Monday Macro – what to invest (according to asset allocators), vol spikes and big government debt
US interest rates come down at last but the UK pauses.
I’m away in sunny (I hope) Italy next week, so no letters next week.
Last week was busy in Macro land. At long last, the US Federal Reserve cut interest rates by a confidence-boosting (for investors) of 0.50%. The UK paused any further cuts, pushing the sterling higher again. My guess is that the US Federal Reserve will probably pause for now, echoing their BoE peers, although I think we may get another UK rate cut before the end of the year. Here’s a quick summary of the main points from the Daily Shot:
The Fed implemented a 50 bps rate cut, signalling concerns about the labour market.
However, Chair Powell downplayed the likelihood of further outsized rate cuts moving forward.
I do not think that anyone should look at this and say, ‘Oh, this is the new pace.’ I think we’re going to go carefully, meeting by meeting, and make our decisions as we go.
The FOMC projections signal another 50 bps of cuts this year, followed by 100 bps in 2025 and 50 bps in 2026. Markets interpreted Powell’s comments and the rate projections as somewhat hawkish. Here is the dot plot.
Source: @TheTerminal, Bloomberg Finance L.P.
The FOMC statement indicated that employment and inflation goals are now “roughly in balance.”
The BoE left its benchmark rate unchanged and reduced the pace of bond buying.
The Committee voted unanimously to reduce the stock of UK government bond purchases held for monetary policy purposes, and financed by the issuance of central bank reserves, by £100 billion over the next 12 months, to a total of £558 billion.
Source: CNBC Read full article
UK core inflation remains above that of the Eurozone.
Source: @TheTerminal, Bloomberg Finance L.P.
Markets have reacted, somewhat predictably, to this big-picture signalling.
If we look at September returns to date (until this weekend), US equities (S&P 500) are up 1.23%, while UK equities (FTSE All Share) are down 1.47%.
Looking more broadly, the FTSE All-World index is in the black, up just under 1%. The big winner so far for September has to be China —the FTSE China 50 index is up 3.55% in September so far, while the Hang Seng Index is up 3.14%.
The Canadian market has also scored some gains—up 2.2%—while Indian equities continue their rally. The India BSE 100 index is up a staggering 22.2% year to date. Indian equities have now increased by 84% since January 2021 while Chinese equities dropped by 47%.
Looking at another measure (in 2024) using the MSCI India index, local equities are up 22% in USD to the end of July, despite earnings being revised only 2% higher. The share of foreign institutional investors (FIIs) in the Indian markets has fallen to about 15% of the total market cap. By contrast, domestic savings plans known as SIPs now contribute $2.5bn per month to the market, compared to $25bn of foreign inflows for 2023. Local investors are powering Indian equities on an unprecedented scale.
What to invest in: the asset allocators’ views
September, along with January, is prime crystal ball gazing time. Investors come back from their holidays, expecting the big banks and fund managers to roll out their forward-looking projections. I’ve been collecting some of these as they come out – a small selection of the key ideas for investors follows.
Let’s start with Deutsche Bank in the US:
“Our base case sees a recovery from the current ongoing pullback melding into the potential typical election pullback, before rallying into year end.
The current pullback has been driven by the de-rating of MCG & Tech and labor market fears. The Tech de-rating looks done for now, with positioning having been cut back to being in line with slowing earnings growth and relative performance at the bottom of its long-run trend channel. Labor market growth more than anything looks simply to have landed back to steady pre-pandemic trend rates. More broadly, we see the cycle as having plenty of legs with early indicators picking up, several aspects of the cycle yet to kick in, solid spending growth and inflation diminishing as a driver.
However, the focus will soon shift to the close US election, with the playbook historically being for the market to pull back (4-5%) starting a month before (early October) and then rally into year-end on our assumption of a clear resolution.
We see robust and broadening earnings growth continue in the low double digits, in line with typical growth rates outside of recessions, taking S&P 500 EPS to $258 (13%) in 2024 and $285 (10.5%) in 2025. Valuations are at the top of the fair value range, but we see them being well supported by solid equity demand-supply and we nudge our year-end target for the S&P 500 up from 5500 to 5750.
At the sector level, we remain neutral MCG & Tech; overweight the Financials, Consumer Cyclicals and Materials; remain neutral the Industrials and Energy; across defensives, we move Utilities back to neutral, remain neutral Real Estate, and remain underweight the rest of.”
Sticking with the US, we have another big investment bank next, the French house SocGen. It also just released its seven key calls for the next few months:
· The Fed matters more than the US election. Yield curve steepeners to sustain in DM and EM, while flatteners in Japan on further BoJ hikes
· Market leverage in this cycle comes mainly from the Japanese currency – not from corporates or households. The unwind of the yen carry trade has much further to go
· US growth drivers remain solid, but some measures are cooling fast from the overheat, such as: Nasdaq-100 Profit growth rate is slowing
· Continue to like Periphery Europe and the UK over Core European countries in Rates and Equities
· Asset allocation: Big changes in FX with further allocation to JPY to 20% from 12%; in equities, Japan allocation dropped for the third time in last 12m and now to 0%! small shifts in the US equities to 27 from 30% (still the biggest asset in the mix). Staying bearish on Oil (demand-supply mismatch continues) and bullish on Gold
· The outcome of the US election matters but mostly in a ‘sweep’ scenario. Equities are more sensitive to corporate taxes (-6% S&P 500 EPS impact in Dems / +5% in Republicans) and tariffs, while the USD and USTs are more sensitive to deficits and geopolitics.
· We carry out an in-depth review of the stakes surrounding the Trump and Harris policy agendas, highlighting the key potential policy differences and their likely impact on major asset classes under different scenarios (see 3rd table below), also considering the impact of a Republican or Democratic sweep versus a split Congress.
Next, we have Amundi, one of the biggest asset managers in Europe. Its Amundi Institute just released the latest version of its Global Investment Views.
“Market moves over the summer have served as a reminder that, at a time of high valuations, any mismatch on corporate earnings or monetary policy expectations and any scare on growth could be triggers for sudden falls. While most major markets have recovered from the volatility seen in early August owing to the Fed put, we cannot ignore the fact that some segments are still priced for perfection. This points to corporate earnings and policy actions coming under the spotlight even more, particularly as inflation cools, economic activity weakens and the noise around US elections increases.
US soft landing, no-recession scenario in the US is confirmed. Slowing but not collapsing labour markets and weak fixed investments all point to a mild deceleration. For the UK, we marginally upgraded growth forecasts for this year but there are still question marks on domestic demand.
Disinflation trend confirmed in US and Europe. We revised down our Q4 2024 headline consumer price inflation projections for the US due to weakness in unit labour costs and the employment cost index. An improvement in labour productivity should also foster disinflation. In Europe, the speed of disinflation is linked to services inflation, which could be sticky.
The phase of central bank divergences may be coming to an end, with Japan an outlier. We expect three rate cuts from the Fed, and three each from the ECB and the Bank of England for the remainder of year.
China is facing a difficult road to recovery. Support for the housing markets has been short lived even as labour markets deteriorated. Corporate profitability is being affected by worsening consumer confidence.”
Sticking with the European fund manager space, I’d highlight the Dutch firm Robeco, which has a fab reputation for systematic investing. It just released the 14th edition of its regular Expected Returns Forecast for 2025 through 2029 under the title Atlas Lifted.
“This year’s report features the mythological titan Atlas who lifts the world on his shoulders with the help of entrepreneurial innovations in artificial intelligence and an abundance of other profitable investment opportunities. Atlas is not only lifting the world, but also investment returns on most major asset classes. In our base scenario, the world’s continents are not drifting further apart economically and politically, as in our bearish scenario, but we also do not foresee that they become much more connected, as in our bullish scenario.”
Key headlines:
· 5-year outlook sees a shift away from limited government
· Emerging market equities and bonds are the preferred asset classes
· Base, bear and bull cases focus on outlooks for inflation and growth
Base case: ‘Atlas Lifted’ (50% probability)
In this scenario, Robeco anticipates moderate but steady economic growth, driven by advancements in AI, with US GDP per capita expected to grow by 1.75% annually. Other advanced economies, particularly in Europe, are anticipated to catch up with the US, contributing to balanced global growth. Investment opportunities are expected to improve as capital allocation becomes more efficient. Inflation is predicted to average around 2.5%, with central banks potentially underestimating higher neutral interest rates.
Bear case: ‘Atlas Adrift’ (30% probability)
This scenario envisions persistent inflation and stagflation in the US, driven by ongoing high government deficits and shifting global power dynamics. Inflation could remain elevated, threatening overall economic stability. This scenario suggests that while the battle against inflation may seem won initially, the overall economic stability will be under significant threat, similar to historical periods of high inflation.
Bull case: ‘Atlas Connected’ (20% probability)
In the most optimistic scenario, rapid AI adoption leads to significant productivity gains, with annual growth reaching 2.25%, driving robust economic performance, with real GDP growth approaching 3% and inflation remaining around 2%. Improved geopolitical stability and increased capital deepening would contribute to a favourable investment environment, where central banks maintain neutral policy rates.
Expected Returns
Investment implications
Base case: Asset returns in euros are projected to be below long-term averages, with exceptions in emerging market debt, investment-grade assets, and commodities. Risk-free rates are expected to rise, reducing risk premiums across most asset classes. Emerging market equities are expected to deliver the highest returns, with EM stocks projected to return 7.25% annually in euros, followed by emerging market debt at 6.0%. Developed market equities are expected to return 6.5%. In the credits space, investment grade corporate bonds are seen yielding 5.25% over the next five years, rising to 5.5% for high yield. Real estate is seen returning an average of 5.5% a year in the base case, while commodities are expected to bring 4.75% in returns.
Bear case: Inflation and instability could hurt returns, especially in high-risk investments, though commodities may benefit, with returns potentially rising to 8.0%.
Bull case: AI-driven productivity could lead to above-average returns for EM debt and commodities, with other sectors also performing well.
The Looming Debt Crisis?
Call me an old-fashioned fiscal hawk, but if I were a bond investor, I’d be focused on the rise of big government and the remorseless increase in government debt, especially in the US and, to a lesser degree, the UK (and France).
I am not one of those slightly ideological types who think that once you get past debt ratios of say 100%, you are automatically doomed – the example of Japan shows that high levels of debt are manageable and can be sustained for many years.
It is also the case that the UK has had much higher levels of debt in the past. For instance, the Great War, WW1, caused an explosion in the National Debt, up to 135 per cent of GDP in 1919. Then, in the economic troubles of the 1920s, it rose to 181 per cent in 1923 and stayed above 150 per cent of GDP until 1937. The National Debt dipped to 110 per cent of GDP in 1940 before soaring to 238 per cent of GDP after the close of World War II in 1947.
So, we shouldn’t think that once the 100% level is broken – public net debt to GDP, its hell in a handcart time. However, we must also be aware of practical consequences, especially for monetary and central bank policy (The Japanese have had to run term premia policies for decades). High interest rates also impose a heavy burden on servicing the debt, although this can be managed by monetary policy. And there’s also the spectre of ageing societies, imposing ever more costs on society and pushing up debt levels even higher.
Most smaller countries like the UK and France are now figuring out how to reduce their yawning deficits (clue to the UK solution – more taxes), but the Yanks are oblivious. Both election manifestos from the two parties are full of promises to spend more and tax less. Both have had their manifestos costed, and both will add even more debt to the existing pile of debt. Worries about this debt aren’t going away. As Torsten Sløk, chief strategist at the massive US PE firm Apollo notes, government debt levels will rise from 100% to 200% of GDP. Deficits are projected to be more than $1 trillion yearly for the next 10 years.And, crucially, $9 trillion of government debt will mature over the coming 12 months alone. Since the Fed started raising rates, households, pensions, and insurance companies have been buying more Treasuries.
The bad news is that China has lowered its holdings of Treasuries from $1.2 trillion in 2015 to $800 billion today. Therein lies the challenge. More spending and bigger deficits begets more debt to issue, but some of the big buyers (the Chinese) of that debt aren’t playing anymore. At the moment, the weighted average maturity of debt outstanding is currently 6 years, but a rising share of debt outstanding is T-bills, currently 22%, and these need to be constantly reissued. Treasury auction sizes will in 2024 increase on average 27% across the yield curve. Sløk observes that debt servicing costs are currently 12% of total government outlays and could go higher despite lower interest rates. Already, interest payments have doubled from $1 billion per day before the pandemic to almost $2 billion per day in 2023.
The August volatility spike
The events of late July and early August seem like an eternity ago – at the time investors genuinely seemed to be concerned we were heading for some sort of crash. One way of measuring this is to look at the volatility index for US shares, the Vix. This has been becalmed – by historic measures – for much of the last few years. But then, for a few days, the measure shot up – smashing past the long-term average at around 20. The chart below shows end-of-day levels for the widely watched Vix index, which charts the turbulence of the S&P 500. The chart starts in early July 2023, and you’ll quickly notice a sudden spike to over 38 in early August.
But this chart hides a secret—it doesn’t show intraday peaks. On August 5th, the Vix actually peaked within the day at 65.7. You might remember that day – if you weren’t ignoring it all on a sunny Greek beach – because Asian markets (especially Japanese equities) lunged downwards while overnight hedging activity in VIX futures ended up at a much higher level than average. The relative volume peaked at around 6x the 10-day average and VIX futures then started heading lower.
At some point in the morning of 5 August, the spot VIX started to diverge significantly from the traded VIX front month future and the VIX went on to print 65.7. What happened? SocGen options analysts have dug around and reckon that the S&P500 option markets underwent significant technical problems overnight.
They report that “anecdotal evidence shows that some market makers were caught short on volatility contracts on Monday morning, and the liquidity issues likely created a vicious volatility spiral, which abated only when cash market opened, and volatility sellers stepped in”.
The investment bank’s researchers reckon this was an anomalous move in the VIX on 5 August. “The reaction in the price of VIX was too extreme compared to data from the past 32 years and was a result of the technical problems faced by the S&P500 options market.”