DAILY STRATEGY: The past few days we have focused on why the 10yr fair value range of ~4.5% is not a scene changer for indices or equity internals over the medium-term (ex-Iran*). Quickly, 4.5% on the 10yr is not an issue because the neutral policy rate (rate that is neither stimulative nor restrictive) has also moved higher. 4.5% was the threshold at which equity sensitivities to yields increased, but we expect that level will move higher over time (HERE). Today, we focus on the conditions and level that would be restrictive.
Higher yields will be more of a market headwind IF yields increase because of core inflation beats. We don’t expect higher than expected inflation readings in part because the labor market does not appear to be an inflationary impulse (HERE). Measures of slack have not tightened meaningfully (HERE). The standard inflation model would imply core inflation returning to target. The risk is that core inflation has been too hot without the inflationary impulse from the labor market. The bottom line is we need to following the data.
When thinking about the 10yr level that would be a problem for risk assets, 4.75% is more obviously restrictive than 4.5%.
IF CPI and PPI releases next week imply >0.3% core PCE, yields are biased higher and there is downside risk to indices, Cyclicals, and risk-on factors (pure Momentum, high Earnings Vol, high Debt Risk, Unprofitable names). IF CPI and PPI imply <0.3% CPCE, it will reinforce our notion of a higher neutral rate, and there is upside to those factors even at current 10yr yield levels.
To be clear, we prefer longs in fundamental factors (Growth, Earnings Momentum, Value, GARP) in the current economic backdrop (HERE). IF the inflation readings are benign, it may be interesting to look for longs in Momentum and high Earnings Vol heading into earnings though. The fundamentals for those groups, as a whole, have been extremely strong the past few earnings seasons. Sales and earnings beat rates have been well over the long-term median for the last four quarters. Strong results have been driven by the AI buildout (semis, in particular). We aren’t the experts in whether that will continue this quarter, but the macro will be more conducive to positive returns over earnings if inflation is benign.
*Jacob Kirkegaard, 22V’s Geopolitics expert, believes both Iran and the US are incentivized to make a deal. From Jacob, “In the end, this standoff looks likely to have to be resolved by one or more of Iran’s regional neighbors proposing a design of a “future Strait of Hormuz administrative entity” that is in the end acceptable to both Iran, the United States and the rest of the international community (strongly opposed to the precedent of tolls). When precisely such a proposal emerges remains to be seen, but it could come at any moment.”
Charts…
Higher yields driven by stronger inflation remain the key headwind for markets, making next week’s CPI and PPI critical. If the data point to core PCE above 0.3%, inflation would likely finish the year well above the Fed’s 3.3% projection, while monthly prints closer to 0.21% would keep that target within reach.
The signal value from inflation expectations is muddled by the movements in oil. Track inflation data directly.
Risk-on factors will continue to come under pressure if inflation data is hot. If not – watch for a possible rebound.
Momentum and high Earnings Vol have had a string of very strong earnings seasons. IF inflation is benign, then idio will matter more during earnings season. There could be a fundamentally-driven rebound in performance.
