Markets React to Fed Cut: Citi on Earnings, AI Spending, and the Road to 2026

Cheddar News

Citi’s Drew Pettit breaks down how the Fed’s latest rate cut is reshaping equity markets, earnings expectations and sector strategy.

Transcript

00:00Drew Pettit joins us now here on the trading floor of the New York Stock Exchange.

00:04One day after the central bank, as expected, cut short-term interest rates,

00:08Drew is a director of U.S. equity strategy at Citi.

00:11Here to wrap up Q4 at the NYSE. Nice to have you.

00:14Yeah, thanks for having me in. Always love being at the NYSE.

00:16Before I ask you about the Fed's decision, as you and I are sitting here,

00:20the S&P 500 is up 16.3% year-to-date.

00:24If you and I were to go back to one year ago, December 2024,

00:27would that have been your expectation?

00:29No, we would have been light of that.

00:31And honestly, what's really changed this year is the fundamental expectations have been all over the place.

00:37You trip into January, you have deep-seek concerns.

00:41What does that mean for AI?

00:42Then you go into tariffs. That could be another hit to EPS.

00:46Then you get tariff delays, positive news on the policy front with OBBBA.

00:52And all of a sudden, here we are.

00:55Earnings estimates, where we thought they would be,

00:57but the volatility to get there, a little bit more than we expected.

01:00I totally forgot about deep-seek. Thank you for reminding me.

01:02But how do you forget these big intraday sell-offs that kind of define the market?

01:06The Japanese yen carry trade, the hedge fund unwinding trade, basis point, right?

01:11You mentioned one big, beautiful bill.

01:12What's on your horizon for 2026 as we see more parts of that legislation go into effect?

01:18So to us, you're finally past tariff uncertainty.

01:20I hate to couple these together, but when you think of OBBBA and tariffs,

01:26when you put them together, they offset.

01:28And now that we have the good news to offset the bad news,

01:31companies can finally plan, adjust, move forward.

01:35That's fundamentally positive for us.

01:37So companies do a really good job dealing with issues.

01:41Efficiency gains are there.

01:42Margin improvement is there.

01:43They just need to know the rules of the road.

01:46So again, past all the uncertainty, at least from the policy front for now,

01:51that's a positive for equities going forward.

01:54As expected, the Fed cut interest rates 25 basis points, three dissenters,

02:00though not dissenting for the same reasons.

02:02How does that, plus the addition of a few new voting members in 2026,

02:08pave the way for what to expect after the new year?

02:10So look, high-level economics team expects cuts to continue.

02:15So we should see another three or four more cuts if you get some weakness in the labor market,

02:20especially as you cycle in some new voters.

02:22But connecting this back to equities, the good news is, while the Fed's cutting,

02:27we actually don't have earnings going down.

02:29We have earnings going up.

02:31So when you pair those two together, Fed easing, companies making more money,

02:37that's a really attractive world for stocks.

02:39We would call it an equity soft landing.

02:41What's your view on how consolidated this market tends to be?

02:45I mean, we just passed the three-year mark for this current bull run.

02:48Undoubtedly, it's been the mag-7.

02:49Now it's the AI trade.

02:50The durability has been questioned from time to time.

02:53But for the most part, it's been incredibly resilient.

02:55I've noticed that the one-off defensive days, we have health care kind of outperform.

02:59We might see utilities kind of pop up as tech and discretionary fall.

03:03But for the most part, it still seems pretty top-heavy.

03:05These consolidated names are still doing a lot of the heavy lifting.

03:07So we think the beta will broaden.

03:09So let me unpack this.

03:10So the growth side, NASDAQ, tech, we still like that.

03:14So there's a secular trend here in theme, and it's AI, and we think it's real.

03:18We'd rather classify AI as a boom rather than a bubble.

03:22So that's step one.

03:23So we're okay with that risk.

03:24With the Fed cutting and cyclical earnings finally inflecting,

03:28now we can find a new source of risk or beta that we like adding to portfolios, and that's cyclicals.

03:34So it's funny.

03:35If I were to do this from like an index level, I would own NASDAQ,

03:39and I would also own the Russell 2000 and small cap, and just kind of don't buy the middle.

03:44We want to own those two corners of risk.

03:47We think that makes a lot of sense for kind of core positioning into 2026.

03:50How are you thinking about yields right now?

03:53We know where the administration would like to see yields go,

03:56but we've had this kind of fascinating look as yields have continued to tick higher,

03:59at least over the better part of the last week and a half, two weeks or so.

04:02And on the sessions that I'm down here, I notice as yields go up,

04:06we tend to see the homebuilder stocks, for instance, obviously take a hit.

04:09How much is that component on your radar for the new year?

04:12So it's funny.

04:12When we look at that cyclical inflection, some of that is rate-driven.

04:16So the homebuilders, you kind of nailed it there.

04:19But there's a bunch of other names that are basically,

04:22they had tariff headwinds, and now we're moving past that.

04:26So it's not all rate-driven on the earnings growth inflection.

04:29When we think about the equity market in general,

04:33look, our rate strategists think the 10-year should come down.

04:37They're looking at about 375 for year-end next year.

04:40Wow.

04:40That would be supportive evaluations where we are today.

04:44So look, rates come down, equity multiples are high.

04:47That's supportive.

04:48That could be a little bit sticky.

04:50Again, backdrop with good earnings, supportive for equities.

04:53375 would be the low going back to about September, October of 2024.

04:58So that's sort of a bit of a retracement level your analysts see.

05:01Yep.

05:02But honestly, the other key of that is the front end moves down more.

05:06So that actually supports another part of the cyclical trade, which we like,

05:09and it's financials.

05:11Steeper curve, good for banks.

05:12Banks, we think, are still a winner into next year.

05:15Okay.

05:15I assume the big banks more specifically.

05:18Yeah, but honestly, when we dive into inflecting growth,

05:22there's some of those kind of mid-sized banks that are a little bit more credit

05:25and rate sensitive than the money centers that have a lot going on.

05:28So look, we're not afraid to go down cap when we're thinking about financials as well.

05:32Sure.

05:32Pricing pressures on the consumer.

05:34How are you thinking about the strength or weakness of the consumer into the new year?

05:38We've talked a lot this year about the difference between the soft data versus the hard data.

05:42We're talking a lot more now about higher income earners,

05:45increasingly value shopping to a stretched consumer throughout maybe many parts of more

05:50moderate to lower income bases.

05:53And have the tariff pressures worked their way through for the consumer?

05:56So it's funny.

05:57I think the companies are adjusting to tariff pressures.

06:00We've seen some decent data of late.

06:03But look, where the labor market goes is going to dictate this trade.

06:06The problem with the consumer trade to us,

06:09when you think about it from a stock perspective,

06:12rather than just kind of the sector or that portion of the economy,

06:16it's these big names that are taking share.

06:17So again, we're not really bulled up on consumer.

06:20We would actually rather be underweight something like consumer staples.

06:24I think inflation there is actually good for those names.

06:27Sure.

06:28But consumer discretionary, look, I'd rather play some other cyclicals than that.

06:33If I'm going to live in that space, I want people that are investing in their business,

06:37finding operating improvements, and taking share.

06:41I don't think there's a tailwind to really buy all the consumer names.

06:44Any sector or group of stocks in a basket that you think we're not talking enough about?

06:50So it's funny.

06:51Everyone thinks quality is this great factor you can kind of own.

06:56And everyone talks about quality.

06:57And they have different ways of measuring it.

07:00To us, it's not quality.

07:01It's quality improvement.

07:02So our favorite trade to talk about is not who's at high quality and might be coming down.

07:07We want to see companies where the expectations are for quality to move higher.

07:11The big overarching theme in the economy is productivity.

07:16Productivity, productivity, productivity.

07:18It shows up in AI.

07:19It shows up in earnings call for typical companies just trying to be more efficient.

07:24If you can find companies that are expanding margins and operating more efficiently,

07:29more efficiently, you want to buy those names.

07:32So quality improvement is our favorite, I would say, quasi-factor when we're stock selecting.

07:38I haven't asked you about small caps, but I want to get your take on it.

07:42Another all-time high yesterday after the Fed rate cut.

07:44Are they well-positioned in an easing cycle to maybe even outperform?

07:49I think so.

07:50It's funny.

07:50Back to what we want to own.

07:52I think it's a great pair with that large cap, mega cap growth tree.

07:56So it's funny.

07:57You need the earnings growth inflection.

08:00I find this a little bit cute.

08:01But when you really think about why would anyone want to buy a small cap stock?

08:05Because you don't think it's going to be a small cap stock forever.

08:07You want that to get bigger.

08:09You want that to grow.

08:11What have we not had in small cap for years?

08:13It's been earnings growth.

08:15What do we have now?

08:16Finally, some earnings growth and the macro tailwind of Fed cuts.

08:20We're at $6,864.

08:23You got a target for the end of 2026 for the S&P 500?

08:26No, we're still looking at mid-year right now.

08:28So more to come from us.

08:29But looking around $6,900.

08:31You know, bull case up into the kind of low sevens.

08:34Okay.

08:35Drew Pettit, Director of U.S. Equity Strategy at Citi.

08:37I have so many more questions, but I know that's all the time I have for.

08:40Thanks for coming in.

08:41All the best for the holidays.

08:42Good to have you.

08:42Yeah, thank you.

08:43Always glad to be here.

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