The Market Is Rotating Faster Than Policy Can Keep Up | Weekly Roundup

Forward Guidance Roundup – January 26th, 2024 Summary

Key Concepts:

• Run It Hot: The current market narrative of sustained economic growth despite potential inflationary pressures.
• K-Shaped Economy: A scenario where economic recovery is uneven, benefiting higher-income individuals and sectors while leaving lower-income groups behind.
• Mag 7: The seven largest US technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) and their outsized influence on market performance.
• Cyclical Stocks: Stocks whose performance is closely tied to the economic cycle.
• Sentiment Surveys: Indicators measuring investor optimism or pessimism.
• Credit Spreads: The difference in yield between corporate bonds and government bonds, reflecting perceived risk.
• VIX: The CBOE Volatility Index, a measure of market expectations of near-term volatility.
• Capex: Capital Expenditure – funds used by a company to acquire, upgrade, and maintain physical assets.
• Treasury Companies: Financial institutions specializing in issuing and managing corporate debt.

I. Market Sentiment and Potential Corrections

The episode begins with a discussion of rising bullish sentiment, indicated by surveys showing the highest levels since November 2023 (Slide 42). Goldman Sachs client polls (Slide 43) reveal bullishness at levels seen only three times in the past decade, historically preceding market corrections. Goldman’s risk appetite indicator (Slide 51) is at the 96th percentile, suggesting limited upside and increased potential for pullbacks, particularly given high systematic investor leverage when the VIX is low. The concentration of market gains within the “Mag 7” companies is highlighted as a factor contributing to this potential vulnerability. Rotations are occurring beneath the surface, with various sectors experiencing gains while the Mag 7 lag.

II. Shifting Market Dynamics & Sector Rotations

A key argument is that the market is experiencing a “changing of the guard.” While Mag 7 concentration remains high, small-cap stocks and cyclical sectors are breaking out, a contrast to the situation a year prior. The Russell 2000 has seen an eight-day winning streak, while the Mag 7 are showing signs of slowing. This suggests a broadening of economic participation and a potential shift away from tech dominance. The XRT (SPDR S&P Retail ETF) is rallying, indicating a recovery in consumer spending. City’s stimulus basket (Slide 52), tracking companies leveraged to low and middle-income consumers, is also showing positive momentum. A breakout in the restaurant index (John Kinsky at PTIG) further supports this trend.

III. Credit Conditions and Liquidity

Credit spreads remain remarkably tight (308 basis points – Slide 48), significantly below historical averages, even during non-recessionary periods. This suggests ample liquidity and a willingness to take on risk. However, this also implies limited room for further spread compression and a potential for asymmetric downside risk if sentiment shifts. The hosts emphasize that stimulating financial markets and stimulating Main Street are distinct processes, and caution that focusing solely on financial asset inflation may not translate to broad-based economic benefits.

IV. The Role of Monetary and Fiscal Policy

The discussion turns to the upcoming Federal Reserve meetings and the potential impact of a change in leadership. The current expectation is for no rate cuts under Powell’s remaining tenure, which could constrain the “Run It Hot” narrative. The impact of potential tariff changes under a new administration is also considered. A key point is that the current economic imbalances and political pressures could lead to interventions that distort market signals. The hosts note that Trump’s comments on credit card interest rates have already had a noticeable impact on the market, demonstrating the power of political influence.

V. AI, Capex, and Long-Term Growth

The conversation highlights the significant capital expenditure (Capex) boom driven by the growth of Artificial Intelligence (AI). TSMC’s projected sustainable margins of 56% or higher (Slide 50) demonstrate the scale of investment in the semiconductor industry. This investment is seen as a potential driver of long-term economic growth, creating new economies of scale and opportunities. However, bottlenecks in resource availability (transformers, copper) and the increasing costs of data center electricity are identified as potential constraints. The hosts note that the electrification of data centers is a significant contributor to recent CPI increases.

VI. Geopolitical Risks and Market Volatility

Geopolitical risks, particularly the situation in Iran, are acknowledged as potential catalysts for market disruption. The hosts emphasize that these events often occur when markets are fully invested, increasing the potential for sharp corrections. They suggest considering a long volatility position as a hedge against these risks.

VII. Japan, Currency Dynamics, and Global Capital Flows

The situation in Japan is discussed, with its stock market experiencing significant gains and the yen remaining weak. The potential for the Bank of Japan to intervene and defend the yen is considered, as well as the implications for global capital flows. The hosts note that a shift in Japanese monetary policy could lead to a sell-off of US Treasuries and a rise in yields.

VIII. Crypto Market Dynamics

The crypto market is discussed, with a recent bounce attributed to factors such as tax-loss selling and the unwinding of short positions held by treasury companies. While acknowledging the potential for further gains, the hosts remain cautious, citing the weak dollar and the lack of broader market support. They suggest that a significant catalyst, such as a major policy change or a shift in global capital flows, would be needed to sustain a long-term bull market.

IX. The Consumer and the Stimulus Effect

The hosts discuss the impact of stimulus measures on consumer spending, noting that the consumer was “beaten up” at the end of last year and is now responding to increased liquidity. They highlight the breakout in the restaurant index and the City stimulus basket as evidence of this trend. They also point out that stimulating Main Street does not necessarily translate to gains in financial assets, and caution against assuming that a strong stock market will benefit all segments of society.

Conclusion:

The episode conveys a cautious optimism about the current market environment. While acknowledging the positive momentum in cyclical sectors and the potential for long-term growth driven by AI, the hosts emphasize the risks associated with high valuations, concentrated market leadership, and potential policy shifts. They advocate for a balanced approach, suggesting a willingness to take profits, hedge against volatility, and remain vigilant for emerging risks. The overall takeaway is that the “Run It Hot” narrative may be ahead of its skis, and that a period of consolidation or correction is possible.