Weekly commentary

1. We recently raised our end-of-year S&P 500 Index target from 6,600 to 7,000 which represents 23x 2026 S&P earnings with that high multiple justified due to ongoing AI boom and increased visibility on Fed rate cuts.

2. We continue to be bullish on Treasury bonds with a 3.75% year-end yield target on the 10-year. The economy is slowing (see details below) and weakness in the US job market will likely force the Fed to cut 2 more times this year. Importantly, 3 members of the 7 member Federal Reserve Board are in favor of aggressive rate cuts. The market had failed to recognize that tariffs are recessionary/deflationary as the tax revenue reduces the deficit.

   1. US 10-year bonds are 70% correlated to the expected terminal Fed Funds rate and 25% correlated to global bonds (see attached slide).  The budget deficit is relatively static and has been in the 5% of GDP range for years, so not a driver of interest rates in the short to medium term.

Market implied policy rate continues to forecast 10-year yields

3. Addressing Fed incompetence is far more important than preserving theoretical Fed independence.  The current Fed is highly partisan similar to the Supreme court where political views drive “objective” opinions.  The implicit adoption of its arbitrary 2% inflation ceiling in 2005 led to the Fed raising rates 17 meetings in a row despite inflation never significantly exceeding 2% resulting in the Great Financial Crisis.  In 2018, the Fed raised rates 5 times and nearly triggered a recession despite inflation being below the Fed’s 2% ceiling.  The Fed also failed to tighten policy in 2021 despite obvious signs of runaway inflation, and now the Fed refuses to recognize that tariffs should be treated as a tax and ignored for the purposes of formulating monetary policy.  Finally, the Fed refuses to recognize the BLS’s calculation of shelter is inflation lags market rates by 2-years, and, therefore, inflation is already below the Fed’s target (see chart below).

   1. In summary, the Fed has 3 fatal flaws:  1) Their policy target of 2% is completely made up and too low 2) Their target is based on an Index preprepared by the BLS that has a two year lag, and 3) The Fed has no ability to forecast inflation or the economy as it ignores changes in the money supply.

CPI-R continues to be a leading indicator for CPI-U

4. The monetary base is the critical leading indicator of inflation and GDP growth.  M1 and M2 have become outdated indicators after the GFC as banks now have massive excess reserves so the Fed can no longer control the size of bank balance sheets to restrict credit.  In addition, non-bank lending has growth exponentially further limiting the importance of M1 and M2 relatively to the monetary base.

• The monetary base is flat Y/Y vs. a normal growth rate of 5% which is deflationary and could lead to a recession.

5. We were in favor of firing the head of the BLS, but for an entirely different reason than the President. Specifically, we believe the BLS needs to enter the 21^st century and modernize its data collection processes to capture the vast real time data available on the internet and from other sources such as ADP.  Most importantly, it needs to modernize its methodology to calculate the shelter component of CPI, which is purposely delayed by 6 months and uses delayed data on renewing leases and a far too narrow and, therefore, unreliable panel of homes and apartments.  We publish a real time CPI estimate that calculates the shelter component pf CPI utilizing real time, national data from Zillow and Apartment list.

6. The US economy is weakening and will enter a recession if the Fed does not cut interest rates significantly.  GDP growth has only averaged 1.5% this year and the interest sensitive construction and residential sectors have contracted over the last year in response to tight Fed policy.  In addition, employment growth has stalled with less than 22k jobs created on average over the last 4 months according to the employer survey showing no growth over the last 7 months.  Continuing claims also remain elevated at almost 2MM.

Private investment drives economic cycles

• The only reason the US economy is not in recession is the housing sector has become less cyclical as home building has remained muted since the GFC with only an average of 1.1MM homes started with a peak of 1.8MM.  During the 10 years prior to the GFC starts averaged 1.7MM with a peak of 2.3MM.  Consequently, there is a significant shortage of homes in the US of approximately 4MM homes.  Also, there is now an active group to investors buying new homes to rent which provides for more resilient demand than existed in the past. A decline in the housing sector accounted for 12 out of 13 post WWII recessions.

U.S economy less cyclical as housing starts are less Volatile

7. We favor Governor Waller for the next Fed Chair as he is a monetarist from the St. Louis Fed and understands the money supply matters (similar to having a Pope that believes in Jesus) and that tariffs are a one-time increase and should be ignored for the purpose of making monetary policy.  We are opposed to Kevin Warsh as Fed chair as he is way too hawkish and was involved in precipitating the Great Financial Crisis by raising rates 17 meetings in a row.

   1. The Fed is now highly political with the 4 democrats on the Federal Reserve Board continuing to site tariffs as a risk to inflation despite overwhelming evidence to the contrary.  Moreover, tariffs are a one-time increase that should be ignored for the purpose of setting monetary policy.  The two Republicans on the Fed Board have called for a July cut.

   2. We disagree with Peter Navarro’s op ed that stated that Powell is the worst Fed Chair of all time as we only think he is the worst since WWII as Eugene Meyers was worse as he shrunk the monetary base during the great depression. 

   3. The President definitely has the authority according to the Humphrey’s Executor case to fire the Fed Chair for cause based on his neglect of duty and incompetence as he precipitated the Great Inflation of ’21 while advocating for high government spending and developing the “Transitory” theory of inflation.

   4. An appointed agency official with a fixed term cannot be removed by the President early from office simply because the official disagrees with current policy decisions but the Chair can be removed for cause.

   5. The law specifies that cause can be inefficiency, neglect of duty, or malfeasance in office (INM)

   6. Its more important to eliminate Federal Reserve Board incompetence than protect the illusion of Fed independence.

8. Asset Class Considerations 

• Large Cap Defensive Dividend Stocks are generally attractive during normally volatile Fall period:

• We also believe investors can utilize high yield bonds and preferred stocks as we do not expect a big increase in defaults and we expect treasury rates to decline below 4% as the economy weakens.   

• Large Cap high Beta Dividend Stocks and Stocks that may benefit from AI IPO boom and continued momentum in the M&A market.  

• Small Cap dividend stocks 

9. Tariffs are positive for economic growth in the medium to long term as the additional revenue from tariffs reduces the federal budget deficit and crowding out of private investment.  Savings and investment are 70% correlated with GDP growth globally according to an IMF study. 

• We forecast that the Federal Budget deficit declines to $1.3 Trillion in Fiscal 26 with tariffs contributing $350 billion of incremental revenue based on an expected average tariff rate of 20%.  This deficit is only 4.1% of GDP which is sustainable with nominal GDP likely to grow in the 5% range over time. We forecast that the reduction in the deficit will boost sustainable GDP growth by .2%.

• Tariffs are politically unpopular with 58% disapproving of Trump’s tariffs and only 38% approving.  Taxes are unpopular and it would be impossible to pass the Trump tariffs through legislation.

10. We reiterate our StagDeflation call as the 2 critical drivers of inflation are the money supply and oil prices.  We estimate that headline inflation will not be significantly impacted by tariffs as manufacturers are absorbing a large portion of the tax and imports affect less than 6% of CPI.  In addition, flat money supply growth year over year and normalizing shelter inflation offset the small increase from tariffs. Oil prices are still down approximately 10% on the year, despite volatility related to the war in the Middle East. Recent inflation data has continued to decline with last 5 months annualized core CPI coming in at 1.7%, core PPI coming in at 2.1%, and PCE Core coming in at 2.1%.

    1. The OBBBA is not a budget buster despite talking points to the contrary as the budget impact relative to current law is actually an annual reduction in the deficit of $100 billion per year with another up to $350 billion coming from higher tariffs.  Even before these reductions, the budget deficit is projected to decline from $1.9 trillion or 6.5% of GDP to $1.7 trillion or 5.5% in fiscal 2026 by the CBO which does not include revenue from tariffs as we do above. 

    
    

11. We lowered our 2025 target on oil from $80 to $70 (range of $60-80) as it has become clear that Trump will use his influence with the Saudis and Russia to limit price increases despite tighter sanction on Iran.  This policy will offset a good portion of one-time price increases from tariffs.  We do not expect an increase in US production.  We do see support for oil below $60 as most forecasters ignore the price elasticity of supply and demand for oil.  Middle East wars will only impact prices if oil production facilities are destroyed.

    
    

12. The current Fed policy framework is very dangerous and needs to be reformed.  Specifically, it slavishly follows an index that trails real time market inflation by two years, resulting in the Fed being constantly behind the curve.  In addition, the Fed’s arbitrary 2% target has been proven to be too low as it precipitated the Great Financial Crisis.

    1. The Fed should adopt a more flexible target range of 2-3% and modernize CPI/PCE to ensure real time pricing of inflation.  It should also adopt an unemployment target range to balance out its stated dual mandate. It should adopt a more free market approach of targeting steady growth of the money supply in line with nominal GDP growth and letting the Fed Funds rate float within a larger band based on market conditions.  Finally, the Fed needs to modify its inflation forecasting models to incorporate the money supply as the critical independent variable. The new Fed Chair should be nominated that is committed to modifying the current dangerous policy framework. 

       
       

13. Inflation is always caused by excessive money supply growth as occurred during the Pandemic (22% inflation with 22% excess money supply growth) and never by tariffs and deportation.  The money supply (M0) shrank 5% Y/Y indicating that prices will continue to decline.

    
    

14. The “Hatfield Rule” is a recession indicator which states that if housing starts drop below 1.1MM there will be a recession.  It is superior to the “Sahm” rule as housing is a leading indicator and employment is a lagging indicator.