Tactical Take^®

JACK JANASIEWICZ: I'm Jack Janasiewicz. 

BRIAN HESS: I'm Brian Hess. 

JACK JANASIEWICZ: This is Tactical Take. 

BRIAN HESS: All right, Jack. Welcome back. How are you? 

JACK JANASIEWICZ: Pretty good. It's good to be back in the seat again. 

BRIAN HESS: Yeah, exactly. I hope everyone is having a good summer. Now, that we're in mid-July, another earnings season is kicking off in the US. And we have the banks start the earnings season last week. So I thought maybe we could start there. Check in on what we're hearing from these national banks that operate in lots of different parts of the economy. 

Maybe first talking about the macro implications, and then we can get into some of the banking sector fundamentals as well. 

JACK JANASIEWICZ: Sure. Yeah. And it's always important to hear what the banks say, because they're, basically, the ones that are dealing on the front lines of the consumer and the economy, and also, at the corporate level. So we get some pretty good insights into what they're seeing and how they're operating going forward. 

And I think, by and large, when we look at the summary for what they told us, that the backdrop for the US economy is still pretty solid. And more importantly, the consumer remains in still pretty good shape. So those two things taken together, it still points for a pretty good outlook for the remainder of the year. 

Maybe one thing that I thought was interesting that I took away from a lot of their conversations that they were talking about in their earnings calls, the non-accrual portions of their loan balance sheets. It's thinking of things like the bank lending to a lot of these private credit markets. And private credit is still in the headlines. You're still hearing about a fairly good chunk of redemptions hitting a lot of these vehicles like BDCs and so forth. 

So it's always a concern, and we've talked about this in previous recordings about the potential for this to maybe expand to the broader economy. And we've been saying for quite some time the risks still seem idiosyncratic, but there's always a risk that we could be off on this and it could be more of a systematic issue. 

And when we look at these things, like the non-accrual loans on the banks that just reported, they're actually going down. So I think that's a pretty good sign that at least what we're seeing from the private credit sector still remaining somewhat contained, and we're not seeing it really morph to the broader economy, which means these are more idiosyncratic risks still. 

BRIAN HESS: I just want to make sure everyone understands. When you say non-accrual loans, can you just define what that means? 

JACK JANASIEWICZ: Sure. These are just loans on the balance sheet that haven't been serviced over the last 90 days. So they're not accruing income or earning income for the bank. 

BRIAN HESS: So these are like troubled loans, basically. 

JACK JANASIEWICZ: Exactly. Right. 

BRIAN HESS: Got it. All right. So on that front, the banking sector fundamentals look good. And then zooming out, big picture macro wise, the consumer seems healthy. And what they're seeing just in the broader economy, whether it's business lending or other things also looks good. 

JACK JANASIEWICZ: And the other one, maybe to focus there too is the loan loss provisions. Again, if the banks are starting to see a slowing in potential, squeezing of the credit backdrop, they'd probably start setting aside some assets against those receivables just to pad themselves and give themselves a cushion. 

And again, when we start looking at those loan loss provisions, those are actually going down. So again, no signs that the banks are worrying about. 

BRIAN HESS: So they're not like worrying behind the scenes and ratcheting up those safety valves. That's good to hear. We've been looking at regional banks for our models and haven't done anything yet. But do you think the story is pretty similar as we move down in market cap and maybe get to more geographically concentrated banks? 

JACK JANASIEWICZ: Sure. And I think some of the tailwinds that we've been hoping for, maybe a little bit more slow to manifest. But again, I think with the Warsh Fed coming into play that maybe starts to see a little bit of these potential pushes for legislation shifts, some of the restrictions that have been placed on them loosen up a little bit, and I think that'll be a net positive for more of the regional, smaller cap banks going forward. 

So that deregulation, so to speak, I think, is still a tailwind that potentially could emerge here in the short term, along with the economy still doing quite well. 

BRIAN HESS: That's something that could definitely benefit the smaller banks, where compliance costs can be a large percentage of their operating expenses. And they don't have the benefits of the capital markets desk we saw from the bulge bracket banks. They did very well in equity trading. They did very well, I think, even in M&A and equity issuance. 

So that's been really good for Morgan Stanley's, Goldman Sachs. But the regional banks don't have that same catalyst yet. If we can lift the regulatory burden while the economy is still good, could be an interesting story. 

JACK JANASIEWICZ: 100%. 

BRIAN HESS: And they trade a lot more cheaply, I think, than the bulge bracket banks. 

JACK JANASIEWICZ: Yep. 

BRIAN HESS: All right. Now, shifting away from financials towards another part of the market, since we last chatted, there's been a pretty vicious momentum unwind in markets. And AI-related stocks have come under serious pressure from late June into mid-July. They might be bouncing now, but it's kind of early to say. 

So I'm curious if you've heard anything so far in Q2 earnings that reveal information about AI CapEx spending and intentions there. 

JACK JANASIEWICZ: Yeah, a couple of things that popped up. The first one, there's still, obviously, a supply shortage. There's still constraints on that. The natural distribution channel for a lot of the AI and AI-related CapEx, whether it be infrastructure, RAM, DRAM, memory, go through the whole list, there still plenty of evidence that there's still supply constraints. So that's one of the big takeaways. 

The second one, what I also thought was interesting, though, and we're hearing from some of the companies that are basically maybe reallocating some of their resources away from your traditional, maybe, software spends in reallocating back that towards the AI side of the equation, because they're trying to get ahead of the potential price increases on top of seeing strong demand. So they want to make sure they can get filled in as well. 

So it's interesting you're seeing a little bit of a shift underneath the surface from some of these budgets, moving more towards actually trying to get in front of the AI CapEx surge, if you will. And I think that's probably just increasing that sort of demand, so to speak, near term. 

BRIAN HESS: So is there any evidence that there's overordering going on? I remember during the pandemic, you had a lot of that, people putting in two or three times what they really needed, knowing they're going to get cut back. Do you think there's a risk of that? 

JACK JANASIEWICZ: I'm sure there is. It's tough to quantify that. But padding your order, so to speak, to make sure you at least get something, I'm guessing is probably somewhat of what we're seeing in the marketplace right now. 

JACK JANASIEWICZ: Yep. And I think the other big takeaway too, and we've been paying attention to, and it's still early in the CapEx season for us here in terms of the announcements. But the budgets are still coming in, at least in line with expectations with, hence, maybe even coming in higher than expected.

And so back to your point, when you're talking about the CapEx spend that we're hearing from the hyperscalers. And if I look at the full estimates for 2026 and compare that to US GDP, you're talking about something close to 2.5% of US GDP. These are huge numbers. 

And so they're having massive ramifications across the economy. But right now, it still seems like those CapEx intentions are still pushing higher, despite all the concerns about ROI and everything else we're hearing in the news. 

BRIAN HESS: So the fundamentals sound good, and you're highlighting that pretty clearly through all your different comments. And I mentioned there's been a momentum unwind in the markets, in stock price terms. So we've had a lot of debate internally about whether this is the end of the AI trade, so to speak, or if it's just a correction in an ongoing uptrend. 

And I'm curious, what are your thoughts on that? How do you see the market evolve from here? Because it could be a situation where we saw in precious metals earlier in the year, for example, gold had this parabolic blow off in the first quarter. And since then, it's just been down to sideways. Do you think that's what we're up against within tech or is it just a play? 

JACK JANASIEWICZ: Yeah, it certainly seems like the fundamental backdrop is still intact. And I think what I would say is the most recent correction that we've seen in the marketplace has really been a function of technicals. And you were alluding to the factor unwinds, so to speak. And as you mentioned, we've talked about this quite a bit in our portfolio management meetings behind the scenes. 

And when we think about the factors that are really the overarching ones that are pushing the markets right now, it's both the beta factor and the momentum factor. And when we look at where those are trading relative to history and the performance over the last three months or so is basically putting it into the top decile, so to speak. 

So putting those two factors together, both having these eye-popping returns, something we haven't necessarily seen for quite some time. And then when you expand that out and you look at things like the dispersion trade, where you're buying volatility on single-name stocks and selling the overall index, in this case, the VIX, we're seeing the dispersion trade really being at these extremes that filters its way into the correlation markets. 

And we've seen correlations really crumble down. And so all of these are signs of massive crowding in these same trades. And it goes back to these momentum and beta factors that we're talking about. 

So it's not surprising that we've had this huge crowding. And all of a sudden, you get a little bit of unwind, and that just snowballs into something bigger. And when you start to put a lot of these things together, the calendar, I think, also has quite a bit to play with this as well. 

Because you're talking about a potential period where you're at quarter end, month end. So you've got pension rebalancing. You've got option expirations all coming together. Index rebalancing for both value and growth had some pretty big shifts underneath the surface. So all of these things together creates a little bit of volatility. 

All of a sudden, you get some unwinds. You get the spike in volatility. That creates a little bit of risk, de-risking, so to speak, and selling begets more selling. And all of a sudden, you see these momentum factors, these beta factors really unwind. And I think that's at the heart of this, which is all rolling into the AI trade. 

BRIAN HESS: So to put that very briefly, we may have gone too far too fast. And now, we're just coming back based on a lot of this crowding that you've highlighted. You mentioned correlations falling. And one area where we've seen some different performance this year has been in the pick-and-shovel plays, so like memory and the things that go into supporting the AI trade versus the hyperscalers who are doing a lot of the spending. This would be like your Googles and your Alphabets, rather, and your Metas, and those types of names. 

And some of them are down on the year, while memory stocks are way up. So I'm curious, do you think that trend is set to persist, or could there be an opportunity to maybe, look at some of the Mag Seven names, which have fallen out of favor after many, many years of being market leaders? 

JACK JANASIEWICZ: Yeah, and I think the questions are still out there that needs to be answered. We're hearing a lot more of capacity potentially coming online for the memory backdrop. You're hearing all sorts of investments from SK Hynix, Taiwan Semi. The list goes pretty far on and on. 

But the issue there is by the time those get up and running and are able to actually start to fill some of these demand needs, are we talking 2030? The question there, though, is the market already going to price that in today, even though we've seen some pretty significant margins and significant revenues? 

And those are probably persist over the next couple of years. You start to look out three or four years, that's probably not going to be sustainable. So does the market start to reflect that today? Good question. It remains to be seen. 

On the Mag Seven front, I think the question there would be, yeah, they look cheap. It looks like the trade has been to sell Mag Seven, sell software, for example, and buy all the memory names that we were just talking about. Could you get a potential reversal as a result of that? Maybe. 

But again, it comes back to, I think, the visibility on that ROI from all this CapEx spending that's still, I think, is what the concern for the market is. And until we start to see the return on investment, some investments clarity on that and the investors can get comfortable with that, it's going to be, I think, a little bit of a slog back and forth here. 

BRIAN HESS: So we still have overhangs on the software names, obviously, made apparent by the announcements of budgets shifting. And now, you're saying there's probably a bit of an overhang on the hyperscalers just because of the amount of spending they're doing. 

JACK JANASIEWICZ: 100%. 

BRIAN HESS: And that leaves the memories stocks and the picks and shovels as the main play. So we are seeing a narrowing of the AI bull market. Got it. Now, against this backdrop of AI-related volatility, we've also seen a resumption of volatility in Iran or hostilities, basically, between the US and Iran. 

This has led to a fresh rise in oil prices and energy markets. Now, after June's inflation report, the CPI report, I have to admit, it seemed like maybe we don't really need to worry about rate hike. Because the headline number, the core number, both beat expectations handily. 

And it wasn't just like an energy thing or something. It was broad based. Services inflation was really weak and even shelter, the housing component, was like, there was no housing inflation month over month, and shelter was like 1/10, which is quite low. 

So I guess given what's happened with oil in the past few weeks, where now, I think on Brent, we're pushing at $100 a barrel and knowing what we about the June inflation report, how do we manage the competing risks? Do we just write off that June inflation report because there's this new shock to inflation through the oil market? Or is it enough, if services inflation remains tame that the Fed can look through the energy price shock? 

JACK JANASIEWICZ: Yeah, welcome to the new FOMC chair there, Kevin Warsh it's not a easy backdrop to walk into. But a couple of things that are probably worth highlighting against that backdrop. One, we've been here already with the oil price spike. I think for the market to maybe move away from that blueprint, you'd expect to see maybe an increased escalation. 

What does that mean, an escalation in terms of hostilities with Iran? Does that mean boots on the ground? Is that what the potential incremental escalation could be. Or is it simply now you're hearing about the Houthis trying to close down the Red Sea? Incremental escalation on their front. 

So maybe there is a little bit of a different shift from what we've already seen. So the question there is simply, looking at that forward curve, again, we're kind of back to the highs that we had seen, the y's that we had seen just several months ago. 

So will oil continue to push wider than that remains to be seen. We'll see how this plays out over the next couple of weeks. But certainly, inflation backdrop looked like it was finally heading in the right direction. You hit on a bunch of the key takeaways there. Does the oil backdrop change that? 

And I think when I start to think about how the Fed should be looking at this, again, some of the other pieces within that inflation basket that are pushing things up is anything related to the AI trade. So you're seeing price pressures coming from memory. You're seeing it from peripheral computer hardware, those sort of things. 

Those are really supply-chain related, bottlenecking issues. It's like the oil backdrop. Again, supply chain related issues, not something that's really demand driven, so to speak. And the Fed hiking rates, I think, is more a function of trying to address the demand side of the equation. 

So will hiking rates, address higher oil prices? Will hiking rates address higher DRAM prices? Probably not. And this is that rock in the hard place that sits with the Fed. I think what they end up doing is they basically sit pat, but talk a tough game and try to jawbone the market, so to speak. 

BRIAN HESS: So you still think there's a possibility that the Fed won't need to hike in 2026?

JACK JANASIEWICZ: Hopefully, correct. Yeah. I mean, the market is still pricing in, I think a little bit less than 2 between—

BRIAN HESS: Almost 2, like 1 and 3/4 as of yesterday.

JACK JANASIEWICZ: And so maybe put a gun to our heads here. We would argue maybe that's a little bit aggressive. So the front end might look a little bit more interesting, so to speak. But listen, I think from the bias from the Fed, it's certainly the risk is that there is a hike. You've got a little bit more of a hawkish bias that's still within the Fed members. 

So we're not certainly dismissing this whole backdrop. There is a risk for hikes, but we still think the base case is there's. No hikes. 

BRIAN HESS: Got it. Yeah, that's certainly reasonable I think on the oil issue, the thing is the longer we stay at these elevated levels, the less you can characterize it as a spike. And the more it's like, oh, this is a different environment now, with higher oil prices. 

JACK JANASIEWICZ: And keep an eye on those longer term inflation expectations. We're paying attention to that one year, one year forward number, the five-year forward numbers, still remaining fairly benign. But if those start to creep higher, that changes. I think, the trajectory of how the Fed thinks about things. 

BRIAN HESS: Yeah, that's, I guess, an important indicator of pass through into the broader economy and the risk of the second-round effects. The longer oil stays elevated, the greater risk it starts to seep into core inflation. 

Now, the other day I reached out to you just asking, hey, is there anything in particular you'd like to talk about on Tactical Take this month, as we usually do. And one of the things you came back with was the idea that the US economy might slow during the second half because some of the supportive tailwinds could fade. 

That surprised me a little bit. And so I thought maybe we could just dive into that. You could walk through, because I haven't read, like you haven't put out too many negative notes or anything pointing to a slowdown risk. So let's just walk through it first here on Tactical Take and get into it. 

JACK JANASIEWICZ: Sure. Yeah. And I think a lot of this is coming from the idea that, what people are asking what our second half outlook is. So within the second half, outlooks are always what are some of the risks? So we need to figure something out to put in that category. 

But I think there is some issues there that could potentially-- and again, I don't want to come across as being bearish. I think we're still optimistic between now and the end of the year that stock prices push higher. But we're certainly, I think, seeing a backdrop that may be less supportive, and there's some modest headwinds that are taking up. 

And so the first one simply-- and we just talked about it-- the market is still pricing in rate hikes. And when you look at where, for example, wages are relative to just let's call it the Fed funds rate, wages are actually growing at a rate slower than where the Fed funds rate is. And that, I guess, could be a proxy for maybe marginal tightness in financial conditions, so to speak. 

So that's one. I don't see any reason why we're going to see a significant turnaround in wage growth here, where all of a sudden wage growth is going to start to re-accelerate. So that modest tightening probably would be a headwind going forward. 

One of the big boost to I think, the consumer were the tax refunds. That's largely in the rearview mirror now. So as we push to the second half of the year, the benefit from those tax refunds is gone or fading anyway. And also, when you think about the flow through from the One Big Beautiful Bill, looking at projections, those impacts really start to flip, basically, the third quarter. 

So a little bit of a tailwind from the One Big Beautiful Bill probably starts to work its way through as well. So put all these things together, real rates are still pushing higher, as we just talked about. And the potential for the dollar may be to strengthen as real rates push higher. That actually might put a little bit of upward pressure on the dollar, all of these things together at the margin, small tightening in financial conditions. 

So just something that we're thinking about for the second half of the year, not enough to derail the economy, but certainly, something that maybe is a headwind, so to speak. 

BRIAN HESS: Got it. So there's not one smoking gun here. It's more like the accumulation of a bunch of little things that could actually result in a decent consumption slowdown. 

JACK JANASIEWICZ: Yep. 

BRIAN HESS: Now, we've been becoming increasingly interested in long duration treasuries. For our models, we've been talking about that as a group. And 30 years, in particular, have been rising. They're now at cycle highs. So they're at their highs for the bear market that started back in 2020 or 2021. 

And one of the reasons we have been unwilling to engage with extending duration so far is because we felt like, well, maybe we're not at the right phase of the cycle for it. The economy is still doing well. Economic surprises are still elevated. 

And so it's been a valuation story where, yeah, we like a five handle on 30s, but we're missing that cycle component. So I'm curious, do you think this slowdown you're talking about for the second half of the year could be enough to maybe unlock some value in 30 years and allow for a rally at the long end? 

JACK JANASIEWICZ: Yeah, it's a great segue right into our thoughts on the treasury market. And I think, yeah, if anything, maybe we get a bull steepener in here. As I mentioned before, if the market is already pricing in the two hikes between now and the end of the year and we're still thinking the Fed sits on its hands, the front end probably comes down a little bit, and that gives you a little bit of that steepening. 

And again, from the backdrop of the inflation expectations that we were just talking about, that slowdown at the margin probably puts a little bit of downward pressure on inflation expectations. We're not seeing any sort of re-acceleration in wage growth.

So maybe, all of a sudden, the inflation backdrop that really had everybody worried may get a little bit more comfortable with the idea that, yeah, maybe it's sticky, but we're drifting in the right direction. And all these things put together means, yeah, maybe we get a little bit of a tailwind for the longer end of the curve, and as a result, you get that bull steepener, and duration actually ends up being fairly useful at this point. 

BRIAN HESS: What I think is interesting about the long end is that your scenario could very well play out where if the Fed doesn't need to hike, the yields come down a bit, particularly at the front end, as those get taken out. If the Fed has to cut rates for some unforeseen circumstance, it certainly, would benefit the entire curve. 

But even in a scenario where the Fed delivers into those almost two hikes that are priced, I don't necessarily think the 30 year has to go up a lot in yield, because the curve should flatten into that type of environment. And we've already got a decent amount of steepness to compensate you for moving out the curve. 

So we could be setting up for an interesting risk reward opportunity at the long end, and an opportunity, maybe, to buy some less expensive insurance in case there were to be some more equity volatility. 

JACK JANASIEWICZ: Yeah, and I think you hit on the key point there. It's the risk return profile and what's priced in relative to what we're expecting. That skew, I think, does favor a little bit more, so in terms of the positive side of adding some duration in here going forward. 

BRIAN HESS: Exactly. All right. Well, sounds good, Jack. Thanks very much. I hope everyone enjoys the rest of summer, and we'll see you next month. 

JACK JANASIEWICZ: Awesome.