There’s some funny things are going on in equity markets at the moment
I posted a LinkedIn article a few weeks ago (access it here) highlighting that Gross Domestic Income in the US has been negative whilst GDP has been positive, even though they are essentially the same thing. It got a lot of attention – but that just scratched the surface.
We’ll look at things on the economic front, then the US equity market to draw out some questions, we have been asking internally.
Equity markets are rallying on the back of 3 big line items, supported by a 4th assumption essentially making the 4 legs of a chair:
- Strong positive GDP
- Reducing Inflation
- Robust employment
With the underlying assumption interest rates will be cut in 2024 – this makes the unstable 3-legged chair a solid 4-point-of-contact chair to base equity market bullishness upon.
Our job is to question these sorts of narratives, and if the evidence proves we are wrong, for us to change our positioning accordingly. So, to dissect this argument, we will first look at the economy, as there’s a lot of things below the surface that paint a different picture.
On the surface, the US economy seems (and is) strong. However, employment, GDP and even inflation are generally lagging indicators, it pays the well researched and informed investor to be looking to the future, not just the present or past to make investment decisions (we’ve all heard of analogies of driving whilst looking in the rear-view mirror). When we dig into some more nuanced components of the US economy we find the below:
- Yield curves remain inverted, signaling softer conditions in the future
- Manufacturing PMI’s are in contraction
- nonfarm payrolls missed expectations
- Gross Domestic Income is negative
- retail sales are missing expectations
- new home sales are worse than expected
- housing starts are less than forecast
- Temporary workers YOY are negative
- productivity is negative year-on-year
- we’ve started to see earnings downgrades; and…
- Fitch just downgraded the US’s credit rating from AAA to AA+
There is a plethora of indicators outside the basic GDP and Inflation data pointing to more difficult times ahead. More than just the above though, if GDP remains strong and continues to surprise on the upside whilst employment remains strong, why would the Federal Reserve start cutting rates? The market seems convinced that the Fed will be cutting rates in 2024, as we’ll go through below. I know, the argument is that inflation is also falling – but something seems to have been missed by many participants, and that is that the base effects that caused inflation to be extremely high early in 2022 (because it was coming off a low base), and that inflation started to fall meaningfully YoY to now has been because the starting rate 12 months ago was high – both of those are gone. Now the base, or 12 month prior monthly inflation reading is only moderately high, not extremely low or extremely high. Research done by Jim Bianco of Bianco research tested a number of scenarios – if we continue to run at the average inflation rate post COVID of 0.41% per month, what would that look like? By December the inflation rate will be back up to 5.31%. If we average the pre-COVID .16% monthly inflation rate, US 12 month inflation be 3.91%. Finally, he asked what would happen if inflation reached an extreme of 0% MoM to the end of the year – and found we would still have an inflation print of 3.15% – well above the 2% target.
So where is this euphoria that falling inflation combined with high GDP and employment getting its 4th leg of the chair to fuel the rally – that rates will be cut? Why would the Fed cut rates if inflation is still persistently high, employment is strong and the economy is doing fine? We don’t know, yet the stock market is pricing in meaningful cuts in 2024:
Source: Bloomberg and Innova Asset Management
If the Fed were to cut rates into a strong economy and still high inflation, they would likely cause a stock-price bubble that could have devastating after-effects when it pops – and they know this – not to mention they would fan the flames of a second wave of inflation. So why would they cut? Either the economy would need to break or the stock market break – or both for them to consider cutting rates when inflation is still above their 2% band.
Now we turn to the market. This is where things have gotten really strange:
- long duration stocks fell the hardest in 2022 as rates rose because the discount rate went up, and they earn the majority of their cashflows in the future (meaning that if the discount rate is higher, those future cash flows are worth less today)
- This year, rates have stayed high and even risen further, yet these same stocks have rallied, presumably on the assumption of rates being cut in 2024
- But rates can’t be cut unless there’s a reason to cut them. Just bringing inflation in line with expectations (which is unlikely) will not be enough to trigger rate cuts, there needs to be some form of weakness somewhere that they are trying to stimulate by cutting rates – this is likely to be economic weakness, poor employment numbers or a stock market crash
So something is not adding up in all this. The ‘Goldilocks’ soft-or-no landing scenario is being assumed to coincide with rate cuts – but if it were to occur (and the 11 points we highlighted above suggest it’s actually a low probability of occurring) then there’d be no reason to cut rates. Unfortunately, the maths just doesn’t add up.
Technology businesses, almost by definition, are interest rate sensitive – they trade on high valuations as it is assumed that meaningful cash flow will be earned a long time out to the future. This makes them very interest rate sensitive. If interest rates go up, the value of those future cash flows goes down (one way is via the discounting mechanism in the Discount Cash Flow [or DCF] model favoured in academia and amongst practitioners). This means as rates go up, the future cash flows are worth less – this makes intuitive sense, if future interest rates are higher, then the cash flows earned in the future don’t offer as high a premium over them (i.e. the difference between them is smaller – so the price you pay for them should be less).
We saw the effect of this occurring from the beginning of 2022 to the end of ‘22 – rates went up, and tech-heavy (we’re using the Nasdaq as a proxy), interest rate sensitive stocks went down (in the chart below the teal arrow goes up, the magenta arrow down). Then, between Jan and March 9, interest rates fell, causing tech stocks to rally (red arrow down, green arrow up). March 10 signified a meaningful change in the market – the collapse of Silicon Valley and Signature banks resulted in a meaningful increase in rates, which have trended up ever since – but for some reason the interest rate sensitive tech-sector continued to rally as well (marked by the black arrows below):
Source: https://fred.stlouisfed.org/; Innova Asset Management
This latest move is what doesn’t fit – it breaks with logical, fundamental reasoning. The rally in interest-rate sensitive US equities into the face of higher rates gives us pause. No matter what the bulls argue, this makes no fundamental sense. Euphoria, guessing who will be the next big winner in the A.I race – we’ve seen this playbook before throughout history. Punting on who you think the winner will be assuming you have a 20 year time horizon… well, that’s an investment strategy, but don’t forget – online retail giant Amazon was one of those winners, but before becoming one it’s stock went from $5 to $0.46, and Microsoft dropped from $58 to $22 – both went on to ultimately achieve enormously higher highs, but you had to wait 16 years for Microsoft and 11 years for Amazon to make your money back, before they REALLY took off. So, investors in expensive generative A.I. stocks may ultimately be proven right, but rather than waiting 10 years just to make your money back before you make the real gains, there’s plenty of safer places to park your capital in the meantime.