The Air Is Getting Thinner Up Here
Global equities continued their march higher last week, with the Dow moving above 40,000 for the first time since May 17th (up +1.6% on the week), the S&P 500 climbing +0.9%, and the Nasdaq Composite gaining +0.3%. Last week, better-than-expected inflation data triggered a growth-to-value rotation into value and small-caps, with the Russell 2000 surging +6.0% for the week as it rose to its best level since January 2022. If current levels hold through the end of the trading day today, with the Russell 2000 up +2.0% as I type, this will mark the fourth straight session of at least +1.0% gains for what was a battered market cap segment of the equity market.
Meanwhile, the S&P 500 Equal Weight index rallied nearly +3.0% last week as hopes rise that the Fed just may be able to engine a soft landing – I still retain some skepticism on this outcome, but such a view is inconsistent with how equities are trading. So, I’m not fighting it, but it’s disingenuous of me not to admit to having my antenna up. For the moment, capital markets are embracing the goldilocks backdrop of inflation retreating to the Fed’s target and growth slowing, but if economic data continues to slow like we saw last week, there will be a point in the future where slowing growth worries supersede falling inflation and a Fed rate cutting cycle.
Economic data has been visibly slowing across the board over the last two months, and the combined performance of both ISM indices in June attests to this reality. The manufacturing and service sector composite slid from 53.2 in May to 48.8 in June – this takes out the nearby low of 48.9 in December 2022 and is the lowest reading since May 2020. It has been below the 50 level (the level that indicates expanding or contracting activity) in two of the last three months, and the most recent reading is at a level you are more likely to see in a recession than in an economic expansion.
Furthermore, the combined prices paid index has fallen for back-to-back months to its lowest point of the year and is -9 % below the long-run norm. This signals that inflation will continue to slow and that the Fed is operating on borrowed time in its ‘higher for longer’ policy setting. The combined employment indices have been below the cut-off level for growth (100.0) in each month dating back to last October. This growth slowdown is corroborated by the Atlanta Fed Nowcast model, which forecasts Q2 real GDP growth to come in at +2.0%. It is not a scary number on the surface, but when you peel back the onion, you learn that +0.7% of that stems from an inventory build. The St. Louis Fed model is down to +0.68% for real GDP growth (from +1.25% a month ago and +2.3% in mid-May), and if that number is on the mark, it will be a big surprise to risk assets.
Look, I know it's difficult to entertain the notion that recession probabilities are on the rise at a time when the S&P 500 is logging all-time highs daily, but incoming economic data (from consumer spending to housing to manufacturing and industrial production) is not telling a similar story. This is why it's hard for me to get too excited about a sustained ‘growth’ to ‘value’ rotation in stocks. Slowing economic growth favors growth companies, not value, because value companies are more reliant on higher interest rates (not falling), rising inflation (not declining), and vibrant/accelerating growth (not slowing).
Equity market bulls definitely have the upper hand (and I’ve been one) based on price action, but recent gains are incongruent with fundamentals. Sure, earnings have risen over the past year, but the advance in the S&P 500 over the past 12 months is three times the rate of earnings growth. Talking heads can get away with saying that this is an earnings-driven rally, but it’s a bit disingenuous when you leave out the magnitude of the difference between the two. The S&P 500 trades at a historically rich 21.6x forward P/E multiple or a 4.6% earnings yield. Admittedly, valuations haven’t been the best investment guide over the past decade and a half, which has been driven more by flows, technicals, and policy, but they do matter. When they do, investors will want to understand what margin of safety they do or don’t have.
Meanwhile, investment-grade corporate paper offers yields in the mid-5s, and two-year T-bills are paying a safe and secure 4.5%. Don’t get me wrong; over the long term, equities are vastly superior to fixed income for a whole host of reasons, but right here and right now, I find the risk-adjusted return profile of short-term fixed income alluring. The U.S. equity market is the most concentrated it has been since the late-1990s. Positioning is skewed toward the bull's side of the boat, particularly at the household level, with the latest data showing 401k plans exposure to equities at 72%, the highest level since January 2001. Not to mention sentiment is reaching bullish extremes, with the latest Investors Intelligence survey showing the bull camp up to 63% (above 60% is at the high end of the historical data) and bears below 18% (below 20% is the low end of the historical range).
As for interest rates, the yield on the 10-year T-note closed out last week at a four-month low of 4.19%. Its yield is down more than 50 basis points since its April peak, and following last week's inflation data, futures markets are pricing in 94% odds of a rate cut at the September 18th Fed meeting and 100% odds of at least two rate cuts (25bps) by the end of 2024. Odds for three rate cuts have climbed to just over 50% from less than 30% a week ago. While the CPI and PPI data are encouraging from a Fed-policy perspective, the details reveal a loss of corporate pricing power, especially in the most cyclically sensitive sectors (last week's bank earnings showed just this) that populate the value index. This is one of the primary drivers that restrains me from thinking there is any sustainability in a growth-to-value rotation.
The Fed is now behind the growth curve regarding rate cuts, just as it was behind the inflation curve with rate hikes back in 2021. But this is the nature of the beast; the central bank is always slow to react at phase transitions and in both directions. This is one of the ingredients in the economic cocktail that explains why we have business cycles. By staying on hold at this juncture with inflation falling, the Fed is de facto implementing a backdoor tightening – real rates are rising. The U.S. economy is on the backend of digesting one of the most massive tightenings in real rates in history: the 10-year real interest rate, as measured by the Cleveland Fed, bottomed at -40 bps in August 2020 and now sits at 205 bps (a 245 bps rise in real rates). That is the largest increase since the start of 1982 and larger than the 204 bps of tightening from May 1983 to July 1984.
According to the Fed’s updated R-star assumption of 2.75% (R-star is the rate at which the Fed thinks interest rates are neither accommodative nor restrictive), the Fed would have to cut the Fed Funds rate 250bps (10 cuts) before policy would be accommodative. Once the Fed moves, the markets will be quick to price in more. Recall that following the November 2023 Fed pivot in policy bias, we came into 2024 with expectations that the Fed would cut seven times and the yield on the 10-year T-note slipped to 3.8%, but that proved to be way too premature a move by Mr. Market with the yield moving back up to 4.7% in April and Fed cut expectations drifted down to just two cuts at most.
All roads lead to a Fed removing its excess restraint over the coming months and quarters. The pace and magnitude will be governed by incoming data where faster and deeper cuts will be a negative for risk assets as they would most likely coincide with an economic recession. Slow and steady calibration cuts would be consistent with a successful soft landing.
Luke Gromen’s latest FFTT publication turned me on to the recently published BIS Annual Economic Report, “Laying a robust macro-financial foundation for the future” where the acknowledgement of fiscal pressure points caught my attention:
“The environment of higher interest rates further weakens fiscal positions that are already stretched by historically high debt levels. Indeed, the support from the negative gap between real interest rates and growth rates (that is, r–g) has shrunk in recent years, is projected to stay much smaller going forward and could even turn positive. Curbing fiscal space further is rising public spending in the coming years, given the needs stemming from the green transition, pensions and healthcare, and defence. Though financial market pricing points to only a small likelihood of public finance stress at present, confidence could quickly crumble if economic momentum weakens and an urgent need for public spending arises on both structural and cyclical fronts. Government bond markets would be hit first, but the strains could spread more broadly, as they have in the past.”
There is a lot of valuable information in the report, but humor me as I cherry-pick this section to highlight a structural force I think investors need to be thinking about. There are a lot of important differences between the U.S. economy and its financial system relative to emerging markets, but the burgeoning debt situation in the U.S. is becoming emblematic of what you see in emerging markets. The reason this is important is that in emerging markets with high debt and deficits, when growth slows to the point that it threatens to make the sovereign’s debt unsustainable (threatens to touch off a debt spiral), government bond yields in those nations rise on slowing growth and/or recession.
The fact that the BIS is openly writing about this dynamic in its annual publication is noteworthy because it implies that this debt paradox is starting to become institutionalized. No, it’s not consensus or mainstream yet, but the heavy hitters and big-picture thinkers are starting to game this out in markets. Game out the possibility/probability that Western sovereign debt (U.S. treasuries included) will sell off any time growth (“g”) gets too low relative to interest rates on sovereign debt (“r”). How this would look in capital markets would be to see real assets rally relative to long-term treasuries during periods of economic weakness, i.e.) Nasdaq, S&P 500, gold, bitcoin, and commodities are rising in value relative to Treasuries. Precisely what we have been seeing over the last six months as economic growth has decelerated, yet long-term Treasuries remain down on the year while almost everything else has generated a positive total return.
No, this is not a get-out-of-jail-free card where investors can take risk with no consequences or that they should never own bonds again—there will be moments when this relationship breaks down—but structurally, I think it’s the right approach for how investors should view this dynamic. As long as sovereign debts and deficits continue to rise with little to no semblance of fiscal rectitude coming from political leaders then investors should and will continue to shift their capital into assets that better protect purchasing power as these policymakers are forced to implement policies that keep interest rates (“r”) lower than growth (“g”) in order to maintain the solvency of the system.
The following chart from Luke does a great job illustrating the evolution of this dynamic over the last six decades using “debt as a % of GDP” and bubble narrations of various periods. This chart also illustrates the degree to which the U.S. economy has fallen subject to ‘hyper financialization’ (its fiscal standing and economic performance becoming dependent on the performance of asset prices) with a change in debt/GDP dynamics occurring post the popping of the Tech bubble in 2000. Where debt-to-GDP now rises even in good times and rises dramatically during economic downturns.
It's concerning to see U.S. debt to GDP rising again despite stocks at all-time highs, house prices at all-time highs, and nominal GDP (“g”) above 10-year Treasury yields (“r”). A dramatic and sustained slide in asset prices causes this debt dynamic to rise dramatically, which starts the domino chain of the U.S. treasury market becoming dysfunctional. This is a slow-moving train wreck that could derail in a month, a quarter, a year, or several decades from now. The timing is unknowable, but being aware of signs to watch and how to be positioned as it evolves is paramount. The bottom line is that over time, the economy and financial system will require larger and larger doses of liquidity and structurally accommodative monetary policy to function normally (or what we understand to be normal). As a result, real assets and equities will remain superior investments relative to long-duration bonds for as long as this dynamic persists, but they will also require a stronger stomach as volatility and sporadic periods of extreme swings will occur.
One last comment before signing off, and it's on the political front. The market is starting to price in increasing odds of a Trump return to the White House and a GOP sweep come November. This weekend's assassination attempt on the former President appears to have given him a ‘sympathy’ boost, much like the Gipper got back in 1981. I am going to refrain from any further comment on politics as the subject has become so charged that it’s as though it has taken the baton from religion in its ability to divide society and become a spark plug for igniting ugliness. However, politics, as it relates to policy, is 100% on the table. A GOP sweep would have significant implications in that it means Trump’s tax cuts get extended, and potentially even more tax relief comes our way. Deregulation remains part of his platform as well as a heightened focus on tariffs and trade. Still, there probably won’t be much change in regards to fiscal probity as today’s Republicans may well have less regard for fiscal discipline than Democrats. What this would mean for inflation is a question mark. Most assume a Trump victory means higher inflation, but that was also the expectation during his term from 2016 – 2020, yet the inflation rate under his presidency went from +2.5% to +1.4%, with +2.9% being the highest it ever reached. Let’s face it the economy did well during this period and when you remove the pandemic (which should be done because never in history had an economy had to be such down and then reopened) 7 million jobs were added under his leadership.
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