Investment Insights

 — Steve Orr 

Bounce

Tech to the (earnings) rescue last week. Four of the Magnificent 7 mega techs reported last week — two were OK and two were strong. In response, the big U.S. indices bounced between 2% and 4%. The Dow Industrials and Transports were the outliers, positive but not making it to 1%. Stocks put in their best weekly performance for the year. Alphabet (Google) and Microsoft turned in excellent beats, Meta beat, but the stock was taken to the woodshed. After falling 51% from its high last July, Tesla bounced 12% after missing revenue and earnings estimates. A stock bounce in a declining sales business is just short covering.

What separates the good from the so-so in Tech? Yep, it’s the return of the artificial intelligence theme. Please remember most of the hype to date is around the “cool factor” of the software. Most of the general public’s AI knowledge stops with Large Language Models like Chat GTP and Google’s Bard.

LLMs will play roles in certain industries. AI software — machine learning and genetic algorithms — will play much bigger roles in industrial automation and medical fields. All these applications will need hardware and electricity. After 20 years of software “eating the world” as Marc Andreessen put it, it is nice to see “stuff” be back in the driver’s seat. Selling shovels and picks to the miners: always a money maker.

One week does not change the intermediate trend for stocks. The Dow Industrials, S&P 500 and NASDAQ are all consolidating near recent new highs. Election year Aprils have averaged about a 1.3% gain, according to our trusty Stock Trader’s Almanac. Through last Friday, most of the headline indices were running 3% to 5% lower for the month, bringing down the average. May averages flattened to less than 1% losses over the past 50 years, so here’s to beating the average after decent earnings reports. China’s internal stock market has put on an impressive rally over the past few weeks. The A-shares Shenzhen 300 rallied 13% from its early February low and nosed above its 200-day moving average early Monday. The rally almost breaks a three-year downtrend. We would note that the government created the rally by easing regulations and adding stimulus to the markets. 

Raising the roof

Roughly half of the S&P 500 have reported first quarter earnings. The percentage of beats and the size of the beats are running above the 10-year average. FactSet reports that the blend of reported and those yet to report earnings’ growth is 3.5%. Not bad considering some estimates hovered between 0 and 1%. Only three sectors are showing negative earnings growth: energy, materials and healthcare. Top line revenues are growing year-over-year at a respectable 4%. We would point out that most of the bottom-line growth last quarter appears to have come from expense reductions, not top line growth.

The parade continues this week with 166 members reporting. S&P 500 stalwarts McDonald’s (McRib!), Paccar, 3M and DuPont represent the old guard. And there are plenty of headliners too: Starbucks, Pfizer, Generac, AMD and Kraft Heinz. The Magnificent 7 headliners are Amazon on Tuesday and Apple Thursday. NVIDIA is always “last” and does not report until May 22. 

Lower growth

Earnings at least are out-pacing the overall economy. GDP growth last quarter grew at a 1.6% annual rate in the Commerce Department’s first estimate. The headline was well below analyst estimates of 2.5%. But, that 0.9% difference was net imports dragging down the GDP calculation. It reminds us of the first two quarters of 2022 when inventories and net imports lowered reported growth. Government and consumer spending were on the lighter side last quarter. Year-over-year GDP growth notched a still-respectable 3% growth. No stagflation or recession in the data or headline.

A better measure of what is happening in the U.S. is the GDP series “Real Final Sales to Domestic Purchasers.” This series focuses just on activity inside the U.S. As long as it and a couple of other series stay above 2% growth, we should stay out of a recession. Last quarter’s report of 3.1% shows the economy rumbling along in second gear. 

Ceiling

One area of growth the bond market did not like was Core PCE. The Personal Consumption Expenditure measure of inflation continues to drift lower at a 2.7% year-over-year rate. What unsettled the bond market last week was the past three months’ reading of Core PCE rolling higher at a 4.4% rate. That and other inflation readings have pushed the 10-year Treasury over four-tenths of a percent higher this month. Two-year Treasurys are back knocking at the 5% door, returning to last October’s levels.

Where do rates go from here? The 10-year Treasury generally has a yield close to nominal GDP. At the moment, 10s trade around 4.65%, making them expensive relative to nominal GDP growth of 5% to 5.25%. Pushing rates above 5% would require surprising economic growth at home and abroad. Some combination of cheaper crude, lessening global tensions and massive stimulus in Europe and China would also be on the growth menu. Odds? Pretty low.

Cutting rates by a full percent would help the mortgage market, among others. Persistent inflation is staying the Fed’s hand from cutting short-term rates. How else to get rates lower? Possible drivers could be rapid escalation of the Middle East conflict and/or recession in the U.S. Steady 3% domestic GDP slowing to 2.2% in the middle of this year puts small odds on a big rate drop. We think rates stay in a third of a percent up/down range for the balance of the year, waiting on the election. The yield curve should Bear Flatten slightly as long rates rise. Upward momentum in rates relies more on continued borrowing by the administration than great growth in the economy. After the new Congress is seated, we may get a better idea if austerity or continued wonton spending will rule D.C. In short, second gear economy will not let rates fall; second gear economy will not push rates much past a 5% ceiling. 

Reality

Back to the present, this is Fed and Jobs week. What could be more fun, er volatile, for traders? Wednesday’s FOMC press release should show rates were left unchanged and that the Fed may be winding down its portfolio runoff program. Both political parties have made noises recently about getting more control over the Fed, so expect Powell to make some headlines about “Fed independence” in his press conference.

April’s preliminary employment surveys should show the unemployment rate unchanged at 3.8% and net-new payrolls near 200,000 new jobs. Not bad for a late cycle, second gear economy. We expect March’s blowout +303,000 number to be revised lower. Durable Good Orders (think airplanes and big machinery), Factory Orders and PMI indices round out a busy data week.