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Inside Markets — Curve Flattening

Curve Flattening

July 31, 2024

Before earnings season started, consensus was looking for S&P 500 (SPX) revenue growth of ~4.5% and earnings to grow ~8.5%. With 55% of the SPX having reported (includes FactSet this morning) revenue growth is closer to +5% and earnings growth is closer to +10%. The average net profit margin is 12.1% vs. 11.8% in Q1 24Q1 and the five-year average of 11.5%. The biggest upside surprise comes from the Financials sector with +15.0% EPS growth vs. expectations for +4.3%. Unlike most quarters, Q2 SPX EPS estimates didn’t decline coming into reporting season, so earnings surprise metrics are slightly below 5-year averages. But blending the 55% of reports to date with consensus estimates for the remaining 45% makes this the best quarter since Q4’21, in terms of absolute growth.

The preference to own cyclical/value over secular growth stocks (Tech) was driven by rapid steepening in the 5/30 yield curve following the cooler June CPI report on 7/11. The cooler inflation data resulted in increased expectations for 50bp of Fed rate cuts in ’24, pulling short-dated bond yields lower. Ten and 30-year yields that reflect market expectations of future inflation rates declined by smaller amounts, leading to a steeper 5/30 curve. The move was exacerbated by US political polling data suggesting an increased likelihood for the extension of current tax policy. It’s estimated that the ‘Trump’ tax cuts from 2016 (in effect 2017) drove ~30% of SPX earnings growth over the last 7 years. Improved economic growth should give you higher prices in the future. A fundamental fair value model on using current data and inflation break-even yields implies that 10-year nominal yields are still 16bp too high. At the same time, 2-year yields are likely too low if Powell doesn’t provide any calendar guidance on the pace of rate cuts later today. The combination implies near-term expectations for the 5/30 curve to flatten in the near-term and provide cover for an oversold Tech sector to recover further. Curve flattening that implies slower growth in the future makes secular growth stocks (Tech) more attractive relative to cyclical stocks. The Russell 2000 (RTY) is a cyclically-sensitive small cap index that benefits from lower interest rates because smaller companies tend to issue more floating rate debt. Recent upside in the RTY and downside in the Nasdaq 100 (NDX) may seem extreme, but borrowing rates and tax rates are major inputs for future economic growth/earnings. The Discounted Cash Flow (DCF) valuation model is heavily dependent on bond yields for a reason.

With inflation levels remaining sticky near 3%, markets are eagerly anticipating a decline in the lagging shelter component of inflation indices. The latest data compiled in the BLS All Tenant Regressed Rent Index (ATR) showed a -1.1% decline in annualized rent growth for 2Q24. The ATR has preceded moves in the official shelter measures in CPI and PCE by ~1-2 quarters, so there is reason to believe the shelter component is set to take a step lower in the coming months’ official data. A second consideration for impending disinflation comes from ‘normalizing’ inventory levels. The US manufacturing PMI orders-to-inventory ratio peaked in July 2021 at 2.6 and has declined to 1.04 in its most recent reading. Rising inventory levels with declining levels of new orders should constrain prices in the long term.

Friday brings the July Jobs Report, which provides an update on the Fed’s second mandate to maintaining maximum employment. Consensus is looking for nonfarm payrolls of +175,000 and unchanged Unemployment Rate at 4.1% and wages at +0.3%. The BLS weeklong survey period ended on 7/12 which covers the impact of Hurricane Beryl that made landfall in Texas on 7/8. As a result, you could see lower payroll gains (~150,000) and increased wages (+0.4%) from a reduction in hours worked. This week’s other data implies a slowly softening labor market with lower JOLTs job openings declining quite a bit, and declining layoffs. The data suggests a softening due to a decline in hiring rather than an increase in job losses.

Overnight capex guidance from MSFT suggests that recent concerns about AI capex stalling out may be misplaced. MSFT’s commitment to cloud capex came in at $19B, which was the largest sequential increase (~$5B) in the company’s history. The earnings call Q&A also included the following: “expect capital expenditures to increase in coming years to support growth in our cloud offerings and our investments in AI infrastructure and training” and “expect Azure growth to accelerate as our capital investments create an increase in available AI capacity to serve more of the growing demand.” GOOGL’s capex and capex guidance also improved with commentary that suggests the risk of under-investing is “dramatically” higher than the risk of over-investing.

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