DAILY STRATEGY: We got pushback against our view that the market isn’t pricing a hawkish bias; investors pointed to a rate hike already priced in by March 2027. Our point is that a rate hike reflects a higher neutral rate of interest. A hawkish bias would mean the Fed attempting to force GDP growth lower (to well below 2%), accepting the higher recession risk associated with that. Equity markets would have downside risk, and the riskiest factors (Earnings Vol, Price Mo, Leverage, Small size) would underperform. That is not the case now.
The rate hike that is priced is meant to set the policy closer to neutral, meaning a level that is neither stimulative nor restrictive. The appropriate neutral rate appears to be higher because the economy has proven more resilient than expected to the Iran war. The Atlanta Fed GDPNowcast is currently tracking +3.3% “core” GDP growth (consumption + investment) for 2Q. We cover the details in full in a short video HERE.
For the Fed shifting to a hawkish bias, meaning setting policy that is restrictive, would likely require a series of high inflation prints over the summer (roughly a series of 0.3s on core inflation) to bring the Fed’s 2026 forecast close to 3.5%. June-September prints will be very important.
CASH RETURN: We model fair value for the S&P 500 by discounting expected cash return (dividends + buybacks). Cash return as a percentage of net income has declined as Hyperscalers redirect toward AI capex, weighing on fair value estimates. Investors are concerned that the persistent competition between Hyperscalers could impair cash returns for years. However, NVDA’s earnings highlighted a more optimistic case to consider even if Hyperscaler cash return remains impaired. NVDA is returning more of its revenue, partly from Hyperscaler spend, to investors.
Ben Thompson, a well followed Tech blogger and podcaster, flagged that NVDA intends to return 50% of its free cash flow to shareholders this year. Based on NVDA’s guidance, that implies cash return roughly doubling from its trailing twelve month reading ($54B to $111B, +$57 billion). NVDA doubling its cash return would add another 50bps to the S&P 500’s total cash return ratio.
The implications are broader. If Hyperscaler spending flows to companies who then increase cash return – chip makers, energy providers, companies involved in the data center buildout – the net outcome could be a rebound in the S&P’s cash return. The practical implication would be long the S&P 500.
We chart out S&P 500 fair value under different cash return ratios below.
Charts…
The Atlanta Fed’s GDPNowcast for underlying demand – personal consumption and fixed investment – is tracking +3.3% for 2Q. A hawkish bias would mean the Fed attempting to force GDP growth well below 2%.
Cash return (dividends + buybacks/net income) dropped in 4Q to its lowest level since the immediate aftermath of COVID and the GFC as Hyperscalers pivoted away from cash return.
Investors are concerned about cash return from Hyperscalers remaining impaired. IF cash return stays at its 4Q level in perpetuity, fair value is another -12% lower from here. However, there’s upside IF cash return rebounds, and NVDA’s dividend and buyback announcements highlight an underappreciated way cash return can rebound even if Hyperscalers are stuck in a prolonged spending battle.
In our model, we assume cash return returns to a “sustainable” level implied by ROE. Basically, given ttm earnings and book value, the index retains the necessary earnings to grow future earnings at the terminal rate, returning the rest as cash. The index has frequently had a cash return ratio above this level.
For Fair Value estimates, we use a cash return model based on Aswath Damodaran’s methodology. Great resource on this HERE. Table demonstrating the calculation below.
