The Week Behind

In the wake of an apparent Fed pivot, the rotation from the Magnificent Seven to other sectors accelerated. Outperformance belonged to the equal-weight S&P 500 (RSP) and small-caps (Russell 2000), gaining 3.75% and 5.5%, respectively. That being said, the major indices had strong weeks as well, each rising between 2.5%-3%, extending their climb beyond their 52-week highs. Notably, the Dow reached a new all-time high, closing above 37,000.

Highlights 

• Despite a broadly in-line print, CPI did raise some inflation concerns. However, PPI, a leading indicator of inflation, printed firmly below expectations, effectively silencing inflation hawks mid-squawk.
• Although the Fed’s decision to maintain rates and quantitative tightening was expected, the dovish surprise in the SEPs – coupled with Powell’s remarks – left the market with a high degree of certainty that the Fed has indeed pivoted.
• Defying analysts’ expectations, retail sales increased 0.3%, outperforming the projected -0.1% decline.  This robust number underscores impressive consumer activity this holiday season, offering a positive omen for consumer discretionary trades.

A Pivot for Christmas

Heading into Wednesday’s FOMC meeting, investors expected the Fed to step away from market expectations: undermine 2024 cuts, temper inflation optimism, hold firm on “higher for longer”, and emphasize a willingness to endure “pain” in the fight against inflation.

Contrary to these expectations, the Fed stepped toward the market. The Summary of Economic Projections (SEPs) revealed a more constructive inflation outlook, allowing for the possibility of 75 basis points of cuts throughout 2024. Prior to this meeting, it seemed the Fed would only cut if compelled by a weakening economy. This meeting demonstrated the Fed’s willingness to cut from a position of strength, acknowledging the ongoing decline in inflation before economic conditions necessitate accommodative measures against a recession.

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The Fed is now more concerned with the economy than inflation. This is the pivot.  

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While this sounds great, take the dots with a grain of salt. Remember, the dots are merely projections, not policy. Case in point, the final dot plot of 2022 projected only 75 basis points of hikes for 2023. As you’re aware, the Fed ended up raising rates by ~525 basis points. Don’t get me wrong; good news is good news, and this is good news. However, history suggests that a healthy skepticism is prudent.

The Week Ahead

It is a huge week for inflation as the Fed’s preferred measure and critical housing metrics are set to release. The Fed was clear: rate cuts are contingent on inflation. This message is what caused the remarkable rally last week. To keep prices where they are, the story needs to play out, which means you cannot afford to go into these prints blind.

Macro Releases:

• Housing Starts (Tuesday): Median forecast is for 1.36M new housing starts, which is nearly 1% below the prior month. The bar is low for an upside surprise, which would be welcome by the market as a tailwind for housing disinflation.

• Personal Consumption Expenditures Index (PCE, Friday): The focus will be on core metrics. Monthly forecast is at 0.1%, while the yearly forecast is at 3.2%. Ideally, PCE aligns with or is below expectations, furthering the disinflationary narrative. However, the recent Fed messaging suggests an acknowledgment that the prevailing trend in inflation is down, implying some tolerance for contrary data points as long as they remain in the minority.

Micro Releases: 

• FedEx (FDX, Tuesday): Now that the Fed has shifted its focus from inflation to the economy, I anticipate the market will soon follow suit. Their upcoming report will update investors on global economic activity and holiday spending. Bulls will be hoping their commentary paints a picture of normalizing freight costs (inflation) and a resilient economy.

• Small-to-Medium Sized Business: Paychex (PAYX) and Cintas (CTAS) are set to report on Thursday. With their close ties to small-to-medium-sized U.S. businesses, these two companies offer unique insights into a crucial U.S. growth driver and job creator. Their performance can be used to extrapolate the well-being of this meaningful economic cohort.

• Nike (NKE, Thursday): Just over a month ago, NKE traded below $100. Despite the quick move to ~$120, I believe this stock will remain a battleground. The bull case relies on the holiday season creating a positive inventory position, enabling management to leverage the Olympics as a tailwind. Without a hostile Fed, perhaps the market gives management the benefit of the doubt. However, similar sentiment surrounded 2022’s FIFA World Cup. NKE performed horribly throughout the event. It was until the quarter after proved the company leveraged the opportunity that investors were rewarded for holding the stock. 

A Refinancing Rally

It may be hard to fully grasp, but the outlook for U.S. businesses materially changed at 2 PM on Wednesday.

As the Fed appeared to pivot, interest rates experienced a dramatic decline. This substantial drop significantly reduces refinancing risk for small and medium-cap companies expected to access the debt market in the next 1-5 years. Suddenly, analysts can model these companies refinancing at a lower rate. Refinancing at a lower rate means lower interest rate payments to bondholders, translating to more profit for stockholders.

This explains why lower-quality names performed the best in the latter half of the week. Their worlds underwent the most significant, positive change. The higher the refinancing risk, the more their profitability outlook improved. For example, a company that was priced for bankruptcy in 5 years at 1:59 PM needed to be repriced to survive at 2:01 PM. The same degree of repricing does not apply to higher-quality companies.

While the reduced refinancing risk allows for more stocks to perform, it won’t sustain all stocks indefinitely. As the euphoria fades, the good companies (growing, profitable) will thrive, while the bad ones (stagnant, unprofitable, overly speculative) will deteriorate. I’ve capitalized on the broad rally to trim the bad, ensuring ample resources for the good.

It may be wise to consider the same.