Issue 74: Notes on January PCE

This Week’s Highlights

• January bounce threatens PCE disinflation
  The stock market rallied on a report last Thursday that core PCE inflation had moved from 2.9% YoY in December to 2.8% YoY at the end of January—although MoM it was the biggest move up in the Fed’s preferred inflation measure since January 2023, raising concern over sticky prices.
• AI theme remains strong—even outside NVDA
  Enthusiasm for artificial intelligence remains one factor boosting equity valuations again in 2024, with investors bidding up less familiar players outside the Mag 7, while mega-cap tech firms and governments alike plow billions into new AI research initiatives, at home and abroad.
• Turkish tech leads global equities so far in Q1
  So far this year, the Istanbul Borsa Technology Index has put in a 56% return in US dollar terms, as domestic retail traders flock to one of the only asset classes capable of matching 65% inflation: a sign of how hot a speculative theme can get in a market ruled by local retail investors.

The CIO’s Take:
At least part of our thesis has played out in 2024, as yield traders moved from pricing six rate cuts in the wake of last December’s pivotal FOMC to a mere three cuts as of last week. Driving that reassessment of Fed policy has been ample evidence of 1) the US economy’s remarkable strength, and 2) apparent stickiness in prices. Last week, the latter was on display, as core PCE—the Fed’s preferred measure of inflation since 2000—popped by 0.4% in January, sending the annualized six-month rate of core PCE inflation handily above the central bank’s 2% target after two months below it. That’s a step in the direction of one scenario many, ourselves included, have feared: inflation appears on the downtrend, only to surge back and threaten 2024 rate cuts and the possibility of a soft landing. Despite such uncertainty, stocks continue to rally as the AI boom extends into its second year. As before, we think that while this presents plenty of opportunities for stock pickers, it makes the broader set of risk assets a bit expensive against such a precarious backdrop. On the basis of these views, pending more data that could shed light on the Fed’s likely path in 2024, we remain defensive: focused on growth at a reasonable price, international diversification, and attractive yield at the front end of the curve.

Notes on January PCE

Core PCE continues trending lower
Given the hotter-than-expected January CPI, markets have been eagerly anticipating data on the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) Index. While these measures can be closer over long horizons, they sometimes diverge. That has been the case in recent years, as the rise in prices measured from PCE—which captures a broader basket of goods and services, more frequently updating their weights in consumers’ expenditures—has frequently run somewhat below CPI inflation. Last Thursday, the US Bureau of Economic Analysis (BEA) made its report of January PCE, which came in at 2.4%, year-over-year, in line with economists’ expectations and down from a 2.6% reading in December. Central bankers keep a closer eye on core PCE which, like core CPI, excludes volatile food and energy prices. That measure increased by 2.8% year-over-year, also in line with forecasts, and down from 2.9% last month: the slowest inflation consumers have seen since March 2021, when core PCE came in at 2.3% year-over-year (see below).

But PCE climbed MoM in January

While it’s great to see PCE inflation trending down, the BEA report also showed January’s month-over-month surge in the CPI clearly wasn’t an isolated measurement. Core PCE climbed 0.4% from December to January, higher than the 0.1% a month prior and the biggest increase since January 2023. In the plot above, that pop in core PCE is clearly apparent in the six-month annualized change, running below the Fed’s 2% target into the end of last year, but jumping much higher in the most recent observation. So-called “supercore” PCE inflation, excluding shelter costs, came in at an even higher rate of 0.6% month-over-month, mirroring supercore CPI’s 0.9% January increase, something Citi economist Andrew Hollenhorst called “troubling” and viewed as lifting the odds of a hard landing for the US.

Possible cuts in ’24 likely measured
We likewise view the dichotomy in January results—year-over-year inflation on the downtrend, but monthly numbers showing a resurgence to start the year—as complicating the soft landing narrative, though not everyone agrees. Capital Economics’ Paul Ashworth, for example, justified the higher supercore PCE reading in January as a result of outsized investment gains based on strong recent US equity market performance. Consistent with an outlook for financial easing, ABN Amro’s Bill Diviney argued declines in leading indicators imply weakening price pressures through the rest of the year, despite a bounce to start 2024. We don’t see January’s inflation data as dooming rate cuts this year, but maintain an expectation for measured easing in 2024, perhaps three cuts, starting no sooner than June at the earliest; yield traders have moved to price roughly that view as of last week. The fact that stocks rallied further on Thursday’s report, with the S&P 500 closing the week at another all-time high, leaves us cautious on risk asset valuations, which seem to rise even as prospects for sudden and massive easing in 2024 evaporate.

A.I. Isn’t Just NVDA

Nvidia rides another stock’s wave
Despite our defensive stance on US equities as a whole, last week’s Perspectives made a case for Nvidia’s stock as potentially being a bargain at its current valuation. After some weakness to start last week, NVDA shares closed above a $2 trillion market cap for the first time on Friday. Given that Nvidia has often driven market sentiment over the last year, it may come as a surprise that the chipmaker’s Friday rally stemmed not from news of its own, but following an upbeat report by another tech name that might be more familiar to investors who were around during the late-90s bull market: Dell. While the original Dell Inc. went private through a leveraged buyout back in 2013, the firm returned as a publicly traded company, Dell Technologies, in 2018. On Friday, shares in the company that used to be known for selling PCs—“dude, you’re getting a Dell”—soared as much as 38% on earnings boosted by increased demand for AI servers, a fresh sign that AI hype can extend well beyond the Magnificent 7.

Amazon, Apple increasing AI bets
And within the Mag 7, it’s not just Nvidia whose fortunes are hitched to AI. Amazon’s head of corporate venture capital, Franziska Bossart, recently announced an acceleration of his fund’s AI investments planned for 2024. Among other things, Amazon is making a big bet on generative AI for robotics and automation—areas of obvious interest to the firm’s retail business. That explains the Amazon Industrial Innovation Fund’s recent outlays on robotics and automation start-ups, which include around half a billion dollars plunked down in 2022 on industrial robotics and sorting systems at its European centers. Amazon is also planning to invest up to $4 billion in generative AI start-up Anthropic, focused on large language models to rival OpenAI’s ChatGPT. Apple’s announcement last week that it will abandon its decade-long effort to develop an electric car is likewise more a story about its pivot to AI, an area in which it has been seen to lag its peers in the US tech sector, with 2,000 employees previously assigned to EV reportedly being moved over to the company’s AI division. Applications of AI to Apple’s wide range of consumer products, including the newly added Vision Pro, are obvious enough that the market actually reacted positively to news the company would abandon its automotive aspirations.

Playing the AI theme abroad
What about AI outside the US tech sector? It’s clear from valuations of US mega-caps like those among the Magnificent 7 that the benefits of the AI boom have primarily flowed, so far, to American companies. That’s not to say there aren’t international firms also participating. EM stalwarts like Korea’s Samsung Electronics and Taiwan’s TSMC have added nearly $50 and $130 billion in market value, respectively, over the last year. Dutch semiconductor manufacturer ASML has likewise added almost $135 billion in market cap in the last twelve months. For stock pickers, the notion of playing the AI theme outside America’s borders is compelling, with an opportunity to significantly expand the investment universe—including to names that might not be on every investor’s radar. Where might there be especially good opportunities? One catalyst could be countries’ government investment into AI research, which turns out to be a rather uneven playing field (see below).

According to data from AIPRM, although the UK ranks #3 on dollars allocated toward AI research, based on its current rate of state spending on R&D, it would take the nation another 79 years to reach the level of spending projected for the US in 2030. Some other nations are centuries behind. China, the second biggest spender on AI, seems like a better bet, lagging just 14 years behind America’s expected 2030 outlay.

Turkey Tech Mania

Borsa Istanbul tech on fire in ’24
Staying on the topic of non-US tech, readers will not likely have noticed that the biggest gainer year-to-date is not Magnificent 7 stocks in the US, but the tech sector in the country of Turkey, up over 67% in the first two months of 2024! That rise, in fact, nicely illustrates what can happen when AI euphoria spills over into a much smaller, much shallower emerging market. By comparison, tech stocks in the S&P 500 have “only” posted a 10.5% gain so far this year. The broad Turkish stock market, it turns out, is also doing quite well, up around 27% year-to-date in local currency terms. Interestingly, part of the reason Turkish stocks have risen so much is that with Turkey’s January inflation hitting 65%, equities are seen as just about the only viable “inflation-protected” haven for domestic investors. That inflation eats a little into stocks’ performance on USD terms, but even adjusting for currency effects, Turkey’s tech and broad market indices are still up 56% and 20%, respectively, through February.

Retail enthusiasm driving the rally
Based on data from financial information provider Finnet Electronic Publishing, flows into Turkish tech-focused funds in 2024 have already tallied TL7.2 billion (US$230 million), versus an outflow of around TL841 million last year. Though a few hundred million dollars may seem like a rounding error relative to US valuations, it’s a big deal for Turkey’s market, according to Tunc Yildirim, head of institutional equity sales at Istanbul-based investment bank UNLU, who attributed the flows to domestic retail investors. That has made individual investor sentiment a driving force in the country’s 2024 tech rally, even as foreign investors hold off on allocations given political risk ahead of upcoming elections and the prospect of deviation form tight monetary policy—interest rates are up to a whopping 45%, from 8.5% in June—which has targeted the nosebleed level of inflation referencing before. Given that uncertainty, not to mention challenges foreign investors have accessing Turkey’s market, the rally described above provides more of a curious case study than anything else, illustrating the potential effects of AI enthusiasm and retail trading against an extreme macro backdrop.