What’s Going On?
October 25, 2024
It was a pretty slow week on the data front, but not uneventful. The financial pages were filled with spreads on why bond yields have risen as much as they have since the Fed cut the policy rate by 50 bps to 5.00%. For example, the yield on 5-year US notes, on which I base my neutral rate calculation, rose by 65 bps, attributing 40 bps to real growth, and 25 to what the bond wonks call term premium, which refers to the extra compensation demanded by investors for the risks of holding government debt over a longer period of time.
This latter point makes sense to me because bond volatility has not only surged, but gone through the roof. The MOVE Index, formally known as the “Meririll Lynch Option Volatility Estimate”, a barometer of sentiment and uncertainty for assessing potential risks in the bond market, rose from a low of 90.1 to 129.3 in just 1 month, up a whopping 45%.
In spite of all the brouhaha surrounding the potential of a red wave election, which would understandably ease the implementation of Trump's economic plans’ possibly nefarious effect on inflation, it has not been able to destabilise the stock market rally. The S&P 500 closed at 5808 on Friday, down only 57 points from last week.
As far as I'm concerned, Trump's trade talk is simply talk. Contrary to what the media seems to believe, the steep rise in bond yields is really about a no-landing scenario. The economy got off to a good start in Q4, a pair of S&P surveys finding that US manufacturing PMI had stayed negative, but crept up, while the service index edged up above 55 for an exceptional reading. The New York Fed Staff Nowcast is predicting a 2.6%(saar) growth for Q4. Meanwhile, a survey conducted by S&P Global revealed that businesses were adopting competitive pricing, which in turn helped drive selling price inflation for goods and services down to the lowest level since the initial pandemic slump in early 2020, suggesting that these weaker price pressures are consistent with inflation running near the Fed’s 2% target.
This could keep on going because the money supply is currently running at the annual rate of 6.0%, which is harmonious with solid growth and price stability. In this connection, it is conceivable that international speculators were reinstated and are back in the fray, taking advantage of the yen and euro carry. These traders have borrowed yen and euros for substantially less than they could have in the US (3.25% and 1.95%), and at the same time have profited from the rise in the US dollar. In the past 4 weeks, the USD, expressed in yen, increased 6.6% to 151.67 and in euros 3.0% to 92.67.
P.S. 1: On the cusp of a “lost decade”. There are a lot of things to like about the state of the current stock market, such as solid economic growth, falling inflation and strong earnings. David Kostin, Goldman Sachs’ chief equity strategist - the best and brightest - believes that the S&P 500 will attain 6,000 before year-end and crawl to 6300 in 2025. Nonetheless, he created a furor on Wall Street, following a strong statistical argument that it won't do any better than 3% per year over the next 10 years, compared to an average return of 10.6% on 10-year rolling periods since 1930. Some blame is put on the metric-rich S&P 500 evaluation, whose forward P/E has increased 45% from 15.3 to 22.0 since October 12, 2022.
However, the bulk of the accusation falls in the extraordinary concentration on the recent runup on 8 highly profitable tech giants, plus Berkshire Hathaway and Eli Lilly, with the resulting 10 names accounting for 35% of the market capitalization of the S&P 500. While history is inimical to the idea that winner-take-all businesses can maintain and expand their lofty levels of sales growth and profit margins forever - think IBM, Kodak, Xerox, Cisco, General Electric -, it remains that Goldman Sachs doesn't know the future any better than we do. Long-term returns of 3% or less have happened just a few times - only 9% of the time since 1926 - and usually correspond to rare catastrophes like the Great Depression of the 1930s, the Stagflation of the 1970s and the Great Financial Crisis.
The problem that I have with Goldman Sachs’ grim forecast is their lack of taking into account the probability of the ongoing productivity boom extending into the 2030s, as more and more companies across all industries reap the spreading benefit of AI, updated robotics, and innovative software. Acknowledging that companies have embedded pricing power at a time of robust productivity growth, which tends to lower unit labour costs, such a combination would keep profit margins strong and revenue growth positive. In this regard, it wouldn't be unreasonable to clock the annual rate of growth for the S&P 500 earnings per share at 5.75% over the next 10 years should employment, productivity and inflation increase at an annual rate of 1.25%, 2.25% and 2.25% respectively for the comparable period. This tantamounts to a pretty robust business environment.
P.S. 2: Who are the Buyers of US Treasuries?
The U.S. budget deficit grew to $1.8 trillion in fiscal 2024, which ended on September 30, as health care services, military spending and social security payments grew to record levels. The federal budget deficit was up 8% or $138 billion to 6.3% of N-GDP. A pertinent question is who have been buyers in the last 12 months? Given that the Federal Reserve has shrunk its balance sheet to the tune of $500 billion, and central banks in the rest of the world have ditched roughly $100 billion worth of U.S Treasuries, the buyers must have been both foreign and domestic investors including seekers of short-term liquidity.
Foreigners have poured approximately $800 billion into the US not because they like the state of the union, but because of America’s enduring superiority in economic growth, technological advancement, physical geological isolation and defence capability. While the latter is all fine and dandy and does inspire confidence, there is perhaps a structural shifting in the buyer base from price-agnostic buyers of US Notes to price-sensitive investors, which is appalling and dangerous. When one combines this with growing concerns over the size of the Federal deficit and where it’s going from here, there is little wonder why the term premium is back where it should always be in the first place.
P.S. 3: The Incredible Odd Performance of Gold
The gold price has not only failed to respond in its usual predictable manner, to inflation, money supply, real interest rates and the dollar, but the conventional relationship between the aforementioned variables has broken down. Strangely, gold mining stocks have not been able to keep up either. Year-to-date, gold is up 35%, and almost 8.0% to $2750, since September 17, when real rates started to rise. It begs a question: who is doing the bidding? According to the World Gold Council, it's not the central banks. They did buy a lot of gold in 2022 and 2023, but not in 2024. The Journal came out with a very revealing article a few days ago, saying that Chinese residents have rushed to get money out, using everything from crypto to fine art and perhaps gold to escape China’s strict capital controls.
We’ve reduced our gold exposure from 8,5% to 5.5%.
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