Published August 4, 2023
Here we are in the thick of summer, or perhaps the end of it, depending on where you live and when schools open (if you have children so involved). This week’s article is a bit more long-form, hardly the typical lightweight summer fare. We share JP Morgan analyst Michael Cemblast’s observations/thoughts on why markets have seemingly ignored recessionary economic indicators and blasted higher so far this year. Here’s Mr. Cemblast:
“Legend has it that Rasputin was poisoned, shot twice, beaten, then drowned before finally succumbing to Russian nobles trying to end his sway over the Czar. I’m reminded of this (probably false) account when looking at global resilience. Despite 400-500 basis points of rapid policy tightening in the US and Europe (since 2021 ~95% of the world’s central banks have raised rates, even more than during the 1970’s inflation shock), and despite a very tepid Chinese recovery, global Q3 GDP growth is still projected to be ~2% and the MSCI World Equity Index is up 18% this year.
How can we explain this? The obvious place to start: the decline in inflation surprises and in related measures (core, trimmed, sticky and median measures of consumer price inflation; NY Fed underlying inflation gauge; “truflation”; the Global Supply Chain Pressure Index, the jobs-workers gap, etc). But there are 6 other factors worth reviewing as well, which is the subject of this month’s note.
 The “inverted yield curve -> recession” argument is premature. Yes, inverted yield curves tend to precede recessions as shown on the left. But why was it such a consistent signal? Before prior recessions (other than COVID), yield curve inversion reflected policy rates that were restrictive in real terms (i.e., relative to inflation). This time, policy tightening in the US is barely restrictive at all, as shown on the right. And while a simple read of the yield curve points to recession, the health of the US corporate sector does not: the corporate sector financial balance is still in surplus, a condition which has never preceded a recession (see chart below).
 Central banks have only removed around one third of the $11 trillion in global liquidity they created in 2020/2021. In other words when considering points #1 and #2, there’s still plenty of liquidity in the system and the cost of money is not prohibitive.
 Biden’s industrial and fiscal policies offset part of the drag from higher policy rates. The charts below show the construction bounce in the manufacturing sector, and the direct government spending and tax incentives associated with semiconductor, infrastructure and energy bills. And don’t look now, but US fiscal policy has become very loose again: the latest fiscal deficit is not far off the peak deficit during the financial crisis of 2009.
Bidenomics, opioids and the Third Man. I’ve got questions on the long-term inflationary impact of Bidenomics. Two examples: the ultimate cost of US semiconductor production compared to Taiwan, and the cost of energy systems with large amounts of renewable power that also require substantial backup thermal power and/or energy storage. Also, the notion that hiring IRS agents will raise enough money to finance the energy bill and reduce the deficit is to me totally implausible. But there’s one thing to be optimistic about: the potential for industrial policy to partially revitalize US manufacturing communities that were left in the dust by China’s entry into the World Trade Organization. I’ve written before on the connection between post-WTO Chinese FX intervention, US manufacturing job losses and US opioid addiction rates (see Eye on the Market 7/13/2021). The “battery belt” that will stretch from Michigan to Georgia through Ohio, Kentucky and Tennessee will be welcome news in many communities.
 Rising interest rates will take time to flow through to profit margins and household balance sheets. In contrast to some US banks that made extremely poor decisions to extend asset duration at the lows in rates2, many US and European companies extended liability duration and enjoy the lowest levels of interest expense to cash flow in decades. As shown below, for the first time on record, corporate interest expense is falling as the Fed is hiking rates. US household debt service costs are also low. One reason: the average coupon on outstanding residential mortgages is ~3.5%, immunizing many homeowners from the spike in mortgage rates to ~7%. Credit card and auto delinquencies are rising, but from low levels and are now back at 2010-2020 averages.
While higher interest rates hit US housing pretty hard, the lowest housing inventory in decades3 offsets what might have been an even sharper decline in home prices, permits and starts. Also: tight US labor markets have sustained personal income and spending. While goods spending is weakening, services spending and auto spending are holding up. Note how the timing and magnitude of the expected consumer slowdown has changed since January. Tech layoffs have declined by 50%-75% from peak levels according to Challenger data; the AI frenzy came just in time for some.
Note that the US government is not nearly as immune from rising interest rates as households or companies. Net interest payments to GDP have already risen from a post-war low of 1.2% in 2015 to 1.9%, and are heading to 3.2% by 2029 which would match the post-1960 high last seen in 1991. See our American Gothic piece from January for more on the long-term unsustainability of US Federal debt, entitlement spending and interest.
 Just wait, economic weakness is coming later this year or in early 2024. Monetary policy tightening works with a lag and is occurring after a period of unprecedented stimulus. Excess US household savings are projected to run out sometime in 2024, and while current economic indicators are robust, there’s weakness in Conference Board leading indicators.
We also monitor the longer-dated indicators shown in the table. The overall pulse does not point to a significant contraction, just to modestly weaker US conditions in 6-9 months. Furthermore, new orders less inventories (#5) has improved three months in a row. We watch this metric closely given its leading signal on the PMI index, a useful predictor of economic growth and stock market returns over the long run.
 YTD US equity returns have been substantially boosted by rising valuations of a few mega-cap stocks, most of which have not seen their earnings projections grow at all this year. We covered this issue in June, and J.P. Morgan’s Global Markets Strategy team wrote on the topic as well.
- While NVDA and META earnings projections are rising for 2023 and 2024, they are flat for MSFT, GOOGL, AMZN and AAPL. Even so, the latter 4 stocks are up 40%-60% this year. TSLA, whose earnings are projected to decline by ~30% from 2022, has risen by over 100% this year
- Market cap concentration in a handful of stocks is at its highest level since the early 1970’s, even narrower leadership than during the 2000 TMT Bubble. Also: the increase in market cap concentration just reached its highest level in 60 years
- Six mega-cap stocks (MSFT, GOOGL, AMZN, META, NVDA, CRM) explain 51% of S&P 500 performance and 54% of the Nasdaq 100
- Crowding in growth factor investing has reached the 97th percentile, eclipsed only in early 2000
- A steep rise in concentration and narrow market leadership has historically reversed with the S&P 500 equal-weighted index outperforming the market-cap weighted index
The bottom line: risk appetite is back, courtesy of immaculate disinflation and plenty of liquidity
The equity rally can be justified on the grounds that the Fed’s “immaculate disinflation” was not expected by many investors, some of whom added risk this year after conservative positioning in 2022. But: rising valuations account for 90%+ of the gain in the S&P 500 this year, with earnings growth accounting for the rest. Multiple expansion has occurred despite the lack of a rebound in long term earnings growth expectations. As shown on the left, this is unusual. In other words, there’s a lot of good news priced in at current levels and little room for any negative developments in the Russia-Ukraine war and global energy/food prices next winter.
More signs of investor optimism:
- market sentiment is in the 95th percentile of bullishness
- the cost of a one-year 95 strike put on the S&P 500 is in the 85th percentile of cheapness since 20085
- the Dow Jones Index rallied for 13 consecutive days through July 26, the longest streak since 1987
- don’t look now, but the YUCs (young unprofitable companies) are rising again. The rally in electric aviation company JOBY is a prime example…see our energy paper on the dubious prospects for electrified aviation.
The equity rally is also taking place when fixed income is competitive with equities from a yield perspective for the first time since 2002, as shown on the right. For risk-averse investors, some fixed income opportunities offer compelling risk-reward compared to equity counterparts.
After the Flop, waiting for the Turn: China’s reopening fizzles due to real estate overhang
China’s grand reopening has apparently flopped in 2023. The latest problem with China’s economy stems more from misallocated investment in residential real estate than from excess industrial capacity. China’s home ownership rate is ~90% (a figure unheard of in the US even during the most feverish attempts by the FHFA to unsustainably inflate it), and 20% of Chinese households own more than one home. Vacant properties amount to 2+ years of sales, and consumer confidence remains low despite low mortgage rates designed to boost leverage and homebuying.
China relies on large amounts of trapped domestic savings to finance itself. Rather than a balance of payments or banking crisis, the housing situation in China has resulted in a period of slower growth and an equity market that trades at 10-12x earnings, a steep discount to the developed world. The Chinese Politburo appears to have announced intentions to provide more stimulus, but the timing and amounts are unclear.
Warm wishes and until next week.