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2024 Balance of Risks
I am a risk manager, both literally and figuratively. Literally, since whether it is with our own funds and strategies or allocations for individual investor clients, or with my trading book back when I worked on Wall Street, the hard constraints are always capital, capital, and capital and so managing risk is part of how you make sure you don’t lose that capital. But also figuratively – my natural disposition is conservative, which is why I am a bond guy (concerned with getting my original investment back at par, at the end) rather than an equity guy (filled with dreams of a 10-bagger because I’m the first guy to figure out that Blockbuster Video is going to revolutionize video rental, and not so worried about how it will vanish almost overnight to Netflix).
So when I look at the investing landscape, I’m generally not focusing very much on ‘what I think is going to happen’; rather I spend more time thinking about the range of possible things that might happen, and their relative likelihoods. In theory, all rational investors do this but the markets do not trade like it. For example, currently Crude Oil trading at $72.60 does not seem to put any weight on the possibility of a hot war in the Middle East that could abruptly spike prices to $125/bbl or more. That’s not a prediction there will be a conflict that disrupts oil production or distribution (which, since there’s already a conflict – even though it hasn’t impacted oil production and only marginally impacted distribution – doesn’t seem like the sort of tiny-risk possibility we can ignore), but merely an observation. If you think there’s even a 10% chance that oil spikes $50/bbl, it would be worth $5/bbl. “But Mike,” you say, “maybe that’s already in the price and but for that possibility oil would be $5 lower?” Well, the risk manager in me looks for confirmation that the market is at least a little nervous, and with the Oil VIX trading at its long-term average and well below the average of the post-2020 spike it strikes me as hard to characterize the energy markets as ‘nervous.’
Anyway, this is why I dislike year-end ‘outlook’ pieces and why when I forecast CPI for a year or two out I almost always focus on a range of probable outcomes rather than a point estimate.[1] Honestly we should all do this, but not enough people have studied enough statistics to understand the significance of the error bars. If you have an experimental mean, and a nice large error bar, it signifies that you can’t reject the possibility that the true mean is anywhere in the range covered by the error bar. And that’s why, when someone introduces a new rent index that supposedly is more current but by their own admission has 15 times the standard error…I ignore it.
Enough of the preliminaries. Let me get on with this. Here are my thoughts about the balance of risks for just a few important items:
Interest rates: balance of risks is clearly higher. This was even more true at the end of the year. But with 10-year rates at 4.11%, down from 5% in October, keep in mind that two ways to get lower interest rates are already priced in: the short end of the curve reflects expectations (despite Fed officials’ protestations to the contrary) of roughly 150bps of cuts in the overnight policy rate this year, and the long end reflects inflation expectations of only 2.27% inflation over the next 5 years and only 2.30% inflation over the next decade. On top of this, consider that with the trade deficit declining but the budget deficit not declining, more of the budget deficit will have to be funded from domestic saving – and the Fed is still shrinking its balance sheet, so it is pushing in the opposite direction. The balance of risks in the bond market is to higher rates.
Stock market: balance of risks is lower, with the caveat that the picture is much better if looking at the market ex-the ‘Magnificent 7’ hot stocks (Apple, Nvidia, Meta, Tesla, Amazon, Microsoft, and Google). The S&P currently has a P/E of 21.4 and is up 24% since the end of 2022. The S&P ex-Mag7 has a P/E of 18.4 and is up 11% since the end of 2022. The Magnificent 7 themselves have a P/E of 39.5 and are up 110% over the last year.
The overall market P/E looks not-too-bad, until you remember that this is only because profit margins are currently only just a bit below at least 30-year highs (and probably lots longer – this is as far back as Bloomberg has trailing-12-months margins). The balance of risks is definitely for lower margins, which means lower earnings, which means the same equity prices would represent higher P/Es. Oh, and whatever happened to those people saying that the high equity prices were due to the really low interest rates? Haven’t heard from them in a while.
Where I have clients who are long equities, they’re long equal-weight indices so as to lessen exposure to the Magnificent 7. But even if those stocks were the only ones overvalued, it’s not reasonable to think that they can come back to earth and not bring down the rest of the market. If Apple, Nvidia, Meta, and Microsoft drop 30%, the rest of the market isn’t going to go up. However, if such a thing were to happen the market outside of the Mag 7 could feasibly eventually get to looking cheap.
Credit spreads: balance of risks is wider, with the 10-year Baa credit spread near 30-year lows. Really, how low does this go? And the tails are obviously one-way.
So I’ve said the balance of risks favor higher interest rates, wider credit spreads, lower corporate margins, and lower equity prices. It’s also useful to think about where the risks are in my risk assessments. If we get lower interest rates, instead of higher, then it’s very likely due to the economy being a lot weaker than it currently is, and the Fed ends up having to ease more than 150bps in 2024. That seems unlikely to me, but if it happens then notice that probably also means that credit spreads will widen and corporate margins, earnings, and stock prices decline. So, if you’re bullish on bonds and stocks, it seems to me you’re taking a dangerously narrow path. The balance of risks to me look bearish on both sides of that, but the bullish outcome for bonds implies (I think) a bearish outcome for stocks. It’s difficult for me to see an environment with appreciably higher stocks and bonds, unless the Fed eases aggressively without any economic weakness. So that’s your implied bet.
On the other hand, being bearish both stocks and bonds doesn’t carry such a narrow path risk. Unless the Fed eases despite a solid economy, It isn’t hard to envision an environment with lower stocks and bonds. Heck, we had just such an environment a few months ago, pre-‘pivot.’ It’s not a reach.
None of the preceding is a forecast. But investing and trading are about evaluating the range of risks, and trying to take positions with asymmetric risk-adjusted payoffs. In my opinion, long-only investors should be playing short on the yield curve (and going up credit, and inflation-linked rather than nominal) and anti- cap-weighting their stock holdings.
That’s as close to an outlook piece as I am doing this year. Have fun.
[1] In the last few years, I’ve started putting a point estimate for CPI in my Quarterly Inflation Outlook, but I also report what I see as the 1 standard deviation range so I can indicate the skewness of the risks in my view.
Three Colliding Macro Trends
It’s ironic that I had planned this column a couple days ago and started writing it yesterday…because the very concerns I talk about below are behind the overnight news that Fitch is lowering its long-term debt rating for US government bonds one notch to AA+. That matches S&P’s rating (Moody’s is still at Aaa).
Let me say at the outset that I am not at all concerned that the US will renege on its bonds in the classic sense of refusing to pay. Classically, a government that can print the money in which its bonds are denominated can never be forced to default. It can always print interest and principal. Yes, this would cause massive inflation, and so would be a default on the value of the currency. Again classically, this is no decision at all. However, it bears noting that there may be some case in which the debt is so large that printing a solution is so bad that a country may prefer default so that bondholders, and not the general population, takes the direct pain. I don’t think this is today’s story, or probably this decade’s story. Probably.
But let’s get back to what I’d intended to talk about.
Here are three big picture trends that are tying together in my mind in a way that bothers me:
- Large, and increasing (again), federal deficits
- An accelerating trend towards onshoring production to the US
- The Federal Reserve continuing to reduce its balance sheet.
You would think that two of the three of those are unalloyed positives. The Fed removing its foot from the throat of debt markets is a positive; and re-onshoring production to the US reduces economic disruption risks in the case of geopolitical conflicts and provides high-value-add employment for US workers. And of course all of that is true. But there’s a way these interact that makes me nervous about something else.
This goes back to the question of where the money comes from, to fund the Federal deficit. I’ve talked about this before. In a nutshell, when the government spends more than it takes in the balance must come from either domestic savers, or foreign savers. Because “foreign savers” get their stock of US dollars from our trade deficit (we buy more from Them than They buy from us, so we send them dollars on net which they have to invest somehow), looking at the flow of the trade deficit is a decent way to evaluate that side of the equation. On the domestic side, savings comes mainly from individuals…and, over the last 15 years or so, from the Federal Reserve. This is why these two lines move together somewhat well.
Now, you’ll notice that in this chart the red line has gone from a deep negative to be basically flat. The trade deficit has improved (shrunk) about a trillion since last year, and the Fed balance sheet has shrunk by 800bln or so. But, after improving for a bit the federal deficit is now moving the wrong direction, growing larger again even as the economy expands, and creating a divergence between these lines. This is happening partly although not entirely because of this trend, which will only get worse as interest rates stay high and debt is rolled over at higher interest rates:
The problem in the first chart above is the gap that’s developing between those two lines. Because the difference is what domestic private savers have to make up. If you’re not selling your bonds to the Fed, and you’re not selling your bonds to foreign investors who have dollars, you have to be selling them to domestic investors who have dollars. And domestic savers are, in fact, saving a bit more over the last year (they saved a LOT when the government dumped cash on them during COVID, which was convenient since the government needed to sell bonds).
So here’s the problem.
The big picture trend of big federal deficits does not appear to be changing any time soon. And the big picture trend of re-onshoring seems to be gathering momentum. One of the things that re-onshoring will (eventually) do is reduce the trade deficit, since we’ll be selling more abroad and buying more domestic production. And a smaller trade deficit means fewer dollars for foreign investors to invest. The big picture trend of the Fed reducing its balance sheet will eventually end of course, but for now it continues.
And that means that we need domestic savers to buy more and more Treasuries to make up the difference. How do you get domestic savers to sink even more money into Treasuries? You need higher interest rates, especially when inflation looks like it is going to be sticky for a while. Moreover, attracting more private savings into Treasury debt, instead of say corporate debt or equity or consumer spending, will tend to quicken a recession.
I don’t worry about recessions. They are a natural part of the business cycle. What I worry about is breakage. Feedback loops are a real part of finance, and out-of-balance situations can spiral. The large deficits the federal government is generating, partly (but only partly) because of prior large deficits, combined with the fact that the Fed is now a seller and not a buyer, and the re-onshoring trend that is slowly drying up the dollars we send abroad, creates a need to attract domestic savers and the only way to do that is with higher interest rates. Which, ultimately, raises the interest cost of the debt, which raises the deficit…
There are converging spirals, and there are diverging spirals. If this is a converging spiral, then it just means that we settle at higher interest rates than people are expecting but we end up in a stable equilibrium. If this is a diverging spiral, it means that interest rate increases could get sloppy, and the Fed could be essentially forced to stop selling and to start ‘saving’ again. Which in turn would provide support for inflation.
None of the foregoing is guaranteed to happen, but as an investment manager I get paid to worry. It seems to me that these three big macro trends aren’t consistent with stable interest rates, so something will have to give.
One of those things was the country’s sovereign debt credit rating. The Fitch move seems sensible to me, even if that wasn’t the original point of this article.
Signs of a Top, OR that I am a Grumpy Old Man
I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.
This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.
That’s borderline crazy.
It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.
There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:
- In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
- In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.
It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.
After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.
Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.
I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.
I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.
However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.
