DAILY STRATEGY: The inflation data yesterday was soft enough that only an extremely strong CPI/PPI print would make and October hike the baseline. Market based odds of an October rate hike are down to 38%. Markets are still pricing 4-5 hikes in total this cycle. Peter Williams is at 2-3 total (HERE), slightly more dovish than market-based expectations. That assumes the recent tightening of financial conditions leads to some slowing in economic growth (HERE) and a lack of UPSIDE inflation surprises. This is also why we are less interested in playing for upside UST yields. FROM HERE.
To realize the market’s 4-5 hike path requires inflation at or above the current Fed forecast (Fed forecast is 3.4%, to reach this MoM core PCE would need to come in at 0.33%) and a labor market that keeps retightening (urate below 4.0%). Strong GDP growth, defined as real GDP growth above the economic speed limit of roughly ~2%, with inflation in line with Fed forecasts will keep rates elevated but not lead to more than 2-3 cumulative hikes.
Yesterday, the yield curve steepened as 10yr yields moved higher again. The yield curve is now steeper than it was going into last month’s hawkish Fed meeting. The steepening of the curve reinforces our view that STRONG economic growth is the main driver of rates and helps explain why the VIX is at 16 and credit spreads are stable despite the 10yr surge.
What the 10yr reacted to – As Gerard noted, based on “the sum of Personal Consumption Expenditures and fixed investment — or GDP less government, inventories and net exports if you prefer subtraction to addition. The 2-quarter growth rate there was revised from 2.8% to 3.2%. The revision itself is not such a big deal. What is striking is the absolute value. Near or above 3% is quite strong, especially if you think the non-core elements of GDP are just noise that will mean revert inevitably.” Growth continues to surprise investors to the upside.
MOMENTUM INTO EARNINGS: We are long the Momentum factors (Price and EPS Momentum) factors into earnings. Both have much higher-than-expected EPS growth relative to the market and will benefit, RELATIVE, as other areas of the economy slow.
The average excess return for an EPS beat was negative last quarter for Momentum names, the lowest excess return since the GFC. We expect a better average excess return this quarter. Ahead of 2Q earnings, Momentum’s implied equity risk premium (discounting the future dividends and buybacks of the Momentum factor constituents) relative to the S&P 1500 had richened to its lowest level (highest PE) since 2023. Heading into this quarter, valuations are richening again, but only to the median relative to the index. If valuations are moving ahead of earnings, the implied bar is lower this quarter.
The underlying macro condition – AI activity strengthening relative to non-AI cyclicals and AI implementation improving fundamentals – is a tailwind to Momentum long term. Recall that going long Momentum after an initial rally and subsequent drawdown does not lead to worse forward returns, just more volatility (HERE). In other words, the historical data does not suggest returns are stacked against Momentum here simply by being “late.”
Charts…
The yield curve steepened as 10yr yields moved higher yesterday.
To reach the Fed’s 3.4% Core PCE 2026 forecast (which is a Q4 average) from the September SEP, MoM Core PCE would need to come in at 0.33% until the end of the year.
Momentum was trading at a richer valuation – using our preferred method of discounting future dividends and buybacks – ahead of last quarter’s earnings, on its own and relative to the S&P 1500. Assuming valuations are moving ahead of earnings, the implied bar to clear is lower than last quarter, which saw outlier bad excess returns to beats.
Momentum is off the floor, but still in a 90th percentile drawdown.
Cutting up the forward return profile of Momentum given different decile bucketed drawdowns shows 1) better forward returns starting in the 4th – 6th decile buckets, with 2) forward vol increasing exponentially as drawdowns deepen. The forward return profile deteriorates for even deeper drawdowns, but the sample becomes recessions, which is not a good comp to now. We take the practical implications to imply forward returns aren’t stacked against Momentum here. We can be comfortable leaning into a macro thesis to be long Momentum.
