SUMMARY: There was a fair amount of Fedspeak yesterday reinforcing a few themes. 1) the Fed sees the path back to 2% inflation as bumpy but still expects inflation to continue trending in that direction. 2) They are not ready to declare victory. 3) Many at the Fed maintain a strongly held view that economic growth will be below trend this year (<1.8%-2%). If that doesn’t happen, there is less of a need to cut rates for risk management purposes. As yesterday’s GDP report highlighted and 1Q24 data has reinforced, final sales to domestic purchasers (analog to core GDP) is strong (HERE). The Fed cutting less because growth is firm is fine for risk assets. The Fed getting hawkish because growth is running above 2.75% (HERE) is a problem.
Few quick thoughts ahead of PCE today: Consensus has core at 0.4% and a small sample consensus for core services ex housing at ~0.6%. Generally, PCE is not far off from consensus as we get the inputs from CPI/PPI. Expect the focus to quickly turn to payroll on 3/8 and CPI on 3/12 unless the Core services ex housing PCE number is above 0.6.
More on Fair Value: Yesterday we talked about upside to S&P fair value if the long-term cash return ratio stays elevated. Monopolies and platform effects may potentially keep cash return ratios elevated. Mature companies’ return on invested capital is supposed to gravitate toward their cost of capital. That assumption may not hold for monopolistic companies with network affects. Check out the ROIC vs WACC of the Mag 7 below. FYI Ben Thompson does great work on why network effects are so powerful – check out his stuff HERE. Worthwhile reading.
As noted yesterday (HERE), buybacks rebounded in 4Q and the outlook for cash return is constructive. Buybacks are still a preferred use of capital, even with R&D and M&A expanding in 4Q.
The net net is ROIC vs WACC tells us the Mag 7 is likely to keep generating large amounts of cash, and use-of-cash data indicates returning some of that cash to shareholders is still popular. That has the potential to raise fair value significantly. More in the full report below…
MARKET VIEWS: There was a fair amount of Fedspeak yesterday and the comments reinforced a few themes. 1) the Fed expects the inflation path back to 2% to be a bit bumpy but expects inflation to continue its return journey to 2 percent. 2) They are not ready to declare victory. 3) Many at the Fed are also maintaining a strongly held view that econ growth will be below trend this year (below 1.8%-2%). If that doesn’t happen, there is less of a need to cut for risk management purposes. As the GDP report highlighted yesterday and 1Q24 data so far has reinforced, final sales to domestic purchasers (analog to core GDP) is strong (HERE). The Fed cutting less because growth is firm is fine for risk assets. The Fed getting hawkish because growth is running above 2.75% (HERE) is a problem.
Source: BEA, NBER, FH calculations
Data are as revised to Q4.
Few quick thoughts ahead of PCE today: Consensus has core at 0.4% and a small sample consensus for core services ex housing at ~0.6%. Peter Williams noted “there’s a risk that seeing something like those consensus numbers, if they happen, could spook markets a bit, especially those a bit less in the weeds.” Above point 0.6 on Core Services ex housing would be bad. 0.5 likely somewhat of a relief. Generally, PCE is not far off from consensus as we get the inputs from CPI/PPI. Expect the focus to quickly turn to payroll on 3/8 and CPI on 3/12 unless the Core services ex housing PCE number is above 0.6.
More on Fair Value: Yesterday we talked about upside to S&P 500 fair value if the long-term cash return ratio does not return to the ‘sustainable’ level implied by the ratio of earnings to book value to the risk-free rate. In our fair value calculations, we use the below calc to estimate the long-term cash return ratio, which is based on a classic stable growth model.
Monopolies and platform effects may potentially keep cash return ratios elevated. Mature companies’ return on invested capital is supposed to gravitate toward their cost of capital. That assumption may not hold for monopolistic companies with network affects. Check out the ROIC vs. WACC of the Mag 7 below. FYI Ben Thompson does great work on why network effects are so powerful – check out his stuff HERE. Worthwhile reading.
A drawback of the formula we use is that BVPS doesn’t include intangibles, and intangibles as a percent of book value have been increasing for the S&P.
As noted yesterday (HERE), buybacks fell in 1H23 as earnings contracted and macro uncertainty peaked. In the second half, buybacks rebounded. S&P EPS is expected to expand 9-10% in 2024, setting the stage for a rebound in buybacks. Upward surprises on revenue, margins, and EPS + easing of economic tail risks suggest buybacks will continue to move higher throughout 2024.
Buybacks are still a preferred use of capital, even with R&D and M&A expanding in 4Q. ROIC vs WACC tells us the Mag 7 is likely to keep generating large amounts of cash, and use-of-cash data indicates returning some of that cash to shareholders is still popular. That has the potential to raise fair value significantly.
