnings season—including five of the Magnificent Seven stocks reporting in the span of a few days—overshadowing a Fed meeting which, despite little uncertainty over a continued hold on policy rates in January, promised to reveal more as to the central bank’s thinking on the timeline for cuts. US tech earnings, although somewhat mixed, provided enough of a boost to growth to bail out what has, thus far, been a fairly lackluster Q4 reporting season for the rest of the S&P 500. Amidst generally high valuations among growth stocks, we still see interesting opportunities from a stock-picking perspective. (Indeed, we were thankfully overweight Meta in our equity models!) Optimism over strong tech earnings was apparently enough to lift bulls’ spirits after what we saw as predictable disappointment in an FOMC hammering home the message that the Fed is in no hurry to cut rates: a sentiment presumably reinforced by hot job market data released on Friday. Along those lines, we continue to see the market pricing a bit too much optimism and thus remain relatively defensive.
Meta shares jump on outstanding Q4
Earnings upstaged the FOMC last week, as five of the Magnificent Seven stocks reported, including Meta, Amazon, Apple, Alphabet, and Microsoft. Despite some negative surprises coming out of the Fed meeting, investors found enough to be thrilled about in these mega-cap tech companies’ reports, bidding stocks in the S&P 500 to a fresh record high by Friday’s close: the fourth straight winning week for the index. The highlight had to be Meta’s results, as the social media giant posted top and bottom line beats, gave better-than-expected guidance, announced a stock buyback authorization to the tune of $50 billion, and initiated a quarterly dividend. Mark Zuckerberg’s “Reality Labs” foray into the metaverse remained a drain in Q4, losing around $4.7 billion for the quarter—bringing its total shortfall to $16 billion for the year—but there has been enough good news in recent quarters that investors barely seem to remember Meta’s faltering pivot into virtual worlds that saw the stock bottoming out at close to $90/share in late-2022. Indeed, Friday’s post-announcement trading pushed Meta 20% higher to close at almost $475/share, adding almost $200 billion to its market cap: according to Bloomberg, the biggest one-day jump in market history.
Magnificent 7 stocks mixed, overall
Of the four other nominally “magnificent” stocks reporting last week, not all impressed like Meta. Amazon did its part, reporting solid earnings on the back of recovery in its Amazon Web Services (AWS) division, whose advertising sales were up 27%, the fourth consecutive quarter of acceleration; the company’s shares popped nearly 8% on Friday. Apple and Google’s parent company Alphabet, by contrast, saw their stocks sell off in post-earnings trading after hours. Although Apple’s EPS beat Wall Street estimates, investors had big concerns about China sales, which fell slightly short of analyst expectations as a result of the country’s economic challenges and gains by domestic competitor Huawei. Investors were disappointed by Google’s ad revenue growth, which came in just below consensus forecasts. For its part, Microsoft reported the strongest revenue growth the company has seen since 2022, as its big footprint in AI continues to give it a leg up, though cloud growth for the quarter wasn’t as robust as some analysts had hoped. All in all, against the staggeringly high expectations against which Magnificent Seven earnings were being judged, it’s clear Q4 was something of a mixed bag—but still strong enough to buoy US stocks amidst otherwise mediocre earnings growth outside of that vaunted cohort.
Don’t lump top US tech stocks together
Of course, it’s not surprising Magnificent Seven stocks don’t move in lockstep. Although investors have grouped US tech’s top contributors and given them a catchy name, there are significant differences in these firms’ business models, their earnings growth rates, and—especially important to us as active investors—their stocks’ valuations. Nvidia’s focus on chips for the AI market, for example, presents a sharp contrast to Apple’s positioning as a high-end consumer brand. Likewise, we’ve seen how differences in these companies’ focus have given rise to divergent trends in terms of growth, and their stocks’ action in recent weeks highlights how investors are baking these differences into prices. Of course, differences in these businesses and differences in investor opinion are what give rise to opportunities within the tech sector, and that gets us excited as active portfolio managers.
Wide moats could merit a premium
Past Perspectives have sometimes commented on overall lofty valuations for US tech and how fragile those highwater marks become when markets price in excessively optimistic forecasts of future growth. We will close this update with a chart from Numera Analytics we came across last week. It nicely illustrates another aspect of Magnificent Seven valuations that keeps us interested in the sector and, for select stocks, could help to justify a seemingly rich price tag: the sheer dominance of their share in markets in which they compete.
It’s precisely the dominant position of US tech firms in these industries that raises regulators’ and legislators’ ire around questions of market power and anti-competitive forces. That’s a potential risk for such market leaders on the legal front. At the same time—and probably more importantly—the oligopolies and near-monopolies on display above mean rapid growth in things like AI and cloud will pay the biggest dividends to just a few firms, who will then be uniquely able to make the massive investments required to continue moving the frontier forward in areas requiring a massive R&D outlay to sustain progress. Even in more challenging environments, a leading position gives pricing power that could allow the most entrenched firms to protect margins, even as demand slows.
Fed meeting outcome disappoints
At the outset of this commentary, we mentioned “negative surprises” in last week’s FOMC, although nothing revealed upon that meeting’s conclusion was shocking to us. It was only because market expectations for the pace and scale of easing in 2024 were so high going into January-end Fed deliberations that investors perceived disappointment. As has been the case in recent months, almost everyone agreed ahead of Wednesday’s Fed decision that there would be no rate cuts to start the year; CME Group data showed the market-implied probability of a ‘hold’ in January was 98% one day before the meeting. Instead, observers of the Fed’s official statement and post-meeting press conference were mainly focused on the tone and signaling of the US central bank and what that might reveal about the timeline for easing. On both counts, while the news wasn’t bad, it was worse than what the market expected, sending the S&P 500 and NASDAQ down -1.6% and -2.2%, respectively, last Wednesday.
Powell signals March cut a longshot
In its official statement on the January FOMC, the key takeaway—and what clearly rattled investors—was the Fed’s acknowledgement that they still need “greater confidence” in disinflation sustaining to their 2% target before they will be comfortable cutting rates. After December’s soft core PCE print, we expect many investors were hopeful the committee had already reached that level of comfort. From the January statement, that is clearly not the case. Fed chair Jerome Powell reinforced that notion at the post-meeting press conference, all but ruling out a March cut, which the market had been pricing at nearly 50-50 odds before the January meeting. In the wake of Wednesday’s FOMC, odds of a rate cut by March have plummeted to just 20% (see below), though the market is still pricing in a 90% chance of at least one cut by May, while handicapping rate cuts by the end of June as an absolute certainty.
Seeing the FOMC glass half full
Wednesday’s meeting brought some good news for the doves, even if most chose to hang on the negatives. For one thing, a comparison of the official statement with last month’s reveals committee members seeing “two-sided” risks—a weakening economy vs. resurgent inflation—as more balanced at this point, and the mention of decisions about “additional policy firming” was removed, i.e., expectation of further hikes is apparently out the window. In the presser, Powell also suggested rate cuts are likely to come at some point this year, though it’s admittedly hard to regard that as ‘news’, given everyone inferred it from the committee’s December dot plots. We’re seeing the market react negatively because, although the official statement and Powell’s comments reinforce that we’re probably at peak rates and headed for at least one cut later this year, expectations were for up to six cuts and a pretty aggressive timetable for easing. Of course, that’s not what we got out of this week’s FOMC.
Ramifications for future policy
Ultimately, we read this meeting’s outcome as the Fed seeing the market’s anticipation of rate cuts building—which in and of itself leads to an easing of financial conditions—and pushing back on that a little bit. They also probably imagine they can get away with being a bit more deliberate, given how strong the US economy looks based on the last couple months’ data, something we foreshadowed in recent Perspectives commentary. Policymakers will still have concerns about overshooting, to be sure, but they also worry if they ease off the brakes too quickly, inflation could come back: a much bigger problem. As long as GDP growth is strong and the job market hasn’t shown more meaningful signs of cooling, we expect the Fed to err on the side of holding here and observing inflation’s trend until they’re comfortable. That’s pretty much what you got from the official statement and press conference, though markets continue not to take the Fed at its word. The upshot seems to be a greater risk of disappointment now than upside surprises in terms of Fed policy.
US labor market remains red hot
Friday brought one more market-moving economic release last week: the US Bureau of Labor Statistics jobs report, which showed the labor market kicking off 2024 with a burst of energy. Nonfarm payrolls surged by 353,000 jobs in January, nearly double the consensus estimate of 185,000 jobs, and higher than December’s gain of 333,000 jobs—itself significantly higher after revision from the preliminary number. Even considering the potential inflation in January jobs from large seasonal adjustments, the degree to which it surpassed expectations leaves little doubt as to the strength of the US labor market entering this year. Job creation in January was broad based, with the private sector contributing 317,000 positions and the government sector adding 36,000. Within the private sector, the service sector was particularly strong, adding 289,000 jobs, led by substantial hiring in health care, professional and business services, and retail. The goods sector also saw a notable increase, with 28,000 jobs added in construction and manufacturing. The unemployment rate remained steady at 3.7%, close to a 50-year low. Wage growth came in hot, as well, with January witnessing an acceleration in average hourly earnings, up 0.6% month-over-month, equating to a 4.5% year-over-year rise, the fastest annual growth reading since last September. Judging by the status of employment inflation costs at the end of last year (see below), the notion of stalling progress in cooling wage growth will surely make the Fed uneasy.
Productivity gains help defray costs
That last observation on wage growth is clearly most concerning to policymakers who view inflation in labor costs as a potentially persistent component of rising prices, complicating the timeline for easing. Digging more deeply into the data, there are indications of a gradual rebalancing that would help with respect to inflation. Those signs include slower hiring and quitting, as well as productivity gains that help to offset growing labor costs. For example, Q4 of last year saw a notable 3.2% increase in labor productivity in the nonfarm business sector, the third consecutive quarter of productivity gains above 3%. Such gains have been critical in balancing out a rise in compensation costs, which totaled 3.7% in Q4, putting unit labor costs up to a more modest increase of 0.5%. In other words, productivity improvements are supporting economic growth without exacerbating inflation. Chairman Powell acknowledged that trend in his remarks last week, though he cautioned that there is still doubt as to how sustainable such productivity gains might be.
Recent data put the Fed, market in a tough spot
Last Friday’s scorching jobs report, along with a slew of other economic data coming in over the last couple months create a conundrum for both Fed policymakers deciding what to do with rates and the traders attempting to call those moves. On the one hand, given the Fed’s self-professed “data-driven” approach, a tight labor market both increases the risk of inflationary pressure and—as mentioned above—gives the Fed some breathing room to hold rates high for longer and see inflation down closer to the 2% target. On the other hand, 525 bps of rate hikes in less than two years represents aggressive tightening, and it’s unclear just how much pain that will inflict on the economy with a lag, such that the Fed must also consider the possibility they’ve already overshot, in which case a rapid path to easing might be the only thing that saves a recession in which those currently cheerful numbers turn gloomy on a dime. Investors, meanwhile, will see continuing job market strength as one more big point in favor of a soft landing, which just might be enough to support risk assets’ present valuations.