Fed's Dovish Pivot, Consumer Spending and Japanese Equities

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January 2024

Current Equity Exposure

Stocks continued their winning streak in December on lower-than-expected inflation data, market expectation of interest rate cuts early in 2024, and optimism that the U.S. economy will be able to avoid a recession. The S&P 500 and the Dow advanced 4.5% and 4.9%, respectively, while the technology-heavy Nasdaq rallied 5.6% for the month. The recent runup in equity prices is primarily due to expectations of earlier interest rate cuts, rather than a significant improvement in corporate earnings expectations. The current equity market volatility is unusually low, but we believe that market volatility will increase significantly if the Fed does not cut rates as early as the market is hoping for. Although the recession risk has certainly decreased considerably these days, we expect global growth to slow to below-potential next year. Our equity market outlook remains cautious given the continuing negative impact of high interest rates, the fading tailwinds from consumer support, rich equity multiples and lingering geopolitical risks. With this backdrop, we maintain a cautious allocation to equities and keep our U.S. equity exposure at 43% and international equity exposure around 76% during the month.

The Factors

Valuation

Valuation metrics
for equity remained negative. P/E increased from 21.9 at the end of November to 22.9
at the end of December.
Forward P/E increased to 22.1
at the end of December from
21.1 at the end of November.
Inflation-adjusted valuation metrics continued to be negative.
Equity valuation metrics relative to bonds remained negative with high bond yields.

Sentiment

U.S. manufacturing activity contracted for the 13^thconsecutive month, with the ISM manufacturing index remaining at 47.6 in November.
The University of Michigan Consumer Confidence Index increased significantly to 69.7 in December from 61.3 in November, driven by a notable decrease in inflation expectations.
The NAHB index increased modestly to 37 but remained well below the neutral level.

Technical

Technical indicators were positive overall, with positive momentum and fear signals outweighing negative reversal signals.
The S&P 500 was 10% above its 200-day moving average, 7% above the 100-day average, and 6% above the 50-day average.
The VIX index remained low during December and settled at 12.5 at the end of the month, with improved risk sentiment and low levels of realized equity volatility.

Macroeconomic

Nonfarm payrolls rose by 199,000 in November, showing signs of a cooling labor market (abstracting from the impact of the UAW strike). The four-week moving average of initial jobless claims remained steady at 212,000 as of December 23.
Retail sales improved modestly and rose 0.3% in November.
U.S. industrial production rebounded in November, expanding 0.2% after a 0.9% contraction in October.

What's Driving the Markets?

Fed Dovish Pivot: As widely expected, the Federal Reserve kept the target range of the Fed funds rate unchanged at 5.25% to 5.5% at its December meeting. The markets viewed December’s meeting as the most dovish since the tightening cycle, as the committee signaled that it will likely cut interest rates by 75 basis points next year (compared with 50bps in September’s projection). Also, for the first time, the post-meeting statement acknowledged that “growth of economic activity has slowed” and “inflation has eased.” More encouraging is that December’s Summary of Economic Projections indicated that the Fed expects a soft landing, with projections for real GDP and unemployment rate little changed. The markets have reacted positively to the meeting, with the U.S. Treasury yields declining significantly during intraday trading and all three major U.S. equity markets closing up about 1% for the trading day.

Consumer spending outlook: As consumer spending accounts for more than two-thirds of the Gross Domestic Product (GDP), it plays a critical role in the strength of the economy. Real spending growth has fallen behind real GDP in four out of the last five quarters. At the same time, the personal savings rate in the U.S. has fallen back to around 4%, well below the long-term average of 8.9%. Moreover, we have seen a clear trend of rising delinquencies in credit cards and auto loans, as well as an increase in Chapter 11 filings. Looking forward, we believe the risks of consumer spending are skewed toward the negative side. We expect the labor market to continue to cool down with the headwinds of lagged effects of high interest rates. Ultimately, the slow real income growth will dampen consumer demand and soften economic growth.

Japanese equity outlook: Japanese equities are up 20.3% in U.S. dollar terms, and its performance in local currency was even more impressive (up 36.2% YTD). Our outlook for the Japanese equity market is positive for the following factors: 1) While most of the developed countries are fighting against stubbornly high inflation, Japan has welcomed the resurgence of inflation, with a core CPI of around 4.0% year over year in recent months. The high wage growth would imply higher consumer demand, leading to high revenue growth for consumer-oriented companies. 2) The Bank of Japan has begun its policy normalization, and the transition from negative interest rates to positive ones would be beneficial for the Japanese banking sector as banks would be able to generate interest on excess reserves and be able to charge higher interest rates on bank loans. 3) The Tokyo Stock Exchange (TSE) governance has improved, and the TSE has encouraged firms to enhance profitability and improve stock valuations by reducing excess cash and divesting underperforming businesses. We believe that Japanese equity is an attractive long-term investment opportunity given its function as a hedge against global inflation, its relatively attractive valuations, and the improved governance of the Tokyo Stock Exchange.

As of 12/31/23. Data provided by Bloomberg, NorthCoast Asset Management, Federal Reserve History.

¹ The NorthCoast Navigator is a market barometer displaying NorthCoast's current U.S. and international equity exposure and outlook. This aggregate metric is determined by multiple data points across four broad market-moving dimensions: Technical, Sentiment, Macroeconomic, and Valuation. The daily result determines equity exposure in our tactical strategies.

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