I think there’s a better way to do this. So, I am launching this Substack to develop a network of investors, operators, industry experts, and first adopters across the technology landscape. This is a collaborative relationship—I’ll get to ask many questions about the critical factors impacting my coverage to the network, synthesize it into something cogent, and share what we learned with our subscribers.

What should you expect? (1) Periodic emails discussing industries, verticals, and companies we cover, along with the critical factors we are doing research on. In those emails, we’ll put out a survey or questionnaire for insights. (2) Results and key insights from the surveys and questionnaires. (3) Periodic investment memos on companies or verticals that incorporate the insights we gained from the community. Win-win.

Ultimately, the objective is to create a high-quality research community where contributing a few minutes of perspective can produce a much richer body of insight for the group. This totally opt-in and will take a couple of tries to get right, but I think it’ll be worthwhile.

What are the sectors and industries we cover?

• Hardware: semiconductors, consumer devices, enterprise and data center hardware, electric vehicles, robotics, clean and renewable energy.

• Software: Hyperscalers, AI labs, neoclouds, cloud infrastructure, data management / observability / DevOps, cybersecurity, enterprise software.

• Internet: Social media, adtech, consumer services, streaming & entertainment.

Let me know what you think and if you have any questions or ideas to help make this more successful.

Cheers,

Muhammad

Note: by participating, you agree not to share any material non-public information.

PS: By the way, if you are an expert, then you should definitely sign up to GLG/guidepoint/tegus for supplemental income. However, you should also subscribe here and be part of my surveys (in exchange for the implication to the stock)!

For informational and educational purposes only. Nothing on this site constitutes investment advice, a recommendation, an offer, or a solicitation. Views are the author’s own, may change without notice, and may differ from those of Wahdy Capital or its affiliates. The author and affiliated entities may hold positions in securities discussed. Past performance is not indicative of future results.

1. Strange deals are obscuring significant capacity constraints in the AI compute. Recent news of Nvidia’s $100 billion investment in OpenAI, OpenAI’s AMD deal (+ warrants!), and OpenAI’s huge $300 billion commitment to Oracle has raised eyebrows among investors and skeptics alike. Morgan Stanley recently published a chart outlining the web of intricate deals:

While much of the media, fintwit, and commentators have expressed skepticism over the entangled web of AI investments, we see a much simpler answer: compute shortfalls relative to targets. Our reference point is McKinsey’s April report on the cost of compute power, which suggests capital investment of $3 to $8 trillion needed by 2030. Since then, while the number of deals announced has increased, capacity build out is actually tracking at a lower run-rate than needed – pointing to AI compute constraints into 2028. Due to the significant amount of capital and resources needed, including the buildout and expansion of supply chains, we see the web of entanglements driving cash flow from high margin parts of the value chain (Nvidia) to low margin or capital-intensive parts (Oracle). In the interim, CEO hesitation (e.g. Satya Nadella’s caution in December 2024) resulted in an even larger constraint going into 2026. This is forcing hyperscalers like Microsoft to contract with neoclouds (e.g. Coreweave and Nebius) to bring in capacity in order to recognize revenue. These bottlenecks have become so intense recently, according to Bloomberg News, that Microsoft has had to turn away customers.

…but what about recursive revenue? E.g. Nvidia giving OpenAI to buy more Nvidia chips?

While vendor financing is not a new thing, the sheer magnitude and concentration of Nvidia – OpenAI and OpenAI - AMD deals imply some degree of risk. The way we think about it is that Nvidia is effectively subsidizing AMD in the near-term, similar to what Microsoft did with Apple in the late 90’s. In this case, it’s different because AMD is largely doing okay without Nvidia’s help. Ultimately, these deals are increasing potential supply in ’26-’30, which is needed to bridge the constrain gap. Why does this matter? Because OpenAI cannot generate sufficient revenue to fund commitments without access to adequate compute capacity… therein lies the biggest risk – not of an AI bubble bursting from the lack of customers, but of a painful reset driven by OpenAI’s revenue limited by compute capacity.

2. Our outlook for Q4 is for stronger than expected growth driven by upside to AI investment and better real-wages as the dollar rebounds modestly. Consensus estimates for Q4 2025 are 1.4% and is driven by worries of consumer spending decelerating into year end, lower private investment as housing continues to soften, modestly higher fiscal spending, and less trade. We are more optimistic – our forecast for growth in Q4 2025 is 1.7% Why? We see a strong wealth-effect driving consumption and support spending into 1H of 2026. On the investment side, we expect AI capex to step up substantially from Q3, with the limiting factor coming from lead-times on energy components. Real wages should also improve as the Fed’s cutting cycle, while real, is less dovish than the market was expecting earlier this year – and will lift the dollar into year-end. Fiscal spending and trade are the primary wildcards in our analysis, and could swing our estimates by +/- 0.3%.

3. New tariffs were announced. On Friday, President Trump announced new tariffs and export controls on China starting November 1 in the run-up to his meeting with Chinese President Xi at the APEC summit in Seoul at the end of the month. This was in response to China’s recent restrictions on rare-earth materials, which is largely seen as part of a maximalist strategy to Beijing to get the US to roll back much of the current tariffs and export restrictions – cumulative tariffs on China are estimated to be at around 57%, down from over 120% prior to the May 14 Accord. “China’s economy, which remains export-driven, has suffered from weaker global demand

Q4 Outlook Detail

Scenario Outlook

· We expect US Real GDP to grow between 1.7% to 2.1% between 2025 and 2028.

o In consumer spending, a smaller labor pool due to shrinking immigration will keep upward pressure on wage growth, even as jobs growth falls. If the job market breaks (unemployment rate > 4.7%), we would shift our thinking.

o In private investment, we expect a much higher rate of data center capex will boost corporate investment. In addition, an emerging wave of humanoid robotics and L4 autonomy in vehicles will drive the edge case for AI, potentially spurring another wave of capex in in ‘27+. Housing, while currently weak, should see support from lower interest rates. However, tariffs on softwood lumber and crackdowns on immigration may temper any improvement in affordability.

o Government spending is expected to rise based upon the OBBB Act, with significant increases to ICE and DHS budgets. We expect a rise in tech procurement from government as the administration aims to reduce headcount.

o Trade will rise modestly, with the trade deficit increasing as the import of components for data centers will drive the marginal shift in flows through a period where trade ex-AI will see a volume detraction due to tariffs.

· In the near-term, our Q4 forecast is for the US economy to grow at 1.7% Q4/Q4. We see a strong wealth effect driving consumption, upside to real wages from a modestly higher dollar, and higher-than-expected AI data center spending in private investment. Government spending and trade remain wildcards and can change our forecast by +/- 0.3%. The US Government is currently shut down over a budget fight between Democrats and Republicans, with no clear near-term path to resolution. We expect federal workers will miss at least two pay periods before a potential reopening (30+ days). On the trade front, recent new tariffs on industrial metals and autos will impact trade volumes modestly. We currently see steep auto tariffs and recent action on China as a negotiating tactic into the APEC summit by end of the month.

· In this scenario, goods imports will see rises, but we don’t see significant headwinds to inflation from tariffs after the initial step up. We are more concerned about services’ inflation, which could push the Fed into greater patience given its recent rise. Below is a chart of Core CPI YoY with indicators for when Fed meetings occurred.

· In monetary policy, we expect the Fed to cut between one and two times this year and up to two times next year, for a cumulative cut cycle of 100bp from September’s FOMC meeting. We expect the target rate to land at 3.25% with the Fed preferring to front load cuts. Recent action by the Trump administration to layoff workers will result in marginally weaker payrolls data that will keep the Fed defensive, barring a huge cyclical recovery (which we view as extremely unlikely).

· Ultimately, our view rolls up into a scenario of modest stagflation with upside risks to growth, driven by resilient consumption and stronger AI capex. While hot stagflation is still a risk, we think that would emerge in late 2026 after a big step up in ICE actions. We currently do not forecast a recession (odds less than 20%).

· From an asset class perspective, we favor equities and credit. Despite rallying over 10% this year, the S&P 500 can rise modestly into year-end, potentially crossing above 6,900. The core driver is better earnings prospects from megacaps which are predominately exposed to AI or an improving product cycle. We are cautious on the dollar, though expect it to trade slightly up into year end. While we liked Gold, we would trim holdings here and look to add to industrial metal exposure. In fixed income, we prefer US high yield but remain neutral on duration.

· What would change our mind: (1) sticky services inflation that delays cuts, (2) a term-premium shock driving long rates and USD up, and (3) capex digestion in AI supply chains driven by free cash flow concerns.

Positioning and Flows

· Gross leverage is elevated (95^th to 98^th percentile).

· Momentum factor has high exposure (>80^th percentile).

· Mega-cap concentration is near extreme levels.

· Software ownership is light, semis are crowded.

· October put-call ratio was above 4 coming into the month, implying markets are hedged and suggests a “buy the dip” stance on major drawdowns.

Sector Views

Hardware – we remain long AI infrastructure as we expect continued strength in AI capex with deferred normalization in ’27 or beyond (see our forecast on page 2).

· Our base case for ’25-’26 is for easier financial conditions to support global capex and the AI infrastructure build out. We expect autos and smartphone to exit inventory recessions on new product launches and lower interest rates. While AI infrastructure remains a secular growth driver, we see risks emerging from power constraints.

· Risks to watch include a sell-off in the long end of the curve or delayed rate cuts tightening financial conditions. Export-control escalation (H20, CoWoS, etc.) and capex digestion also remain a concern.

SOX / IGV Spread looks a bit stretched:

Software – the setup for software remains attractive as sentiment is weak despite better incremental data points. We expect usage reacceleration into 2026 as employment remains soft but productivity rises, allowing IT budgets to rise.

· Our base case for ’25-’26 is for rate cuts and easier financial conditions to boost software multiples. We expect IT budgets to expand modestly due to greater productivity. Cloud and AI spending will remain elevated as the cost of compute falls and investment in AI workflows increases.

· Risks include a patient Fed, major slowdown in AI adoption, and margin compression from AI infrastructure costs.

AI Winners / IGV Spread also looks stretched:

Disclosure
The information contained herein reflects the views and opinions of Wahdy Capital LP (“Wahdy Capital”) as of the date of publication and is provided for informational and educational purposes only. It does not constitute investment advice or a recommendation to buy or sell any security or to adopt any investment strategy. The views expressed are subject to change without notice and may differ from those of other professionals or market participants.

Although the information contained herein has been obtained from sources believed to be reliable, Wahdy Capital makes no representation or warranty, express or implied, as to its accuracy or completeness. Past performance is not indicative of future results. All investments involve risk, including the potential loss of principal. Any securities or strategies referenced may not be suitable for all investors.

This material may not be reproduced, redistributed, or transmitted, in whole or in part, without the prior written consent of Wahdy Capital LP.

Going in, markets had already tempered their bullish take on July’s weak NFP print. Fed funds pricing eased from 5.06 to 4.99 cuts, and equities retraced 1.5% from recent highs. Hotter incremental data this week — firmer PMIs, higher inflation sentiment — framed Powell’s comments. During this week, incremental information came in a touch hotter, suggesting that the weakness in July's payrolls would see a partial give-back in August, while inflation sentiment rose with the U Mich survey last week and flash PMIs this week.

Data Points:

• U Mich inflation expectations ticked higher (1Y: 4.5% → 4.9%; 5Y: 3.4% → 3.9%), underscoring concern over expectations unanchoring.

• Flash PMIs showed business activity and hiring at a 3-year high, reinforcing the case that growth momentum is intact despite July payroll weakness.

Highlights from Powell's Speech:

• Powell said that downside risks to the labor market were rising, with non-linear jump in unemployment possible.

• On the inflation front, Powell reiterated that the Fed wouldn't allow a one-time price increase to drive inflation further. He acknowledged the risk with Core PCE at 2.9% and the impact of tariffs on prices.

• Powell said that the policy stance is restrictive, now ~100bp closer to neutral, but that the balance of risks may justify adjustment.

Muhammad: Powell delivered a risk-balancing message. I don’t see this necessarily as a green light for an easing cycle, but it increases sensitivity to August payrolls. We may see the Fed cut in September while revising up its growth/inflation projections, underscoring a continued tension in policy.

Darren: To me, the most important point he made was that tariffs are unlikely to lead to a lasting wage-price spiral. That, combined with his comments on the weakening labor market seals the rate cut, for now. Separately, some interesting commentary suggests that without the quirky effects of the birth death adjustments on the payroll data, we would have seen a negative print.

Appendix:

Nonfarm Payrolls are currently expected to print 85k vs. 73k prior, with private payrolls of 75k vs. 85k prior.

Average hourly earnings YoY%:

JOLTS Jobs Openings Rate:

Indeed Job Postings:

Homebase data:

Dallas Fed's weekly economic index:

Before we take a look at what the Fed said, let’s consider the backdrop:

In the December FOMC, the Fed shifted to “patience” (deferring cuts) with the Fed Funds Rate at 4.25-4.50%. Going into the Fed meeting was fading concern over the health of the economy, primarily stemming from weak jobs data in August. But in the Summary of Economic Projections (released every quarter), the Fed revised growth higher (from 2.0 to 2.1) for 2025 and reduced the number of cuts it expected (from 4 to 2).

By the January/February FOMC meeting, the Fed incrementally shifted hawkishly by removing a reference to inflations progression towards a 2% target. The market saw this as a sign that the Fed would potentially delay Fed cuts even more, and market implied cuts went from ~1.9 pre-FOMC to ~1.7 post-FOMC.

Then, in February, the trade and tariff chaos began. First with a 25% tariff on goods from Canada and Mexico (delayed to April 2) and 10% additional tariff on China, supposedly as a response to the fentanyl crisis. Second, with a restoration of Section 232 tariffs of 25% on steel and aluminum. Third, Trump announced the administration will reveal their reciprocal tariff plan on April 2. We see this as the beginning in a reconfiguring of global trade and supply chains, as part of the de-globalization trends Trump’s first term initiated.

Markets fell as the trade policy and the DOGE agenda drove uncertainty to new highs:

The mechanism for lower equities is through both this years’ earnings estimate (EPS) and the growth rate through the near-term (Multiple). Why would earnings move lower? Aggregate GDP is constructed as equal to the sum of Consumption, Domestic Investment, Government Spending, and Net Exports. Trade restrictions reduce consumption and imports, which reduces fixed investment. DOGE and government budget cuts also imply lower government spending. While the actual impact is yet to be determined, the base case of 2.1%+ growth this year is at risk, with estimates of a 30-40bp drag on growth due to announced policy changes. This means a growth downgrade to 1.7-1.8%, assuming no further action is taken.

However, while economic surprises moved lower through the second half of January and throughout February, the surprises seemed to stabilize in March:

This implies that the data is no longer much worse than expected, and suggests expectations are close to where data is. Fed Funds Futures were pricing in nearly 3 cuts in the run up to the FOMC, though moved down to ~2.4 pre-meeting. Remember, during the Fed’s last Summary of Economic Projections (SEP) they guided to ~2 cuts for 2025.

Pre-event, equity markets had moved down in anticipation of a weaker economy and higher inflation (2-year breakevens), while treasury bonds rallied unevenly.

FOMC Meeting Recap

The Press Release: The Fed left rates unchanged, reiterating their view of continued expansion, with unemployment rate stabilizing, and inflation remaining somewhat elevated. Additionally, the Fed announced their plan to change their Treasury run-off (“QT”) by reducing the monthly redemption cap from $25bn to $5bn. We see this as positive for Treasury market liquidity through a period of heightened uncertainty.

Summary of Economic Projections:

Note the significant 40bp change to growth in 2025, 20bp decline in 2026, and 10bp decline in 2026.

Key takeaways from the Q&A: Powell said that the Fed’s base case is that tariffs are a one-time hit to prices and hence a transitory impact to inflation. This suggests there is room for the Fed to increase its inflation estimates, as we know that the impact of 2018 tariffs saw inflation broadening to even non-tariffed goods. He also countered weak survey data since February, saying “consumer spending [is] moderating a bit, but still at a solid pace” and that “the relationship between survey data and actual economic activity hasn’t been very tight”. Despite this, he did note that the Fed’s current stance is in wait-and-see mode, requiring further clarity on the path of the economy.

In our January letter, we outlined scenarios for the economy:

Upside (15% probability): GDP grows over 2.7% driven by increasing productivity and higher investment from the administration's policy of tax cuts and deregulation. The higher economic activity would push the unemployment rate lower while keeping interest rates above 4%, despite inflation moderating. In this scenario, the resilient economic growth of 2024 would transform into a sustainable mid-2020s growth trend that would move earnings higher and lift the S&P 500 to 7,000+ by the end of 2025, representing a 15%+ delta to current earnings estimates through the '25-'26 period.

Base Case (50% probability): GDP grows 2% as productivity tailwinds in 2024 carry consumption into 2025. Investment would rise modestly on the back of marginally better regulatory and tax regimes, but weakness from Europe and China would limit upside to supply capacity as interest rates remain elevated. Unemployment creeps up from 4.0% to 4.5% by the end of the year, as firms adjust to late-cycle dynamics of boosting margins as nominal GDP cools. Inflation is stubbornly above 2.5% (core PCE), which keeps the Fed still postured for above-neutral rates. Earnings growth is driven primarily by margin expansion, and the S&P 500 ends the year at 6,450, representing a 6% delta to current earnings estimates.

Downside (30% probability): GDP undershoots, growing by 1.5% as productivity gains fail to offset the declines in investment and government expenditures. Unemployment would rise to 4.5% by Q3 as layoffs from the public and private sector gain steam, prompting the Fed to shift policy in early Summer. Interest rates would fall below 4%, though inflation would remain stubbornly above 2.5% (core PCE). The S&P 500, despite seeing some earnings growth, would fall below 6,000 as realized earnings would come in below current estimates.

Crash (5% probability): A mix of trade, immigration, and domestic policy would structurally shift views of growth rate determinants (Solow-Swan variables), moving US growth to sub-1% growth. Inflation would move higher due to trade barriers and decline in the labor force, driving up prices for goods and services. Reductions in government expenditures and workforce would lead to higher unemployment and lower consumption, exacerbating the cyclical declines. Interest rates would trade below 4% but higher inflation would limit the downside. If the policies are seen as holding through to term, then earnings would see significant downward revisions. Note: this is the nightmare scenario.

Our current view of US growth has shifted from 2% to 1.2%:

Where do we go from here? From our latest investor letter:

The S&P 500 ended February down -1.3%, reacting to Trump’s announcement of new trade and tariff measures on Canada, Mexico, and China. Coming into the new administration, consensus expected Scott Bessent and Howard Lutnick to temper Trump’s aggressive stance on trade. February, however, proved to be a key learning moment for markets, revealing that Trump’s team appears more focused on securing lower interest rates than preserving growth momentum. This marks a shift in priorities that makes us more cautious on the equity outlook for the remainder of the year. As a result, we are downgrading our earnings growth estimates and see the S&P 500 trading within a 5500-5800 range until trade adjustments are absorbed. Risks are now skewed meaningfully to the downside, as both Trump and Bessent have signaled a willingness to accept “short-term pain”, which we interpret as a higher tolerance for growth detractions, including potential recessionary risks. While we are not explicitly forecasting a recession, economic dynamics are complex and rarely linear.

At the March FOMC meeting, the Federal Reserve held rates steady and released a revised Summary of Economic Projections. Growth expectations for 2025 were downgraded from 2.1% to 1.7%, aligning with the OECD’s recent move, while projections for 2026 and 2027 also saw marginal downward adjustments. In contrast, inflation estimates were revised higher, with Core PCE now expected to end 2024 at 2.8%, while projections for 2026 and 2027 remained unchanged. This suggests that the Fed views the impact of recent tariffs and trade policies as transitory price shocks rather than structural inflation risks. The dot plot was unchanged, maintaining guidance for two rate cuts in 2024, one in 2026, and one in 2027.

The market reaction was sharp. Given the setup, we anticipated an equity rally this week on the back of Fed commentary countering “growth scare” concerns. We don’t expect hard economic data to deteriorate meaningfully until mid-April. Ahead of the FOMC, rate expectations had already shifted lower, with December rate cut pricing moving from 3.5+ cuts earlier in the month to just 2.3 cuts into the meeting. In that context, we expected rates to sell off, the 10-year yield to rise above 4.3%, and the dollar to strengthen, limiting month-end selling pressure from Yen- and Euro-based investors. However, Powell’s press conference drove a dovish shift, with Fed Funds pricing in 2.6 cuts for 2024, the dollar weakening, and the 10-year yield falling to 4.24%. This divergence suggests the market is more skeptical of the Fed’s benign assessment.

Our near-term view remains constructive. We believe upcoming data should support the Fed’s posture, allowing the equity rally to extend into month-end. However, we expect softer economic data to emerge in April, with hard data showing clear signs of slowing by May or June. The key risk to this outlook is that dollar weakness exacerbates portfolio rebalancing flows from Yen and Euro-based investors, which could introduce additional volatility. Given these dynamics, we plan to keep net exposure light, expressing views through tactical macro trades on market rallies if the opportunity presents itself.

In short, slowing US growth paired with improving conditions in Europe and Asia warrants tactical shifts: marginally reducing overall equity allocations in favor of fixed income and cash, while rotating equity exposure from the US toward international markets. We think this better aligns global portfolios to the economic outlook we expect through 2025.

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

This note is provided for informational purposes only and does not constitute investment advice, a recommendation, or an offer to buy or sell securities. Views expressed herein are subject to change without notice based on market or other conditions. Investors should consult their own financial advisors regarding suitability, risks, and consequences of any investment decisions.

In the Fed’s Summary of Economic Projection (“SEP” and/or “guidance”), they point to higher FY ‘25 GDP offset by ‘27, better balance in the Unemployment Rate, and still-tracking Inflation story moving to 2% by 2027. With Inflation and Unemployment roughly in balance through the projection period, the Fed is suggesting it is close to Neutral.

Analysis: Coming into the FOMC meeting, the market was pricing in 1 cut today (Dec 24), 2.6 cuts in FY 25 and 0.4 cuts in FY 26, with a terminal rate of ~3.7%. The Fed’s decision today was in-line with market expectations for Dec ‘24, Dec ‘25, but is 2 cuts more than the market was implying for Dec ‘26. After the press conference, the market ended with a terminal rate at ~4% up from ~3.7%.

Our View: This was a “Dovish” cut in that the Fed’s guidance came in below market expectations. However, during the press conference, Fed Chair Jay Powell indicated that policy is entering a new phase, which is perceived to be hawkish. We disagree and think that the Fed’s posture is still more sensitive to the labor market outlook than it is to inflation. The market moved the other way and priced out the cut in FY ‘26 to lift the terminal rate from ~3.7% to ~4.0%, effectively “betting against” the Fed’s SEP.

What about the new Administration’s policies?

As Powell noted, it’s hard to say what will actually come to fruition — between wide ranging tariffs and potentially deporting 10m+ individuals and families, there’s a lot that can happen between now and then. What we do know is (1) where the economy is today, and (2) where the contribution of growth from rate sensitive parts of the economy. Unless the economy were to enter into a new regime (where Neutral is above or equivalent to current Fed Funds Rate), it’s hard to see a reacceleration without a significant exogenous shock.

Macro and Cross-Asset Impact:

• For Growth, we think a higher terminal rate reduces growth in the near-term and maintains pressure on interest rate sensitive sectors (housing, industrials, autos, etc.). We expect manufacturing PMIs to remain range bound below 50, with services growth partially offsetting those declines.

• In Rates, we think the initial bear-flattening (when the front end of the curve sells off faster than the long end) continues into deeper flattening. The path of unemployment is a very important signal, as our analysis suggests the degree of labor market cooling is sufficient to keep the Fed tilting towards cuts. We see some value in duration with the 10Yr at +4.5%.

• For Equities, we expect estimate revisions on interest rate sensitive sectors to continue to weaken, though a higher terminal rate should boost NIM in financials. Risk assets may see a small correction of 5-10% if bear-flattening persists.

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

Learn More | Investor Letters

• Treasuries are being sold: 2Y (+7.1bp), 10Y (+13.1bp), 10s-2s spread widening (+3.6bp)

• Rate cut odds are shifting: 1.6 cuts by Dec 2024, 4.3 cuts by Dec 2025

• Risk assets are being bid: Bitcoin (+7.22%), S&P Futures (+1.85%), Nasdaq Futures (+1.73%)

In our prior note we wrote:

Investors should trim duration exposure in front of a potential Trump victory. This is because policies stated by Trump imply a higher R-Star (neutral rate of interest) with higher risk of inflation, which is bad for the growth factor and duration.

This largely seems to be panning out with the Russell outperforming Nasdaq and the long end selling off vs. short end. But what does the performance differentials of these assets mean for a portfolio moving forward?

In short, we think investors should remain long risk assets (equities, commodities, high yield) with a preference for USD vs. g10 and EM. Fixed income allocations should aim to balance duration with yield, though with spreads being so narrow, a cash (CD/MM) position remains competitive. The economy is fluctuating between a “mid cycle” and “late cycle” environment, while risk assets are trading “early cycle”. With positioning near the max, this means that expectations are quite high and we don’t recommend extending risk in this environment.

Beyond the election, this week we have an FOMC meeting with a press release and conference on Thursday. We expect a 25bp cut given the language in the beige book, okay-ish wage data (mixed), soft payrolls, and still depressed manufacturing PMI. The Fed remains on track to deliver 100bp of cuts this year (25bp this week, another 25bp in December).

The market expects 1.7 cuts this year — 98% chance of a cut is priced in for November while just under a 70% chance is for December. We have not seen any data that would counter that path. However, it is possible that the Fed begins to communicate a refocus on inflation and activity. We think that shift will impact rate cuts for next year (market is pricing in 2-3) with a terminal rate over 3.7%. For comparison, the Fed pointed to 3.4% in their latest Summary of Economic Projections.

Ultimately, a weaker economic backdrop makes us think that the Fed will remain in cutting mode.

Some charts to mull over:

(1) Equity performance post-election tends to be strong. Below is a chart comparing Nov 2015/16 to Nov 2016/17, where a clear trend post-election took place:

(2) In our last note, we shared this analysis suggesting subsequent 1-year performance on the S&P averaged over 15%:

(3) However, our economic regime model (Change in ISM, New Orders, Unemployment Rate, 2Yr Yield, and 10Yr Yield) points to a weaker backdrop vs the economy in 2016-2017:

(4) Current regional health views:

(5) Futures positioning remains elevated as of the last COT report:

(6) The Treasury Sell Off:

(7) The Hawkish 50bp cut:

(8) Weakness in Auto manufacturing employment, Temp & Professional, and Construction employment are sensitive to interest rates and economic activity — we think they have further to decline.

Note on the election — regardless of who you voted for, I wish our new President the best of luck and hope we can come together to work towards building a more prosperous and free country.

Sincerely,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

• Paul Tudor Jones, a Trump ally, said this morning on CNBC: “All roads lead to inflation. I’m long gold. I’m long Bitcoin. I own zero fixed income. The playbook to get out of this [debt problem] is that you inflate your way out.”

We have seen bonds sell off with rising Trump odds. However, we also believe that betting markets are currently pricing in near-peak odds of a Trump victory. As the election is close (poll spreads within standard error), we expect the Trump-Harris odds spread to narrow as we move towards election day. Investors have some time to modify their posture, but prudence is warranted.

What you need to know:

• The S&P 500 Index has a degree of recurring volatility around the election. At the Index level, October tends to be weak into an election, with markets rebounding after the election takes place.

• Who wins the election is less important for subsequent returns — since 1988, only the 2000 election saw a lower 1-year return for the S&P 500.

• However, intra-market returns will vary greatly, driven by policy-induced sector rotation. The Wall Street Journal did a survey of economists to assess the potential impacts of a Trump or Harris presidency (read it here). Effectively, the differences are that:

  • Donald Trump’s policies of lower taxes, lower immigration, increased tariffs, and cutting social services seem to echo Nixon more than Reagan.

  • Kamala Harris’s policies of higher taxes, investment, agency expansion, and pro-immigration echo’s a mix of Obama and Clinton.

• How is the market positioning for this?

  • Trump is widely seen as being bad for bonds — JP Morgan estimates a 10% tariff would lift inflation by 1.5% and the 60% China tariff would add an additional 1.15%. This would imply a terminal nominal yield at 5%+, up from 3.4% in the Fed’s latest guidance, and represents significant risk to bond holders — similar to the bond reaction in 2022. Fun chart of how higher Polymarket (an elections betting website) Trump odds correlates to higher US bond yields:

    

  • Harris is seen as more of a continuation of the status quo in the economy, with a limited impact to the current path of interest rates and inflation. However, with bonds pricing in greater odds of a Trump victory, we expect a giveback of the election risk premia if the outcome turns for Harris.

  • Equity performance under Donald Trump’s last term was largely similar to equity performance today — tech outperforming with industrials, energy, and financials underperforming:

    

• How should investors position? Instead of trying to invest based upon who wins the election, we think a better approach is to invest more broadly and reduce non-systematic risk in passive portfolios. In equities, we would prefer domestic or global index ETFs like SPY, SPTM, or ACWI. In bonds, AGG and IAGG make sense, though Trump victory odds suggest it would be prudent to trim duration exposure.

• With that being said, Polymarket odds for Trump is near its peak. As the election is most likely a coinflip, we expect the Trump-Harris spread to narrow as we move towards election day:

  

A few charts to consider

• Oct-Nov seasonality during election years:

• 1-year subsequent returns post-elections, since 1988:

• Current SPX positioning: (AM = asset managers, HF = hedge funds)

• Dispersion post-election:

Highlights from the Summary of Economic Projections (“SEP”)

Portfolio Manager Views

Muhammad: “This was a hawkish 50bp cut. If you look at the rates market, SOFR and Fed Funds Futures were pricing in closer to 3% (10 cuts) vs. the Feds 3.4% (8 cuts) by 12/2025. Since the FOMC, yields have risen, corroborating my view that the Fed has marginally tightened financial conditions. The Fed seems to be betting on a soft landing scenario, and very recent data flow is neutral or leans slightly positive. However, I remain cautious on equities in the near-term as we enter a seasonally difficult time due to the blackout window limiting buybacks, quarterly rebalancing, and my view on incremental economic data. I’m not calling a recession, just a weaker growth environment as the tailwinds from the post-Covid boom fade.”

Darren: “I’m a bit more bullish on the economy. I expect a soft landing, not a recession. Powell did a great job of threading the needle and recalibrating policy, and the market is accepting that. We’re in a pretty good spot, and can move forward as macro uncertainty diminishes. Importantly, we should begin to see more of the factor rotation as the equity market broadens. The marginal dollar will flow towards cyclicals and may pose a headwind to parts of our coverage, but as equity correlations drop, bottom up stock picking should perform.”  

Cross Asset Views

• Rates: With the Fed communicating a slightly higher rate by 12/25, bonds should sell off marginally with the 10-year anchoring between 3.6-3.8%. Bonds are reflecting a very weak growth outlook for 2025, so if data begins to skew neutral or positive, there is room for further bear steepening.

• Dollar: A higher-than-expected rate outlook means the dollar will rise relative to other major developed market funding currencies, such as the Euro and Yen.

• Commodities: The start of an easing cycle will boost demand for commodities as the industrial sector tends to rise as interest rates fall.

• Equities: A soft-landing scenario will support higher earnings expectations and drive a sector and factor rotation. On the margin, expect headwinds to Mag7 stocks and other high growth sectors, as small cap and cyclicals are bought.

Exposures and Factor Tilts

With a soft landing likely and factor rotation underway, we expect our small-cap exposure to rise, while trimming our large cap and crowded names. We’ll stay agile, ready to adapt to market shifts, and will closely monitor risks like inflation and geopolitics.

Thank you for your continued support and trust in us.

Best regards,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

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• In the June FOMC meeting and SEP (Summary of Economic Projections), the Fed moved from a “2 cuts or 3 cuts +” regime to a “2 cuts or no cuts” by 2024 regime.

• We saw that as a mistake and weren’t convinced that hard data was bad enough for the Fed to shift the regime back to a “2 cuts to 3+ cuts” regime in July.

We expected Powell to double down on the June SEP projections. Instead, Powell stated that as long as the data moved in-line, a September cut was “on the table” which was a firm rejection of a “no cut” scenario. Don’t be alarmed if you’re confused — this sort of policy and macroeconomic volatility is confusing everyone.

Here’s a rough approximation of how the Fed’s implied regime’s have switched:

Key takeaways from the press conference:

• Powell stated that being data dependent is not the same as being data point dependent — in other words, one bad print wasn’t going to cause panic

• The FOMC feels confident that it can response if labor markets weaken materially; but in their baseline scenario, weakness in the labor market is expected

• Importantly, Powell noted that the Fed does not have a growth mandate — a brief contraction does not necessarily run against the Fed’s targets

• Powell said anecdotal surveys of the economy are not uniformly bad — he mentioned discussions with Regional Presidents about the economic performance in their district and how the picture was mixed but still positive

My takeaway is that Powell, and the FOMC, see the economy on the path towards a 2-cut scenario (soft landing) where they can quickly pivot to 3+ cuts if necessary.

Cross Asset Implications

The immediate reaction to Powell’s comments were a rally in equities. Our thesis of a factor rotation driven by a weaker economic outlook seems to be in play.

The Russell 2000 (small caps) underperformed vs. the S&P 500:

SOFR curves moved lower— pricing lower interest rates and lower growth into 2026:

Our View

At the high level, our view is that the economy is on a slower trajectory into 2025. This should support mega caps and AI hardware winners, with smallcaps and cyclical sectors underperforming. We have advocated for a defensive posture and laid out our concerns for a choppy Q3. However, we are not forecasting a recession or a major market crash.

Today’s market reaction, in the near-term, seems to be an overreaction to Initial Jobless Claims, weak ISM Mfg Employment Index data, and incremental information from earnings (Intel’s job reduction announcement).

In our Q2 letter, we wrote about how we think the market is overextended and saw the July FOMC meeting as a catalyst to the downside.

Near-term Setup

The SOFR curve has bull flattened over the past month as the markets have rushed to price in a rate cutting cycle:

Interest rate probabilities implied by Fed Funds Futures and OIS both show the market pricing in 2.5+ cuts by December 2024:

The Russell 2000 (small caps) has outperformed large caps since mid-July:

The Fed (just last month), in their Summary of Economic Projections, the median dot pointed to 2 cuts in 2024 and 4 in 2025:

Resilient GDP and spending data does not support a shift in the Feds stance:

Because of both stated Fed guidance and supporting data, the Fed will be patient and communicate that (1) interest rates are restrictive, (2) that the Fed is attuned to changes in the labor force, (3) that strong economic data and inflation still above target means the job is not “done”, and (4) that the Fed will be patient in keeping rates higher for longer. In this dynamic, we expect the Fed will push back against market pricing nearly 3 cuts in 2024 and 6 in 2025 vs. the Fed’s guidance of 2 in 2024 and 4 in 2025.

Cross-Asset Implications

Near-term, we expect the yield curve to bear steepen, with the 2-year and the 10-year crossing back up above 4.5%. In equities, an unwind in the recent factor rotation should drive mega caps neutral-to-marginally higher, while small caps will underperform. We are not calling for a major crash from here — the market is already down nearly 10% from its peak in mid-July.

In our strategies we have raised cash, trimmed risk, and reduced net exposure into the second half of July. We anticipate adding back by mid-August.

If you have any questions, concerns, or comments please feel free to reach out to me directly.

Sincerely,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

Learn More | Schedule a Call | Investor Letters

• The Federal Reserve left interest rates unchanged during the March meeting. In their Summary of Economic Projections, they revised growth and inflation higher, tracking the data we have seen year-to-date. Importantly, the median dot for interest rates in 2024 remained unchanged, despite the higher growth and inflation estimates.

• In our February letter, we express our view that the FOMC meeting would not be a significant repricing event, as the Fed would remain cautious. We’re glad to see this play out.

• Overall, the SEP indicates the Fed’s desire to achieve a soft-landing; they do not seem willing to “break” something to reach their 2% inflation target. This is a good thing for the economy.

Market Response

• The yield curve steepened, led by the front end. Markets had begun to price fewer cuts into 2024 -- remember, the year began with over 7 cuts being priced in; prior to the FOMC the market had narrowed that down to ~2.8 cuts. With the Fed reiterating their patience, 3 cuts are back on the table.

• The stock market rallied modestly — investor positioning was marginally hawkish, expecting under 3 cuts.

Our View

• We think mid-February marked the peak in strong economic data for 2024. We estimate economic growth will end the year around 1.5% which is quite below current estimates of 2.1% (2.1% is also the median estimate in the Fed's SEP).

• Our view is based upon (a) interest rates that will keep non-residential fixed investment subdued, (b) a marginally softer labor market and consumer backdrop, and (c) declining fiscal support.

• As the US economy trends towards a 1.5% growth rate, we currently see a 2-year yield above 3.5% to be "restrictive" to interest-rate sensitive sectors. We're not calling for a recession -- just a slower grind through the 2H of the year. This changes if the Fed, and other central banks, shift towards a more dovish policy stance.

What about the stock market?

We are revising our price target on the S&P 500 up to 5300 from 5000, based upon 20.5x NTM EPS of $260. Driving our forecast is an SPX sales estimate that is too low given the level of NGDP growth expected this year, and that an improving margin dynamic, primarily among larger cap companies, will add further to the upside. Fed patience gives us more confidence that the soft landing we are in will persist.

If you have any questions, want to share insights, or chat, please don’t hesitate to reach out to us.

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

Learn More | Schedule a Call | Investor Letters

We are currently experiencing the “soft landing” – whether this persists through the year depends on the pace of rate cuts, disinflation, and if those can happen without crossing into a contraction.

• Positives for US growth in 2024 include an easier stance in monetary policy, low unemployment, and rising real wages. Negatives include weak new order growth, negative credit impulse, and structural headwinds in the labor market. On balance, we’re neutral on the economy but optimistic of our equity coverage.

• Rates should move lower through the year making cash less attractive as the Fed positions to cut interest rates, tapers its QT strategy, and Treasury refunding needs marginally decrease.

• Stocks should rise in 1H of 2024, and we expect earnings estimates to revise higher through the period as real wages offset the marginal uptick in the unemployment rate.

Within our coverage group, we are very optimistic about semiconductors and see pockets of growth in software. Semiconductors are moving into an expansionary regime driven primarily by new workloads creating an upgrade / retooling cycle among data centers. In software, an improving cloud and cyber outlook will lift some boats while slower sale cycles and weakness in SMB will impact certain verticals harder than others.

Market Outlook

Macro volatility to continue in 2024 as “early cycle” monetary policy intersects with structural headwinds in labor, production, and generative AI.

In the United States, we expect GDP growth to remain positive, though weak, through FY 2024. Our view is driven by (a) labor markets where the post-Covid shock jobs rebound is hitting against structural headwinds which will keep labor force participation rate below pre-Covid levels, (b) easier financial conditions to mute the impact of a contracted credit impulse, (c) continued weakness in new order growth to temper business optimism and capital expenditures. In short, no “green light” for the economy, but hard data should stay positive through 1H of 2024.

On the inflation front, we expect consumer prices to continue their descent, led by both a sustained decline in housing inflation (market-based rents are much lower than OER-implied) and healthcare costs.

We expect Monetary Policy to remain active, with interest rates falling through 2024 as the Fed proceeds with 100-150bp of cuts. In addition, the Fed is likely to communicate a tapering of its QT strategy during the January FOMC meeting, though it is widely expected to provide guidance in the meeting minutes rather than the presser itself.

Another theme to watch in 2024 is the disruptive impact of generative ai on a mix of industries and business models.

We were wrong!

We called a recession by the end of 2023 after the Banking Crisis in March of 2023. Though the Federal Reserve and Treasury supported credit markets and banks with BTFP, we viewed the deterioration in credit conditions as a significant driver of weakness by Q4. This has not panned out and BTFP is largely a success (in addition to the Feds RRP facility). Could there be a recession in 2024? Yes, but we do not think the data supports that view right now and the Fed has been largely successful in gliding the economy towards a soft landing.

Consensus estimates point to growth in 2024 with a modest reacceleration in 2025. While we do think that labor market softness may slow consumer spending and that high inventory-to-sales ratios will limit restocking in 1H 2024. We think caution is prudent as macro volatility will offer noisy signals despite an easing Federal Reserve.

Treasury markets are pricing in 5+ cuts through 2024 as the Fed shifts gears…

Markets are pricing in the end of the rate hiking cycle and are beginning to position for cuts through 2025. We agree that 3-5 cuts in 2024 are likely and see a 50/50 chance at the March FOMC meeting this year.

For duration, we expect that tapering QT and a smaller Treasury Refunding will lead to a greater bid to the 10-Yr yield. Due to a slowing nominal GDP outlook, we see the Fed as moderating real rates with them settling closer to 1% through 2024. This drives our outlook for the 10yr yield to trade around 3.5%.  

Credit impulse remains weak, but easier financial conditions should provide some reprieve…

We see the S&P 500 trading around 5,000 this year though our 2H visibility is limited…

·Our top-down estimate of the S&P 500 in 2024 assumes a 13.2% EPS growth YoY and a P/E multiple of 20x. This is consistent with our view of positive-though-weak economic environment, 100-125bp cuts from the Fed, and a 10yr yield around 3.5%. The balance shifts to the downside if the long end of the curve drives a steepening, a scenario in which we think results in a compressed P/E multiple closer to ~18x. On the flipside, weaker economic data will put pressure on our EPS estimate. We don’t think there’s risk of lower economic data through Q1 of 2024.

Headwinds to GDP means we don’t see much greater upside to EPS estimates, we currently project ~$250 for the aggregate index.

High Level Coverage Views

Software

We expect spending to pick up in cloud spending, with budgets for public cloud rising 3-4% YoY, optimizations troughing, and consumption trends back on track.

• While a weaker budget flush is in the cards for Cyber Security into Q4 2023, CIO survey data points to still-strong demand especially within end point and identity security. Pipeline should normalize into 2024.

• UCaaS, ITSM, customer service, and license-based software to underperform vs. consumption-based software, as gen ai shifts the mix of workloads to chatbots and away from human agents.

• An improving net new bookings environment, coupled with a broad-based margin story, should support software valuations, and may push revisions higher through 1H of the year given the large presence of recession assumptions in estimates. Current estimates point to about ~15-17% YoY sales growth across the sector.

However, an elongated sales cycle, weak SMB, and still-constrained corporate budgets (due to weak growth) should dampen any broad-based rally, though pockets of idiosyncratic performance and growth within certain verticals look very promising.

Hardware

We expect a rebound in the semiconductor industry in 2024, with volume and ASPs largely driven by the retooling of datacenters as they shift their workloads for gen ai processes (creating an up-cycle environment for network hardware, memory, and other semis), a modest pickup in traditional server spending due to stabilizing trends in cloud consumption, and an improving consumer electronics backdrop (smartphone and pc shipments).

• EDA and Semi equipment will continue to benefit from Chinese demand along with the trend of custom chips as OEMs seek to optimize silicon to specific workflows.

• On the downside, we continue to see headwinds in auto and industrial end-markets through 2024.

Supplemental Charts

Have comments, suggestions, ideas, or feedback? Send them my way!

Yours truly,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

Learn More | Schedule a Call | Investor Letters

Our view around asset allocation is that investors should start with risk parity (or naive equal weight) and then seek strategic adjustments through our asset allocation framework.

Economic Backdrop

Bond-equity correlations are time-varying as both equity and fixed income securities are driven by (1) changes to the estimate of free cash flows, (2) changes in the discount rate, and (3) the time period of the analysis. Separating the idiosyncratic drivers of returns from systematic ones is a necessary step in asset allocation.

Systematic factors tend to increase correlation while idiosyncratic factors tend to decrease it. The most important systematic factor, in our view, is duration risk. Duration, the time it takes for a security to pay back its value, is a good proxy for investor speculation of monetary policy and economic growth, both of which are primary drivers that influence the discount rate. Simplistically, duration impacts equities through the multiple, causing P/Es (and other valuation metrics) to expand or contract. Whether duration is attractive, neutral, or not depends on the investors view of the economy and monetary policy. A view on duration has implications for both bond and equity exposure.

Idiosyncratic risks for bonds and equities revolve around two primary factors: credit and cyclicality. Credit refers to the types of covenant and cash flow risk an individual company has. Cyclicality refers to how sensitive a company’s revenue and margins are to changes in the economy. After setting a view on duration, investors then need to think about what type of credit and cyclicality is attractive (or not). This informs the sector views on equities and fixed income allocation. Hence, while bond-equity correlations are time varying, sub-factors contain collinearities which need to be stripped out when evaluating an asset allocation strategy.

To recap: bonds and equities share some similar drivers of returns, mainly the impact from duration risk. We recommend investors develop a view on duration separately from their views on credit and cyclicality. Creating this distinction is part of our asset allocation framework.

1. Risks & Returns

We like to organize asset classes into three primary buckets: cash, economic risk, and alternatives. We think investors should build portfolios that start with equal-weighting risk across these buckets.

• Cash — the yield on cash and short-term treasuries, which is primarily a function of central bank policy

• Economic risk — which includes the returns from equities, commodities, and credit where returns are driven by the business and interest rate cycle

• Alternatives — returns generated from non-cash and non-economic risks such as relative value, event driven, and volatility

Within each bucket, there are sub-asset classes, strategies, and securities that can be tailored to enhance the risk and return profile.

We describe our overall view as the asset quadrant.

2. Asset Allocation

Our approach to asset allocation is rooted in risk parity portfolio construction. The premise is that forecasting future returns is hard; understanding the range of historical risk is much easier.

What makes our asset allocation advice different from a traditional risk parity portfolio is that we modify it based upon changes to duration and cash yields. Bond yield spreads dictates the mix of treasuries and credit, while cash yields dictate the allocation to cash (and short-term securities).

A hypothetical implementation of our asset allocation strategy outperforms a 60/40 portfolio.

3. Active Management

We believe in active management. Indexes play a key role in a portfolio, primarily for exposure, access, and comparison. However, we think good active management and robust security selection can reduce risk and improve returns in ways that are not correlated to general economic or market conditions.

In other words, once the asset allocation is determined, we think investors should prioritize on maximizing returns at the sub-asset and security level.

How do investors benefit from this approach?

• It simplifies asset allocation by focusing on the drivers of systematic and idiosyncratic returns.

• It helps investors by reducing their portfolio covariance and collinearities (“double dipping risk”).

• It limits drawdowns by increasing the importance of cash in the portfolio.

How does this fit into Wahdy Capital’s investment strategy?

In addition to running our long/short strategy, we work with investors to build and manage custom portfolios, where asset allocation plays a big role as part of the investor mandate and benchmark for the portfolio.

US inflation data came in soft today, with headline and core CPI missing consensus estimates. Core came in at 0.2% MoM driven by lower auto prices and cooler shelter inflation.

Key takeaways

• Lower auto prices helped keep inflation low last month — excluding car prices, core goods were nearly unch MoM

• Shelter inflation, which surprised economists last month, seems to have reverted back to trend (and should continue to slow given the lagged nature of OER)

• Transportation services rose MoM despite falling airfare

Cross-Asset Impact

Bond yields being bid — Bofa (Mark Cabana) notes that this CPI print means no more Fed hikes. Equity futures are up over 1% on Nasdaq and S&P 500.

In the commodity space, there’s a small rally with metals and crude up.

Impact to View

Coming into Q4, we expected the path of data to come in weaker as the initial wave of fiscal spending (IRA and other initiatives) and stealth easing (regional bank crisis) faded. We remain on-track for our outlook.

The Fed left interest rates unchanged at 5.25 to 5.50% during their latest FOMC meeting, citing tightened financial conditions, lower credit outlays, and the yet-to-be-felt cumulative effect of monetary policy. In their press release, they noted strong economic growth in Q3 2023, but see risks as being double-sided and prefer a cautious stance. During the press conference and Q&A session, Fed Chair Jerome Powell stated that policy was restrictive, and that the Fed would remain restrictive in policy until they were confident that inflation was on the right path to the Feds’ 2% objective. Powell did note that stronger economic growth could warrant further rate hikes.

Key Takeaways

• Chair Powell said financial conditions had tightened recently driven by higher longer-term yields -- for context, the US 10-Year Treasury Yield was flirting with ~5.0%, up from 4.4% during the prior FOMC meeting.

  

• The Fed will watch financial conditions and sees that as supporting monetary policy as long as (1) tighter conditions are persistent, and that (2) the move in longer-term rates was not just a reflection of expected policy moves.

  

• A key point of discussion among FOMC members was whether policy was as restrictive as it needed to be; however, the takeaway Powell expressed is that the Fed is willing to raise rates again in the future if inflation accelerates.

  

Economic Outlook

We think that the Fed is done raising interest rates for now and expect the Fed to shift stance from hawkish to dovish as the path of data worsens through the quarter. Our base case is for a recession by the end of the year, and hold that view with moderate confidence.

Scenarios:

We consider four scenarios in our outlook — a “goldilocks” scenario where growth reaccelerates, a hard landing (recession), a soft landing (no recession but weak growth), and a stagflationary outcome (weak growth and high inflation).

Goldilocks -- 15% Chance

• Unemployment rate stays below 4%

• US GDP does not dip below 1% QoQ SAAR

• Inflation moderates to ~2%

• Reacceleration in survey data, lending, and new orders

Hard Landing (Recession) -- 45% Chance

• Unemployment rate exceeds 4.2%

• US GDP dips below 0% QoQ SAAR

Soft Landing -- 30% Chance

• Unemployment fluctuates around 4%

• US GDP growth between 0.5% and 2% QoQ SAAR

• Inflation moves below 2.5% by 12/2024

Stagflation -- 10% Chance

• Unemployment fluctuates around 4%

• US GDP growth is tepid (averages below 1% QoQ SAAR)

• Inflation remains above 3% by 12/2024

We believe that the Fed is currently on track for a soft landing. However, our view is that the Fed will not begin to cut interest rates fast enough, which means a soft landing will slip into a hard one by the end of this year. We do not see a big risk of a stagflationary outcome, as the structural impediments required currently do not exist. A goldilocks outcome, where economic activity accelerates, is also not very likely, though in our view, is more likely than a stagflationary outcome.

Why we think a recession is the most likely outcome:

• Interest rates remaining elevated despite an expected drop in nominal GDP -- with interest rates at above 4.5% on the US 10Yr, the market implied real rate is over 200 bps, which we think is excessive.

• Weaker consumer impacted by depleted excess savings, a restart of student loan repayments, and lower wage growth -- this is showing up already in credit card and automotive delinquencies (though we should note that for the former, we are normalizing back to pre-covid levels).

  

• Tighter lending standards and lower credit growth (via SLOOS), weak new order growth, and dwindling backlogs pose a risk to employment levels.

• Fiscal impulse and stealth easing post-SVB and UK LDI debacle during 1H 2023 are fading.

Cross-Asset Strategy

Our cross-asset strategy is driven by the economic path we see unfolding -- a deteriorating labor situation will result in a recession by year end.

• We expect interest rates to remain elevated between 4.2 - 4.8% on the US 10Yr before sliding below 4.0% as employment data weakens further.

• Sector and factor rotation within equities should support tech and defensives vs. cyclicals and small cap. We revise our year-end target for the S&P 500 up to ~4,300. However, near-term seasonal factors should boost equity returns through early December (~4,550).

• We are neutral on housing, as structural shortages may offset a pickup in volume.

• The dollar should initially outperform DM peers, as Eurozone's contraction is happening at a quicker pace.

While we still two more sets of employment and inflation prints left for the year, we remain worried that risks are tilted to the downside.

If you have any questions, comments, or feedback, please don’t hesitate to message me directly.

Sincerely,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

• Equity down $SPX (-12bp) and $NDX (-16bp), with a choppy open. Equity markets last week -- $SPX (-4.02%), $NDX (-3.62%) -- all lower during an intense week of central bank events. Among key events was the Fed's "Hawkish Hold" (5.50%), Bank of England's surprise hold (5.25%), and BoJ's in-line unch (-0.10%) . The global monetary cycle is near its peak and markets are digesting a world in which rates stay higher for longer (note: we think it doesn't).

• With a looming Government shutdown, we expect hedging activity to increase:

• Commodities last week saw oil prices slightly negative $WTI (-1.11%), $Brent (-0.73%), with industrial metals like Copper (-2.18%) and Aluminum (2.31%) mixed, and Gold down marginally (-0.50%).

• In the US rates space, the US 10yr briefly crossed above 4.50% -- the highest since 2007. Real rates, which are nominal yields - inflation expectations (US 10yr Breakevens), remain the primary concern. Economic theory points to the neutrality of money (simplistically: the level of interest doesn't matter in the long run), but we do worry that elevated real rates across the term structure points to tightness that can impact economic growth in a variety of ways: higher borrowing costs, reduced consumption via increased savings and negative wealth effect, lower asset prices (driving negative wealth effect), higher dollar (decreases US exports), debt burden, and business confidence.

This chart shows the SF Fed's Proxy Implied Policy Rate vs. the NY Fed's R-star estimate for the quarter.

Events we are covering:

• Monday: German IFO data (85.7)

• Tuesday: US Consumer Confidence, US New Home Sales

• Wednesday: US Durable Goods

• Thursday: US GDP Revision, German CPI

• Friday: US PCE, Japan CPI / New Housing / Retail Sales / Industrial Production, Eurozone HICP

• Saturday: China PMI

We expect US data to come in soft through the week (more on that below).

Commentary & Research:

JP Morgan:

• Upgrades energy to overweight due to a positive macro-outlook, attractive valuations, and bullish indicators like potential OPEC supply addition. JPM is optimistic on gold & silver due to increased central bank buying and geopolitical factors.

• Monitoring China's Golden Week holiday (Sep 29 - Oct 6) as a demand indicator. Preliminary data suggests improvement, but the translation to real demand is uncertain. Notes growth in Asian tech exports and surge in China's auto sector.

• Systematic strategies are delevering after recent market dips, likely leading to more selling flows; factors like momentum shifts and dealer hedging intensify movements.

• Sees diminishing pricing power as a headwind to corporate earnings.

Goldman Sachs:

• Says we are in the middle of the worst seasonal period of the year. Since 1928, the last 10 out of 11 days in September are negative. CTA trigger levels of $4353.30 on SPX -- GS estimates at least -$17b to sell. Dealers -- GS estimates we are in negative gamma period, where dealers get significantly more short if we sell off into month end. Corporate blackout period, about 80% of corporates are in their blackout period; Nov-Dec is the best period for execution.

• Cash is yielding more than stocks (GS), 0DTE option activity continues to move higher (OCC), liquidity is boosting large cap vs. small cap, GS highlights energy is underweight. Brent crude continues to shift higher; Capital markets (IPOs) to resume; and Financial conditions are tightening, which should is needed to cool the economy (sees risk of economic upside).

Morgan Stanley

• Shutdown to be a drag to growth in Q4 if persists for more than a few weeks; should limit the risk of bonds underperforming vs stocks; sees a material drag on PCE inflation in Q4 even without shutdown; Growth headwinds in Q4 to challenge the growth narrative.

Our View

• Economic surprises and Fed guidance drive market positioning in rates. We expect data in the US to trend lower through the rest of the year as consumer spending marginally declines due to (1) higher energy prices, (2) UAW strikes and Gov shutdown potentially adding to unemployment, (3) restart of student loan payments in October, and (4) a pickup in unemployment driven by lower equity prices.

Here's a simple diagram that outlines our thinking:

Analyst Actions:

• Notable Upgrades & Initiate Buys: KMX, MSFT, SEE, STLD, ZGN, BE, DTC, PLUG

• Notable Downgrades & initial Sells: BHP, FL, NKE, QSI, SLGC, URBN, BTE, GLNG, ALEX, CART, TTGT, UPST, WRBY, ZD

Economic Summary:

• Growth & Employment: Trend-plus growth is evident, but with tighter credit standards. August showcased solid job numbers at 187K, higher than the 3-month moving average (3MMA) of 150K. The unemployment rate rests at 3.8%, up slightly from a year ago, which is indicative of increased labor force participation (now at 62.8% from 62.3% a year ago). Hourly earnings have grown modestly. Based on these indicators, the expectation is for the Federal Reserve to pause rate adjustments in September.

• Inflation: Current signals indicate moderating inflation. The Core PCE deflator for July was recorded at 2.9% for the last 3 months and 4.2% for the last year. However, achieving the 2% target remains a challenge, suggesting rates might remain higher for longer.

• Federal Reserve Stance: Under Powell, the Fed maintains a restrictive policy to combat inflation, continuing its rate-raising policy in July. Balance sheet reduction persists. A pause is anticipated for both September and November.

• Global Markets: The Russia-Ukraine conflict escalates, influencing energy prices and consequently growth in Europe and the UK. China's economic opening has been less than expected, relieving pressure on commodity prices.

International Overview:

• Japan: GDP for 2Q exceeds expectations. The Yen has seen fluctuations based on decisions from the Bank of Japan. News headlines highlight the demographic and financial challenges Japan faces.

• Russia-Ukraine: Conflict persists, causing a spike in Russia's interest rates due to a plunging ruble.

• China: Economic recovery remains fragile, evidenced by recent headlines from Barron's and WSJ. Additionally, currency and debt concerns are raised in the region.

• Eurozone: Economic indicators lean towards a downturn. Forecasts for 2023 and 2024 remain modest. Several headlines emphasize challenges in the Eurozone, especially concerning manufacturing and German's economy.

• UK: Economic forecasts suggest modest growth. Interest rates stand at 5.25%, with the economy impacted by weather conditions and industrial actions.

• Canada: Growth forecasts for 2023 stand at +1.3%. The CPI rate hovers around 3.8% for 2023. The central bank suggests potential restrictive policies in the future.

Long-term U.S. Outlook:

• The Biden budget does not anticipate significant long-term gains, with growth expectations declining. This situation presents challenges with deficit financing. Options for resolution include increased taxes, inflation, and interest rates. Recent headlines suggest financial challenges for the U.S., including potential credit rating downgrades and increasing debt concerns.

• Leading indicators suggest mixed outcomes for growth. Specific markers like ISM orders and consumer sentiments provide varied readings. Inflation readings suggest a mild moderation. Recent weekly news has indicated fluctuations in housing, global CPIs, and central bank policies. Market prices for commodities and indices, such as oil, gold, wheat, and equities, have displayed mixed trends over the last month.

If you have any questions, comments, or feedback, please feel free to contact me directly.

Best regards,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

Dot Plot Higher

Comments:

• Fed rose its GDP expectation for 2024; this has implications on where it thinks the natural interest rate is, and how durable they see the economy to weather higher interest rates.

• The Fed’s view of the labor market widened but moved lower, hinting at greater uncertainty around the path of unemployment but also that they see the path of unemployment as more stable.

• Core PCE forecasts from the Fed are quite lower, indicating they see the pace of disinflation to persist — ultimately, they expect inflation to be firmly within the 2% range by 2026. However, they also see greater upside risk to near-term inflation.

Market Reaction

Comments:

• Treasuries sold off led by the short-end as the curve inversion deepened. I expect the belly to continue to sell-off as markets reprice “higher for longer” for longer.

• Equity markets sold off though the S&P 500 is only ~4% lower from its July peak. I see today’s FOMC meeting as bearish for equities near-term, as markets digest the impact of higher interest rates through next year. The primary transmission will be through multiple contraction as Fed cuts in 2024 are pushed out further. Real risk revolves around cyclical industries that are interest-rate sensitive, such as housing, autos, and to some degree retailers.

• The dollar rallied but is still below its early-September peak.

Longer-Term View

While today’s FOMC leaned hawkish, and I think equities and rates will sell off over the next few weeks, my risk view is that the Fed is already done raising interest rates and will need to cut early in 2024. There is potential that economic weakness will emerge over the next few months and challenge the narrative from the Fed.

• Unemployment is likely to move higher on the back of a government shutdown, UAW strikes, and the overall cooling trend in labor markets. Although initial jobless claims have been improving, if strikes continue for another week they’ll begin to show up in the data which could surprise the market. I expect October’s NFP to surprise lower (released in November), with a potential for a negative print.

• Although data out of China has shown a pickup in demand, the United States and Europe continue to struggle with new orders, and this is likely to persist as interest rates remain elevated. I expect a big risk to manager confidence as nominal and real GDP trend lower, given how unprepared markets and executives were for higher interest rates for longer.

• The services economy is likely to remain okay for as long as nonfarm payrolls remain positive. Previously, a sufficient margin of error existed in retail sales given higher bank account balances and wage growth. But with wage growth slowing, core retail sales ex-gas has shrunk enough, and I think will continue to struggle with higher energy prices (which act as a tax on consumption).

My view is that a recession (negative GDP print and rising unemployment) is likely by the end of the year.

If you have any questions, comments, or feedback, please feel free to contact me directly.

Best regards,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

NVIDIA continues to power ahead on its “platform shift” thesis. Management sees a change in data center mix as the biggest driver for NVDAs growth, driven by the adoption of generative AI workflows and accelerated computing.

Q2 2024 Result

• Q2 revenues were $13.5b vs. consensus estimates of $11.1b (guidance was for $11b +/- 2%). Operating margins came in at 57.6% vs. 52.3% consensus, as product mix shifted to higher ASPs given the surge in demand for chipsets.

• Data center demand continues to outpace supply, though management expects supply to increase each quarter through next year. Management guided $16b in Q3 sales, a whopping 27% above consensus for Q3. To put this in perspective, the street did not expect NVDA to cross $16b in sales until Q2 2025.

• Gaming revenues, the traditional bread and butter for NVDA, also beat consensus estimates, supporting a broader improvement across their end markets. Autos came in weaker, as expected given the macro climate.

Valuation

Price Target

• We estimate that NVDA can grow sales sequentially over 20% through the next few quarters, given the demand-supply gap, which drives our variance to consensus. Our price target for NVDA is ~$700 based upon 24x NTM EBITDA.

  

• CSP spend and data center capex will be important to watch, though we are more skeptical of peer read-throughs given the difference in product mix and end markets. For example, while NVDA is a major customer to TSMC, the bulk of the foundries output comes from smartphone end markets, which NVDA has little to no exposure on.

• We are bullish on the stock and see the opportunity for sequential beat and raises given the streets hesitency to price in the secular tailwinds boosting NVDAs sales.

• Risks to our outlook include: (1) a worsening macroeconomic condition, (2) a material slowdown in CSP spend, (3) regulatory or international trade issues, and (4) major supply disruptions.

Disclaimer: The information provided herein is for commentary purposes only and does not constitute financial or investment advice. Wahdy Capital and/or its affiliates may hold positions in the securities described. Always consult with a professional before making any financial decisions.

We continue to project a steep decline in economic activity by the end of 2023 and through early 2024, as higher real interest rates intersect with still-weak new orders in manufacturing, tighter credit conditions, and a deteriorating global economic environment. While hard economic data (GDP, NFP, Employment Report, etc.) continue to show resilience, we are seeing cracks in the data, and expect further deterioration through the 2H of 2023.

In this environment, we continue to like long-duration assets, like Nasdaq over S&P 500, and dislike commodities, cyclicals, and interest-rate sensitive sectors. As economic risks pick up, however, we believe a greater allocation to cash and short-duration may be warranted.

FOMC Recap

The Federal Reserve raised interest rates on Wednesday to 5.25 - 5.50%, up 25 basis points as widely expected. Through the press release, and subsequent press conference with Fed Chair Jay Powell, we see view the move as incrementally dovish and think it is likely that this is the last rate hike of the cycle.

Key Takeaways

(1) The Fed cited tighter credit conditions as a weight on economic activity, hiring, and inflation. The FOMC saw a preview of Monday’s (7/31) Sr Loan Officer Survey and it sounds like the data will point to further tightening in credit conditions. The current data, last updated in April, pointed to the weakest credit demand since the Great Financial Crisis.

(2) During the press conference, Jay Powell said that Fed staff economists are no longer expecting a recession. This is an important change of opinion, as Fed staffers are considered to be more skilled forecasters and, for the past year, had seen a recession in contrast to the FOMCs “soft landing” scenario. This change in view has important implications as it means GDP estimate revisions are likely to move higher in the near-term. Today’s strong GDP print of 2.4% (ann.) actual vs 1.8% (ann.) expected supports that view.

(3) The Fed is not committed to any further rate hikes — Jay Powell stressed that every meeting is “live” as in, they will determine what to do at each meeting. The market is currently pricing in a ~40% chance of a hike by the November FOMC meeting.

Economic Scenarios

We are cautious on the path of US economic growth and see recession risk, by the end of this year, as the base case.

Market narratives today center upon these core scenarios:

1. Soft landing, where US GDP growth moderates (between 0.50% to 2.0%, inflation comes down over time (under 3.0% core PCE by end of 2024), and US labor markets remain resilient (unemployment remains below 4.0%). Rates remain high (2Y at 4%+) through 2024. No recession.

2. Goldilocks, where US GDP growth reaccelerates and we enter a high growth phase on the back of strong labor markets (unemployment unch. at ~3.6%), inflation moderating around 3.0%, a rebound in China (led by pickup in US consumer activity), and a Fed on pause (0 to 1 more rate hikes). Fed begins to cut by 2H of 2024 on improving inflation data (but still above 2.5%). No recession.

3. Hard landing, where US inflation begins to reaccelerate due to rising real wages with the Fed and other developed market central banks being forced to consider higher rates (higher SEP forecast of inflation and level of rates). In this scenario, the Fed also considers a 2.0% inflation target do-or-die and is willing to sacrifice pain in the labor market (rising unemployment, from 3.6% to 4.0%+) to see it happen. Ultimately results in a recession in 1H of 2024.

4. Soft-ish Landing, where US sees a pickup in unemployment in the 2H of 2023 as weakness in new orders (PMIs) drives economic weakness as backlogs (PMI) fall. Inventories remain depressed, as consumer spending fails to rebound due to rising unemployment led by auto and housing sector, as real rates elevate the cost of financing and push unit demand lower. Disinflation speeds up, with the Fed having a small window to cut rates before a real recession takes hold. Expect a shallow recession, though tail risk (especially left tail) increases.

Our View

In our Macro Note in December 2022, we laid out our view that the US economy would see a pick up in growth through 2023, driving asset prices higher. Then, due to the SVB crisis in March, we shifted our view in April to expect a recession in the 2H of 2023. The 1H resilience we expected has borne out, but the global economy has changed in meaningful ways since then.

Two points drive our view: (1) that real interest rates are quite restrictive, driving yield curve inversion and creating stress in credit markets; and (2) a sustained period of contracting new order growth, compounded by economic weakness in China and the Eurozone. Those two points drive our outlook of heightened risk of a credit event and a higher chance of a recession by the end of 2023.

(1) Real interest rates are now at GFC-era levels; credit risk is rising in the financial sector. Commercial real estate will drive realized losses at banks, as they seek to roll debt as it matures.

(2) New orders and Backlogs remain weak. Despite a strong 2Q GDP print and a solid durable goods orders report, unless new orders begin to pick up, the diminishing backlogs will result in less demand for labor.

Real Yields — a Lurking Danger

In the aftermath of SVB, the Fed’s decision to raise its SEP and target a higher-still Fed funds rate is sustaining a deeply inverted yield curve. We believe real rates this high (and accelerating) will create further dislocations and increase the chance of a major credit event. Because real rates are simply the nominal yield - inflation expectations (and minus term premia depending on the tenor you’re examining), as inflation continues on its path towards 2.0%, the real rate will move higher.

What’s going on with inflation?

• While inflation spent much of last year exceeding estimates, the 3-month annualized rate of inflation is well below 2.0% and has come in below economist projections recently.

We expect disinflation to continue based upon…

(1) Falling car prices — we expect assemblies to continue adding to the stock of inventories at major auto OEMs which will boost car price disinflation.

(2) Weaker demand for fuel — based upon a weaker Chinese consumer and seasonally weaker August and September for US passenger air travel.

(3) Weaker job openings to reduce wage pressure — despite headlines of major Union contract negotiations. In fact, wages and job growth are making significant progress towards being consistent with a ~2.0% Core PCE YoY target.

Asset Class Outlook

Through the rest of 2023 and into the first half of 2024, we expect economic prospects to diminish, putting pressure on the Fed to cut rates. We see the Fed cutting 50-100bp by the end of Q1 2024 if our economic outlook is realized.

• Rates should reprice and experience a bull steepening led by a fall in the front end from ~4.9% on the 2Yr to about ~4.0%. The 10Yr will move as well, we expect from ~4.0% to ~3.25%.

• Equities will see a repricing as well, with a further divergence between SPX and NDX as cyclical sectors underperform vs. growth sectors. Our year-end target for SPX is ~4000 if our recession thesis plays out, though we think equity markets will see progress from current levels by mid-2024. Industries we think will outperform are value chains around aircraft manufacturing, semiconductors, and cloud infrastructure.

  • Our risk to equities is that we are wrong and SPX outperforms NDX.

• Our view on energy prices is constructive post Q4 2023. We think oil will likely stay within the ~$70-90 range, with a soft-floor thanks to SPR refill activities. We do not like energy as an equity sector, however.

• Dollar strength should persist against EM currencies until early winter 2024, and trade in range against EUR and GBP. No comments on the Yen and recent YCC adjustments.

• From a tactical asset allocation standpoint, we like pockets of equities (and prefer to be long NDX against short SPX), we prefer the 2Y to the 10Y but like duration in general, are neutral to slightly negative on commodities, and like the dollar vs. EM FX.

For a deeper read on our Equity Strategy, please reach out to us directly by emailing me (wahdy@wahdycapital.com).

Best regards,

Muhammad Wahdy
Portfolio Manager
Wahdy Capital

1. Every quarter the Federal Reserve provides a Summary of Economic Projections (SEP), where FOMC members disclose their outlook on a variety of economic variables. This FOMC meeting included the SEP as it coincides with the end of Q2.

2. Below is a screenshot of Q2 SEP summary table, outlining a (1) higher outlook of real growth this year, (2) lower unemployment, (3 & 4) higher core inflation, and (5) higher interest rates:

   

3. This outlook supports a soft landing, as described by scenario (1) in our June FOMC Preview. The big surprise here is that the new SEP points to two further rate hikes (up from one more expected) this year, which also coincides with scenario (3).

4. When asked why the Fed didn’t just go ahead and hike at this meeting, Chairman Powell said the decision to pause/skip was due to the desire to slow the pace of rate hikes given how quickly they moved up since last year.

In our view is that, while the Fed is unlikely to commit to two full hikes, July is clearly on the table. Markets, thus far, are not fully reflecting even a July hike (which would put the implied yield at 5.375):

Cross Asset Strategy

• With the Fed raising rate expectations for the year, we believe deeper inversion is likely, which will support duration and tech stocks.

• In the near-term, we see economic data supporting a July hike (which we think is a mistake), and which may have an impact on equities more broadly.

Thank you for reading.