by Hubert Marleau, Market Economist, Palos Management
October 18, 2024
A month ago, the Federal Reserve delivered to the market two big things - a supersized 50 bps interest rate cut, sending a strong signal of more chips to come. The good news was that the deflationists will have to keep on waiting for a contraction to happen, while the bad news was that inflationists were given a free pass.
While the current path of inflation is encouraging, the bond market and its derivatives have sent sceptical messages that it is still not “mission accomplished”. My take is that investors have manifested more confidence in near-term inflation pressure easing than over the mid-term, i.e. since September17. This give-and-take between a near-term and mid-term inflation outlook has caused a lot of bond-market volatility and a serious flattening of the yield curve. For the period under consideration, the ICE BofAML MOVE Index rose to 122 versus 100, as did the spread between 10-year Treasury yield (4.10%) with 3-month T-bills (4.65%) widening to -55 bps from -125.
The U.S. economy may have once again dodged a recession; however, median inflation has increased to 2.7% at the 3-year horizon and to 2.9% at the 5-year one, according to the NY FED’s Center for Microeconomic Data. Interestingly, the swap market predicted on Friday that year-over-year consumer prices would be 1.2% in one year’s time but 2.9% in 2026.
There are several headwinds for inflation over the horizon: Fed overstimulation risk, unrelenting fiscal deficit spending, abrupt decline in immigrant labour supply, broadening restrictions, generalised deglobalisation, restrictive regulations and the clean energy agenda. Yet I don't believe that investors should succumb to these fear-driven predictions that inflation brings about. I understand that corrections, stemming from rising inflation, can bring inevitable market corrections. However, this time may be different because the economy is on the brink of an AI-driven productivity boom. The Atlanta Fed’s GDPNow tracking model raised Q3’s real GDP growth rate from 3.2% to 3.4% on Thursday, suggesting that an 2.1% annual rate of increase in labour productivity had likely been achieved. Productivity gains and rising inflation, combined with more wealth transfers to the public, stemming from the government deficit spending, should bring higher before-tax corporate earnings. Not fearing the potential nefarious effect of the growing national debt, stocks have kept on rolling up. The S&P 500 closed at 5865 - a new all-time high -on Friday, registering a weekly gain of 50 points or 0.9%.
P.S 1: “American Exceptionalism” has incentivized an avaricious foreign appetite for U.S. assets. In the quarter ended June 2024, international investors poured $1.4 trillion into the economy and financial systems, notably through purchases of stocks and bonds and direct investments plus financial transactions, bringing it to a staggering total of $58.5 trillion. Significantly, foreign claims on equity and bond portfolio assets totalled $16.7 trillion and $15.4 trillion respectively, while equity-related foreign direct investment amounted to $14.8 trillion. The remaining $11.6 was tied up in financial derivatives and other investments. What is particularly interesting is that Americans are relatively less inclined to part with their own capital, as their foreign investments amounted to only $36.0 trillion. In other words, foreigners have invested $22.5 trillion more in the US than Americans have in the rest of the world. This works out to an increase of $4.3 trillion from last year. As a result the U.S.net international investment position ($22.5 trillion) is 77.5% of the N-GDP. (As an aside, wealthy foreigners, who have decided to leave their country, are choosing UAE, US, Singapore, Canada, and Australia.)
P.S. 2: According to 2⁄3 of economists polled by Reuters, the Bank of Canada will cut its policy rate by 50bps on October 23. Headline consumer inflation slowed to 1.6% y/y, comfortably within the 1% - 3% range the central bank seeks.
P.S. 3: An adult discussion on the national debt is needed. The US federal budget deficit for the fiscal year ended September 2024 stands at $1.8 trillion representing 7.2% of the gross domestic product, the third highest in history. Unfortunately, we are not about to get a political response. It is indeed striking to observe that solutions used in the past to fix possible public debt crises like inflation, spending cuts, capital controls, or interest cancellations are left out of the political debate. The balance of power between taxpayers, wage-earners, pensioners and bondholders is just too chaotic to resolve the issue. The last time the US government had a surplus was 23 years ago under Clinton's administration. It was engineered by a bipartisan approach and effort. Today, there is no apparent political commitment to narrow the deficit, let alone the $36 trillion debt. Are there concerns about this? Definitely, in some quarters. Crossborder Capital, a highly reputable research organisation in London, insists that in a world dominated by debt financing, a large pool of liquidity has become necessary to grease the weight of the financial sector’s balance sheet. What is worrying is that roughly 3 in every 4 trades now made through financial markets simply refinance the roll-over of existing borrowings. So far so good, but regrettably, liquidity is cyclical.
I cannot tell you when but a day of reckoning is fast approaching. Incidentally, the default swap market for over 100 S&P 500 companies is faring better than for the US government itself. I cannot remember the source, but I did come across this fact.
Thankfully, a small number of Congressmen and Senators have become aware that something needs to be done. I think more of these types are bound to join this small gang of conscious and attentive politicians.
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