Rolling over
May 8, 2024

It’s been over two years since I last published here. Since my last post, when I highlighted risks I saw in the equity markets, the S&P 500 fell roughly 25% from its highs, and then, despite interest rates rising to levels not seen in decades, it proceeded to retake and exceed the previous highs in one of the most powerful rallies in market history.

I haven’t posted in the interim, partly because I was skeptical about the rally, and partly because I have no readership. Both are still true, but now I’m even more skeptical: I think the markets are about to roll over yet again. So here I am with another post.

The rally thus far has been supported by a “wall of worry,” namely the almost-universal belief that the US would fall into recession after the Fed aggressively raised rates to 5% and pandemic stimulus faded. There were good reasons for these predictions; leading economic indicators strongly signaled an imminent slowdown.

Why didn’t it materialize? There are many stories, but these resonate most with me:

1) Fiscal spending was never withdrawn, and deficits were maintained at 6-7% of GDP, levels you’d expect to see in the depths of a severe recession as government spending kicks in counter-cyclically. This time, the counter-cyclical spending came before the economy had cycled, preventing a recession from happening in the first place.

2) The US economy as a whole was less sensitive to rate increases, because homeowners and corporations termed out debt. Additionally, many participants didn’t (and don’t) believe that rates will stay high, so they are “holding” (delaying home purchases, extending-and-pretending with loans, etc).

3) The Treasury muted the Fed’s hikes by opting to increase Bill issuance as opposed to Notes and Bonds which compete with other long duration assets (like equities). Because there was so much cash in money market funds after the pandemic response, these funds absorbed the new debt without any impact on broader markets by simply swapping Bills for an similar Fed facility they had been invested in (the Reverse Repo).

4) Consumers were cooped up for a year and wanted to get out and spend money. Savings rates have plummeted, reflecting changing priorities. The labor market has been tight and brokerage accounts have been bright green, so people haven’t felt the need to rein in their spending as a percentage of disposable income.

5) In a hyper-concentrated stock market, earnings for big tech came in fairly strong on the back of significant margin improvements, driven by cost-cutting and higher pricing. And, of course, a great story emerged with artificial intelligence, igniting a speculative mania. Although the majority of stock price appreciation has come from multiple expansion, higher stock prices reflexively supported consumer spending and company earnings via the wealth effect.

What’s changing?

What a run. I believe it’s now ending, because we are seeing certain things start to roll over.

First, the labor market appears to be rolling over. Although top-level labor metrics have been quite strong, job gains have been driven by government, healthcare, and hospitality jobs. These gains are now moderating, and in the context of much higher immigration, the payrolls miss last Friday seemed like a watershed moment. The household survey is showing jobs in decline, and an estimated 3-4% of Americans are involved in gig work that may be suppressing unemployment and claims.

Second, the low end consumer is clearly rolling over. A growing list of companies is seeing emerging weakness in spending, including Starbucks, Ulta, Citi, McDonalds, and many others. Dollar stores and pawn shops are seeing declining fundamentals and stock prices. Credit card delinquencies are rising and a hangover from opaque buy-now-pay-later credit also seems likely. Surveys of consumer confidence are ringing alarms. Although jobs are available, inflation is inflicting a regressive tax which is hurting low-end consumers. These consumers are being forced to cut spending as pandemic savings run dry or “trickle up” to wealthier households.

Third, corporate margins are likely to roll over soon or at the very least stop expanding. Due to pushback from customers, companies are reaching the limits of their ability to increase prices. Volumes have declined materially; companies have been reporting this for two years, and it’s showing up in freight weakness. Also, it’s unlikely that big tech can repeat the trick of making large cuts to headcount to boost margins. In fact, aggressive capex spend around AI should start to show up in depreciation expenses which will will be a long-term drag on margins.

There are other things rolling over too. Fixed debts are finally starting to roll over, which will materially reduce earnings. UST Bills will have to be endlessly rolled over, and eventually longer term debt issuance should start rising again, likely pressuring yields, although the Treasury seems to be waiting until after the election to announce this.

Short sellers have completely rolled over –– positioning in the market is incredibly bullish, meme stocks and crypto are soaring again, and the “wall of worry” is gone. The market now expects “higher for longer” and believes that this doesn’t really matter for equities or the broader economy. The rapid rebound in stock prices likely cemented the belief among many investors that US equities always rise, and that passive investment into these indices is a no-brainer, regardless of price.

What’s next?

Today we have one of the most expensive and concentrated stock markets in history, with some of the highest margins in history, supported by consumer and government spending that is ultimately unsustainable, in an economy where we have ratcheted up rates abruptly but still have not fully quelled inflation.

Many are predicting a market slide after the election, but my sense is that it may come sooner. A few more weak employment statistics combined with resilient inflation could easily cause mayhem in the markets. The story around AI is pretty compelling — as is the broader story around American exceptionalism and the invincibility of US companies — but it is starting to run out of steam, as the narrative is too far ahead of the numbers. As we begin to roll over, I believe reflexivity will kick in: spending will fall, earnings will fall, stock prices will fall, managers will cut jobs to protect margins, and income and spending will fall further.

Then of course comes the easing. This is where things get tricky. My guess is that the Fed will cut abruptly and deeply regardless of the inflation data. They will assume that inflation will fall along with aggregate demand. What will stocks do? If history is any guide, they will soar, and this expectation is arguably a major reason why they haven’t yet fallen in the first place. However, with a CAPE multiple of 34, higher than at any point during the post-GFC ZIRP era, are stocks even discounting high rates today? If the Fed eases into weakness that actually comes through in lower earnings, we could see multiples go stratospheric. And my guess is that investors will ultimately balk.

My bigger concern is that if the economy wasn’t sensitive to rates going from zero to 5%, why do we expect it to be sensitive in the other direction if they suddenly reverse? The refinancing boom is likely to be much smaller than in past easing cycles (because so many borrowers never had to reset to higher rates this time), and the wealth effect from higher asset prices will be limited because asset prices are starting from such a high level already. It’s unlikely Congress will be able to apply the right kind of redistributive policy mix to support spending.

Furthermore, in every easing cycle since 1980 up to the GFC, we’ve taken rates lower than they were at the previous low — and when we hit zero post-GFC, we used QE to bring down rates across the yield curve. In the pandemic we resorted to outright helicopter money, which caused a surge in inflation, decimating bond markets. It seems inevitable that we will have to do this again, but this time it might be for different reasons. With US deficits already at crisis-level highs, as automatic stabilizers kick in (e.g., unemployment insurance), spending will explode and there is a good chance that investors will not finance it due to fears of another inflation wave. The Fed will have to step in, not just to prevent a yield spike, but also to simply fund the Treasury.

How this goes down in practice will be one of the more consequential decisions in modern American history. There is a decent chance the US could see a form of yield curve control for the first time since the Fed-Treasury Accord after WW2. The Fed may functionally lose its independence, and interest rates and the level of spending and ultimately inflation would be up to the President and Congress. Given the dysfunction in the US government today, this should terrify any rational person. The likely outcome of this scenario is a collapse in the US dollar, capital flight, and multiple dystopian outcomes raised by the hard money sects that dominate much of the conversation on this topic.

However, if there is one person capable of navigating a crisis like this, it is Chair Powell. For all the criticism leveled at him, he has proven to be one of the most pragmatic and principled policymakers in Washington. It is clear he cares about the Fed as an institution. If Trump isn’t able to force Powell out, I expect a replay of the LDI crisis in the UK, where the Fed smoothes extreme dislocations in Treasury markets, but ultimately commits to independent rate policy and long rates that are set by the market. This will force Congress to accept a level of austerity that enables them to sell debt at a price and quantity deemed fair and reasonable by investors. Still, it is likely that fiscal restraint would hit demand and all asset prices fall substantially.

If handled well with smart fiscal policy, this could reset inequality to a lower level, improve many macroeconomic imbalances, and set America up for another multi-decade period of prosperity. It could also be handled poorly and could amplify the distrust, uncertainty, and insecurity many Americans already feel.

As the market starts to roll over, I am not expecting a crash, but instead an incredibly choppy slide. However, I am mindful that the structure of the market today is arguably unprecedented. Just as everyone opened their banking app and tried to withdraw funds from SVB at the same time, all investors today have an iPhone app where they can not only sell their Apple stock instantly, but also buy leveraged same-day puts in a gamified UI. The environment today seems a lot like 1987, when there was broad recognition that the market was overvalued, yet risks abounded. Widespread retail usage of options could be the new portfolio insurance. The lack of any index-level volatility in the US equity markets has been astounding in the face of high volatility in rates markets, and in individual stocks. The doomer in me is waiting for the Minsky moment when this bizarre calm comes to an end.

However, if the US achieves the much-discussed soft-landing, with inflation coming down alongside rates as earnings continue to rise, then markets will likely keep rising as well, and multiples could keep expanding. There is a chance that the US continues to kick the can on debt sustainability issues, as it has done for decades. At some point, however, there must be a limit to multiples and margins, even if narratives are unbounded. My feeling today is that we are closer to that limit than many believe, but that the market narrative will take time to weaken and unwind.

This brings me to the end of my bearish ramble. I look forward to seeing how things unfold and where I am wrong. I’m sure it won’t go quite as I’ve envisioned, but I’m very confident the path will be interesting.

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