Good afternoon, and welcome to the August Eye
On the Market audio/video podcast.
I'm not really in San Francisco.
That's just a Zoom background.
But I have this fancy new microphone, because some of you
have commented that the audio from my iPhone headphones
is terrible.
So I now have a professional Edward R. Murrow-style
microphone.
And you'll be able to see this on video
if you're accessing it through our website rather
than the Spotify or Apple Podcast portal.
Anyway, welcome to the August Eye
on the Market audio-visual extravaganza.
So I-- like everybody else, I'm somewhat
surprised that despite 400 to 500 basis points of tightening
in the US and Europe and a very weak Chinese recovery,
the equity markets are up globally about 18% this year.
And Q3 GDP looks like it's globally going to hang in
and still poised for around 2%.
So the reason I'm calling this the Rasputin recovery is
if you remember the legend around Rasputin, which
is almost certainly false-- but he was I think beaten,
poisoned, shot twice, and then finally drowned before he dies.
And it's a proxy for how I see the global economy right now.
No matter what the central banks are throwing at it,
it continues to exhibit some resilience.
And the same goes for the equity markets as well.
How can we explain this?
Well, the obvious catalyst is the decline
in inflation surprises.
So we've got a chart in here that shows for the US
and globally what those inflation surprises looked
like just in the beginning of this year.
And they have collapsed.
And whether you're looking at core inflation, trimmed
inflation, sticky price inflation, median inflation,
and then a bunch of other measures related
to supply chains and the jobs workers gap,
the inflation outlook has cooled, more or less, the way
the Fed thought it should.
It just took them another year or so before it
started to happen.
And that's the obvious big catalyst,
but I wanted to walk through six other important catalysts
so that everybody understands where we are,
why the markets are doing this well,
and where we go from here.
I think the biggest surprise to some people
has been a chart that we have showing that
on seven prior occasions, every time the yield curve inverted,
you had a recession.
And it was almost automatic.
And there were very few, if any, false
signals where you had an inverted yield curve
and you didn't get a recession.
So we have a chart in here with these little red arrows
showing that if you look at the yield curve inversion
from three months to 10 years, it
was a really consistent signal.
And as you can see, the yield curve
is mega-inverted right now.
But I don't think this is such a great signal this time around.
And I've been explaining to clients this year
when I've been meeting them that the reason why
that inverted yield curve was such a successful signal,
if you look back, was the yield curve was inverted,
but that's because the short end of the curve
was really high relative to inflation.
And if you look at a chart on the real cost of money
associated with those yield curve inversions,
you saw real cost of money--
2%, 4%, 8%, maybe even 10%.
This time around, the real cost of money
is still barely positive.
So I think it's premature to even look at this recession
indicator inversion thing because the real cost of money
this time around is barely positive at all.
And it's a sign of just how far behind the Fed got relative
to inflation.
The other thing, too, is if you're really
into that kind of yield curve inversion always
predicts a recession stuff, then you've
got to look at the corporate sector financial balance, which
is a broad measure of the profitability
of the entire corporate sector, not just public companies,
net of capital spending and other kinds of transfers.
And in the past, you got a recession
because that corporate sector financial balance
went negative.
This time around, it's still substantially positive.
So if you're into recession indicator tracking,
the corporate sector financial balance would offset the yield
curve inversion signal even if you believed it, which I don't.
The second thing is, yes, the central banks
are starting to take back some of the stimulus,
but if you look broadly across the Fed and Europe and Japan
and the Swiss National Bank, Canada, Bank of England,
and then the relevant comparable entity within China,
only around 35% of the emergency stimulus
from a monetary perspective has been withdrawn.
So there's still a lot of money sloshing around,
and the real cost of money is not prohibitively high.
Those are the first two takeaways
in terms of why things are doing so well
despite 5% higher Fed funds rates
than we started the year with.
The third factor is fiscal stimulus.
And we have a chart here showing the spike, a really big spike
in construction spending not related
to commercial real estate but related to manufacturing.
And that started to happen shortly after the semiconductor
bill and the energy bill and the infrastructure bills
were passed.
There's a lot of money getting spent here.
And more broadly-- this is the amazing part--
the fiscal deficit in the United States
is almost as large as it was at its peak level in 2009
when you had the global recession.
So yeah, there's a lot of monetary tightening taking
place, but there's a lot of fiscal easing offsetting that.
Our partners in the investment bank,
they have a great economics team.
And Mike Feroli and his team wrote a piece
on analyzing what's driving the US deficit.
And that's a lot of little bits and pieces,
but lower income and payroll tax receipts,
drop in remittances from the Federal
Reserve to the Treasury, more cost-of-living adjustments,
higher Medicaid and Medicare outlays,
higher interest on the federal debt, and then, of course,
don't forget about the last one, which
is increased FDIC payments to depositors after the bank
failures that occurred earlier this year.
But the bottom line is there's a lot of fiscal stimulus taking
place.
The fourth factor that has helped
contribute to this Rasputin market and Rasputin economy
is it's going to take a while for higher interest rates
to feed into the corporate sector and the household
sector.
And so there was a chart in here.
And I'll be honest with you.
I can't tell you exactly why this is happening
because it's remarkable.
But it shows-- we have a chart that shows that every time
since the early '70s when the Fed funds rate went up--
in other words, when policy rates went up--
corporate interest payments as a percentage of their profits
went up too.
This time, not only is that net interest payment ratio
not rising, it's still falling.
And now, there's a number of things
that could be contributing to this,
notably companies that have a lot of short-term excess cash
are reinvesting and earning higher rates.
And those same companies, one can infer,
extended duration massively at the low rates.
How ironic is it that the corporate sector understood
the assignment when rates were-- when 10-year rates were
at 1.5%, the corporate sector extended
duration, whereas some of the banks who you would assume
were experts in asset liability management-- some of the banks,
as you now know, extended their asset duration
at the lows in rates while the corporate sector got it right
and extended their liability duration.
I think it's kind of ironic.
But you can see in this chart that the corporate sector
is not really getting hit right now from higher interest rates.
Most certainly, that has something to do with having--
their having extended duration when rates were much lower.
And same for the household sector.
Look at the rate on outstanding mortgages.
That rate has come down steadily and is now around-- let's say
around 3.5%.
So in contrast to Europe, most homeowners in the United States
have long-duration fixed-rate mortgages.
And while mortgages look prohibitively expensive
for new home buyers, existing home owners
have locked in really low rates, which
is one of the reasons why the debt service to income
ratio of the US household sector has gone up
a little bit with higher rates but is still
close to the lowest levels that it's been at since 1980.
So not just the corporate sector has
been resilient to higher rates, but also households.
And housing has gotten hit pretty
hard in terms of starts and permits
and mortgage applications and the normal stuff
that you'd look at.
But housing would have looked much worse if not for the fact
that we have very tight inventory levels in terms
of single-family homes.
We have a chart in here showing that we're still close
to the levels of the last 40 years
or so in terms of the supply of existing single-family homes.
So that tight supply-- now, there's
all sorts of problems related to that
in terms of productivity and employment and labor mobility.
But this time around, it's made the housing markets
more resilient than it might have been to rising interest
rates.
So if we step back and look at the US consumer,
in January of this year, the consensus forecasts
were a consumer-led recession by the summer.
All of the factors I've just walked through
have helped prevent that from happening so far.
And now when you look at those same forecasts,
the decline has pushed out a little bit
but notably doesn't go negative on any kind
of year-on-year or quarter-on-quarter basis.
So the forecast of the consumer slowdown
has changed in terms of both timing and magnitude.
And the other thing-- and this gets discussed a lot,
and I think it should--
households are still burning off massive amounts
of excess savings that they got during COVID
via both fiscal stimulus means and monetary stimulus means.
Here are three different forecasts
from three different parts of JP Morgan we have in this chart,
and they're all pointing to the same thing, which is sometime
in 2024, that runs out.
But that still gives you at least a few months of cushion
where households will have the ability
to spend in excess of their earned income.
Now, even with all of that, just wait.
The leading indicators are still projecting weakness
this fall, Q4, Q1.
We have a chart in here showing you can split leading
indicators into coincident indicators,
meaning the stuff that's happening now,
and leading indicators, which is the stuff that's expected
to happen in a few months.
And the coincident indicators all
look fine, whereas the leading indicators still
look pretty weak.
And so we take a closer look than just
at these aggregate baskets, and we
track 20 or so long-dated leading indicators
that give us a sense for what might be happening anywhere
from three months to six months, nine months, 12 months.
They don't look terrible.
We have a color-coded table in the Eye
on the Market that shows roughly what we're
expecting based on each one.
And there's a modest slowdown expected later this year
or early first quarter that I would
put at something like 1% growth rather than recession.
But that does have implications for how large an equity
market drawdown you might expect, even if there is one.
And a lot of these signals look a lot less malevolent
than they did a few months ago.
Now, of course, the last and the sixth factor
is what's been driving the market this year is the return
of risk appetite in a big way.
So just be aware of that.
This is not an earnings-led recovery.
First of all, the market cap of the largest seven companies
is at its highest level since the 1970s.
It's even narrower market leadership
than during the TMT bubble during 2000.
And you've all read about this.
We've written about it before.
The crowding and growth factor investing
has reached the 97th percentile eclipsed only in the year 2000.
There was a very good piece that the investment bank--
JP Morgan's investment bank put out last week
by the US equity strategy team that gets detail on this.
I cited in the Eye on the Market the name of that piece in case
you want to look at it.
And for those of you that are fans of the Eye on the Market,
just be aware the YUCs are back.
So we track the percentage of overall market cap made up
of the YUCs, which are the Young, Unprofitable Companies.
One of the signals that I wrote about a lot
that I was very worried about where
markets were valued in 2021 and early 2022
is how high this was.
It corrected in 2022 in the fall but now is going up again.
And so just be aware rising YUC shares of the overall market
is--
there's a reason we call it YUC.
I'd rather not be seeing this in terms
of how stable this rally is.
And then I think the most important chart, in some ways,
in the piece we have is one that looks
at the rise in the valuation multiple on the P/E
ratio for the S&P compared to long-term earnings growth
forecasts.
Now, sometimes long-term earnings growth forecasts
take a while to change.
Corporate guidance and the analyst community
have to get on board and reflect what they're seeing.
But undoubtedly, the chart we've got here
shows the valuation multiple has gone up almost 4 points, maybe
3.5 points, without any movement higher in long-term earnings
growth forecasts.
That's unusual.
That doesn't happen a lot.
And there's no escaping the fact that there's a lot of good news
priced into the markets right now
and not a lot of room for negative developments
should they come from Russia-Ukraine war,
global energy and food prices, or anything else.
So I think there's a reasonable foundation for the rally that's
taking place this year because inflation has outperformed
almost everybody's forecasts in terms
of how quickly it would fall.
Wage inflation is declining a little bit more slowly.
And a lot of people were under-invested
at the end of 2022.
They added risk.
I get it.
But I think it's important to understand exactly where we are
at this point in a earning-less appreciation cycle that's
taking place in a handful of stocks.
So just a couple more things.
First, I think this is the best time for risk-averse investors
in 20 years.
So why do I say that?
We have a chart at the end of the piece that
looks at the earnings yield on the S&P, which is basically
earnings divided by price, and we compare that
to the short-term returns on corporate bonds and treasuries.
And they've all converged to somewhere around 5% to 5.5%.
The last time you earned more money on treasuries
than you did on equities was in early 2000.
So it's been over 20 years since a risk-averse investor could
look at the fixed-income markets and consider
them roughly comparable in earnable yield terms compared
to equities.
And that's where we are right now.
So one last thing I wanted to mention,
and I hope I'm not running out of time.
But I normally-- I don't do any press.
I don't have a lot of time for that,
and our compliance people generally get very nervous
when I'm put in front of press people, which I can understand.
But I agreed to do this video podcast of a money
manager called Josh Brown, and he
does an in-depth 90-minute video podcast a couple times a month.
And I joined over the summer.
And the reason I'm mentioning it is at the end of the podcast,
he asks the people that joined for that session
to name a book and a movie that they liked.
And I started thinking about Bidenomics,
which is essentially the United States having
an industrial policy for the first time, really,
in 50, 60 years.
And there's a lot of money that's
going to be spent in terms of direct government spending
or tax expenditures on infrastructure,
energy, semiconductors.
I have questions about the long-term inflationary
consequences here.
How much will it eventually cost to produce semiconductors
in Arizona versus Taiwan?
What's going to be the cost of energy
once you have both the cost of storage
and backup thermal power added on to the cost
of a high renewable system, things
we explore in the energy paper?
So I've got some questions about the inflationary consequences
of this.
But one thing I am optimistic on is the ability for Bidenomics
to reverse some of the damage that was done to manufacturing
communities in the United States after China joined the World
Trade Organization.
I showed some research a couple of years
ago that after China joined the WTO
and then started engaging in currency intervention,
US manufacturing employment and wages plummeted,
and opioid use started rising specifically
in the counties that had the most
intense competitive economic pressures with China.
And so I'm hopeful that the Battery Belt that
will stretch from Georgia up to Michigan and some
of the other monies that get spent here
alleviate some of the pain and suffering in those communities.
And on the podcast, I mentioned the book Empire of Pain
about the history of the opioid crisis and the family
behind it.
And I mentioned the movie The Third Man with Orson Welles
because there's a scene where he's
explaining his justification for his tainted penicillin scheme.
And I thought that that was a nice way
to wrap the whole message up together.
Anyway, thank you for listening/watching.
I hope this all worked, and we'll see you sometime
in September.
Thank you.