mattee2264
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Posts posted by mattee2264
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There is a bit of circular reasoning going on.
Fed backing off a bit because it sees long bonds doing the rest of the tightening. Long bonds yields promptly slide sparking a rally.
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US fiscal deficit $1.7TR. That probably goes a long way towards explaining resilience of the US economy compared to the ROW. That is a pretty massive fiscal deficit to be running when the economy is at full employment. By contrast 5% interest rates are pretty much neutral. So no surprise who is winning the tug of war.
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It seems obvious to me that there is a lot of unutilised retail and office space as a result of the shift towards online retail and flexible/remote working patterns. Surely this could just be converted into flats?
Also when there is a housing crisis you should have disincentives against buy-to-let and foreigners using US property in big cities as effectively a bank account.
But agree that those in power are property owners and have vested interests that make them want to keep house prices high.
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Worth factoring into that assessment that for much of the early period the world was on a Gold Standard which was pretty effective in keeping inflation low and allowing for lower rates. 2nd half of the 20th century 5% was the bottom of the range rather than the average. 21st century it was the top of the range but that reflects that in the 21st century monetary policy has been pretty irresponsible.
Who knows what the future holds. Some argue for higher structural inflation driven by food and other resource shortages, de-globalisation etc. Others argue that technology will continue to have deflationary impacts as will slower growth necessitated by pursuit of net zero targets and the deflationary impact of massive amounts of debt.
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What is interesting is that because policy operates with lags you are still seeing the benefits from the unprecedented easing during COVID while the full impact of the rate hikes/QT and less effective fiscal policy (still trillion dollar deficits but not helicopter money the way it was during the pandemic) is yet to be felt but will weight on the economy in 2024 and 2025.
All bets off of course if the Fed does a shock-and-awe pivot but monetary policy is so reactive that it will only do that when a recession is confirmed by which point the market will already be down considerably. As for the US government they will come under more and more pressure to reign in spending and even if the Democrats stay in they will probably cut back post-election.
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Amazing how Big Tech earnings are so good but they are still selling off. Goes to show just how high expectations are from these market darlings and that sentiment has shifted from "AI is the future, the sky is the limit" to "Is this as good as it gets and concern about forward guidance for the core non-AI businesses".
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We haven't had the hard landing yet. And based on the resilience of the economy unless something major breaks then Powell's envisaged scenario of a period of below trend growth will probably be how things play out. Especially if some fiscal discipline is imposed by bond markets.
But as a minimum you'd expect some repricing of financial assets as the long bond rate goes higher to establish a proper term premium and optimism about a pivot in 2024 starts to fade as people realise that so long as employment remains strong and nothing major breaks Powell will stay the course.
And even if people don't believe in higher for longer then if anything that increases enthusiasm for bonds because it means there is a limited time opportunity to lock in a long term return of 5% + as well as enjoy some capital appreciation if rates do fall. Or for the more speculatively minded with the TLT down 50% there are bottom fishing opportunities. Either way equity allocations are bloated so it wouldn't take much of a rotation into bonds to result in quite a bit of downside to equity markets.
The economy is probably as good as it gets at the moment. So the idea things will get better and there is a broad based rally encompassing non-tech stocks seems unlikely. And even if the economy only gets a little worse it will continue to depress the prices of non-tech stocks and if sentiment sours and tech results disappoint then a lot of the YTD gains could be given up and when Magnificent 7 are 30% of the index and have gone up 70-80% on average YTD then that again adds to the downside risks.
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Yeah I think "wealth effects" are massively overrated. Asset price appreciation has been insane since the depths of the GFC but until the US government started running trillion dollar deficits we struggled to get GDP growth anywhere near 3%. Also the wealth effects during the 90s leading up to the dot com bubble top did little to prevent the house of cards from collapsing.
Most people have however seen a reduction in their real wages and are finding it a lot more difficult to spend more than they earn now that credit is a lot more expensive and banks and other lenders are starting to tighten lending standards. Also the stuff that people actually spend money on such as rent, energy, food etc has gone up massively so the reduction in real wages is greater than the inflation figures suggest.
It is difficult for the Fed to lower rates so long as the economy remains resilient and the US government continues to run trillion dollar deficits. And I think that a lot of the apparent economic strength does reflect that fiscal policy is so ridiculously expansive.
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The double whammy comment was specifically in relation to the Magnificent 7. MAG 7 have an average PE multiple of over 45 times earnings. And for some context the lowest multiple was around 20x set at beginning of 2019 and in the depths of COVID which with benefit of hindsight were excellent buying opportunities. Their current price is only about 5% below the end of 2021 peak. As we all know their stock prices are up 70-80% YTD.
So not difficult to imagine a lot of downside if earnings disappoint.
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10 year valuation is misleading when you consider that the last 10 years were in a very low interest rate environment. And an equal weight deserves a lower multiple considering that the highest quality stocks generally dominate indices and therefore your average stock probably doesn't have much of a moat.
But agree that most of the overvaluation reflects the Magnificent 7 who are now about 30% of the S&P 500 by market cap.
I think if we avoid recession there might be more of a rotation as a lot of people are treating Magnificent 7 as safe havens.
But if there is a recession then you'd imagine even Magnificent 7 would see a fall in earnings and market has some distance to fall because lower earnings and a lower multiple is a double whammy.
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I don't think that is true at all. We've already seen ~10% price declines from the peak with very little change in unemployment. And somewhat higher price declines in more overvalued housing markets like Australia and Canada.
In a market with not much liquidity it doesn't take that many people to decide they need to downsize or move to a cheaper area to bring prices down. And even fairly modest job losses (and remember we are at full employment so I am hardly advocating for mass unemployment) would probably do the trick. Another driver of house price declines would be buy-to-let investors selling out because they reach the limits of passing on higher costs to tenants and facing negative cashflow decide to sell.
Of course you are right that in major cities foreign cash buyers would swoop in and that would moderate the decline and be a negative. But it is the society wide myth that house prices can only go up that encourages so many investors to buy real estate to the detriment of potential owner occupiers.
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It is not the number that is magic and of course 2% is somewhat arbitrary although as explained there is some reasoning behind it.
The magic is that if you have a target that central banks are accountable for achieving and it cannot just be changed anytime it suits then that anchors long term inflation expectations which has economic benefits both from an efficiency but also an equity (fairness) standpoint.
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And if higher interest rates eventually result in a decline in house prices of 20% or so that would be a good thing.
House prices would be more affordable which is good for first time buyers especially as because they are priced out of the housing market they are at the mercy of greedy landlords.
If people have to downsize because they bought too much house when interest rates were near zero it is not the end of the world.
Given the run up in house prices and the acceleration post-pandemic most homeowners would still have positive equity
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It is not completely made up. 2% is seen as low enough to deliver the benefits of price stability but also providing a margin of safety against deflation (which worries central banks a lot more) and allowing for the fact that a little inflation improves the flexibility of an economy preventing downward wage rigidity etc.
Even within the confines of a 2% inflation target central banks move the goalposts by changing the measures of inflation and many central banks also adopt a range approach with Powell's average inflation targeting the latest example of that. But at least having a 2% number that is pretty much orthodox in the developed world provides some kind of anchoring to inflation. That anchor will be undermined if central banks can just change the inflation target whenever it suits them.
For example if we decide it is too painful to return to 2% inflation and adopt a target of 4% inflation then what happens when that target becomes difficult to achieve? How on earth are you supposed to anchor long term inflation expectations on that basis?
In fact a lot of the problems we are facing is because the Fed extended its mandate too far. And as a result kept interest rates too low for too long and allowed imbalances in the economy to build up to an extend that normalising interest rates to a reasonable level is causing issues.
And also because the US government is irresponsible and is still running trillion dollar deficits when the economy is at full employment which is adding fuel to the inflationary fire which is requiring the Fed to be more aggressive than it would ideally like to be.
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We've had these rates before. What is different this time is we haven't had this extent of household and government debt.
The other factor is the speed at which rates have increased which has resulted in a lot of bond portfolios deeply underwater.
Of course there are a lot of individuals and businesses insulated from the rate increases because they have 30 year mortgages taken out at cheap rates and have a lot of cash on hand as a result of borrowing at low rates in the past and most of the really big companies generate tons of cash and actually benefit from getting a better rate of interest on their cash balances.
But there is always a degree of contagion in the economy. The Fed can probably mop up any difficulties in financial institutions with bail outs.
And the government can put pressure on banks to hold off on foreclosing properties and so on.
But if enough individuals and businesses get into trouble and have to cut back on consumption and spending that will start to affect even the large cap companies.
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Yeah I remember Buffett often talked about interest rates being like gravity and hedging any market commentary by saying "the market looks cheap if interest rates stay at X%". Well we've seen a big adjustment to interest rates but after the initial market panic wore off no real adjustment to valuations.
Worth noting that valuations are a lot more reasonable if you look at foreign markets or US markets ex-Big Tech and you are still getting an equity risk premium of a few hundred basis points. Only problem is that you aren't getting much growth and you are much more vulnerable to margin pressure and cyclical risks.
With Big Tech you are clearly paying up for the growth and so long as secular growth prospects are expected to remain intact and in line with the outperformance over the last decade then that is going to be a lot more attractive than a 5% fixed return in bonds.
History would suggest that it is hard for companies to grow faster than the world economy for extended periods. Especially when you have a trillion dollar market cap. But in a winner takes all scenario that dynamic can probably continue for some time longer especially as more and more dollars of consumer and business spending continue to get reallocated to Big Tech. That was the dynamic during the pandemic with remote working, almost universal adoption of e-commerce and far more time spent online. And could well be the dynamic in the future as companies spend on AI.
But where I think investors could be getting it wrong is that
a) AI might not be that profitable in the early years as it will require massive investments
b) Tech hasn't been tested by a proper recession. COVID didn't count because they were pandemic beneficiaries. We've already seen revenues go ex-growth during the slowdown which has so far been offset by popular cost cutting initiatives and AI hype as well as optimism there will be a pivot. But we saw in 2022 how far Tech can fall if investor sentiment sours towards them.
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Yeah that is the flip side of avoiding recession.
Running trillion dollar deficits with the economy at full employment is a recipe for inflation and 5% interest rates are not going to be enough to bring inflation back to target.
Fed doesn't have the balls to do much more than higher for longer and hope.
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Fascinating that when you look at the EAFE index that total returns for the last 5 years and 10 years have been around 3-4% a year and YTD its been pretty much flat and the index is pretty much back where it was before COVID. And difficult to imagine things getting better as inflation is higher than the USA and growth prospects are weaker and unlike the USA the markets impose fiscal discipline and the companies in the index are more economically sensitive.
And I am sure if you took the Magnificent 7 out of the S&P 500 then a S&P 493 would probably be more like high single digit returns over those time spans and also probably trading around the same level as before COVID and showing very little recovery YTD after the initial bounce from the August/October 22 lows.
And Magnificent 7 now make up around 30% of the S&P 500. And seem fairly immune to the macroeconomic backdrop. Probably because if you have a long duration and don't think there is a sea change and higher interest rates are temporary and a hard landing is off the cards then why would you even worry and risk getting off the gravy train especially with AI extending the growth runway.
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I think Marks is making the common mistake of ascribing far too much importance to interest rates. Interest rates stayed low post GFC because the economic recovery was weak and growth remained anaemic. That changed post COVID because the government started running trillion dollar stimuluses and continued to do so even after the economy was back online and that contributed to a lot of inflation a lot of growth and consequently higher interest rates.
In other words interest rates are more of a resultant rather than a cause. And unless the markets can impose fiscal discipline the way they did with the UK then trillion dollar deficits will continue and so will economic growth which will support higher interest rates and valuations.
But agree with him about sentiment. We saw that investors were initially shocked by the rate hikes and we had a bear market in 2022. But once inflation started falling and there were no signs of recession they just looked through the rate tightening cycle and towards future rate cuts. And markets continue to ignore any hawkish rhetoric and rally on anything remotely perceived as dovish. If we are in a higher for longer environment it will take time for that to be reflected in market valuations but there will be a potential offset from higher growth and earnings. So perhaps markets will continue to go sideways for the foreseeable future.
Also while professionals like Marks may see better risk-adjusted returns in bonds most investors aren't going to get that excited about high single digit returns on bonds when they have been used to double digit returns on equities and for more active investors doubling or tripling their money in short periods of time.
And if inflation does take off again and rates need to go higher that will eat into real returns and result in interim losses. For there to be more appreciation of the virtues of bonds I think we need to experience a more prolonged bear market. Not another short lived one with a V shaped recovery which reinforces attitudes such as "buy the dip" and "hold on and wait patiently for the inevitable recovery".
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What concerns me a little is that yes the Fed isn't going to be much more aggressive but you'd expect a little more of a term premium as the yield curve continues to un-invert. I think historically it is something in the range of 100-150bps. And that is what I think the Fed is banking on. It is also difficult to imagine much of a pivot when IMF forecasts see the US avoiding recession. And the US government is still running trillion dollar deficits which will mean a lot of supply to absorb.
But seems like a decent insurance policy given that if there is a hard landing and a hard pivot you can probably make around a 20-30% return + interest and have dry powder to buy at much lower stock prices.
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Household net worth clearly is way higher than pre-COVID. The stock market and the housing market are a lot higher even allowing for the 10% or so decline from all time highs. And with TINA I don't think individuals hold bonds to the extent they used to and its mostly leveraged financial institutions who took the hit.
But wealth effects are pretty pathetic when it comes to stimulating consumption. The stock market has increased severalfold since the depths of the GFC and before the pandemic giveaways GDP growth was pretty anaemic.
And it is ironic really that just as ZIRP had a redistributive effect benefiting middle/upper classes by increasing asset prices the normalization of ZIRP is mostly hurting the poor who are reliant on credit cards, are seeing their rents skyrocket as landlords try to cover higher mortgages while its now even harder to get on the housing ladder as banks are tightening lending standards and mortgage rates on new mortgages are sky high. And of course at the same time they are no longer getting their stimulus checks and the cost of everything that matters to them (food, shelter, energy etc) continues to be a lot higher than pre-pandemic and going higher.
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Yup. The slightest hint of dovishness from the Fed and global markets rise around 1%.
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Isn't this metric a bit meaningless now that US companies are so global. Obviously a lot of the market cap is inflated by Big Tech companies but they have eaten the world.
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Another consideration is that if it is small companies that bear the brunt of the adjustment to higher rates then will that just reinforce the preference of investors for big companies (and Big Tech in particular) and result in even higher multiples for such stocks?
If the AI bubble like the Internet, in what year are we now?
in General Discussion
Posted
It is exciting for sure. But what is underappreciated is how much upfront investment is required and how long it might take to get a return on it.
Currently the economics of Big Tech are incredible. Capital intensity is very low. Pricing power is very strong as everyone is hooked on their products. Even as revenues are slowing they are still posting double digit earnings growth. They are free cash flow machines and a lot of that free cash flow has been allocated towards share buybacks and reinvesting in their very profitable core businesses with fairly limited risk.
If they start investing a lot in AI there is a lot more risk. Big Tech have an edge because they have incredible financial resources and are already pretty proficient in the use of non-generative AI. But IBM was a behemoth and lost its way as technology changed. And new technologies sometimes benefit users more than the providers. There was a lot of excitement as the 90s tech giants built out the internet. But it was only much later that very profitable internet companies emerged that were able to harness the technology for their benefit.