Misdirect

Barriers to Entry (The AI Story): The issue with AI, from an investment standpoint, is the only barrier to entry was a monstrous amount of capital. When everyone jumped in, it turned out to be not much of a barrier. The news that China’s offering in the space is finding quick success translated into cratering tech stocks this morning. This alludes to an end state for AI, whether it’s five or 10 years down the road, that it’ll be somewhat of a commodity as everybody will be doing it and you really can’t pay 30- and 40-times earnings for a commodity. This was the game of musical chairs that has been propping up Nvidia et al. While there is great opportunity in all the applications that AI will enhance, if the commoditization means it is open to everyone, multiples should be at or below market levels. There will be a rotation to yield instruments, whether it’s fixed income or higher-yielding equities in the short term. While in the short term, stock indices have rebounded off their 100-day moving averages, the true re-pricing comes later. The real story may reside in slow-moving write-downs in Private Equity and Venture Capital portfolios. Watch credit spreads for clues as to when the smoke clears.

BoJ Rate Hike: Butterfly Wings Flutter

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With everyone hyper-focused on Washington, our contrarian streak pushes us to look eastward, not to DC, but to Tokyo and Beijing. The Bank of Japan (BoJ), as expected, raised its official discount rate by 25 basis points to 0.50%. This relatively tiny move could carry big repercussions. The BoJ wrote that improved corporate profits and a shrinking supply of workers will result in higher wage inflation during March’s labor negotiations. Even with inflation being above their 2% target, it appears the BoJ is hoping these increased labor costs will create another round of price hikes passed through to consumers. 

The central bank is maintaining a hiking bias despite soft spots in the economy. The BoJ’s Outlook Report stated that the “recent potential growth rate is estimated to be around 0.5%.” The central bank is not operating with a large enough margin for error and if they raise rates again, it will be the highest level in 30 years. The rush to normalize monetary policy against a backdrop of fully mature global business cycles may turn out to be a bad experiment.

Nakamura Toyoaki was the lone dissenter on the Monetary Policy Committee, and in our eyes, he correctly preferred to wait until the March 18 meeting when the Committee could confirm “a rise in firms’ earning power.” Japanese equity owners may begin to agree, this could create a parallel to the small hike of 25 basis points to 0.5% in 2007. That hike led to a July peak in the Nikkei, which may have been a factor in leading to the major October 2007 equity high. US investors need to be on top of events in Japan because they matter to our markets.

China Vanke: So Bad it’s Good?

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Will the Chinese government go back on its promise and bail out a troubled real estate firm? Vanke’s troubles could not come at a worse time because homebuyer confidence was just stabilizing. If they go under, what little real estate liquidity is available could completely seize up and could unravel into a financial market crisis. Vanke just announced a $6.2 billion loss last year from plummeting sales, and the Chairman and CEO just resigned this morning. Its September financial statements have already warned it will not have enough cash to cover its short-term debt. The Shenzhen Government owns one-third of Vanke through a state-owned firm, but officials were clear they would not inject more cash. Banks are unwilling to lend since they too view it as throwing good money after bad. The only road to avoid default appears to be asset sales to other state-owned corporations. 

We believe Vanke’s predicament could be an inflection point for government policymakers. The unfinished housing projects from Vanke, Evergrande, and recently defaulted Country Garden still present a major deflationary overhang weighing on the entire economy. Beijing can ill afford more deflationary pressure in the face of U.S. tariffs and does not want to negotiate from a position of weakness. While President Xi could yield and invest in the U.S. to avoid tariffs, that may seem to be a face-losing proposition. Alternatively, this shock could motivate the Chinese to finally mobilize fiscal policy and inject funds into these troubled real estate developers. A far less favorable alternative could take the form of a vigorous pushback, such as retaliatory tariffs and restrictions of existing foreign investment or even mobilizing the military to surround Taiwan.

FOMC Musical Chairs

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There are four central bankers coming in off the bench in 2025, and they are bullish. Every January, there is a changing of the guard among the nineteen members of the Federal Open Market Committee (FOMC). Only twelve vote, eight of whom are permanent voters with four voters rotating yearly among the regional bank presidents. The most dovish of the regional bank presidents, Austin Goolsbee of Chicago is voting this year, and he is often in the media. This year, his comments will carry more weight with investors and help support equity prices. He is a strong proponent of further rate cuts.

Additionally, Boston’s Susan Collins joins Goolsbee, and they both favor lower rates. This could change the overall tone of the meetings to side more with Jerome Powell and Williams, who expect inflation to ease to 2%, allowing continued rate cuts. Pushing against this view will be new voters Alberto Musalem of St. Louis and Jeffrey Schmid of Kansas City, both leaning toward being more cautious about cutting rates.

Pay attention to Fedspeak from Goolsbee, Collins, Musalem, and Schmid for clues to future Fed decisions, but expect a more market-friendly tone.

What to Look for This Week

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1.  Wednesday, January 5 at 2:00 p.m. E.S.T. Fed rate announcement, certain to contain no surprises. The more important event is 30 minutes later, at Chair Powell’s press conference. The dialog is expected to be noncommittal because there is so much policy uncertainty between this meeting and the next one on March 18-19. 

2. Friday, January 31 at 8:30 a.m. E.S.T, December PCE. As we wrote last week, “Core PCE price data is scheduled for January 31, after the January 28-29 FOMC meeting where rates will be left unchanged. Although the market consensus is not in line with Waller, if the inflation report comes in steady, investors will remember Waller’s optimism and celebrate.”

3. Thursday, January 30 at 6:30 p.m. E.S.T. Japan’s January Consumer Prices report. Now that the Bank of Japan has raised rates to 50 basis points, if there is further strength in this report, especially for core CPI above March 2024’s 2.5% (the high for last year), it would be above consensus and push forward speculation over the next rate hike.

Note: Mega cap tech earnings: Wednesday  (after close), Tesla, Microsoft, and Meta. Thursday (after close), Apple.