Charts for the Week
Bond Market | Signaling the beginning of the end?
April 14, 2025
Financial markets remained highly volatile last week. The stock market bounced back after the proposed tariffs were largely put on pause for 90 days, but the bond market sold off heavily as the 10-year Treasury yield jumped nearly half a percentage point – the largest weekly increase in long-term interest rates since 2001. The continued climb in the benchmark 10-year rate even after the release of an unexpectedly low CPI inflation report for March may merely be due to deleveraging by hedge funds, but it raises the specter that the implicit arrangement that the world has been operating under for decades may be beginning to end.
Since the 1980s, the US has been the consumer engine of the world economy. We have bought the world’s goods and run large trade deficits, while foreign savings has flowed into the US, lowering our interest rates and raising our asset prices. This in turn has incentivized us to save less and consume more foreign goods, which in turn has caused more foreign savings to flow in, further lowering our interest rates and raising our asset prices. Round and round, higher and higher. It was a mutually beneficial arrangement but one that, in concert with our own fiscal and monetary policies, also fostered an unsustainably low level of domestic savings.
Much as it is a chicken-and-egg story as to whether the trade deficit or the inflow of foreign savings came first at the start, the same could be said about the potential end. Domestic savings could be increased (e.g., by dramatically lowering the federal deficit) to reduce the trade deficit, or foreign capital could flow out first increasing domestic savings via the pull and push of higher interest rates and lower asset prices.
If long-term interest rates, especially real rates, continue to rise in the coming weeks in the face of a weakening economy, it will likely be a sign that foreign capital has decided to retreat first.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Tariffs | Breaking investors' rose-colored glasses
April 7, 2025
The US stock market crossed the point where future returns were likely to be meager a long time ago. The only question has been whether those low returns would be realized via a relatively calm sideways march or a large market decline. Last week the odds of a market downturn increased with the announcement of much higher tariffs than expected.
The goal of the president’s tariff policy is unclear given conflicting statements by members of the administration, which makes it hard to gauge the ultimate effect. But crashing the stock market was undoubtedly not the intended purpose, thus the powers-that-be will likely offer some soothing words for investors in the coming days and weeks. And such swift market selloffs are usually followed by large up days and have historically proven short lived with stock prices significantly higher a year later.
However, investors' animal spirits may not be quickly revived this time as there are several differences between the current moment and the market volatility seen in 1987, 2008 and 2020. First, the economy is more sensitive to moves in the stock market than was the case just five years ago, so the market selloff could help prompt a recession. Second, market valuations are much higher than they were in those three previous periods, so the upside from here remains limited. Lastly and perhaps most importantly, the federal government is less well positioned or likely to unleash a tsunami of stimulus to boost the market.
Of particular note, unlike other periods of extreme volatility over the past forty years, Fed policymakers showed no inclination last week to step in to calm the market. If the downside volatility persists, that may change, but a Fed constrained in any way by high inflation would be a truly discombobulating adjustment for investors.
Source: YCharts, https://fred.stlouisfed.org/ , www.cmegroup.com/ , AOWM Calculations
The Economy & Market | Where to from here?
March 31, 2025
Higher than expected inflation data even before a potential tariff war commences kept downward pressure on the stock market last week. Sentiment has swung swiftly from invincible optimism to vulnerable apprehension about the future. The 2020s have been punctuated by unusual periods of high uncertainty and volatility, and the current moment certainly qualifies as one.
Wherever we go from here, the market and economy are apt to head in similar directions in the coming months. When a recession is averted, stock market corrections typically don’t manifest into prolonged, deep downturns. And the economy continued to hum along through the end of last year. The Bureau of Economic Analysis reported last week that real Gross Domestic Income surged in the fourth quarter at an annualized rate of 4.5% and corporate profits remained robust – which makes an imminent recession seem unlikely.
However, economic projections are even more useless than usual in the present environment. What can be said with some confidence is that profit margins are poised to come under pressure in the coming years one way or another. Given the still high valuations placed on current high profit margins, the market reaction to the direction the economy takes is likely to be muted on the upside and amplified on the downside.
Source: YCharts, https://fred.stlouisfed.org/ , Schwab , AOWM Calculations
The Fed's Outlook | 2% always on the horizon
March 25, 2025
Federal Reserve policymakers once again pushed off when they anticipate achieving their 2% inflation target with inflation now expected to run above that level through 2026. Nevertheless, the central bank still projected lowering its target overnight interest rate by half a percentage point before the end of the year and by another half a point next year. The Fed also announced that it was slowing the run off of its balance sheet to a trickle starting in April.
While tariff concerns have pushed inflation forecasts higher, policymakers appear unlikely to tighten policy in response to any tariff-induced price increases in the belief that the inflation would be transitory. Despite the Fed having a bad track record with such projections, investors continue to give policymakers the benefit of the doubt and cheer the prospects of lower interest rates.
The rising price of gold might be one of the few market indicators flashing a warning about future inflation. But that may be less a sign of near-term inflation concerns than a symptom of the global financial system moving slowly away from the US dollar as the world’s reserve currency – which could increase inflationary pressures down the road.
Source: YCharts, https://fred.stlouisfed.org/ , www.gold.org/goldhub/data/gold-demand-by-country , AOWM Calculations
Inflation | Increasingly divergent outlooks
March 17, 2025
CPI inflation moderated slightly in February, but forecasts for future inflation are increasingly divergent. The threat of tariffs has some consumers bracing for a resurgence of high inflation. Others believe either that the proposed tariffs are just a negotiating tactic that will ultimately lead to lower tariffs everywhere or that any negative effects of the tariffs will be more than offset by other pro-business policies.
There’s also the contingent who think tariffs won’t be inflationary because they will tip the economy into a recession. However, history would suggest that a recession will not immediately lead to lower inflation. Indeed, an inflation shock from tariffs that led to a recession would fit the historical pattern well with inflation potentially falling when the economy is on the rebound and price increases from tariffs have levelled off.
In the short run, the government deficit also continues to put upward pressure on inflation, and a recession is only likely to exacerbate that problem. Inevitable fiscal tightening could help lower inflation for a time; however, the federal debt looms ever larger and will quietly bias policymakers in the years to come towards letting inflation run hot. Central bankers will be reticent to ever explicitly target high inflation. Instead, they are likely to pay lip service to inflation concerns while suppressing real yields in the spirit of helping to finance the federal debt.
Thus, inflation is poised to be higher than investors are anticipating over the next decade, though with luck not as bad as some now fear.
Source: YCharts, https://fred.stlouisfed.org/ , https://data.sca.isr.umich.edu/ , AOWM Calculations
Uncertainty | Making a recession more certain
March 10, 2025
The economic data continues to be generally good. The unemployment rate remains low at 4.1%, and the economy added jobs in February for the 50th consecutive month. However, a side effect of the fast pace of change emanating from the nation’s capital is a growing sense of uncertainty. After the election, business optimism increased with expectations for a more business-friendly administration that would cut taxes and regulations. The stock market rallied on that hope as well but has since given back all its post-election gains.
Uncertainty around tariffs, government downsizing, international relations, a potential government shutdown, and what policies will actually get through a closely divided Congress is weighing on business and consumer confidence and risks starting a negative domino effect that could lead to a recession. Moving fast and furiously is clearly part of the White House’s strategy with the belief that any resulting downturn will be short and shallow. But, no matter the party in power, the imbalances built up over several administrations were never likely to be unwound painlessly.
Source: YCharts, https://fred.stlouisfed.org/ , www.policyuncertainty.com , AOWM Calculations
The Economy | K-shaped Achilles' heel
March 3, 2025
The post-pandemic economy has been described as K-shaped with some doing well while others have struggled. The strong headline economic numbers have not created an era of good feelings outside of the financial markets. Surveys of consumers continue to reflect a dour mood that is at odds with reports of strong consumer spending.
The top-end of the income ladder, which also holds the most wealth and has benefited the most from the increase in asset valuations, has driven consumer spending the past couple of years. An analysis by Moody’s Analytics found that the top 10% of earners now account for half of consumer spending – the highest level over the period analyzed back to 1989.
If the economy does slip into a recession, for which concerns are again on the rise, and asset valuations normalize, the negative wealth effect could amplify the downturn more than has been the case in previous recessions, especially if inflation keeps the Fed from excessively juicing the financial markets as it has done in recent decades.
Source: YCharts, https://fred.stlouisfed.org/ , www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html , Moody's Analytics, Wall Street Journal, AOWM Calculations
Government Tailwinds | Fading slowly but loudly
February 24, 2025
The federal government is shrinking. How much and how fast is hard to tell. Quickly cutting government outlays could tip the economy into a recession, for which the financial markets are ill-prepared. Large government deficits have boosted the economy and corporate profits in recent years, and shrinking those deficits will be discombobulating, even if necessary for the long-run health of the nation.
However, truly changing the trajectory of the federal deficit will be challenging, so the fiscal stimulant is unlikely to be rudely taken away despite all the sound and fury. While the overall government tailwind for the economy will probably fade slowly, the noise coming from the nation’s capital still risks frightening the animal spirits most responsible for driving economic growth.
Source: YCharts, https://fred.stlouisfed.org/ , usafacts.org , cbo.gov , www.brookings.edu/articles/is-government-too-big-reflections-on-the-size-and-composition-of-todays-federal-government/ , AOWM Calculations
Inflation | Pressures persist
February 17, 2025
Inflation continued to pick back up in January with the Consumer Price Index (CPI) increasing at the fastest monthly rate since August 2023. Annual CPI inflation is back up to 3% and core CPI inflation remains stubbornly stuck around 3.3%. There are always one-time events that can explain inflation away, but the trend in recent months is indicative of inflationary pressures that have not been subdued.
High government deficits and elevated asset values are juicing aggregate demand beyond the economy’s limits. And the Fed has dubiously piled on additional stimulus by lowering its target overnight interest rate by 100 basis points last year.
While investors have increased their short-term inflation expectations, concerns about long-term inflation risks remain oddly non-existent. We are still on the optimistic side of the mountain where every cloud has a silver lining. Indeed, investors found in the internals of the inflation data sufficient encouraging news to boost the odds for a second Fed rate cut this year, mellow long-term interest rates, and send the S&P 500 back to within a whisker of its all-time high.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Reality | Somewhere in the middle
February 10, 2025
Over the course of the recovery from the pandemic, the labor market data has been telling conflicting stories. Most glaringly, the monthly survey of businesses has shown solid growth in payrolls while the survey of households has shown stagnant growth in the number of employed individuals with declining full-time employment. Annual data revisions this month suggest that reality is somewhere in the middle as the payroll data was revised lower and a historically large increase in the population estimate due to immigration boosted the number of estimated employed individuals.
There are still plenty of underlying signs of potential weakness in the labor market. However, while clearly weaker than the real-time statistics had indicated, the revised payroll data was not as negative as expected, and the short-term trend in private payrolls is currently stronger than it has been for quite some time. It is unwise to read too much into a few data points, especially in light of recent large revisions. But, for now, the uptick in the payroll data, along with the downtick in the unemployment rate to 4%, is likely to keep the Fed comfortably on pause.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
The Question | Finally asked...
February 3, 2025
Fed policymakers met last week and paused their rate cuts, at least for the time being. On the surface, a pause was well justified (and the previous cuts questionable): GDP is estimated to be growing faster than the long-run limits of population and productivity growth; the unemployment rate remains low; inflation remains above the Fed’s 2% target; inflation expectations and long-term rates have trended higher in recent months; and asset valuations are at historical extremes.
Regarding those asset valuations, a reporter finally asked the Fed Chair about the large elephant in the room. While acknowledging that asset prices are “elevated by many metrics,” Jay Powell insisted “there’s a lot of resilience out there” to withstand a market downturn. A proclamation of “resilience” risks not aging well but also largely misses the point.
At the peak of the dotcom bubble in 2000, Alan Greenspan spoke frequently about the imbalances created when asset prices run well ahead of current income and the need for the Fed to be vigilant against the potential inflationary pressures. At the time, inflation appeared confusingly well-behaved. Greenspan identified the federal budget surplus and our ability to import labor, goods and capital from abroad as mitigating the excess demand produced by the wealth effect – factors Greenspan did not believe the Fed could depend on to restrain inflation indefinitely.
Today, the federal budget is exacerbating economic imbalances, and the other mitigating factors are being reined in by the current administration. This should make the Fed more vigilant against bubble-induced inflationary pressures than it was in 2000. It has not, but nor has there been much pressure to grapple with the question.
Source: YCharts, https://fred.stlouisfed.org/ , www.federalreserve.gov/newsevents/speech/2000speech.htm , AOWM Calculations
The Federal Debt | A threat to Fed independence
January 27, 2025
Federal Reserve policymakers meet this week for the first time under the new presidential administration. Since September, the Fed has already lowered its target overnight interest rate one percentage point despite the economy supposedly running hotter than it has at any point in the past fifty years and asset valuations at historic extremes.
Nevertheless, President Trump has already indicated he would like the Fed to continue lowering rates despite the bond market having suggested that might not deliver the result he wants. The market is fully priced for the central bankers to mildly disappoint the president by taking a pause on rate cuts this month, but a couple more cuts this year are baked into the expectations of investors who are certain the Fed will protect them from any prolonged pain.
Downward revisions to the economic data could help convince policymakers to give the president and investors the lower rates they desire, hopefully without shaking investors’ optimism. However, the perception that central bankers, the president or investors have of their ability to influence monetary policy for their desired ends may be short lived. The leviathan federal debt holds the catbird seat – a reality that could ultimately leave investors feeling as glum as consumers claim to be.
Source: YCharts, https://fred.stlouisfed.org/ , data.sca.isr.umich.edu , peteratwater.com , AOWM Calculations
Inflation | Not shaking faith in the Fed
January 20, 2025
Despite indicating that annual inflation ended the year trending higher, the latest CPI inflation report was sufficiently better-than-expected to reassure investors that the Fed will not have to reverse course and potentially raise its target overnight interest rate this year to combat sticky inflation. Accordingly, while investors’ inflation expectations did not retreat much, real rates declined to push the benchmark 10-year Treasury yield down to 4.61%.
The inflation of the past few years could have reasonably shaken investors’ confidence in the Fed’s commitment to its 2% inflation target, but that faith has never wavered – at least as measured by long-term inflation expectations revealed in the TIPS market. Instead, investors and policymakers have increased their estimates for how high real rates need to be to contain inflation. That the Fed can and will do what is necessary is not doubted.
Investors' confidence in the Fed's ability to both fend off high inflation and support the financial markets when necessary has underpinned asset valuations for years. However, the burgeoning fiscal imbalances of the federal government increasingly threaten that vital flexibility. The current size of the federal debt likely places a cap on how high real rates can go no matter what inflation does – and the age-old answer to too much government debt has been more inflation.
Source: YCharts, https://fred.stlouisfed.org/ , www.clevelandfed.org/indicators-and-data/inflation-expectations , AOWM Calculations
Rising Rates | Catching investors' eyes
January 13, 2025
In the fall of 2023, the 10-year Treasury yield shot up to 5%, and the stock market had its largest correction of the current bull run. Fed policymakers spooked investors by intimating that they would have to keep short-term rates higher for longer to get inflation under control. In the ensuing months, policymakers pivoted to talking about when they would begin reducing rates, and long-term interest rates quickly retreated below 4% helping to fuel a strong stock market rally in the fourth quarter of that year.
Fast forward 15 months and the 10-year Treasury yield is once again marching towards 5% even though the Fed delivered more reductions in its target overnight rate last year than policymakers had projected to begin the year. Sticky inflation remains part of investors’ concern, but real long-term rates have risen more than inflation expectations. Higher real rates imply a strong economy.
Even if the underlying story remains mixed, the headlines of the latest jobs report on Friday supported the narrative of a good economy about to get supercharged by a business-friendly presidential administration.
While a robust economy would seem to be good news for the stock market, higher long-term rates threaten an elevated market by offering a less risky means for investors to earn a return on their savings. Given the current level of interest rates and equity valuations, a passive investment in the US stock market is unlikely to outperform bonds significantly over the next decade. And the odds that stocks will earn an adequate risk premium only grow longer with every tick higher in long-term rates.
Source: YCharts, https://fred.stlouisfed.org/ , https://shillerdata.com/ , AOWM Calculations
2024/2025 | Review and preview
January 6, 2025
Last year in many ways was a replay of 2023. The year began with expectations that the economy would slow, but corporate profits would still expand strongly while the stock market would have a so-so year as it continued to digest high valuations. However, much like in 2023, GDP growth remained stronger than anticipated, earnings growth missed estimates but remained solid, and the stock market exceeded all expectations pushing valuations higher and higher.
Egged on by the stock market’s positive momentum, prognosticators have banished storm clouds from their 2025 forecasts. Inflation may be a little sticky but remain on a path towards 2%. The economy will continue to grow steadily with nary a hint of recession. The ever-rosy analysts’ projections for earnings are particularly optimistic for next year. And market strategists, after being embarrassingly cautious over the past two years, have thrown caution to the wind with predictions that the booming stock market will continue to boom.
In a typical year, the odds are strongly in one’s favor to anticipate an up year for the stock market which occurs three out of every four years. A presidential election year helps to improve those odds to about six out of seven (likely thanks to some economic juicing by the prevailing powers). In hindsight, that was perhaps a reason to have been more optimistic about the past year for the economy and the market. Looking ahead, though, the first year of a new presidency has historically seen higher odds of a recession and a market downturn, especially if it entails a change of the party in power.
That historical experience coupled with the stock market's elevated concentration and valuation make the tamer projections for the economy and the market of past years seem more apropos for the current one.
Source: YCharts, https://fred.stlouisfed.org/ , www.philadelphiafed.org/surveys-and-data/real-time-data-research/survey-of-professional-forecasters , www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html , AOWM Calculations
Investors | Exuberant by almost every measure
December 30, 2024
Investor exuberance appears to have run off the charts - valuations are at or near record highs, households’ allocations to stocks have never been higher, investor surveys betray a carefree confidence, and the options market has become a borderline casino. Far from climbing a wall of worry, the market currently feels like it is rocketing off a trampoline of endless optimism. The growing fear of missing out is palpable, especially with respect to mega-cap growth stocks that dominate the headline indexes. And yet there are at least a few indicators that investors could get even more exuberant.
For one, investors have not borrowed as much money to buy stocks in the recent run-up as they have in the past. The growing use of options and levered ETFs may be disguising the total leverage in the system. Nevertheless, if the growth in margin debt were to reach the levels seen in 2000, 2007 and 2021, the party will get crazier.
Another indicator that bullish sentiment has not peaked is the relatively low level of initial public offerings (IPOs). Peak investor enthusiasm usually engenders a lot of IPOs as companies take advantage of the strong demand for stocks. Uncertainty about the election and structural changes in the economy may partly explain the lack of IPOs; however, it would be an anomaly for the market to roll over before there is a burst of IPO activity (granted anomalies have become less anomalous in recent years).
Barring a technological miracle that is hard to fathom even in an AI world, a passive investment in the US stock market has long since passed the point of offering good returns for a buy-and-hold investor. That does not mean FOMO can’t carry us to new extremes. Record valuations are only reached by exceeding the previously unthinkable.
Source: YCharts, https://fred.stlouisfed.org/ , shillerdata.com , https://site.warrington.ufl.edu/ritter/files/IPO-Statistics.pdf , https://www.citizensbank.com/corporate-finance/insights/private-equity-trends , https://www.tuck.dartmouth.edu/news/articles/where-did-all-the-public-companies-go , AOWM Calculations
More Monetary Easing | Too much of a good thing?
December 23, 2024
The Fed reduced its target overnight interest rate last week by another 0.25 percentage points, but investors were not grateful. The S&P 500 Index fell almost 3% while the 10-year Treasury yield jumped back over 4.5%. Changes in the Fed’s economic projections drove the negative market reaction.
In September, policymakers projected they would cut the fed funds rate another 100 basis points (i.e., 1 percentage point) next year as they have done over the past few months, but last week they dialed that back to just half a percentage point. It hardly seems worthy of a market tantrum, especially as policymakers are still forecasting a reduction in the real fed funds by more than 50 basis points next year, similar to their projection in September.
While market expectations for long-term inflation continue to reflect a high degree of investor confidence in the Fed's inflation fighting credentials, could investors be starting to question the wisdom of cutting rates with inflation sticky and markets exuberant? Could they be starting to see monetary stimulus as too much of a good thing? Probably not - likely just ever greedy for more whether wise or not. But that day may yet come.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Yield Curve Uninverted | What now?
December 16, 2024
The Fed has its last meeting of the year this week, and the market is priced for another reduction in the Fed’s target overnight interest rate. As the Fed has been cutting short-term rates in recent months, long-term rates have been rising and shot higher again last week. On Friday, the 3-month Treasury yield finally fell back below the 10-year yield after more than two years of being inverted – the longest such inversion since the 1920s.
Over the past half century, an inversion of the yield curve had been a reliable indicator that a recession was on the horizon, and the reversion back to its normal upward slope a sign of an imminent downturn. However, as the inversion dragged on and economic growth remained strong, faith in the predictive powers of the yield curve faded. If the economy continues to hum along over the next year, this time will have proven to be different.
Nevertheless, policymakers still – perhaps wisely and despite what they say – don’t really seem to believe it’s true. For if the economy is great, there is dubious rationale for cutting rates when inflation remains above target and asset valuations are at potentially destabilizing extremes. And indeed, the Fed may be done with rate cuts after this upcoming meeting if the economy is in fact healthy and elevated inflation persists. Or the warnings long imbedded in the yield curve may yet be proven out via future data revisions that reveal an economy weaker than currently thought and calling for monetary stimulus.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.htm , AOWM Calculations
The Outlook | Confusing as ever
December 9, 2024
Last week, the Chair of the Federal Reserve proclaimed the economy to be in very good shape, and the S&P 500 notched four new record highs. Everything appears awesome. And yet, interest rates fell as investors increased their expectations for looser monetary policy to help stimulate the economy that is supposedly doing so well, and the equal-weighted S&P 500 declined on Monday, Tuesday, Wednesday, Thursday, and Friday as the stock market rally narrowed once again.
Policymakers and investors appear as confused as the jobs report, which continues to paint a picture of a labor market that is stagnating despite solid economic growth. Payrolls rebounded nicely in November, but the recession-resistant Government, Education and Health Services sectors continue to be the primary drivers of job growth – not historically a good sign. The unemployment rate also ticked up slightly to 4.2%, and the number of individuals in full-time employment remained lower than it was a year ago.
Despite the recurring warning signals in the labor market data and the expectations for the Fed to ease monetary policy like a downturn is imminent, a recession next year would be surprising based purely on the strength of the stock market. The forward-looking stock market does not usually decline significantly before a recession starts; however, the uptrend does typically slow as a downturn approaches, and we have yet to see that.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Historical Parallels | Entertaining caution
December 2, 2024
It was a year of discontent. Despite solid economic growth, low unemployment and a strong stock market, the people were unhappy. A foreign war of containment and rising consumer prices helped to sour the mood. The president – a long-time Democratic senator who had served as vice president and ultimately made it to the mountain top on his own – was unpopular; well into the election year, he decided not to run for re-election. His vice president, promising to bring back the joy, was effectively handed the nomination at the Democratic National Convention in Chicago. The election was close, but the Republican candidate whose political obituary had been written many times eked out a comeback victory on election day, November 5. The stock market cheered the election results and rallied to hit a new all-time high on the day after Thanksgiving, November 29. However, Warren Buffet grew increasingly defensive in the face of rising equity valuations.
The year was 1968… and 2024. The entertaining parallels with the past aside, human nature does sway history – and the markets – to progress with some cyclicality. Actions engender reactions which provoke actions. That doesn’t mean we are about to relive the 1970s, but it is a cautionary tale against betting the house on endlessly smooth sailing.
If the new year brings tougher economic conditions with less government support and a retreat in animal spirits, it will be an old story. But it will not be the end of the story. After all, Warren Buffett closed his investment partnership in 1969 in reaction to “an increasingly short-term oriented and more speculative market,” and he ended up doing all right retreating to the management of a failing textile manufacturer.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
Tariffs | Unintended consequences
November 25, 2024
The exuberant stock market is indicative of the high hopes for the incoming administration with investors discounting Trump’s more disruptive proposals as campaign rhetoric unlikely to be implemented. For example, Trump has proposed imposing 10% to 20% tariffs on all imports and 60% tariffs on Chinese goods which, if effected and sustained, would reduce the trade deficit in a way investors are unlikely to appreciate.
The Constitution gives Congress the power to set tariffs; however, in the decades following the Great Depression through the 1970s, Congress delegated broad authority to the president with respect to international trade. Whether Congress can or has granted the president the authority to set indiscriminate tariffs is debatable. Nevertheless, given the unsuccessful legal challenges to the tariffs imposed in Trump’s first administration and continued by Biden, it seems likely that, if Trump decides to impose tariffs on all imports, he will be able to do so without Congress unless the Supreme Court ultimately decides to weigh in otherwise.
While the trade deficit needs to be addressed, doing so also means reducing the support our financial markets have enjoyed for decades from the persistent inflow of foreign capital. It is a chicken-and-egg story as to whether foreigners’ desire to invest in the US generates the trade deficit or our hunger for imported goods effectively draws in international capital. Either way, they go hand-in-hand; thus, a policy that decreased the trade deficit would also decrease the flow of international capital into the US at a time when domestic savings is minimal.
In addition to reducing the demand for US assets, any inflation generated from new tariffs would be another unintended consequence that could further upset financial markets priced for perfection. And then there are the innumerable unknown disruptions such a shock to the system might bring about, which is understandably all the more reason why investors can’t contemplate the tariff talk in its most extreme form as more than mere bluster.
Source: YCharts, https://fred.stlouisfed.org/ , https://taxfoundation.org/blog/trump-tariffs-revenue-estimates/ , https://budgetlab.yale.edu/research/fiscal-macroeconomic-and-price-estimates-tariffs-under-both-non-retaliation-and-retaliation , AOWM Calculations
Soft Landing | Have we arrived?
November 18, 2024
The incoming economic data continues to be generally good, and last week the Chair of the Federal Reserve indicated that policymakers are not in a rush to cut rates further. If the Fed has successfully brought inflation to heel without a recession, then it may be closer to being done lowering short-term rates than investors suspected just a few weeks ago, and long-term rates may have further to rise.
In the mid-90s, when the Fed last engineered a soft landing, it only reduced its target overnight interest rate by 0.75 percentage points as the economy and markets remained strong. Thus far this time, the Fed has once again eased by 0.75 percentage points, but policymakers are inclined to go further even though the economy seems to be growing steadily, inflation remains above their target, and asset valuations are at historical extremes.
Before fully declaring success, policymakers likely want to see the labor market stop losing altitude with each passing month. No matter what the labor market does, sticky inflation could get in the way of significantly more monetary easing. Although, the powers-that-be have gotten good at explaining away recent inflation as a never-ending series of one-off events that can be disregarded.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
New Old Regime | Same enduring challenges
November 11, 2024
Last week was a good one for the stock market. The election was clearly decided before the next business day even began eliminating concerns of a contentious, prolonged battle, and the Fed continued to ease monetary policy by lowering its target overnight interest rate another quarter percentage point. The reduction in uncertainty, the potential for more corporate-friendly government policies, and looser monetary policy boosted the broad market indexes to new all-time highs.
The market reaction to the election was not uniformly positive. International stock markets were subdued as clouds formed over the future of global trade, and long-term interest rates initially spiked higher on concerns about what the new administrations’ policies might mean for the federal debt and inflation. Inflation expectations have been creeping back up even as the Fed has essentially declared victory. Investors have at least begun to hedge how far and fast they think the Fed will cut rates which is a combination of greater confidence in the economy and fears about inflation.
As for the US stock market, the pre-election exuberance was already a tall order to meet before last week’s melt-up. The new administration faces enduring challenges for which there are no easy solutions. When that reality hits home, investors will likely have to recalibrate their expectations. Until then, irrational exuberance can continue to unduly escalate asset values (to borrow Alan Greenspan’s turn of phrase).
Source: YCharts, https://fred.stlouisfed.org/ , www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html?redirect=/trading/interest-rates/countdown-to-fomc.html, AOWM Calculations
Election Year | Uncertainty that markets love?
November 4, 2024
In theory, uncertainty should increase risk premiums and serve as a headwind to asset price appreciation. However, leading into a highly uncertain election, the stock market has soared. Through October 29, the S&P 500 had returned nearly 44% over the past year which is in the top 2% of annual returns since 1950. Even after cooling slightly in recent days, the market is still having its best year leading into a presidential election in modern history.
While the strength of the rally is surprising, most election years have not been bad for the market. Indeed, valuations have risen over the year preceding a presidential election far more often than not. They have certainly done that again this go-around with the valuation of the S&P 500 stretching to historical extremes.
The strength of the stock market does not tell us much about who will win the election, but whoever does win will inherit market expectations that will be challenging to meet.
Source: YCharts, https://fred.stlouisfed.org/ , AOWM Calculations
The Fed | Getting ready to pull the other lever?
October 28, 2024
Since the Fed’s rate cut of 50 basis points last month, the case for swiftly easing monetary policy has faded pushing up long-term rates and quickly steepening the yield curve. While the market is still priced for further rate cuts in the coming months, lowering the Fed’s target overnight interest rate is not the only lever policymakers have to pull. In the age of supersized central bank balance sheets, when to cease shrinking the Fed’s holdings of US Treasury debt and mortgage securities is another key policy decision.
The Fed slowed its Quantitative Tightening earlier this year but has continued to reduce its balance sheet even as it has shifted to lowering interest rates. Reverse Repurchase Agreements (Reverse Repos) have been the primary liability on the Fed’s balance sheet that has declined over the past year in step with the decline in the Fed’s assets. After peaking at $2.4 trillion, the Fed’s reverse repos are now down to $258 billion – the lowest level since May 2021.
In a reverse repo, money market funds and other market participants loan money to the Fed using the Fed’s Treasury holdings as collateral. As a result, the decline in the Fed’s reverse repos is driven by market participants moving their money into more traditional US government debt (which the Fed is no longer buying as much of as it shrinks its balance sheet), so there is little potential for market or economic disruption. However, as reverse repos dwindle, further reductions in the Fed’s balance sheet are likely to start reducing bank reserves which has a greater risk of upsetting the delicately stacked apple cart.
Stopping the reduction in the Fed’s balance sheet could also ease some pressure on long-term interest rates which have thus far counteracted the Fed’s initial move to ease monetary policy. Thus, for many reasons, an announcement that lays out the Fed's plans for winding down its Quantitative Tightening seems likely before the end of the year. If so, the Fed’s balance sheet will once again be left far larger than it was before the crisis that precipitated its massive expansion – a decision that is not without its own perils.
Source: YCharts, https://fred.stlouisfed.org/ , www.fdic.gov/quarterly-banking-profile/fdic-quarterly-banking-profile-archived-issues , AOWM Calculations
Federal Finances | Precariously profligate
October 21, 2024
Last week, the US Treasury reported that the federal government ran a deficit of $1.8 trillion for the 2024 fiscal year that ended in September. As a percentage of the nation’s economic output, the federal deficit remains elevated at approximately 6.5% of GDP despite solid economic growth and low unemployment. High structural deficits driven by the increasing costs of mandatory spending, such as Social Security and Medicare, have been compounded over the past couple of years by the rising net interest expense on the burgeoning federal debt. More than 27% of the federal budget last year was paid for with borrowed money.
Over the past three years, the federal debt held by the public has increased by roughly $2 trillion each year which has pushed the national debt back towards 100% of GDP. Without a change in policy, the federal debt is expected to continue swiftly growing relative to the size of the economy even if economic growth remains strong. Interspersing a mild recession at some point over the next decade would only exacerbate the problem that is hindering the long-run growth potential of the economy and risks engendering higher inflation and/or interest rates. And a deeper economic downturn could find the federal government without the flexibility to respond like it did after the financial crisis in 2008 and the pandemic in 2020 given the current size of the debt.
Despite the clear and present risks posed by the state of federal finances, little care is being paid to the issue (and in many ways the opposite). Even though the net interest expense on the federal debt as a percentage of GDP has rocketed back to where it was in the 80s and 90s when there was significant societal anxiety about the deficit, the issue is absent from the national dialogue today. That is likely to remain the case until either the financial markets focus the minds of Congress, or the electorate no longer views profligate federal finances as a free lunch.
Source: YCharts, https://fred.stlouisfed.org/ , https://www.cbo.gov/data/budget-economic-data#3 , AOWM Calculations
Investor Sentiment | Too hot?
October 14, 2024
CPI inflation came in higher than expected in September, but that did little to alter the narratives driving the stock and fixed income markets. Bond investors still anticipate the Fed will ease monetary policy aggressively over the next year, and stock investors still see nary a cloud in the sky.
Even if the economy has entered a Goldilocks state, the current enthusiasm for equities risks being dangerously hot. The nation’s Financial Accounts indicate households are allocating a record amount of their financial assets to stocks. In addition, the number of investors professing concerns about the market’s prospects has dwindled, and the options markets - which investors increasingly use to lever their bets - remain largely priced for the good times to keep on rolling over the next year. Such lopsided positive sentiment has often been followed by weak returns.
One potential sign that some investors may be starting to grow a little wary of the stock market’s run to ever higher valuations is the uptick in the “fear” index of expected market volatility over the next 30 days even as the S&P 500 has hit several new all-time highs. But that may be driven more by concerns around the upcoming election than actual fears of a market downturn. If the uptrend in the VIX index continues through earnings season and past the election, that will be a more telling warning about the strength of investors’ animal spirits.
Source: YCharts, https://fred.stlouisfed.org/ , www.minneapolisfed.org/banking/current-and-historical-market--based-probabilities , shillerdata.com , www.aaii.com/sentimentsurvey/sent_results , AOWM Calculations
Economic Data | Positively surprising
October 7, 2024
Recent economic data has been surprising on the high side, suggesting the economy is holding up well. That positive data includes the latest jobs report in which the unemployment rate declined for the second month in a row to 4.1% in September and employers added more jobs than expected. With the labor market appearing stronger than feared, long-term interest rates increased last week, and investors pared back expectations for Fed rate cuts.
While it is the market’s nature to react to every bit of news, the jobs report is inherently volatile, especially the payroll data which is subject to significant future revisions. Little in the report clearly changed the picture of a labor market that is oddly stagnate – neither really expanding nor shrinking. The year-over-year growth trend in the payroll data is still slowing, and the internals of the Establishment Survey remain full of cautionary signals – e.g., the decline in the number of temporary workers persists, and a large percentage of the job gains over the past year have been generated by the government and private education & health services sectors (historically an indicator of economic weakness). The Household Survey also continues to show no growth in total employment over the past year and shrinking full-time employment.
Nevertheless, the recent economic data supports expectations for solid earnings growth in the third quarter. Beyond that, continued economic strength will be essential for companies to achieve the anticipated growth in profits over the next year; even then, it may not be enough to fulfill the hopes and dreams imbedded in the stock market’s current valuation.
Source: YCharts, https://fred.stlouisfed.org/ , www.spglobal.com/spdji/en/indices/equity/sp-500/#overview , AOWM Calculations
Archives
Source: YCharts, https://fred.stlouisfed.org/, BLS, www.global-rates.com/en/interest-rates/central-banks/, www.economist.com/economic-and-financial-indicators/2024/06/06/economic-data-commodities-and-markets, AOWM Calculations
The Economy | Latest news, old news
June 3, 2024
The government’s latest official read on the state of the economy was a continuation of recent trends with steady growth and strong corporate profits belied by statistical discrepancies and cautionary imbalances.
For the second consecutive quarter, the average of Gross Domestic Product (GDP) and Gross Domestic Income (GDI) indicated that the economy expanded by a solid 2.4% over the past year. GDP continues to measure noticeably larger than its twin, GDI; however, the statistical discrepancy is no longer growing and both measures of the economy are now trending in the same direction.
Last week’s report also showed persistent strong corporate profitability with profits continuing to account for an elevated share of national income. Despite corporations’ success in taking more of the economic pie over the past decade, it remains risky to declare that profits have reached a permanent new plateau as a share of national income given rising interest rates and the fiscal imbalances facing the federal government that will likely require higher taxes. Those imbalances are highlighted by the fifth consecutive quarter of negative net domestic savings which threatens to reduce the long-run growth potential of the economy.
One new item of note: nominal year-over-year GDP growth decelerated to 5.38% after the recent revision and is now basically equal to the Fed’s target overnight interest rate. Economic growth and the long-run level of interest rates are linked; thus, it is notable when the fed funds rate crosses paths with GDP growth. Excluding the pandemic, nominal GDP growth has typically fallen below the fed funds rate before or around the start of a recession. That has not happened yet and may not if the Fed starts to lower rates before the end of the year.
