CEO House View | Warsh’s Debut Puts Markets to the Test: Why AI Fundamentals Keep Equities on Top

💡MacroMicro expects the primary market variable influencing June to shift from geopolitics to the Federal Reserve’s leadership transition under Warsh. This transition is anticipated to be a major "expectation reset" event for markets, particularly with the June 18 meeting. The focus will be on potential shifts in the dot plot towards "no rate cuts" or even rate hike projections, decisions regarding the RMPs Treasury purchase program and its impact on liquidity, and the potential for weaker forward guidance, all of which could significantly increase market volatility.

💡The Federal Reserve's dot plot in June is highly likely to shift its 2024 outlook toward "no rate cuts," and there is even a possibility of rate hike projections emerging. This outcome becomes plausible if only three committee members revise their projections upward. Governor Christopher Waller's recent shift in tone, expressing concerns about US inflation not moving in the right direction, further supports this expectation. Additionally, markets should monitor the distribution of these projections closely; if more than three members project rate hikes, it would signal a significant repricing of the Federal Reserve’s policy path, impacting market expectations.

💡Warsh's decision not to continue RMPs Treasury bond purchases, given his historically cautious stance on such programs, would likely lead to liquidity pressures gradually emerging beginning in Q3. This impact is exacerbated by recent trends: RMPs purchase volumes have significantly declined from a peak of $70 billion to $10 billion for May and June. Concurrently, the Treasury Department announced a substantial increase in Q3 debt issuance to $671 billion (from $189 billion in Q2) and a higher Treasury General Account (TGA) target balance of $950 billion. These factors combine to suggest a tighter liquidity environment if purchases are suspended.

💡The third crucial risk stemming from Warsh's potential weakening of forward guidance is a structural increase in market volatility. Warsh has publicly criticized forward guidance, arguing for reduced reliance on it due to limited value. If the Federal Reserve diminishes its use of forward guidance, markets could lose a crucial anchor for rate expectations, resulting in heightened asset volatility. This risk is hard to quantify but potentially far-reaching, necessitating close monitoring of Warsh's communication style, meeting minutes' emphasis on guidance, and the dot plot for unusual omissions at the June meeting.

💡Weaker Federal Reserve forward guidance could structurally increase market volatility by removing a clear anchor for rate expectations. Warsh has openly criticized forward guidance, advocating for reduced reliance on it, which suggests a potential shift away from providing explicit signals about future policy. If the Fed's communication becomes less precise or direct, market participants may struggle to anticipate monetary policy changes, leading to greater uncertainty, increased repricing events, and ultimately, higher asset volatility across various markets as investors react to a less predictable policy path.

💡MacroMicro highlights two long-term analytical frameworks that support a constructive market outlook despite ongoing risks: supportive fundamentals and the enduring influence of Trump’s pressure logic. Global earnings expectations continue to be revised higher, driven by the AI wave and strong demand across the technology supply chain. Although equity valuations appear elevated by market capitalization-to-GDP ratios, they are not extreme from a price-to-earnings perspective, with AI-benefiting economies seeing structural upward P/E re-ratings. Furthermore, Trump's incentive to end conflicts due to rising domestic energy pressure means equities maintain a relative advantage over bonds, under both best- and worst-case scenarios for oil prices.

💡Trump’s pressure logic influences market dynamics by creating stronger incentives for him to bring conflicts to an end, particularly affecting equities and bonds. Recent declines in US crude oil and gasoline inventories suggest rising domestic energy pressure. This dynamic means that under both best-case (quick peace negotiations) and worst-case (oil prices remaining in the $90-100 range) scenarios, equities maintain a relative advantage over bonds. The underlying framework suggests that if oil prices exceed $100 per barrel or Treasury yields approach 4.5%, Trump's stance tends to soften, causing risk assets to ultimately revert to trading on fundamentals.

💡MacroMicro's overall market allocation recommendation for June is to favor equities over bonds. Despite potential near-term volatility stemming from Warsh's arrival at the Federal Reserve, the firm views this as an opportunity rather than a risk. This stance is supported by continuously improving fundamentals, particularly the broad AI deployment trend across major economies like the US, Taiwan, and South Korea, and the enduring influence of Trump’s policy bottom-line framework, which suggests equities will maintain a relative advantage even under challenging scenarios.

💡MacroMicro recommends equity investment in regions benefiting from the broad AI deployment trend. Specifically, the US, Taiwan, and South Korea are highlighted as economies that continue to benefit significantly from this trend. These regions are experiencing structural upward re-ratings in their Price-to-Earnings (P/E) multiples due to strong demand and earnings expectations driven by AI supply chains. This selective approach targets areas with robust fundamental support and significant growth potential within the current technological landscape, aligning with the overall preference for equities over bonds.

💡MacroMicro suggests a fixed income strategy that avoids non-US markets and favors short-duration Treasuries. This recommendation comes amidst expectations of increased market volatility and uncertainty surrounding Federal Reserve policy under Warsh’s leadership, including potential shifts to a "no rate cuts" stance, suspension of RMPs purchases, and weaker forward guidance. By focusing on short-duration Treasuries, investors can mitigate interest rate risk in a potentially tightening or highly volatile rate environment, while generally avoiding international bond markets where risks might be less transparent or harder to manage.