Over the past couple weeks, equity markets attempted to rally from support levels, which is a good overall macro technical sign, prior to pausing as the calendar turned to November. This is consistent with our view at Cornerstone that equity markets have become somewhat of a coiled spring in advance of the midterm elections as sentiment and technicals moved to extreme levels.
Still, before the midterm elections the most important economic data analysis came from last week's Federal Reserve rate decision. Leading into this important decision, we felt there were five reasons why the Fed would become less hawkish compared to the September meeting.
Let’s first recognize that Fed Chair Kevin Warsh is within his first 100 days, thus is still finding his way regarding communicating with markets. With that in mind, here are five reasons we expected Chairman Warsh to be less hawkish leading into last Wednesday's meeting.
- In essence, the September rate hike “shut down” the corporate bond market.
- The Fed’s “trimmed mean” personal consumption expenditures (PCE) and consumer price index (CPI) inflation data shows PCE and CPI inflation tanked.
- Fed rate hikes cannot slow transitory energy inflation.
- The Fed should not be “overreacting” to any transitory factors.
- Fed rate hikes are creating inflation via:
- Higher interest income
- Shortages in housing supply
In other words, The Fed has created financial stability issues within markets by the “hawkish” take since Jackson Hole. The bond market has been effectively shut down since the September hike, with corporate bond issuance down 56% in October and on track to be the lowest issuance month of 2026:
For perspective, history shows bond issuance and initial public offerings ramp up after September and through the end of the year.
Let’s return to the trimmed mean metric. The Federal Reserve Bank of Dallas’s trimmed mean removes both transitory tails under the concept that these are distorted inflation. Fed Chair Warsh himself cited his preference for this measure, and the current reading shows PCE running at 2.2%. That’s 90 basis points below the core PCE of 3.1%.
If you don't believe us at CFS, then believe Goldman Sachs. Its recent research said components do not show a broadening of inflation components while tariffs, oil shock, and distortions account for 75% of the gap.
In other words, the “trimmed mean” arguably says the Fed should be dovish, not hawkish
And this viewpoint is shared by David Malpass, an economist at the Wall Street Journal:
He suggests the Fed use better models. But equally important, Malpass argues that Fed hikes do not fix the supply problems behind inflation (i.e. supply shocks like high energy prices and demand for semiconductors).
We also believe the Fed is now contributing to inflation by raising interest rates. Let’s start with interest income. Interest expense to households is $2 trillion higher than when interest rates were close to 0%:
This is $2 trillion being spent on the debt economy and artificially creating more demand versus supply shocks. If the Fed raises raise further, will it add to this fake interest income supply-and-demand problem?
Leading up to last week's Fed meeting and understanding these data points, we believed the Fed would come across less hawkish. So, what happened?
There was a less hawkish stance overall, albeit not to the level that we’d prefer.
Understanding the slight reprieve that the Fed provided us, how does this affect the overall macro investment and micro AI investment trade?
We know and need to acknowledge that investors are growing weary and cautious about AI. We can see the unease even in conversations with our clients.
Given the consternation ahead of midterm elections, our sense is that many investors want to be sidelined until after midterm elections are over. To an extent, this makes sense. But historically, markets trade tentatively into midterms regardless.
Bullish Data, Growing Profits
Bringing it all home, we continue to believe the risk/reward environment is improving across the board. For example, for the first time in recent memory, we saw the U.S. 10-year Treasury yields drop back below 5%:
What’s more, we've seen the federal funds futures show dovish pivots in the markets since last Wednesday:
This shows an easing of financial conditions, which is further supported by three key technical data points. The first shows the tech trade within the Nasdaq 100 index has reached its technical support level, right on cue:
Next, MoneyFlows’s Big Money Index, which is a 25-day moving average of institutional investor activity, bottomed and has since moved higher up to 37.9%:
And third, we have earnings. Of the S&P 500 companies that have reported earnings so far, 85% of them are beating estimates:
Year-over-year earnings growth so far stands at 30.0%:
In terms of hugely important net profits, S&P 500 companies’ net profit is on track for 14.9% growth over last quarter, which would be the second highest net profit margin over the last 15 years (the only exception being last quarter):
Yes, earnings growth is great, revenue is great, but what really matters at the end of the day for a business is net profit. What’s left over after everything has been made, sold, and all expenses are paid? The more there is, the better the business.
And for S&P 500 companies, that figure is increasing:
Knowing that earnings and profits are still growing, it gives us conviction that the AI trade still has legs.
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