What are the skills of the future? How will AI reshape our work environment? What are the long-term effects of climate change on our political culture? I don’t know. This morning's Early Look will instead focus on an observable trend I do know about: Quad 4 disinflation driving Alpha generation in cyclicals.
There’s some dismay that Quad 4, with decelerating growth and decelerating inflation, isn’t razing equity indices in the last few weeks. But within our cyclical coverage, Quad 4 disinflation is absolutely driving the ‘alpha bus’. From Steel (STLD) and Fertilizer (CF, NTR) on the short side to HVAC/Construction (OC, LII) and defense contractors (HII) on the long side, the “disinflation factor” has been a key driver of performance within Industrials and Materials.
Competitive geography is an interesting framework we discussed in our Building Products Distribution black book yesterday. (Email our institutional sales team if you'd like access). I doubt anyone has combined “interesting” and “competitive geography” before, so this will be an historic discussion of middling importance.
In 2021-2022, high ocean shipping costs left imports from Asia uneconomic for many products. Steel effectively became a domestic industry for a couple of years, complete with management teams claiming “reshoring” trends as a driver for steel profits. That was kind of true, but only because of a lack of the usual imported alternatives. Steel companies even chose to add US capacity…decisions made amid far higher product prices.
Commodity markets saw a similar dynamic playout in steel markets from 2006 to 2008. While there are disadvantages to aging, experience isn’t one of them. I engaged this move in real time pre- and post-GFC. See a chart with AK Steel or US steel and compare it to the Baltic Dry index in that period. There is a reason for those near-coincident peaks. Marginal costs for U.S. steel are generally set by the ~25%-30% of consumption that is imported. Steel shares were amazing shorts once shipping costs collapsed, and, so far, have been again…with a different lag this round. It wasn’t just the GFC; steel producer valuations remained depressed for the next ~15 years, only to soar again on the narrowed competitive geography of the pandemic.
Nitrogen fertilizer producer share prices have declined on similar logistics declines and easing frictions. European subsidies helped undermine the bull case for high European urea production costs. The Saudis may have oil, the Chinese rare earths, but Europe is a subsidy superpower. But the primacy of the inflation to disinflation dynamic hasn’t been limited to base commodities. Fleets saw used equipment prices soar, profits that will fade from income statements as disinflation prevails. Maintenance spending on those used fleets should follow.
Trucking typically trades like Steel on Wheels. Faster modes of transport picked up volume from supply chain disruptions; the need for reduced transit times also reduced price sensitivity. That dynamic is now in a disinflationary reversal, with controlling logistics costs a shipper priority. Too much inventory is emerging as a challenge; at the margin, that pushes volumes back onto rails and boats.
It’s not all disinflationary downsides. Many cyclicals love a dip in the disinflationary pool. Makers of heating, ventilation, and air conditioning equipment face input cost variations that can drive margins. They’ll likely see margins expand as generous IRA subsidies support pricing. Companies supplying goods and services under long-term contracts with absent or lagged inflation adjustments can also win amid sharp Quad 4 disinflation. Railroads and defense contractors often fall into this category; both have not been favored by the market gods year-to-date.
Within our cyclicals-oriented coverage, getting the impact of disinflation right has generally meant getting the alpha right, a trend we expect to continue. Why fight the disinflationary tide, swimming against Federal Reserve police and Quad 4? With CPI expected >500 basis points in just 6 quarters, it remains one of the biggest dislocations with which we’ve worked to align our Best Ideas list.
There is plenty of Alpha in equities to be had from appropriate macro positioning, even if much financial commentary has rotated back to focusing on pondering the bubbly unknowables and the cleverly irrelevant.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets
UST 30yr Yield 3.80-3.99% (neutral)
UST 10yr Yield 3.57-3.83% (neutral)
UST 2yr Yield 4.27-4.63% (bullish)
High Yield (HYG) 73.03-74.99 (bearish)
SPX 4108-4328 (bearish)
NASDAQ 12,623-13,375 (bearish)
RUT 1 (bearish)
Tech (XLK) 157-169 (bullish)
Nikkei 30,532-33,608 (bullish)
VIX 13.47-20.90 (bullish)
USD 103.00-104.60 (bullish)
USD/YEN 138.07-140.99 (bullish)
Oil (WTI) 67.84-74.11 (bearish)
Gold 1 (bullish)
Copper 3.56-3.84 (bearish)
Bitcoin 25,801-27,908 (bearish)
Jay Van Sciver
Industrials Sector Head
