The Investment Journal – Page 6 – The Investment Journal

It was probably only interesting to financial geeks, but for the couple days going into last week’s FOMC meeting there was a real tug-of-war going on between “economists” and the market.

Since the beginning of the year, there had been expectations of interest rate cuts starting in March. Last December, the Fed itself was projecting nearly 100 basis points over 2024.

But then CPI got stuck at 3.5%. (Even the notoriously Fed-friendly PCE was rising 2.7% year-over-year.)

The party had to be postponed.

And after standing pat for a handful of meetings, convincing itself that they really had the inflation beast under control, the Fed finally saw its destiny in the jobs reports over July and August.

Back-to-back misses and downward revisions to nonfarm payroll numbers (which had been building all along) along with an uptick in the unemployment rate shifted their focus. (Or at least their talking points.)

At the Fed’s annual Jackson Hole Symposium, the three day get-together of central bankers and other elite types from around the world to discuss the fate of interest rates, Chairman Powell said the following:

Overall, the economy continues to grow at a solid pace. But the inflation and labor market data show an evolving situation. The upside risks to inflation have diminished. And the downside risks to employment have increased. As we highlighted in our last FOMC statement, we are attentive to the risks to both sides of our dual mandate.

The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.

There was no mistaking what he was saying. So by the time the September meeting rolled around, it was game on for the long awaited cuts. The question wasn’t “if” anymore, but “how much?”

On opening day of last week’s FOMC meeting, the market was all-in pricing in a 64% likelihood of a 50 basis point cut.

“Economists” on the other hand, (105 out of 114 surveyed) were insisting that the Fed would only go 25 bps.

And as the clock struck 2:00PM ET, the Fed dropped the bomb…

50 bps it was.

And after receiving what everyone thought would be the best news possible, the market went haywire and ended up lower on the day…

S&P 500 (5 min)

So What Does All This Mean?

First, it means “economists” aren’t that smart.

Second, it means the Fed is likely more worried about the economy than they’re letting on. The Fed’s rate cut logic goes something like this…

While they’re straining their shoulders to pat themselves on the back for taming inflation, they still insist the economy is doing just fine. So they need to move rates from “restrictive” to “neutral” now, before things do start to slow down and the economy falls into a recession. Thus engineering the mythical “soft landing.”

Let’s break that down…

According to Powell, things are humming right along as even with a Fed rate target of 5.25-5.50%.

On top of that, asset prices (stocks, housing, etc.) at all time highs.

And unemployment estimates are well within the 4% range, a range Powell himself insists is perfectly healthy.

So why cut 50 points now? Why not just 25?

According to JP: they’re trying to get out ahead of a potential economic slowdown by starting to move rates to “neutral” now. (I put neutral in quotes because even according to Powell almighty, the Fed has no idea what neutral is. Like pornography, they’ll know it when they see it!)

The reality is the Fed is completely incapable of predicting anything. I give you their “inflation is transitory” claim from three years ago as proof.

The Fed is easing because of meaning number three: they know the economy is in worse shape than their numbers let on.

They know (and now we do) that the BLS overstated jobs added by over 800,000 over the past year.

They know the unemployment number will only keep rising thanks to the millions of immigrants who’ve crossed the border over the past three years — a fact that Powell copped to in his Q&A.

They know that consumers (who represent over 60% of GDP) are getting crushed.

And they know the economy is hopelessly addicted to cheap money.

So 50 bps it was. (Anything bigger would have incited a panic.) And you can look for at least 50 more by the end of the year.

Longer term, the reality is cheaper money will always ~~inflate~~ benefit asset prices. Period.

That said, a 50 bp cut doesn’t equal “cheap” money.

The real question is how committed are they to trying to find “neutral.”

Because should inflation reheat with unemployment still on the rise, Powell and Co are going to find themselves in the unenviable position of floating up S#!% creek.

Exciting times ahead…

There’s something to be said for government investments…

They’re stupid.

Nearly every foray into industrial policy by a government ends up creating serious unintended consequences.

But that doesn’t mean they’ll stop trying.

This latest government go-round involving the tech industry will likely be no different.

Launching a Giveaway Program

Quick story… When global governments shut down the world during the pandemic, the US became painfully aware of just how dependent its economy was on foreign production of certain key materials. One notable dependency was in the semiconductor segment.

The shortage that followed sent shockwaves through multiple industries that relied on access to these tech components.

In the face of this realization, the government did what it does best.

It threw money at the problem.

In 2022 the Biden Administration (in cahoots with the US Congress) passed something called the Chips Act. The White House assured us that this $280 billion handout would:

…accelerate the manufacturing of semiconductors in America, lowering prices on everything from cars to dishwashers. It also will create jobs – good-paying jobs right here in the United States. It will mean more resilient American supply chains, so we are never so reliant on foreign countries for the critical technologies that we need for American consumers and national security.

In addition to targeting semiconductor manufacturing capability in the US, it would fund R&D in various “leading edge” technologies. (In other words, technologies that don’t have a viable commercial market of their own.)

One of the first to step up to the trough was the former heavyweight champion of the chip industry — Intel.

_{Source: CNBC}

According to the article:

Intel said it would spend its CHIPS Act funds on fabs and research centers in Arizona, Ohio, New Mexico and Oregon. The company previously announced plans to spend $100 billion on U.S. programs and facilities. Intel has announced a plan to catch up in leading-edge manufacturing by 2026.

Intel’s Ohio fab will cost more than $20 billion and Intel said it is expected to start production in 2027 or 2028. Intel is also expanding manufacturing operations in Arizona and New Mexico. Intel says the projects will create jobs for 20,000 people in fab construction and 10,000 people in chip manufacturing.

The company’s stock popped on the news.

Spending Down a Black Hole?

But that was six months ago. And oh how things have changed.

Early last month, Intel released a disastrous Q2 earnings report. Revenues missed expectations and resulted in a $1.6 billion net loss. EPS came in at $0.02 vs a $0.10 expectation.

The company announced it was suspending the dividend it’s been paying since 1992.

And now rather than creating tens of thousands of jobs, they announced they would be laying off 15,000 beginning this year.

The company’s stock is down over 60% year to date.

Intel Corp. (INTC) Year to Date.

_{Source: Barchart.com}

Intel CEO Pat Gensler said, “Our revenues have not grown as expected — and we’ve yet to fully benefit from powerful trends, like AI. Our costs are too high, our margins are too low.”

That may be the scariest statement of all.

For all intents and purposes the AI boom has been fueling the market since late 2022. If they’ve missed the bus for the past two years, it’s hard to imagine how they plan to catch up.

Intel has a bit of a history of being on the wrong side of industry trends. (Like when it opted not to provide Apple with chips for its iPhone.)

There’s always hope to right the ship. (Meta managed to do it after a disastrous investment in the metaverse.) But right now, Intel is nowhere near equipped to spend $100 billion on anything.

And given all this, is this where the government should be spending $20 billion of your money?

According to the Guinness book of world records, it’s the most fearless creature in the world.

A ferocious little critter (only about two feet long when you count their tails) that’s impervious to cobra venom, bee stings and just about every other threat that might be lurking in the African plains. (They’ll even throw down with a lion!)

They eat pretty much anything from lizards to rodents to snakes to birds and bee larvae.

We’re talking about the Mellivora Capensis… aka the Honey Badger.

And as the saying goes, “the honey badger don’t give a $#!%…”

Lately, one market has taken on a honey badger attitude.

In mid-September, the Fed decided it was time for rates to start coming down and they began a new easing cycle lowering their Fed Funds target rate by a full 50 basis points. (An aggressive move by any account!)

But like the honey badger, the bond market didn’t give a $#!%.

As the Fed started its easing cycle, yields on the 10-year note, the US’ borrowing benchmark, bottomed. And in the ensuing weeks they have actually risen from roughly 3.6% to nearly 4.25%!

US Treasury 10-Year Yield

What’s Going On?

The US has just closed out its 2024 fiscal year and the results, as expected, were abysmal.

According to Janet Yellen and the Treasury, the budget deficit hit its highest level in history. (That’s not counting the two outlier years during the pandemic stimmy giveaways.)

The total deficit for FY 2024 topped $1.8 trillion.

And while that’s bad enough on its own, in what might be the greatest irony in financial history, the largest contributor to that deficit was… interest on the debt.

If you scroll down the Treasury’s monthly statement it shows they paid out over $84 billion in interest payments in the last month of the fiscal year. That increased last year’s total interest expense by a staggering 29% to $1.13 trillion.

That was more than the government spent on Medicare and the defense budget.

Needless to say, the exploding interest cost is a serious problem.

When it comes to government debt, nothing gets retired. The Treasury simply rolls its debt over, refinancing the securities that come due. Which simply adds to the total amount of debt — increasing the interest expense they have to pay.

Now interest on the debt will soon become the biggest contributor to the debt itself.

Think about it. This year alone has added over $1 trillion to the annual base borrowing needs of the country. Before we pay for anything else. In that same 2024 fiscal year, the country took in $4.92 trillion in income. The interest cost ate up 23% of that.

This, of course, increases the amount of debt that has to be issued every year. And higher yields make that cost go up exponentially. (You don’t need to be a financial genius to know borrowing at 1% is better than 5%.)

This situation is one of the main (albeit unspoken) reasons the Fed is scrambling to lower rates — to ease the ever-expanding interest burden the spendthrifts in the government keep racking up.

The only problem with the Fed’s plan is that the funds rate is an overnight borrowing rate between banks that no longer have to maintain any reserve requirements.

So it’s basically just just for show.

It would appear the bond market (the folks who actually buy our debt and finance our deficits) knows this — and it doesn’t give a $#!%…

Election issues may be factoring into this rise in yields, but we don’t think it’s to any significant degree.

More likely the market may be reacting to what it knows is going to be an ever increasing supply of bonds they’re going to need to buy. (More supply = lower bond prices = higher bond yields.)

And this could easily force yields, as one Fed chairman once noted, to stay higher for longer. We’ll see as the week’s progress. But should the market take out previous yield highs of 5%, 6.5% could be within reach.

For now understand that when it comes to the Fed… the bond market don’t give a $#!%!

AI explosion creates monster investment opportunity

The government’s on a roll…

The Treasury Department just issued its Monthly Treasury Report and indicated that the government overspent by $296 billion in February.

So far this year they’ve shelled out $593 billion for social security, $369 billion on health care, $363 billion on defense, $350 billion in interest payments, $324 billion for Medicare and on and on it goes. All this deficit spending is finding its way into the economy (and adding to that net interest payment) and giving it the appearance of above average growth. (Perpetual debt isn’t growth… or at least it shouldn’t be.)

But last week the economy actually got some bona fide good news…

PMI is Back in the Headlines

We’ve talked about the Purchasing Managers Index and why it’s an underrated but important indicator.

First is because purchasing managers are in the know about nearly everything that’s going on in their companies.

The second reason is it’s an incredibly straightforward calculation. A net score above 50 is good. A net score below 50 indicates trouble.

The third reason is because it’s as close to a real time indicator that you can get. (It’s not subject to months of revisions like so many other indicators.)

And if you want to add a fourth, it’s a forward-looking indicator. It’s what purchasing managers see coming.

PMI reports (issued by the Institute for Supply Management (ISM) and S&P Global) are reported for both manufacturing and service businesses. Services, which have been the foundations of our economy for some time, had been keeping things afloat over the past couple years.

But in the most recent reports for March, manufacturing readings in both indexes rose back above 50.

And that’s a good sign for the sector.

A Boom in Manufacturing?

A boom in manufacturing would be an honest-to-goodness good thing for the economy.

According to the US census, manufacturing is the fifth largest employment sector in the economy…

The manufacturing sector is responsible for the largest dollar amount of exports in the US…

According to McKinsey:

The country currently meets 71 percent of its final demand with regional goods, trailing Germany (with 83 percent), Japan (86 percent), and China (89 percent).

manufacturing means greater supply chain resilience…

They’ve created a graphic that sums up all the benefits of a healthy manufacturing sector…

So this developmenet is actually osme pretty good news for the economy.

And if the trend persist…

Now Comes the Bad News

Stocks have long been anticipating the Fed to cut rates. Cheap money means “risk on.” And the market’s been risk on since at least November 2023. (If not October 2022.)

An actual boost in manufacturing PMI is probably the worst news they could get.

An actual growth spurt in the economy, one that has come with a funds rate of 5.5%, means easing should be out of the question. (PMI manufacturing prices paid dumped gas all over that fire jumping way above estimates as well.)

Higher for longer carries all kinds of risks for other parts of the financial system. The Treasury has trillions in maturing debt to refinance and regional banks are holding hundreds of billions of CRE debt their books that will need to be refinanced soon as well.

We’ve previously suggested a strategy the Fed might use in the future to justify cuts. It’s still on the table

Tomorrow, however, we’ll get more clarity when official inflation numbers come out.

Today’s investing landscape may be as difficult to navigate as it’s ever been.

This is in large part due to changes that have taken place over the past decades.

Two important distinctions investors should be aware of today.

First…

The Stock Market Is Not the Economy…

Not so long ago, when the US economy was a value-based engine, the stock market could be considered a decent measure of economic activity.

Manufacturing companies who produced and sold more products earned more money. And investors in those companies were rewarded with higher share prices and often dividend payouts.

Everyone’s a winner.

Today we no longer live in a traditional value-based economy. Sure, we have industries that produce stuff that’s sold here and around the world. But more and more that continues to change.

Today, and for the past roughly 50 years, the stock market has turned from a measure of an industrial economy into a tool of financial elites.

A means to make money from money. Period.

If you want the big picture, think of the golden age of the corporate raider — the time associated with the “Go-Go 80s” and personified by Gordon Gekko in the movie Wall Street.

The strategy back then was to acquire distressed manufacturing companies and drain whatever cash flow they could. Corporate raiders cut capital and operating expenditures and sold off assets. In the immortal words of Gekko himself, they’d wreck a company “because it’s wreckable!”

It wasn’t about investing to grow a company. It was about spending money for a fast return.

But the financialization wasn’t limited to the corporate vultures.

Manufacturing companies themselves even got in on the “make money from money” craze.

General Motors Acceptance Corporation and Ford Motor Credit were both established decades ago to finance car purchases. But during that same time they began to expand their interests into all sorts of other financial services including mortgages, insurance, banking and commercial finance.

Their financial efforts eventually began to eclipse their main businesses…

In 2004, GM reported that 66 percent of its $1.3 billion quarterly profits came from GMAC; while a day earlier, Ford reported a loss in its automotive operation but $1.17 billion in net income, mostly from its financing operation.

Today, stock buybacks are all the rage.

After a shaky start earlier this year, Apple announced it would buy back $110 billion of its shares. Without changing a thing in its operations, its share price suddenly exploded making them once again the most valuable company in the world.

Much of the stock market has become addicted to this financialization. And that’s why cheap capital (low interest rates) is so important.

This is an important fact to understand. Stock indexes do NOT represent the economy.

…And Neither Are Economic Reports

The second thing to understand is that “economic reports” don’t accurately represent the economy either.

Case in point.

GDP for the second quarter was just revised upwards to 3% — over doubling the first quarter’s report of 1.4% growth.

If you believe these numbers, business should be booming.

Yet in the first half of this year, corporate bankruptcies are soaring.

According to the June S&P Global Market Intelligence report: “The 346 total filings so far in 2024 is also higher than any comparable figure in the prior 13 years.”

Personal consumption expenditures (the fancy name for consumer spending) rose 0.7% in the second quarter as well. But sales numbers for many consumer-facing companies like General Mills…

MINNEAPOLIS – General Mills (NYSE: NYSE:GIS) has confirmed its financial targets for fiscal year 2025, expecting organic net sales to be flat to up 1 percent, and an adjusted operating profit ranging from a 2 percent decline to flat in constant currency.

…Hershey…

The stock of iconic US chocolate maker Hershey tumbled after the company slashed its sales and earnings outlook for the year as shoppers continue to reduce purchases of higher priced chocolates and candies.

Q2 sales plunged 17% to $2.07 billion, sharply missing the $2.31 billion estimate. Adjusted EPS of $1.27 per share also missed expectations.

…even dollar stores…

Shares of Dollar Tree plunged nearly 12% in premarket trading in New York after the discount retailer, which operates thousands of stores nationwide, posted fiscal second-quarter earnings that fell short of Wall Street expectations. The company also slashed its full-year outlook, pointing to mounting financial pressures on middle-income and higher-income customers. This comes less than a week after major rival Dollar General reported a “financially constrained core customer” that sent shares crashing the most on record.

…have been struggling as well.

And then there are all the jobs that have been added to the economy…

Today, given all the potential for revisions and seasonal adjustments, economic reports really don’t mean much where the future of a stock — or even an entire index — goes.

Heck, they don’t even accurately represent the economy.

These financial and economic “dislocations” can create havoc for investors.

But we make them our business here, to make sure our readers are the best-informed investors they can be.