Diss-onance

The Great Rotation? Capital is flowing into other sectors as technology and the Magnificent 7 consolidate. Equity markets outside of the U.S. (especially Germany and China), along with U.S. value stocks, had a much better month than large cap tech in the US. This rotation appears to be sustainable as the inherent risks to stocks—inflation, policy overreach, or Fed missteps—will disproportionately hit the most expensive and highest beta stocks. We wouldn’t call it a flight to safety trade, but it is a move toward lower priced, less volatile assets until investors gain visibility on U.S. fiscal and monetary outcomes and the global economic landscape.‍

Opportunity?

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Fear is in the air. The equity slide started a week ago Friday, led by the big tech stocks, on a report that Microsoft was getting out of data center leases. That sparked investor worries that the AI hyperscalers were concerned about tariffs slowing global growth and had extended their capex plans too enthusiastically. The selloff continued all through last week, and it has pushed investor sentiment to its lows for the year. This normally sets up a great buying opportunity, especially with renewed expectations for Europe and China to ratchet up fiscal spending. However, with the Fed suggesting they would raise rates to contain the recent jump in inflation expectations, the recessionary implications of a trade war, upcoming federal spending cuts, and consumer sentiment also falling, any bounce may be seen as an opportunity to sell into. 

First, the bad news, which is good news: CNN’s fear and greed index hit its lowest level in a year, except for August 5, 2024, which came in just one point lower. August 5 was a major low that started a 1000-point rally in the S&P 500.  When sentiment is tapped out to this extreme, that generally means we have arrived at a selling climax, and longer-term players start to find value, and a rally ensues. That is exactly what happened in August as the market began to anticipate a business-friendly Republican win. We will scrutinize price action for clues to determine whether investors are looking to add exposure or merely selling into the rally to get more defensive. 

Schmid’s Internal Conflict

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Federal Open Market Committee (FOMC) voters are starting to talk about tradeoffs and triage. Kansas City Fed President Jeffery Schmid spoke last Thursday and noted he is shelving his forecast that inflation reaches the Fed’s 2% target for now. Because inflation expectations spiked in January and February, this puts the Fed in a quandary. While this rise in expected inflation could be fueled by “likely one-off transitory developments,” meaning a one-time bump based on tariffs that eventually flattens out, he sees a scenario where the Fed may need to raise rates. He emphasized that “I am not willing to take any chances when it comes to maintaining the Fed’s credibility on inflation.”

Schmid also warned that businesses around the Kansas City Fed region (Kansas, Colorado, Nebraska, Oklahoma, Wyoming) are becoming cautious due to the economic uncertainty introduced by President Trump’s policies. This is potentially a major problem if “the Fed [has] to balance inflation risks against growth concerns.” We have discussed how the Fed would be boxed in with stagflation, because if the economy turns down and the FOMC eases, then inflation can get out of hand. Schmid implied the Fed may sacrifice economic growth to fight inflation by raising rates because “once inflation is embedded in expectations, it becomes much more painful to vanquish.” He mentioned that raising rates in the 1980s was the cost to put a lid on the deeply ingrained inflation mindset that led to “a steep increase in unemployment and a recession.” 

His comments carry weight because he is a voter on the Committee this year. KC President Schmid may be signaling a shift in tone across the central bank that the balancing act may get resolved by making the choice to raise rates, even if it risks recession. Stagflation followed by rate hikes would undoubtedly be the worst possible outcome for investors.

China Coming Up to Bat

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Things may be turning for the better in China, and it couldn’t come at a better time. The government has taken dramatic fiscal measures not seen since the Global Financial Crisis. We had written last week that the threat of more tariffs could force China to resort to direct capital injections, and it looks like they are continuing what they started with China Vanke. This time, instead of supporting a property manager, they are directing $55 billion in funds to three banks. The government had promised at last October’s major policy meeting to help six state-owned banks with $140 billion, so this recent announcement could be the first phase of that plan. These banks have a $1 trillion market cap, and their net interest margin fell to a record low of 1.5% in Q4 2024, so the intervention is timely. This news pushed Chinese equities higher. The hope is for the new capital to support lending activity.

The question is whether businesses are willing to borrow. Chinese loan demand could be bolstered on good news coming out of this week’s national budget and policy meetings. If there is a realistic strategy that is agreed upon by the Party Congress, then we can hope that sets a true foundation for an economic recovery. That should yield a continuation of the stock rally that hopefully also spills into U.S. markets. If the Communist Party leaders disappoint, it would signal they are holding back out of concern over a prolonged trade war. We would argue that because this is the first time since the financial crisis that the government has implemented direct capital injections, the odds of a positive result from this meeting have increased.

As we mentioned last week: “A particular sequence of events must fall into place for China to be back on track. Unfortunately, there is not enough visibility yet to have confidence, despite the hope from their recent stock market outperformance”. We could have that visibility by the end of this week.

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What to Look for This Week

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1. Friday, March 7 at 8:30 a.m. E.S.T. February Nonfarm Payrolls. The consensus is for little change from January, so any surprise in either direction would catch the market off guard.

2. Wednesday, March 5, marks the beginning of the Chinese National People’s Congress. The National Committee of the Chinese People’s Political Consultative Conference opens the day before on Tuesday, March 4. The ISM non-manufacturing report is also released Wednesday at 10:00 a.m. E.S.T. followed by the Beige Book for the March 18-19 FOMC meeting at 2:00 p.m. E.S.T.

3. Tuesday, March 4, 25% tariffs against Mexico and Canada go into effect. Canadian energy exports will be taxed at 10%, and an additional 10% tariff will be applied to all Chinese goods, doubling the existing tariff. 

FOMC Voters Speaking: Heavy week. The highlight is Jerome Powell’s speech on the economic outlook Friday, March 7 at 12:30 p.m. E.S.T. just after Nonfarm Payrolls. He will crowd out any details of Governor Adriana Kugler’s speech which starts 10 minutes earlier.  Monday, March 3 at 11:35 a.m. St. Louis Fed President Alberto Musalem speaks; because he recently discussed the tradeoff the FOMC could face with stagflation, if he doubles down after Schmid’s comments last Thursday, the is a good chance of a coordinated message coming out of the Fed. NY Fed President John Williams speaks on Tuesday, March 4, at 2:20 p.m. E.S.T. Governor Christopher Waller’s speech will be scrutinized when he talks on Thursday, March 6, at 3:30 p.m. because he has been leaning toward rate cuts after the current pause. Fed Governor Michele Bowman speaks Friday at 10:15 a.m. E.S.T. and may not discuss monetary policy, leaving that for Chair Powell later that day.