Making Sense of the Economy and Markets Now, and Preparing for What's Next

Key Concepts

Uncertainty vs. Risk: Uncertainty implies not knowing the distribution of potential outcomes, while risk involves knowing the distribution and being able to quantify it.
Market Tails: Opportunities and significant risks are often found in the "tails" of a distribution of potential outcomes, representing less anticipated events.
Valuation-Driven Investing: Focusing on what is priced into the market versus the underlying fundamentals.
Fed Policy Uncertainty: The Federal Reserve faces challenges balancing inflation and growth concerns, leading to uncertainty in its policy decisions.
Cryptocurrencies and Stablecoins: Digital assets with varying degrees of underlying value and regulatory ambiguity.
Generative AI (Gen AI): A disruptive technology with potential for productivity gains but also job displacement and application challenges.
Geoeconomics: The use of economic tools like tariffs and sanctions in international relations.
Globalization Shift: A move away from US dominance towards a more multipolar global economic landscape.
Fiscal Sustainability: Concerns about rising national debt and the ability to manage it.
Fed Put: The market's expectation that the Federal Reserve will intervene to support equity prices during downturns.
Capital Stack: The diverse range of investment instruments beyond traditional stocks and bonds.
Central Bank Digital Currency (CBDC): The potential for governments to issue their own digital currencies.

Chazen Global Markets Presentation Summary

This presentation features a discussion between Glenn Hubbard, Faculty Director of the Chazen Institute, and Abby Joseph Cohen, Professor at the school and former Chief US Investment Strategist at Goldman Sachs, on the current state of global markets, economic uncertainty, and emerging trends.

The Chazen Institute and the Era of Uncertainty

Glenn Hubbard introduces the Chazen Institute, highlighting its 35th anniversary and the current era of significant global uncertainty, a stark contrast to the "Great Moderation" of 1991. He emphasizes the distinction between economic "risk" (quantifiable distributions) and "uncertainty" (unknown distributions), setting the stage for Abby Joseph Cohen's insights.

Navigating Market Uncertainty: Abby Joseph Cohen's Approach

Abby Joseph Cohen outlines her career approach, which involved diligent data analysis, leveraging her economics and computer science background, and collaborating with industry experts. Her core strategy was to identify what was "missing from the consensus expectation," focusing on opportunities and risks in the "tails" of market distributions that were not yet priced in.

Key Examples:

Early 1990s Optimism: Cohen was notably optimistic about the US economy's prospects, anticipating a surge in technology investment and a shift from heavy industry to advanced manufacturing and services. This was contrary to the consensus expecting stagflation and US economic decline.
- Evidence: The S&P 500's P/E ratio tripled from approximately 8 to 24 between the early 1990s and 2000.
Dot-Com Bubble Peak (2000): Cohen advised clients to "lighten up on technology" in March 2000, two years before the peak, due to excessive enthusiasm and overinvestment, even though she acknowledged the significant evolution of technology. She noted that many Nasdaq companies lacked earnings or positive cash flow, making traditional valuation models difficult to apply.

Federal Reserve Policy and Market Outlook

The discussion shifts to the Federal Reserve's upcoming meeting amidst high inflation, weakening economic data, and considerable uncertainty.

Key Points on Fed Policy Uncertainty:

Data Focus: The FOMC will consider labor data and demand indicators, which show deceleration in consumer spending and business fixed investment (equipment spending growth slowing from 8-10% to 1-2%).
Dual Mandate Balancing: The Fed aims to balance its dual mandate of price stability and maximum employment. Currently, the near-term concern appears to be growth, with the belief that inflation can be managed later.
Inflation Uncertainty: The Fed is unsure how much of current inflation is transitory (e.g., due to tariffs).
Expected Action: A 25 basis point rate cut is anticipated, as the market has already priced in a 100% probability. The Fed is expected to move slowly and steadily.

Market Reaction and Outlook:

Treasury Market: Already reflects the expected rate cut.
Equity Market: Has performed well, driven by good economic news and the expectation of lower interest rates. However, Cohen warns that this is not a simple equation.
- Argument: While lower interest rates generally boost equity valuations (discounted future cash flows), the underlying cause of rate cuts (slowing economic growth, reduced demand, and revenue) is negative for corporate profits.
- Profit Margin Compression: Expected in the second half of the year due to slower growth and tariffs. Tariffs are a sales tax on consumers, and companies either pass them on (hurting demand) or absorb them (hurting profits).
- Guidance Concerns: Third-quarter earnings reports and forward-looking guidance are expected to be weak in many industries.
- Increased Volatility: Likely for the equity market as current valuations price in continued good performance.

"Go Big or Go Home" Fed Scenario:

Negative Connotations: A large rate cut (50-100 basis points) would signal even weaker economic data and potentially raise concerns about Fed independence if perceived as pressure from the administration.

Cryptocurrencies and Stablecoins: Froth and Skepticism

Cohen expresses skepticism towards cryptocurrencies, questioning their valuation based on momentum rather than underlying value. She notes their primary use in untraceable transactions, with an estimated 90% for illicit activities.

Stablecoins:

Definition: Digital tokens backed by a national currency (e.g., dollar, euro).
Benefit: Faster transactions.
Analogy: Similar to money market mutual funds, which were considered "good as cash" until the 2008 financial crisis when some "broke the buck."
Regulatory Ambiguity: Currently viewed as securities, with ongoing debate between the SEC and CFTC.
Potential: An opportunity if well-executed and regulated, but the US's delay in creating a digital dollar has contributed to the current landscape.
Central Bank Digital Currency (CBDC): Cohen leans towards supporting a US digital dollar.

Generative AI: Disruption and Opportunity

Gen AI is seen as a potential driver of economic growth but also a source of disruption.

Key Points on Gen AI:

Investment Explosion: Significant investment in AI products and services.
Early Capital Misallocation: Similar to past technological shifts (e.g., railroads), early capital investment may not be well-spent due to bleeding-edge technology or inappropriate application.
Data Retrieval vs. Intelligence: Much of what is labeled AI is sophisticated data retrieval, not true intelligence.
Hallucination Issues: AI systems can generate incorrect or fabricated information, requiring human oversight.
Employment Impact:
- Disruption: Iterative jobs (e.g., simple coding, customer service) are at risk.
- Enhancement: Individuals can be retrained and upskilled to higher-value roles.
- Career Strategy: Focus on domain expertise and using AI to enhance productivity, allowing systems to handle repetitive tasks.
Applications: Primarily embedded within companies for tasks like risk determination (financial services) and research (law firms), but with a critical need for human expertise to validate outputs (e.g., AI hallucinating case law).

Geoeconomics and the Shifting Landscape of Globalization

The discussion addresses the increasing use of geoeconomic tools and the evolution of globalization.

Trade Policy and Tariffs:

New Environment: A departure from the post-WWII multilateral trade system.
US Benefit: The US historically benefited from and largely shaped the global trade framework.
Current Approach: Disruptive implementation of trade policy, with tariffs acting as a regressive sales tax on US consumers.
Strained Alliances: The US has alienated key allies like Canada and Mexico.
Ineffective Focus: Concerns are not adequately addressed with larger economies that may be taking advantage.

Globalization's Evolution:

Not Dead, but Shifting: Globalization is moving away from US dominance.
US Losing Dominance and Credibility: Erratic US policy allows other nations (e.g., China) to build their own trade pacts (e.g., in Asia, Africa).
Company Hesitation: Uncertainty in trade policy leads companies to hold back on investment and hiring.
Supply Chain Reconfiguration: The future of complex global supply chains is uncertain.

Fiscal Situation: Debt and Sustainability

The fiscal situation in the US and globally is a significant concern.

Key Points on Fiscal Situation:

Persistent Deficits: The US has had annual budget deficits since the Clinton administration, with deficits growing even during economic expansion.
Government Shutdown Risk: A potential government shutdown on September 30th due to congressional disagreements on the budget.
"Growing Out of It": The idea of boosting productivity and economic growth to manage deficits is discussed.
Disinvestment Concerns: Worry that the US is disinvesting in education and R&D, which are crucial for productivity.
Expenditure Side: Concerns about the impact of certain spending reductions, particularly in science, being counterproductive.
Unsustainable Debt: The current debt situation is unsustainable, with a need for gradual or crash landings.
Future Challenges: Increased military spending and potentially higher interest rates (due to real rates, growth, and inflation) will exacerbate the deficit.

The "Fed Put" and Equity Market Strategy

The market's reliance on the "Fed put" (the expectation of Fed intervention) is questioned.

Argument:

Priced-in Good News: Current equity market valuations (PE ratios, price-to-book, price-to-sales) suggest that good news is already priced in.
Fed Rate Cuts: The market assumes rate cuts will support equities. However, the reason for rate cuts (economic weakness) is a negative for corporate profits.
Diversification: The US equity market has outperformed other developed markets, suggesting opportunities in international markets with lower valuations.
Capital Stack Complexity: Investment portfolios now include a wider range of assets (private equity, private credit, alternatives), requiring careful consideration of their interdependencies.
Private Credit Risk: The lack of a full economic cycle experience makes it difficult to assess the risk management capabilities of private credit managers.

Tariffs and Trade Partner Relations: A Deeper Dive

Cohen addresses the administration's approach to tariffs and trade partners.

Tariffs:

Revenue vs. Efficiency: While tariffs generate revenue, they are an inefficient and regressive way to raise taxes, disproportionately affecting lower and middle-income consumers.
Consumer Impact: Tariffs lead to either higher prices for consumers or reduced corporate profits.

Trade Partner Relations:

Encouraging Desired Actions: If irritating trade partners leads them to align with US agendas (e.g., on drug inflow, Chinese EV tariffs), it could be beneficial.
Reshoring and Industrial Policy: Cohen supports industrial policy for industries critical to national security, advocating for reshoring production to the US or friendly countries like Canada and Mexico.
Avoiding Provocation: Caution is advised against antagonizing friendly nations that are already cooperating.

Fed Rates Trajectory and China Investment

Fed Rate Cuts:

Market Pricing: The market is pricing in three rate cuts, assuming continued economic weakening.
Fed's Approach: The Fed is expected to act in a step-like fashion, likely starting with a 25 basis point cut. A 50 basis point cut would be a significant signal of concern.
Central Bank Independence: Cohen emphasizes the importance of central bank independence, criticizing public comments from the Treasury Secretary on Fed policy.

China Investment:

Past Uninvestability: China was viewed as uninvestible due to its mishandling of the pandemic and subsequent economic slowdown.
Current Rebound: The Chinese market has shown recent strength, partly due to reservations about US trade policy benefiting China's trade alliances.
Investor Reallocation: International investors are reallocating capital from the US (perceived as fully priced) to markets like China.
Caveats: The Chinese government's actions and the unresolved real estate bubble require careful consideration.

Future Outlook: What Might the US Miss?

Looking 10 years ahead, if the US economic performance exceeds current expectations, Cohen suggests the following might have been underestimated:

AI's Impact: The transformative potential of AI could be greater than anticipated.
Policy Reassessment: A willingness to modify policies that prove ineffective.
Relative Global Performance: Other nations making significant economic mistakes could make the US appear stronger by comparison.
Re-establishment of Friendly Relations: Strengthening ties with Canada, Mexico, Japan, and Korea for supply chain resilience.
Energy Infrastructure: The critical need for investment in electricity generation and alternative energy sources (wind, solar, nuclear) to support technological advancements like AI.

Conclusion

The presentation highlights the pervasive uncertainty in the current global economic landscape, from geopolitical tensions and evolving trade policies to the disruptive potential of new technologies like AI. Abby Joseph Cohen's insights emphasize a data-driven, valuation-aware approach to investing, a cautious outlook on equity markets due to current valuations, and the critical need for sound policy and strategic investment in areas like education, R&D, and energy infrastructure to ensure future economic prosperity. The discussion underscores the importance of adaptability, careful risk assessment, and a nuanced understanding of global economic shifts.