Unstoppable deficits_ Pillar behind US' BULL
Hello everyone, here is Dolphin Research's summary of the core information on this week's portfolio strategy:
1. US December inflation data shows that although the last mile of fighting inflation seems to have a short distance, it may take a long time to walk. The expectation of a Fed rate cut may be more related to fiscal deficits and financing.
2. The US fiscal deficit for the first fiscal year of 2024 (ending in December) has contradicted market expectations of a tightening deficit: after adjusting the timing of revenue and expenditure, the deficit reached as high as 550 billion, and it is feared that the deficit will steadily approach 2 trillion in 2024. At this point, we can also understand the Fed's official hint about the pace of quantitative tightening.
3. Based on the speed of consuming 500 billion in reverse repurchase through treasury bond financing, the excess balance of reverse repurchase will be almost depleted within three months. If it turns to long-term bond financing, the equity market will face both positive and negative factors:
a) The Fed's possible rate cut is beneficial for valuation;
b) Long-term bond financing will start to draw away bank reserves, squeezing the equity market.
4. Considering that the rate cut expectation has been fully priced in, the liquidity pressure will increase in three months, which may bring adjustment pressure to equity assets at that time.
The current main contradiction is still the universal rise caused by the Fed's expected rate cut, entering the stage of earnings report season. With the resilience of the US stock market's economic fundamentals, individual stocks are expected to show differentiation in performance and guidance during the earnings season.
Dolphin Research focuses on TSMC's earnings release this week and will provide timely comments. Please stay tuned.
Here are the details:
I. Releasing the Last Mile of Inflation: Short Distance but Time-consuming
The December US CPI data was released, and the rate of decline did not meet market expectations, especially in major weight categories:
a) In terms of energy inflation, energy prices did not fall in sync with retail oil prices;
b) In terms of goods inflation, after the strike, the price of new cars rebounded on a MoM basis, causing the deflation of core goods to pause;
c) In terms of core services, the growth rate of housing costs accelerated on a MoM basis.
Excluding energy, food, core goods that determine the trend of deflation, and housing costs that are difficult to rise under high interest rates, the remaining key subcategories are as follows: medical inflation continues to rise at a MoM growth rate of over 0.5%; entertainment services have seen a significant increase due to price hikes in various movies, performances, and tickets during the year-end.
In terms of categories that are truly deflating, transportation services in December were mainly focused on price reductions in car rentals, repairs, and public transportation services other than air tickets. Overall, core inflation was 0.3% MoM, consistent with the previous quarter, equivalent to a YoY inflation rate of 3.7%.
Over the course of the year, even with the help of supply-side factors, the MoM growth rate of core inflation has fallen from the range of 0.4-0.5% to between 0.2-0.3%, while according to the Fed's 2% inflation target, the MoM target range for core inflation should be between 0.1% and 0.2%. From the current progress, it seems that the last mile to fight inflation is not too long, but it may take a long time to walk, especially now that there are signs that the Federal Reserve may cut interest rates early under fiscal constraints.
II. US fiscal tightening? Not yet!
Since October last year, the US federal government has entered a new fiscal year. After a year of unconventional fiscal stimulus (rare combination of high employment and high fiscal easing), the market's unanimous expectation was that fiscal tightening would occur by 2024.
However, based on the first quarter, it hasn't happened. Excluding the impact of the revenue and expenditure nodes in 2023 and 2024, the actual fiscal deficit in the first quarter was $553 billion (the deficit without adjusting the nodes was close to $510 billion), an increase of nearly $100 billion compared to the same period last year. If the deficit continues to increase at this rate, it is estimated that it will reach $2 trillion for the whole year.
As of December 2023, the US annual fiscal deficit was $2.1 trillion, and during the same period, the US Treasury financed $2.4 trillion. Basically, they borrowed as much money as they lost, and the borrowing was mainly done through short-term debt, corresponding to the continuous decline in the reverse repurchase balance of the Federal Reserve.
As of January 10th, the reverse repurchase balance is currently $1 trillion. With a quarterly pace of $500 billion and the Federal Reserve's $65 billion in Treasury bond sales, the excess reverse repurchase will be exhausted in three months. In addition, the issue of whether to renew the BTFP tool, which is expiring, also needs to be addressed.
Based on the current consumption rate, the Federal Reserve meeting at the end of this month will need to release clear signals on the following issues to avoid ambushing the market:
a) After the expiration of the BTFP liquidity tool for small and medium-sized banks in mid-March, whether to release a renewal and what are the renewal interest rate conditions?
b) Adjustment progress of quantitative tightening: When to slow down and whether there will be guidance on the end point?
Perhaps a friendly Federal Reserve may release signals and nodes for easing quantitative tightening, and the BTFP tool may be renewed under the condition of raising lending thresholds to avoid short-term liquidity shortages in the event of a reverse repurchase crisis. However, a core issue for the market remains:
a) Can the fiscal deficit under a pro-cyclical, high employment rate environment be reduced?
b) After the depletion of reverse repo balances, there is a high probability that government bond financing will shift towards long-term bonds. After this shift, will the Federal Reserve need to cooperate by lowering interest rates to suppress market expectations of long-term interest rates, in order to prevent high interest costs from becoming a long-term structural component of the government's debt portfolio?
c) If bond financing starts to consume bank reserves, on one hand, there will be expectations of a decline in long-term interest rates (which seems to have already been priced in), and on the other hand, there will be short-term liquidity pressures. Will there be a valuation adjustment in the short term?
The decline in bank reserves does not seem to have a direct causal relationship with changes in the S&P 500 before the pandemic. However, after the pandemic in 2020, the trend change seems to be more obvious. Taking a three-month period as a reference, US stocks still face adjustment pressure.
However, the main contradiction in the short term is still the expectation of a rate cut by the Federal Reserve and the verification of earnings reports after the general rise. In the case where the economic fundamentals of US stocks remain resilient, individual stocks are expected to show differentiation based on the strength of their earnings reports and guidance.
III. Portfolio Rebalancing
No portfolio rebalancing this week.
IV. Portfolio Returns
In the week of January 12th, the Alpha Dolphin virtual portfolio had a slight increase of 0.1% in returns, underperforming the S&P 500 (+1.8%), but slightly stronger than Chinese assets - the CSI 300 (-1.4%), Hang Seng Tech Index (-3.4%), and MSCI China (-1.8%).
Since the start of the portfolio testing until the end of last week, the absolute return of the portfolio was 25.4%, with an excess return of 51% compared to MSCI China. From the perspective of asset net value, Dolphin Research's initial virtual assets were $100 million, and it is currently $127 million.
V. Individual Stock Profit and Loss Contribution
Last week, in terms of the types of price increases, it was either related to AI PCs or technology stocks with strong fundamentals and high valuations. On the other hand, stocks with weak fundamentals, such as Tesla, Wolfspeed, and Chinese concept stocks, have already entered a downward trend. The market is starting to anticipate their upcoming earnings verification.
In terms of the Dolphin Research portfolio and watchlist, Dolphin Research analyzed the major gains and losses of companies last week, as well as the possible reasons, as follows:
VI. Portfolio Asset Distribution
Alpha Dolphin's virtual portfolio did not make any adjustments this week, with a total of 26 stocks held, including three standard stocks. The remaining equity assets are underweighted, with the rest in gold and US dollars.
As of the end of last week, the asset allocation and equity asset weightings of Alpha Dolphin are as follows:
Risk Disclosure and Statement for this article: Dolphin Research Disclaimer and General Disclosure
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