Long-end Of The Yield Curve Presenting A Problem
As Q1 came to a close, equity market breadth improved dramatically with investors rotating out of Mag7 names and into cyclicals. The small-cap Russell 2000 is sitting at two-year highs, the S&P 500 equal weight ETF making a new all-time high, the communication services, energy, technology, financials, and industrial sectors all finishing Q1 with gains of > 10%. Last week in particular showed a meaningful change in market character with Tech declining on the week (Nvidia -4%, Meta -4.7%, and Microsoft riding a 5-day losing streak) while small caps, materials, utilities, real estate, financials, and energy showed signs of breaking out (call it a value trade revival).
The quarterly gains to kick off the year are impressive: 22 new record highs, +$4 trillion increase in equity market cap., and this marked the second straight quarter of double-digit gains (only seventh time this happened since 1950). Treasury bonds finished the quarter on the weak side with yields on the 10-yr. T-note at a critical technical juncture of 4.20%. The 50, 100, and 200-day moving averages are nearby where a break lower should send them down to 3.90%, but a sustained break higher likely sends yields to their high for the year. Normally gold would be pressured in such an environment where yields are pushing higher and the U.S. dollar is firm to higher, but that has been anything but the case. Spot gold is trading above $2,250/oz to fresh record highs, it’s up a whopping 15% since mid-February, and +9% in March alone (its biggest monthly gain since July 2020).
It really is odd to observe gold acting as strongly as it is with expectations for Fed easing being pushed back, real rates up significantly, and the general market backdrop being favorable to risk assets – not an anti-risk asset like gold which usually perks up in times of fear and uncertainty. The price action in the yellow metal truly is breathing validity into the currency debasement/ financial repression theory (governments have no other choice than to inflate away their debts). Michael Hartnett’s team over at BofA has been putting out some stellar work measuring the explosion in U.S. debt/deficits over the last several months. The following charts all come from his weekly “Flow Show” publication that is a must read for those that can get access. According to their work, U.S. government debt is rising by $1.0 trillion every 100 days and interest payments from Uncle Sam on U.S. Treasuries over the past 12 months amount to $1.1 trillion (doubled since Covid).
Talk about a nice subsidy for those fortunate savers able to sit back and collect 4.70% - 5.35% risk-free on short-term T-bills. The pace of the rise in national debt is truly breathtaking: set to hit $35 trillion in May ’24, $37tn by the U.S. election, and $40tn in the first half of 2025. This has thrust Treasury Secretary Yellen into action where fiscal dominance is quickly overtaking the late-90’s post-Asian Financial Crisis era of monetary dominance. We are also witnessing a meaningful mix-shift in the maturity profile of Treasury issuance. Over the past 12 months issuance of T-bills with a maturity of 1-year or less has eclipsed $20 trillion.
This has lowered the maturity profile of outstanding Treasury debt to approximately 5 years while increasing the federal government’s sensitivity to short-term interest rates. This could very well be a motivating factor for the Fed to cut rates to constrain the surge in interest costs. Perhaps this is what crypto, gold, and commodity markets are sniffing out – it’s not a matter of ‘if’, but ‘when’ will the Fed have to cut and explicitly embrace its new roll as a subordinate to the U.S. Treasury?
According to Harnett’s team if the fed funds rate remains unchanged over the next twelve months, the trend in debt growth continues, and the U.S. refinancing rate averages 4.4%; the annual interest expense for Uncle Sam jumps from $1.1tn to $1.6tn. However, if the Fed cuts the funds rate by 150 basis points and the average refinancing rate slips to 3.2%; interest payments are likely to plateau around $1.2tn – $1.3tn over the next two years.
If this really is the game we’re playing now, then the price action in markets over the last three months makes a lot more sense irrespective of fundamental developments. Such a backdrop would argue for the TINA trade in equities to be back on, gold and crypto to rip, and commodities to be well bid. Bonds, while offering a higher yield than most of us have seen in the last fifteen years, represent themselves more as certificates of confiscation rather than wealth preservers (in real terms).
Bottomline, we remain in an investment environment where if you’re not a little confused or prudently uncertain then you’re just not paying attention. It’s more than a little surprising to me to see risk assets across the board continue to push higher all year long with the Fed increasingly pushing back on rate cuts. Yes, yes, the data has been solid and better than expectations, but I don’t believe investment grade credit spreads should be down at 93 basis points – their tightest levels since November 2021 and just 14 basis points away from taking out two-decade lows. Same goes for high yield spreads having tightened more than 20 basis points this year and now trading inside of 300 basis points. I also willingly admit that the S&P 500 trading at a 21x forward P/E multiple worries me. So, yes I guess I’m growing a bit concerned and finding it more difficult to find opportunities. Don’t get me wrong, this doesn’t mean I’m fighting the trend or advocating that anyone should be doing so, but I do think its appropriate for all us investors that have been riding this 30% gain in equities over the past five months to temper our forward-looking expectations. Stein’s law comes to mind at times like these, “if something cannot go on forever, it will stop”.
Not even recent hawkish commentary from various Fed members have been able to dent investor enthusiasm. On Good Friday Powell made his latest attempt to strike a delicate balance of embracing the solid backdrop, while pushing back against exuberate expectations:
“The economy is strong: We see very strong growth. There’s no reason to think that the economy is in a recession or is at the edge of one. That means that we don’t need to be in a hurry to cut.”
This comment followed similar sentiments last week from Governor Waller’s “no rush” to cut sermon and Atlanta Federal Reserve President Bostic’s “one cut this year”. The bond market is getting the message as the date for the first-rate cut continues to get pushed out – the futures market is now pricing in a 61% probability of a 25bps cut at the June 12th meeting.
To be frank, as investors, we should be celebrating the return to the old times where constructive fundamental and economic data carried the day and we didn’t have to hang on every word that came out of a FOMC voting members mouth. With that in mind, it is going to take a material weakening in the labor market to get the Fed back into a dovish posture. Even more so with inflation staying stubbornly sticky at the 3% level and well above the Fed’s 2% target. Friday we’ll get the March jobs report where consensus estimates are for a print of +200k which if we get a number anywhere near there or higher you can expect rate cut expectations to be pushed even further out the calendar.
This morning, we got the ISM manufacturing PMI pleasantly surprising to the upside at 50.7 in March versus 47.8 in February. This was the first print in expansionary territory (above 50) since September 2022, breaking a streak of 17 straight months sub-50. The internals of the report were constructive with the exception that prices paid were a little hotter than we’d like to see, but all in all it looks as though the manufacturing recession is coming to an end. This came on the heels of similar data out of China where their March manufacturing PMI index hit its best reading in a year (50.8) and moved out of contractionary territory for the first time in six months. New orders jumped 4-points to 53.0 and the non-manufacturing composite rose to 53.0 from 51.4 in February. It does appear as though the Chinese economy troughed in Q1 and is starting to make the turn. For sure the real estate sector still has a lot of wood to chop with the over building that propped up the economy over the past decade, but this is a positive development for commodity prices and Emerging markets.
Staying overseas, we got some good data out of Japan with the Tankan survey rising to the best level in more than three decades (+34 from +30 in Q4). Japanese equities are in the early stages of a rerating and worthy of consideration for all portfolios. Adding to the Asian enthusiasm was the news that Korea’s tech-centric exports popped +9.9% from year-ago levels last month (outbound chip related sales soared +35.7%). All this data validates what has already been playing out in global equity markets with the MSCI All-Cap World Index up over 8% to start the year (best start since 2019). In mid-January we began to reallocate some capital into Asia for the first time in nearly two years as we were seeing enough signals to give us confidence that a potential constructive turn was about to get underway. For now, we are seeing what we wanted and expected to see and think there is some runway for Asian equities to perform well relative to U.S. equities.
Another area we’ve liked for some time has been uranium as a way of gaining exposure to a budding global nuclear renaissance. What wasn’t in our thesis four years ago was the potential demand from data centers as the A.I. revolution gets underway, but we’ll take it as icing on the cake to a story that was already extremely compelling on its own.
Uranium and uranium miners have been in the midst of a correction since early-February with the price of a pound of uranium falling from above $105/lbs to just under $85/lbs. But the market correction seems to have run its course and found a new floor as the long-term trend reasserts itself. What better a catalyst to get things rolling again than Goldman Sachs initiating coverage on Cameco (CCJ), the worlds second largest uranium miner, with a BUY and a $55 price target. They suggest in their report, “the shares provide investors with an attractive means to gain exposure to the entire nuclear fuel value chain in an environment where increased demand and higher prices should lead to meaningful consensus estimate revisions.”. What gets lost in the stigma that is nuclear power is that it accounts for nearly 20% of the U.S. electricity capacity and this share is destined to drift higher in the years ahead (not withstanding another reactor meltdown).
Let me signoff with some closing thoughts where the herd mentality in equities is as strong as it’s ever been. Bullish sentiment is off the charts whether you look at the Investors Intelligence survey (60.2% bulls versus 15.2% bears), the AAII poll shows bulls up to 50.0% and bears down to a lowly 22.4% (lowest in three years), NAAIM exposure at 103.88, and the CNN Fear/Greed Index in Greed territory at 73. Complacency is becoming engrained in investors disposition which sets equities up for a humbling correction should the right catalyst materialize. What that catalyst is, I don’t know, but will be sure and explain it to you after the fact. That’s what we professionals do so well. But if I were to throw out a guess it would be long-term interest rates. The sell-off we are seeing in the long-end of the Treasury bond market is problematic and if long-term interest rates breakout to new highs I think a lot of risk assets will struggle. All the debt and interest expense charts I highlighted above are what you expect to see in emerging markets, not in the market that wears the crown of the world’s reserve currency.
Two quotes from former U.S. Presidents come to mind when thinking about this situation, and I’d consider them funny if they didn’t ring so true:
“I’m not worried about the deficit, it is big enough to take care of itself.” Ronald Reagan
“Blessed are the young, for they shall inherit the national debt.” Herbert Hoover
All kidding aside, correction or not, I think the backdrop is one where, as an investor, you want to be more exposed to risk assets than not. Global growth is solid and improving in many regions. Global central banks are leaning in the dovish direction and more inclined to cut rather than hike. Consider that 85% of the economies around the world are operating with positive real rates for the first time since 2007, an easing cycle does not seem like a far-fetched option. Surely, the timing and level of rate cuts is up for debate, but the persistent winds of disinflation should allow for a global synchronized monetary easing cycle to kick in sooner or later. This includes the Fed. Moreover, if the Fed is able to engineer the elusive ‘soft landing’ which at this time looks more likely than not and implement a couple ‘calibration’ cuts to align the policy rate with an economy effectively balancing employment, inflation, and financial stability objectives then the S&P 500 is likely to continue to deliver positive returns. Since 1950, there have been seven occasions where the Fed cut and the economy did not fall into recession. In each of those occasions the S&P 500 was higher on a 3/6/9/12-month horizon from the date of the first cut with average returns of 10%/12%/14%/15%, respectively (data according to BofA Global research). The returns going into the rate cut were much more varied, ranging from -8% to +10%.
In a nutshell, be prepared for the rising potential of a correction, but given the backdrop this is likely one you’re better off not trying to be too cute with trading around. Sometimes you just have to endure drawdowns as the best course of action in route to long-term success.
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