SUMMARY: Economic growth is too strong right now. Atlanta Fed GDPNowcast for 1Q24 is tracking 4.2%. That is significantly above estimates of trend GDP (2%ish), and consensus estimates of 2.3%. The Senior loan officer survey (SLOOS) showed a noticeable decline in the share of banks tightening credit standards and recent comments from banks and financial institutions suggests that the credit cycle, especially for the consumer, is normalizing (see Peter Williams’ report HERE for more details). If economic growth is running well above trend, while the economy is at full employment, the risk is core inflation remains too high for the Fed increases.
Just like in 3Q23, when estimates of GDP growth ran WELL ABOVE trend and 10yr yields started to increase, Cyclicals outperformed Defensives. The Cyclical outperformance is concentrated in Early Cyclicals though and the Low Vol factor has outperformed across sectors. Deep Cyclicals have lagged, companies with debt sustainability concerns have been punished (MS22DEBT) and small caps have underperformed. Our call has been for stronger than expected GDP growth in 1H24 (our call is 2-2.5%), but current strength is much more than we expected and punished our calls.
Over the course of 2024 it is highly unlikely data will continue to track 4% and core PCE is highly likely to fall to the 2.5% range, or below, on a YoY basis. But how and why the economic data decelerates will be critical for how risk factors trade.
BOTTOM LINE: Either economic growth is going to slow the easy way or the hard way. The easy way is economic activity moving back toward the 2-2.5% range without a large change in rates or broader financial conditions. That would make the Fed more comfortable, their inflation targets will be met and allow for 3 -4 cuts. Risk-on factors work. Or growth slows the hard way. I.e. persistently stronger growth leads to higher 10yr yields (corporate spreads, mtg rates, etc.,) and expectations of much slower economic growth in the back half of 2024. In the later scenario, risk assets will trade poorly until the slower growth mission is accomplished.
If economic data shows some slowing over February and March without significant FCI tightening, we will become more interested in a risk-on factor rebound. For now, we will wait to see how things evolve and focus more on fundamental factors and mitigating risk factor exposure.
More details in the full report below…
MARKET VIEWS: Economic data last week was much stronger than expected and the Atlanta Fed’s GDPNow estimate for 1Q24 is now 4.2%. The risk is elevated (though not certain) that the Fed delivers significantly fewer rate cuts in 2024. We’re not arguing that 4.2% is accurate – the point is that the data is much stronger than just about everyone estimated has increased the risk of significantly higher 10yr yields. The last few days internals have looked like 3Q23, when the data was much stronger than expected, and riskier equities came under pressure as UST yields increased.
The service ISM yesterday reinforced last week’s strong data. Headline at 54.3 vs 52 expected and 50.5 last. The prices paid component jumped from 56.7 to 64. Risk-off factors were positive (Low Vol +21bps) and companies with debt problems severely underperformed (MS22DEBT Index on bbg -1.23% relative). The Senior Loan Officer Opinion Survey (SLOOS, also released yesterday) showed a significant lessening in the share of banks continuing to tighten credit standards. Peter Williams’ take is that it removes a downside tail for the Fed to risk manage (dovishly). The FOMC had the SLOOS early and removed the bank language from the statement.
The soft ECI and good productivity data last week are helpful to risk assets when growth is +2%, but not good enough with growth at +4%, given the Fed had already pushed back against a March cut pre-Payrolls. Per Peter Williams, “Seems like the ‘why bother cutting given growth’ argument might only get a bit stronger and some of the easiest part of disinflation is done so the m/m wiggles probably start mattering more than they should.” We think that the framework applies to risk factors. Riskier assets need to see some evidence that growth is not at a breakneck pace here, otherwise increases in yields will be a headwind.
The macro regime is VERY sensitive to changes in yields and curve today, and that sensitivity is mirrored in the market reaction to changes in short rate expectations. The probable regime is still one of ‘Growth,’ though those odds decreased 5pp following the move in yields over the past few days. The bottom line is policy uncertainty is feeding rate volatility, which is impacting risk assets. The strength of the macro backdrop supports lower average levels of volatility/correlations, the outperformance of fundamental factors, and Cyclical leadership OVER TIME. For now, concerns are high that growth is far too strong currently and that means tighter for longer policy, and increased risk of a policy mistake. Higher yields and tighter FCI will act as a governor on growth, but we will likely need to see inflation data ease for risk assets to works first.
The practical implication risk rotations will be harder to play here. If economic data shows some slowing over February and March without significant FCI tightening, we will become more interested in a risk-on factor rebound. For now, we will wait to see how things evolve and focus more on fundamental factors and mitigating risk factor exposure.
