The Fed Makes its Move (finally)
The markets finally got what they had been asking for and anticipating since late 2023: a rate cut. Surprisingly, it was a 50-bps cut.
We were expecting a 25bps cut and thought Chairman Powell would remain his usual measured self. We were wrong, as were 105 of the 114 economists polled by Bloomberg, which reinforces how little benefit economic forecasting offers.
The Fed last cut 50bps or more on December 16th, 2008. We don’t need to remind anyone how different things are today than then. However, it raises the question of the need for 50bps in the current financial climate. 50bps cuts are typically reserved for a failing economy or a liquidity crisis. Neither are currently present. We should expect at least two more 25 basis point cuts before year-end and another 100 basis points in 2025. That will drop the Federal Funds rate to 3.25-3.50%.
Since 1990, the neutral rate has averaged 2.8%. In his press conference, Chairman Powell emphasized a 2.9% neutral rate target, so the congruity is in place, in theory at least. Interestingly, the Fed’s quantitative tightening program will continue as planned. Potential liquidity ($25 billion worth of treasuries, $25 billion worth of MBS securities) will be drawn out of the economy every month as the FOMC aggressively eases policy on the interest-rate front.
It is hard to fathom that inflation is contained with the Fed’s balance sheet still near $7 trillion, the annual deficit at $2 trillion, global debt at over $300 trillion, and financial conditions still loose. But that’s the narrative being spun.
JP Morgan noted this month that in the past 40 years, the Fed has cut rates 12 times, with the S&P 500 within 1% of an all-time high. The market was higher a year later, all 12 times, with an average return of approximately 15%.
We’ll wait and see if we can go 13-13, but one thing that is now certain will be the increased importance of economic and inflation reports. The Fed has all but assured us that inflation is in the rear-view mirror, and a handful of market analysts even articulated some deflation concerns. The coming data had better continue to support these claims of slowing inflation because it’s still a tough sell to consumers.
The dark side likes to think the Fed has better economic clarity/information than us mere mortals and is preparing for a much harder landing than is perceived. The realistic side realizes that the Fed, like almost every economist, gets it wrong much more than it gets it right. Again, 115 out of 120 economists polled by Bloomberg expected a 25bps cut last month. The economic reports, especially anything labor-related, will take on increased significance given the 50bps cut. We can expect heightened volatility around these releases for the remainder of 2024.
So far, the only damaging aftershocks of the first cut since 2020 have only been felt in the rate markets, and even that has been muted. 10-year yields went into the September 18th meeting, yielding 3.66%, and finished September at 3.80%. Commodity prices are mainly up across the board as well, mostly the result of a weakening dollar. A graph below confirms this.
Going forward, the US dollar will increasingly play a more significant role in the gauge for global liquidity. That is not breaking news; however, seeing that the Fed has officially kicked off its first cutting campaign since Covid, the emphasis on the dollar will only intensify.
China’s response to the rate cut was a massive stimulus program that surprised even the most giant Chinese bulls. This juxtaposes the BOJ, which has (sort of) begun a hiking campaign and is finally starting to become competitive in the global rate markets, albeit still in the very early stages. We are indeed in a currency war, where a weaker currency offers a competitive advantage. The actions supported in September strongly support this notion.
Sticking with the BOJ, they also held a meeting in September, but there were few surprises. They kept their policy unchanged, as expected, and Governor Udea proved even less hawkish than some, signaling little urgency to raise rates and claiming upside risks to inflation are easing. It should be noted that the yen/dollar cross has displayed incredible resilience since surging higher in August as the carry trade was reportedly unwound (we still have our doubts there, as expressed last month). Still, the swaps markets are only giving a 30% chance of a hike in 2024.
Days later, the plot took an unexpected twist when Shigeru Ishiba became the unexpected leader of Japan’s Liberal Democratic Party. Ishiba is considered a progressive and more hawkish than his peers. He has been openly supportive of the BOJ’s plan to gradually hike rates. On the news, the yen rallied 1.4% versus the dollar, while the Nikkei fell nearly 4%.
We still are in the camp. The yen has tremendous upside here in a longer-term time frame and remains long. As frustrating as the BOJ can be and as meek as it appears at times, the currency will work its way higher. The fundamentals for Japan (ex-population metrics) have always been favorable, but its monetary policy has put a lid on potential appreciation for nearly a decade. One surprising election result does not neuter all that, but it is a start.
So, did the Fed need to cut 50bps because they 1) see a hard landing coming and are trying to get in front of it? Or 2) in hopes of lowering the cost of servicing our nation’s massive deficit and increasingly large amounts of treasury supply that continues to flood the markets (with mostly strong demand, to be fair).
The honest answer is we aren’t sure. The 50bps cut was unnecessary, in our opinion, and Chairman Powell’s attempt at an explanation was fuzzy, at best. But more cuts are coming, and fighting them makes little sense. Easier conditions are an asset’s best friend, and that’s what we have. Play accordingly.
Quick rant..do we really need Fed governors permeating the airwaves practically every day with their personal snippets of Fed policy? Does that require much communication? Do the markets need their hands held this much to function? The answer is a resounding no.
Chairman Powell attempts to convey the Fed’s thoughts eight times a year, and that should suffice. We understand that Fed mouthpieces, along with certain chosen journalists, are sometimes used to test the markets’ reactions, but the practically daily barrage of commentary is simply unnecessary. Rant over.
Oracle’s earnings report on September 9th, which was excellent on all accounts, kicked off the energy as a data center play, which continues to rage on and has a lot of rope left. Some nuggets from the conference call:
“This is how crazy it’s getting. This is what’s going on... We’ve got building permits to build three nuclear reactors - small modular reactors (SMRs) to be precise.”
“Soon Oracle will begin constructing more than a gigawatt data centers.”
Today, Oracle announced the availability of Oracle Energy and Water Data Intelligence, a data unification, analytics, and AI solution designed for utilities.
CEO Larry Elison said they are expanding 66 of their existing cloud data centers and building 100 new cloud data centers.
Not to be outdone, 11 days later, Microsoft announced they had signed a 20-year power purchase with Constellation Energy, owners of the infamous Three Mile Island nuclear power plant. The goal is to secure power for their data centers as the AI narrative grows. Google has implemented the same strategy on a smaller scale.
Constellation has surged 29% since the Microsoft announcement, and the utility sector ETF is now up almost 26% of the year and trading at all-time highs.
Palisades nuclear plant along the shores of Lake Michigan just closed a $1.5 billion loan and hopes to restart production in 2028. Diablo Canyon power plant in California is currently on an extension after being ordered to decommission in 2025. The NRC will render its final decision soon, but there is growing public support to keep it open.
So, it’s game on for nuclear. The game started a while ago, but now it has gone mainstream. AI and data centers are going to need roughly 10x more energy than traditional metrics. Our shaky power grids can’t cut it, so the race for alternative energy is on, and the participants in the hunt have deep pockets.
Some lesser-known names we have on the radar include Vertiv Holdings (data center cooling), Powell Industries, Vistra Corporation, Iris Energy (Australian-based), and Oklo Inc. (a Sam Altman-backed alternative energy company).
It all sets up nicely for a derivative trade on the future of AI. For the past couple of years, the only pure vision for investing was the chip sector, namely Nvidia. But now we can include utilities, nuclear power, alternative energy companies, and natural gas as conduits for the second wave of the AI craze, which shows no signs of slowing as evidenced by the massive revenue gains recorded in Open AI, Anthropic, Perplexity, and a host of other private companies.
However, it must be noted that attached to those impressive revenue gains are massive losses so far. Open AI is scheduled to lose $5 billion in 2024 alone.
“The need for data centers over the next five years is going to be double what is currently in the markets, ”Brad Kim, BlackRock’s Asia Pacific managing director.
Another interesting twist is that Bitcoin miners are now leasing their high-performance computing to companies that need additional computing power. Some of these names include Core Scientific, Hut 8 Corporation, TeraWulf, Mara Holdings, Applied Digital, and privately held CoreWeaver.
Yet another way to play the AI/energy craze is natural gas. Nuclear energy received a lot of press this month, but it will take years to get current facilities up and running and much longer to approve and build new plants. That’s where natural gas comes in. The US has over 300 trillion cubic feet of proven natural gas reserves, and only additional drilling is needed to access them. Which, aside from the environmental disputes, will be an easy sell to our nation’s governors, who would love more job creation in their respective states.
Obviously, another opportunity for exposure is uranium, with its increased importance as the US restarts its nuclear programs. We have discussed a handful of Uranium ETFs in the past, with Sprott Uranium Miners (URNM) being one of the most liquid.
Energy had been left for dead for much of the past two years but has seen a resurgence in the latter part of 2024. Ironically, it has taken AI to bring the focus back, not the increasingly growing geopolitical tensions. This reminds us of our earlier observation that geopolitical strife, while unsettling on a personal level, rarely negatively impacts asset prices in the long run.
Looking Forward and Other Market Commentary: October 11th has been deemed the opening day for the last earnings season of 2024. That day, we will hear from JP Morgan, Wells Fargo, and BNY Mellon to help usher in the report cards from corporate America.
The consensus for the S&P 500 for the third quarter is for year-over-year earnings growth of 4.6% on revenue growth of 4.7%. That’s down from the growth of 4.9% projected just weeks ago. This would also be a slowing from the second quarter, when S&P 500 earnings were up 11.3% on revenue growth of 5.3%. For the full calendar year, the consensus is now for earnings growth of 10%, down from 10.2% on revenue growth of 5%.
The S&P 500 trades for 22.1x forward 12-month earnings estimates, which is rich compared to its 5-/10-year averages of 19.5/18.0x. If S&P 6,000 is in the cards, as many financial prognosticators insist, then the coming earnings season had better be championship quality.
Thankfully, we will get a respite from the Fed in October. But they will reconvene in November, with another 50bps cut? The September jobs report, released on the morning of October 4th, maybe the most significant scheduled data point of the month. A sizeable beat or miss will likely send the markets into a tizzy, at least in the short term, seeing how aggressive algorithmic trading has become.
The ECB will meet on the 25th and are expected to cut another 25bs, while the BOJ meets on the 31st and is expected to stand pat and not hike again until possibly December.
The BRICS will meet in Kazan, Russia, from October 22 to 24. Brazil, Russia, India, China, and South Africa will surely have the US dollar at the top of their agendas as they continue to try to rely less on the world’s current reserve currency. All this while the DXY (dollar) Index teeters at the 100 level. Interesting.
One topic that is beginning to receive more attention is the strike by the Longshoremen’s Association, which employs 45,000 workers at East Coast and Gulf Ports. They are responsible for 60% of US shipping traffic. If enacted, this strike will gum up supply chains and lead to supply disruptions and increased consumer prices. Something the Fed argued was contained. It is also estimated to cost the economy between $3.8-$4.5 billion daily.
It should be noted that the Dow Jones Transportation Index is up just a shade over 3% this year—one of the weakest sectors in the market.
In sharp contrast to Japan, Chinese authorities late this month announced the biggest stimulus package since the depths of COVID-19. The PBOC cut interest rates for existing mortgages by 50bps and the Prime Rate by 25bps. Additionally, the central bank will provide funding for funds, insurers, and brokers to buy stocks on the open market.
All this is to reach the official 5% GDP target. However, analysts were skeptical of the package and maintained their average GDP forecast at just 4.6%. The Krane Shares CSI Internet ETF, listed here in the states, jumped 8.5% on the news and has continued to surge. China currently has two Ds to deal with: Debt and deflation. Their property markets have been mired in a well-publicized debt spiral for years. However, global markets have taken their debt woes in stride, likely because they know the PBOC has the firepower to try to paper over any systemic risk.
Chinese listed ADRs have been a frustrating trade this year, beholden to the whims of a centrally planned government that has been prone to punish extreme wealth (i.e., Jack Ma), but if the tides have indeed turned and the surprising decision by the PBOC to prop up equities, then it could prove to be a game changer, especially given the relative cheap multiples on Chinese tech and e-commerce as compared to their American counterparts.
The last week of September saw the best performance in Chinese equities since 2008.
This month, Super Micro Computer failed again to file their 10-Q, which was the subject of a short report by Hindenburg Research and is being investigated by the DOJ for accounting irregularities. We remain short. They also are Nvidia’s 3rd largest customer.
Bitcoin Update: $70,000 is the number we feel is needed for Bitcoin trade to gather some attention and ignite enthusiasm in the space. Is it an arbitrary number void of any statistical significance? Yes, yes, it is. But after endlessly meandering in the $50,000-$65,0000 range, it is going to take a sharp move into the $70,000s to bring back the positive narrative and front-page headlines.
This month, Blackrock released a 9-page report laying out the path to a $1 trillion market capitalization for Bitcoin. Obviously, Blackrock has skin in the game, as they were the first to come to market with a spot in the Bitcoin ETF. But their conclusions, albeit simplistic, still resonate. They include:
A hedge to global tensions and increasing political instability.
Provides non-correlated diversity (at times, to be fair – a liquidity crisis affects all assets; cryptocurrency will not be spared)
An antidote to our reckless continued federal debt and unrestrained spending.
A pathway to the increasingly viable Blockchain technology.
The Fed’s 50bps cut, along with China’s, has sent the dollar index back near 100 and launched the price of metals. It is a bit discouraging to see Bitcoin continue to languish here and avoid the dance floor. All the positive inputs are present. Perhaps it is just a delayed reaction, and some of the metals money will soon flow into the crypto world. But we need to see $70,000 for confirmation of that.
Famed value investor Cliff Asness recently published a paper titled “The Less Efficient Market Hypothesis.” He argues that the US stock market has become less efficient over the last 20 years, with the current spread in corporate valuations near their 2000 bubble peaks. Asness mostly blames social media-enabled retail traders for this inefficiency and recommends taking the long view with value investing. That is a fair recommendation but also recognize that we must trade the market we have, not some ideal academic environment.
In his paper, he states the following:
Technology has democratized stock trading to such a degree that uninformed investors, empowered but misdirected by social media connectivity, are systematically making stock markets less efficient.
That reiterates the point we have been making for months now: the markets have morphed more into casinos rather than traditional capital allocation venues. We have droned on about 0DTE options, 3x+ leveraged ETFs, and algorithmic and programmed trading that is controlled by an increasingly smaller number of firms. Program trading now accounts for nearly 80% of daily volume. News and the ability to quickly respond to it has never been so accessible as it is today. Smartphones have changed everything. Moves that once took days or weeks now take minutes.
According to several academic studies, passive products/strategies now account for about 75% of daily trading volume. Even more poignant is the estimation that 55% of total trading activity has a term of under one day.
This month, we have another example. LMI3 is a new exchange-traded product that offers investors three times the daily return of MicroStrategy Inc.‘s stock. LMI3 plans to introduce additional products in the coming months.
Whether this leads to efficient markets is a debate that will rage on. Our takeaway is that it has led to better, much shorter-term trading opportunities and has brought tactical trading to the forefront. If your style is compatible, this has opened new profitable lanes that were unavailable in years past.
We are confident that was not Mr. Asness’s paper’s point, but that is our take.
Commodity Update: Here is a quick pop-up test: What happens when the world’s two biggest economies cut rates and artificially stimulate their monetary systems in two weeks?
The answer?...commodity prices rise. And that is precisely what we have seen. Across the board, commodity prices climbed higher at the end of September, led by gold, silver, and copper. The grains and softs have also jumped aboard, with cocoa, sugar, and coffee back to near the year’s highs. Energy has lagged some in comparison but still stands at nearly $70/barrel, while gasoline remains close to $2/gallon. The top section of the graph below clearly shows the surge.
We mentioned earlier that the AI/energy craze has begun and that natural gas is a clever way to capitalize on this. We aren’t the only ones. This snippet from Bloomberg reiterates the narrative:
In the first six months of this year, power producers announced plans to build more gas-fired capacity than they did in 2020. That largely results from soaring demand from data centers, new manufacturing facilities, and electric vehicles. It’s a remarkable change of fortune for gas power in America. A few years ago, climate goals and plummeting clean-energy prices supported the notion that the US was nearing peak consumption. That was before the startling growth of artificial intelligence. Electricity use by AI data centers alone is poised to grow as much as 10-fold by 2030.
We are still in the camp that silver will begin to outshine (sorry) gold in the future. That has been an erroneous take for the most part. Still, the silver’s beta has finally begun to show itself and will only strengthen, supported by the increasingly favorable supply/demand ratios.
It’s a good thing higher commodity prices (input costs) don’t equate to higher inflation; otherwise, the Fed would risk looking foolish in its declaration of tamed inflation. Mission Accomplished?
One name we have mentioned previously and have had a position in at one time or another is Pure Cycle Technology. This small-cap recycling company is pre-revenue and a proof-of- concept stock, which alone suggests it is a highly speculative name. However, early this month, the company announced a $90 million capital infusion was completed, which secures their financing until 2026, and that their Ironton Facility is now in production and is achieving feed rates of 10,000 pounds per hour and nearly a million pounds per week.
Pure Cycle is a controversial name highlighted by the almost inconceivable 37% of the float sold short. With this news, the stock sprinted nearly 60% in just two days as the shorts began to scramble. There is still a lot for this company to prove before it can be considered a serious investment, but this is an industry that we all can agree would be keen to disrupt. The current state of recycling is, in a word – pathetic. It’s estimated that just 10% of all plastics globally and only 5-6% here in the US are recycled. As lovely as it feels to drop a water bottle in a blue bin, the reality is that we aren’t even making a small dent.
The TAM for recycling is enormous, and it is an industry not tethered to the economy or geopolitical nonsense. We can all agree that better recycling methods are a win for everyone. Pure Cycle is a long way off from being a major player, but the prospects are tantalizing.
Finally, Amazon this month reportedly told its workforce its 5-days-a-week in the office or don’t bother coming in at all. That is good news for various downtowns and even better news for CRE investors who just may have weathered the storm.
“You’re getting the triple whammy: players, prices, and indices are all cooperating. It feels like there’s been a flip switch. Everybody seems excited, and we are calling it the beginning of a new liquidity cycle.” – Micheal Gigliotti, Jones Lang LaSalle.
Here in much-maligned downtown San Francisco, AI is spreading its wings, snapping up leases in buildings once left for dead. The iconic Transamerica building finally officially re-opened this month after a $500 million makeover, and the reviews are spectacular.
An investment group just committed $100 million to the Fillmore District, while Apple designer Jony Ive is snapping up property in Jackson Square.
The “doom loop,” as every media outlet loves to promote, ex any due diligence, is now becoming the “boom loop” as downtown is loaded with night festivals, crowded restaurants, and conventioneers that seem genuinely impressed.
Sure, there are still some fleas on the dog, like every major city has. But we cannot wait for the media, with all their previous San Francisco hate-porn articles, to begin to report on the 180-turn that is slowly in San Francisco.
We will be waiting.