After a full week on the road seeing clients and a small mountain of things to catch up on – I’m going to keep this week’s note brief with some meandering thoughts on various markets/topics.

U.S. equities continue to push higher, with the S&P looking destined to reach 6,000 before year-end.  That’s a big move from where it started the year (4,769), but only another 150 points (+2.5%) from the 5,850 level it's trading at today.  Without question, the nearly 23% YTD gain in the S&P 500 has taken almost everyone by surprise; after all, it is nearly 400 points above the highest 2024 year-end price target from Wall Street strategists and 20% above the average target of 4,861 (see Charlie Bilello’s chart below). Still, we are where we are, and this epitomizes the meaning behind the Wall St. adage – “it’s about time in the market, not timing the market.”  Although, I can’t say I fully agree with said adage – mostly, but not entirely.   

Nevertheless, equities are fully embracing the goldilocks backdrop where economic growth remains firm, inflation is trending towards the Fed’s 2% target, the labor market continues to add jobs, corporate profits are growing, and central banks worldwide have shifted to accommodation mode.  What is there not to like?  Well, since you asked, how can a bearishly biased guy like me not jump on that grenade?  For starters, valuations are pushing historical extremes, with the forward price-to-sales ratio on the S&P 500 hitting a record 2.87 (red line) on Friday (see chart below from Ed Yardeni).   

Certainly, valuations alone have shown themselves to be a secondary fundamental variable in the post-GFC era, where liquidity, policy (both monetary and fiscal), capital flows, and the growth of passive investment have become more dominant forces.  But, ignoring them entirely is imprudent as it masks the nonexistent ‘margin of safety’ with an S&P 500 trading at a forward P/E of nearly 22x.  It is not implausible, as we are all witnessing in real-time. As long as growth, inflation, interest rates, employment, and corporate profits are trending in the right direction, they are likely to stay at these levels or even drift higher. Still, all investors need to be mindful of an air pocket should any or several of these variables encounter turbulence. 

As for the Fed, markets are repricing a bit following last week's stronger-than-expected September jobs report and slightly hotter-than-expected inflation prints.  WSJ Fed reporter Nick Timiraos highlighted last week that nearly all Wall St. economists and other professional Fed watchers expect the Fed to cut rates by 25 basis points at each of its next two meetings:

Why this is interesting is because market-based odds of the Fed doing nothing at the November meeting have gone from near-zero to above 10%.  The case for going 50 basis points at the last meeting and not 25 basis points was the concern over the labor market – but the last employment report quashed those fears, at least for the time being.  Then we got the CPI and PPI inflation reports last week that came in above expectations, and now you have the makings of a data backdrop that gives the Fed latitude to hold the line right here if it wants to.  The Fed is data-dependent but not data-point dependent, and unless things begin to cool off in the economy during Q4, the case for the Fed to head back to the sidelines is there.  Not to mention that inflation prints (as priced by the market; see the chart below from The Macro Tourist) throughout the balance of 2024 are expected to show a reacceleration of inflation (these will be reported in November, December, and January).  Sure, they are expected to roll back over as we get into the Spring/Summer of 2025, but that is a lifetime away as it pertains to markets.        

The 10-year T-note at 4.10% is up 48 basis points since the Fed’s 50 basis point cut on September 16th and very well could matriculate to 4.5% if the data stays strong and the Fed goes on hold.  That’s not my base-case scenario, but it’s definitely plausible.  If this were to play out, I would expect the equity markets to have more downside risk than upside opportunity.  The same would apply to commodities, emerging markets, and anything negatively correlated to the U.S. dollar, which would likely be well bid.   

This is a very interesting setup where the Atlanta Fed’s Nowcast model has just been updated to show +3.2% annualized growth for Q3 from +2.5%, so growth is solid, and inflation is set to tick up. 

On the surface, this backdrop does not warrant any more rate cuts, and if anything, an argument could be made for rate hikes.  Once again, this is not my base case, but humor me for a moment as I script out a plausible alternative scenario.  However, if the Fed continues its cutting cycle, one might suspect it is doing so to bail out the fiscal profligacy being propagated by elected officials.  After all, Washington spent $6.8 trillion this year, a 10% YoY increase in federal government expenditures leading to a 2024 fiscal year budget shortfall of $1.8 trillion.  And from what we see on the campaign trail from both Harris and Trump, neither has any inclinations of dialing back on spending, but rather to spend more – it's just that it is for their constituents, which each thinks makes it justifiable.  The two assets to watch are gold and the U.S. dollar.  Gold has rallied all year (+28% ytd), both when the dollar has been strong and weak, but it has had a lot more gitty-up when the dollar was sliding.  A Fed that continues to cut with strong U.S. economic growth, a solid labor market, and stable to rising inflation is a recipe for financial repression on steroids.  Such an environment warrants a meaningful lean in portfolio allocations in favor of real assets (stocks, commodities, precious metals, emerging markets, and real estate) over financial assets (cash, sovereign debt, and long-dated debt in particular).

I’m going to sign off this week’s missive with a piece from Luke Gromen’s “Forest For the Trees” publication – I found it both interesting and thought-provoking.  That’s not to say I totally agree with it, but it is something I definitely have been and will continue to think a lot about:     

There is a widely held view that, “AI and robotics will drive up productivity, which will drive up GDP & employment, and drive down US debt/GDP”

Tree Ring: One pushback we have heard regarding our ongoing point that AI and robotics-driven deflation are fundamentally incompatible with our debt-based monetary system is that “AI and robotics will drive up productivity and people that lose their jobs will find new things to do, which will drive up GDP and employment, and therefore drive down US debt/GDP.”  

On the surface, that makes sense, and so we wanted to see what the data said empirically.  What we found was that while it made sense on the surface, empirically that was wrong.  This has massive implications for macro from here.

The chart below shows US Employment/Population ratio (blue) v. US debt/GDP (red), from 1965-present.  From 1965-2000, US Employment/Population ratio rose secularly while US debt/GDP barely rose, and from the early 1990s to 2000, actually fell.  I.e., from 1965-2000, the “pushback” view held…but in 2000, something broke.

In 2000, US Employment/Population ratio peaked secularly, and it has fallen for 25 straight years now – i.e., productivity gains are NOT leading people to find other work or to “pursue meaning”; it is leaving them structurally unemployed.

Also in 2000, US debt/GDP bottomed secularly, and it has risen for 25 straight years now (other than in 2015-16 when Obama implemented the austerity program he called “ACA” (Obamacare) and in 2020-22 when US real rates were significantly negative) – i.e., productivity gains are NOT driving lower debt/GDP; they are driving HIGHER debt/GDP.

The implication of the chart above is simple, stark, and critical to grasp for macro: If AI and robotics ever do even directionally what the AI and robotics optimists think they will, they will drive the US Employment/Population ratio DOWN faster, and the US debt/GDP ratio UP faster.

From there, the Fed and Treasury (and all global Central Banks) will face a simple choice: More fully reserve the sovereign debt that backs their banks and the global monetary system by printing money and putting most of the sovereign debt on their balance sheet, or let the system fail.  As we noted last week, gold and BTC win either way.

In all likelihood, the Central Banks of those countries with “good demographics” (growing populations, either organically or via immigration) will ultimately likely have to print more and possibly sooner than those with “bad demographics” (shrinking populations), but that is an issue for down the road.  

One last observation: The above is partly why the Fed must be VERY careful about overtightening into a recession – if they get this trend going in the wrong direction by knocking down employment faster, the already yawning gap between Employment/Population ratio and US debt/GDP will blow out nonlinearly.

The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.

Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.