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On Challenges Facing BOJ & ECB And Why Europe Is Appealing
The Bank of Japan isn’t expected to raise its benchmark interest rate this Friday—but should, argues William. Decades of near-zero interest rates have done more economic harm than good, so rate hikes would actually be good for Japan’s stock market. … The European Central Bank is widely expected to raise its key interest rate this week as energy-supply shocks intensify. Europe is a heavy importer of energy, so the Gulf war poses its greatest macro risk and increasingly dictates its rate path. … Toby reports that European equities are trading in that sweet spot investors look for: P/Es are relatively low but forward earnings at a record high, driven by expanding margins.
AI Capex Boom Continues to Boost US Economic Growth
I. On Industrials Investors are suffering from AI fatigue. They've concluded that there is no way to estimate whether all the capital spending on AI infrastructure will generate good ROIs in the coming years. What they do know is that hundreds of billions of dollars are being spent on AI capex in the here and now. That explains why S&P 500 Industrials is the second-best-performing of the 11 S&P 500 sectors with a gain of 17.7% ytd (chart). That's ahead of the 15.4% gain for the S&P 500 Information Technology sector. Within the S&P 500 Industrials sector, several of the industries have benefited from the AI capex boom, especially Construction Machinery, Electric Equipment, and Industrial Conglomerates (chart). They should continue to do so, and we continue to recommend overweighting the sector. The latest manufacturing data support our recommendation: (1) Durable goods. June durable goods orders rose by 0.3% m/m, but the details were much stronger. Orders excluding transportation increased 0.6%, while core capital goods orders (nondefense ex-aircraft), a key gauge of business investment, rose 0.9% and 12.5% y/y, the strongest annual increase since November 2021 (charts)! The major components of durable goods orders are at record highs (chart). Orders for machinery necessary to operate data centers are especially strong (chart). Unfilled orders for computers and electronic products rose to a record $157.4 billion in June (chart). The increase highlights robust demand for AI-related infrastructure, including servers, semiconductors, networking equipment, and other technology hardware. (2) Regional business surveys. Four of the five regional business surveys conducted monthly by five of the 12 Fed district banks are now available through July. The Regional Manufacturing PMI rose to 16.8 in July, its highest reading since 2022, suggesting that the national ISM M-PMI likely remained comfortably in expansion territory during the month (chart). (3) GDP. The Atlanta Fed's GDPNow model is currently estimating Q2 real GDP growth at 1.6% (saar), with consumer spending rising 2.5% and business investment increasing 6.0% (chart). Strong imports of AI-related equipment are depressing GDP growth. Real final sales to private domestic purchasers is providing a better read on underlying economic momentum and is currently tracking at a 3.4% pace, highlighting the continued strength of consumer spending and business investment. II. On US Inflation Historically, core CPI inflation has generally run somewhat above core PCED inflation, with the average spread between the two measures around 0.5ppts (chart). Recently, however, the relationship has flipped in an unusual way, with core PCED rising faster than core CPI. The spread was -0.6ppts during May. The CPI is compiled by the Bureau of Labor Statistics (BLS), while the PCED is produced by the Bureau of Economic Analysis (BEA) Part of this divergence appears to reflect the way that the BEA treats computer software & accessories, whose measured prices have surged recently because the index incorporates certain computing hardware prices that have been boosted by strong AI-related demand. In addition, the BEA's methodology for measuring investment-management services has pushed measured core PCED inflation higher. That divergence is set to narrow. As part of its annual benchmark revisions, the BEA will introduce methodological changes with the August PCED report, due on September 30, and apply them retroactively to the past five years. The agency will revise its treatment of computer software & accessories by incorporating additional software-related price data, investment-management services by better distinguishing changes in fees from changes in assets under management, and legal services by switching to an alternative BLS price measure. The net effect should lower core PCED inflation by roughly 0.2ppts, largely because downward revisions to software and investment-management inflation are expected to more than offset an upward revision to legal-services inflation. The BEA says the revisions are intended to maintain the "accuracy and reliability of BEA's estimates" and better reflect underlying price trends. In short, the changes should make the Fed's preferred inflation gauge somewhat lower and eliminate part of the unusual gap that has recently opened between core PCED and core CPI.
Bond Vigilantes: Fed Needs To Get Ahead Of Inflation
Recent inflationary developments increase the chance that the FOMC will vote to raise the federal funds rate at this week’s meeting. Today, Ed and Elias examine the hawkish shift and explain why it suggests that a 25bps rate hike this week is more likely than not. … Also: The Fed underestimated the persistence of the 2021-22 inflation shock and won’t be inclined to do so again—lending a hawkish overlay to the Fed’s deliberations. … And: The bond market appears to think a July rate hike is warranted, flagging broader inflationary risks than those represented by energy prices alone. … Ed reviews “Odysseus” (+ +).
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