When Will Market Drawdowns Subside? | ITK With Cathie Wood

Key Concepts

• Fiscal Policy: Government spending and taxation.
• Monetary Policy: Central bank actions to manage money supply and interest rates.
• Quantitative Tightening (QT): The process of reducing the size of a central bank's balance sheet.
• Treasury General Account (TGA): The U.S. Treasury's primary bank account.
• Inflation: A general increase in prices and decrease in the purchasing value of money.
• Deflation: A general decrease in prices and increase in the purchasing value of money.
• Depreciation: The decrease in value of an asset over time.
• Accelerated Depreciation: A tax accounting method that allows for larger depreciation deductions in the early years of an asset's life.
• SNAP (Supplemental Nutrition Assistance Program): A U.S. federal program that provides food-purchasing assistance for low- and no-income levels.
• Money Growth: The rate at which the money supply increases.
• Velocity of Money: The rate at which money is exchanged from one transaction to another.
• Yield Curve: A graph showing the relationship between the yield on bonds of different maturities.
• Inverted Yield Curve: A situation where short-term debt instruments have higher yields than long-term debt instruments.
• Labor Force Participation Rate: The percentage of the working-age population that is either employed or actively looking for work.
• Productivity: The efficiency of labor or the output per unit of input.
• AI (Artificial Intelligence): The simulation of human intelligence processes by machines.
• Stablecoins: Cryptocurrencies designed to maintain a stable value relative to a specified asset or basket of assets.
• Liquidity: The availability of liquid assets (cash) to a market or company.

Summary

Current Market Nervousness and Short-Term Liquidity Concerns

Kathy Wood of Arc Invest addresses the current nervousness in equity and crypto markets, attributing it primarily to short-term liquidity drying up. This is linked to the Treasury General Account (TGA) and the Federal Reserve's balance sheet. She anticipates these issues will clear up within the next month, citing the expected end of quantitative tightening (QT) on December 1st. While many expected QT to end earlier, its continuation unsettled markets. Wood expresses concern over some Fed officials' fears of persistent inflation, contrasting it with Arc Invest's strong view of deflationary forces at play.

Fiscal Policy and Government Shutdown Impact

The discussion touches upon fiscal policy, noting the government shutdown and its impact on employment numbers, which are unavailable on this "employment Friday." The budget deficit, while still significant at 5.7%, has improved from nearly 8%. The government shutdown is contributing to a reduction in force and a build-up of cash in the Treasury General Account (currently at $940 billion, above its normal $600 billion). Wood highlights the SNAP (Supplemental Nutrition Assistance Program) participation rate, which remains elevated at 12.5% despite a near record low unemployment rate, suggesting potential overspending or abuse of the program.

Pro-Growth Tax Policies and Future Economic Outlook

A key point is the "one big beautiful bill" (OB3) tax package, which introduces full 100% depreciation for manufacturing structures, equipment, domestic R&D, and software in the first year of service. This is a permanent, pro-growth policy expected to attract foreign direct investment and lower the effective corporate tax rate to approximately 10%. Wood anticipates this will lead to a "productivity-driven almost boom in economic activity" next year, transforming the current "rolling recession" into a "rolling recovery."

Monetary Policy and Inflationary/Deflationary Signals

Regarding monetary policy, money growth is at 4.8% (September), with inflation hovering between 2.5% and 3%. Wood argues that money growth is at the lower end of historical norms, while inflation is at the higher end relative to disinflationary periods. She believes the Fed is overly concerned about sticky inflation and is missing deflationary signals, exacerbated by tariffs and lags in data. She points to falling oil prices (below $60 for West Texas Intermediate) and the "Truflation" index at 2.5% as evidence of deflationary pressures. The consumer confidence index shows intentions to buy are not picking up significantly, countering fears of anticipatory purchasing driving prices higher.

Gold Market Cap to M2 Ratio and Historical Parallels

A provocative chart from Julian (formerly of Arc Invest) analyzes the ratio of gold market cap to M2. This metric has peaked twice before: during the Great Depression and in the early 1980s. Both instances were followed by significant stock market rallies. The current peak in this ratio, driven by a doubling of the gold price, suggests a potential peak for gold relative to M2. This historical parallel suggests positive outcomes for financial markets.

Inflation Expectations and Liquidity Tightening

Inflation expectations, as measured in the bond market, have started to come down after a period of increase, which had made the Fed cautious. However, overnight liquidity has tightened, mirroring pre-COVID levels seen in 2017-2019, which were weaker years for financial assets. Wood believes the Fed will continue to ease, the government will reopen, and the TGA will release funds, but the key uncertainty is the velocity of money. If money growth is positive and velocity falls, it will have a disinflationary or deflationary impact.

Yield Curve Inversion and Economic Weakness

The inversion of the yield curve (2-year Treasury yield vs. 3-month Treasury yields) is highlighted as a typical precursor to recession, with exceptions in the mid-90s and 1998 due to Fed intervention. The 10-year vs. 2-year yield curve has been in a downtrend since 2008-2009, suggesting the bond market is incorporating deflationary undercurrents.

Velocity of Money and Labor Force Participation

The velocity of money is shown to be rolling over, mirroring the decline in the labor force participation rate. This decline is attributed to baby boomers retiring and potential skill set mismatches with new technologies. A falling velocity of money implies that more money growth will be needed to maintain economic growth, potentially requiring further Fed easing.

Productivity and GDP Growth

Real GDP has held up, attributed to productivity gains from new technologies. If these technologies continue to infiltrate the global economy, productivity will rise, allowing for accelerated GDP growth and lower inflation by reducing unit labor costs.

Manufacturing and Services Sector Performance

Manufacturing is stabilizing but still contracting, while services have recently ticked up into positive territory, seen as a "green shoot." However, services prices paid remain high, a concern for the Fed. New orders are picking up, but pricing is not coming down, requiring further investigation into services inflation drivers and tariff impacts.

Employment as a Lagging Indicator

Payroll employment is presented as a lagging indicator, with corporate profits typically bottoming well before employment turns up. This pattern was observed during the tech and telecom bust (2001-2003) and the 2008-2009 financial crisis.

Labor Shortage Index and Layoff Announcements

The labor shortage index is at levels seen during past wars, but Wood suggests this might be due to labor hoarding following COVID-related labor acquisition difficulties. She notes a significant increase in layoff announcements (175% in the latest month), indicating companies are beginning to reduce their workforce as the perceived labor shortage disappears.

Jobs Availability and Entry-Level Market

The "jobs easy to get minus jobs hard to get" indicator shows jobs are becoming harder to get, declining before and during recessions. The unemployment rate for recent graduates is rising more steeply than the overall rate, attributed to AI impacting entry-level jobs.

Quits Rate and Duration of Unemployment

A declining quits rate suggests growing discomfort with the job market, typically occurring during recessions. The duration of unemployment is increasing, which is expected to prompt Fed response as it becomes evident that people are struggling to find jobs.

Job Openings and S&P 500 Response to AI

Job openings have normalized after a COVID-era surge and are now slightly below trend. The S&P 500 is showing a positive response to productivity gains unleashed by AI tools like ChatGPT.

Consumer Behavior and Housing Market

The personal saving rate has not recently increased, suggesting consumers are not significantly pulling back due to caution. Loan delinquencies, particularly subprime, are reaching levels seen in 2008-2009, potentially influenced by the availability of ride-sharing services like Uber and Lyft. Home buying intentions are high, but perceived buying conditions are poor. Pending home sales and new/existing home sales are ticking up but remain historically low. Builders have inventory and may need to cut prices or see interest rates fall significantly. New home prices are falling, and existing home price increases are slowing.

Capital Spending and Trade Deficit

Non-defense capital goods new orders are at the beginning of a significant cycle in the U.S., driven by tax policies and foreign direct investment, with AI and power being key drivers. The trade deficit is building again, which is expected if the U.S. economy grows faster than other economies.

S&P 500 Earnings and Commodity Index

S&P 500 earnings per share have risen, with the "ChatGPT moment" in 2022 marking a turning point. The commodity index is well down from its 2008 peak, indicating a lack of inflationary pressure.

Metals to Gold Ratio and China's Influence

The metals to gold ratio continues to fall, with China's exports to the U.S. down 25% in September. This suggests China is cutting prices more aggressively in other markets, creating a deflationary impulse. Treasury yields are less correlated with this ratio since the Fed began tightening in 2022.

Copper Prices and S&P 500 vs. Gold

Copper prices are increasing, but not as much as gold, potentially due to demand from electric vehicles and data centers. This could represent a relative price shift rather than a broad economic indicator. The S&P 500 to gold ratio is being watched closely; while gold is up and the S&P 500 is wobbly, the expectation is for the S&P 500 to eventually outperform gold, especially if gold prices fall relative to money supply. This is not expected to resolve like the 1970s due to deflationary rather than inflationary pressures.

Treasury Yields and High-Yield Spreads

The long-term trend of declining Treasury yields has changed. High-yield spreads show "not a care in the world," suggesting excesses are not on the equity side but rather in private credit and private equity, driven by a search for yield. More blowups are anticipated in this area.

Bitcoin and Stablecoin Dominance

Arc Invest remains bullish on crypto assets but acknowledges that stablecoins are increasingly usurping the role previously envisioned for Bitcoin as an insurance policy against wealth confiscation or inflation in emerging markets. Stablecoins have reached nearly $300 billion. While this may reduce Bitcoin's potential price upside, the doubling of the gold market cap has offset this impact, keeping Arc Invest's bull price target of $1.5 million largely intact. Crypto assets are highly susceptible to liquidity drawdowns, which are expected to clear by year-end.

Conclusion and Future Outlook

Wood anticipates that liquidity issues will be resolved by the end of the year, with potential Fed easing around December 10th and the return of government statistics, including the employment report in early December. She believes the bull market is firmly in place and will continue at pace.