Macro
US payroll came stronger than expected (272,000 vs 190,000 expected), sending yields up and rate cut expectations further away into December. Also, The unemployment rate derived from the Household Survey conducted by BLS (the Bureau of Labor Statistics) stayed at 4% (6.6m compared to 3.7% and 6.1m unemployed a year earlier) while part-time employment far outpaced full-time positions. However, JOLTS (Job Openings and Labor Turnover Survey) from earlier this week showed that job openings are continuing to decelerate; thus, looking more broadly at the labour market is normalizing.
Fiscal policy is highly expansionary, which provides a substantial economic boost despite the Fed’s desire to stay restrictive with monetary policy. Furthermore, fiscal policy has made the last mile to the 2% inflation target challenging.
Nevertheless, spending will decline over time, and given current economic developments, US inflation could return to FED’s 2% target in early-to-mid 2025. However, this picture’s risks are outside of FED’s control. The effects of increasing fragmentation and polarization of international relations on the global supply chain might keep inflation more sticky at 2.25 to 3%. They are driven by:
- Global Tensions – current military conflicts in Eastern Europe and the Middle East, as well as competition for supremacy between two economic superpowers, China and the US
- Technological Competition – AI, semiconductors, 5G, and EVs are the main battlegrounds impacting trade restrictions.
- Economic Protectionism – retreat from globalization by adopting protectionist policies to safeguard domestic industries
- Reshoring and Nearshoring – mitigating supply chain risks, reducing international dependencies, and increasing control and reliability by moving production closer to home
- Regional Alliance – partnerships to counterbalance US dominance such us RCEP (Regional Comprehensive Economic Partnership led by China)
Rates
Strong payroll report pushed rates up across the curve by 13-14 bps at the front to 10 bps at the end of the curve. It also changed rate cut expectations. It shut the doors on the July rate cut and pushed expectations for the first cut to December, giving a 50/50 chance of a cut in September. Some investors went as far as to say that given the strength of the labour market and the economy, we might see short-term bottoming for the rates.
If the yield curve is so deeply inverted, the question is what real impact the rate cuts will have. Also, even if the Fed starts cutting rates, it might execute two or three and then pause, as it did in the rate-cut cycle in the second half of the 1990s (when the Fed cut in 1995 and started 96′ and then held off further cuts until the end of 1998).
More cautious investors believe it’s not time to dip into extended duration but for clipping coupons. Given the shape of the yield curve, they consider the front end attractive. They manage their risk by positioning themselves in the belly part of the yield curve around 4-5Y points. This part of the curve offers higher rates and less exposure to the risks related to the fiscal deficit than the long end of the curve. They also diversify across IG, HY and EM. Such a diversified portfolio can bring 6-7% returns, not much lower than historical average equity returns but with much lower volatility.
Credit
There is a lot of optimism in the credit market, given that the maturity wall risk has not materialized in the worst way possible. This is mostly due to the good economic environment, which tightened spreads and allowed companies to refinance their debt and, thanks to improved cash flows, retire some of their debt.
On a valuation basis, credit does not look particularly attractive, but some opportunities look better than others. Those opportunities include securitized credit over corporate credit, financial over non-financials, multi-sector credit loans, residential mortgages, agency-backed securities, or CLOs.
Credit investors must remain vigilant to signs of a potential economic slowdown. However, given that the maturity wall was postponed further into the future, there is no imminent catalyst for a spread widening.
Equities
Magnificent-8 is approaching a market cap of $17t, almost 60% of the US GDP and 16% of the global GDP ($108t). They are now trading at 41x GAAP Net Income and 1.6% non-diluted Free Cash Flow Yield. The top three companies, Microsoft, Nvidia, and Apple, have reached a market cap of $10 t, more than a third of US GDP ($28t).
The stock market has had its highest valuation since 1999. However, back then, high valuation was caused by minor to mid-size internet-based companies, many of which needed more revenue or proven business models. Fast-forward to today, we have mega-cap tech, which is high priced but has strong earnings, cash-flows and growth potential, diverse revenue stream, and influence over enterprises space. Moreover, those companies built monopoly-like moats around their business model. Overall, they might look expensive but are a far better value proposition, as their dominance so far went unchallenged.
For a while now, the public has been calling for more regulation of big tech. However, there was no meaningful outcome other than a few financial penalties in Europe and grilling by Congress over the handling of misinformation during the pandemic and election cycle. There is also debate over whether mega-cap technology stifles innovation. Some VCs (Venture Capitalists) argue that those tech giants wield significant market power, which creates barriers to entry and inhibits the growth of
Smaller startups. They also acquire potential competitors before they have a chance to dominate their space and become self-sustaining and profitable. In fact, this practice is so frequent that VCs consider it one of their strategies.
Some thought that AI might be the new technology that disrupts tech giants. However, the development of large-scale projects, such as foundational models, has become increasingly dominated by those companies. They have substantial capital, computational power, and access to vast amounts of training data critical for developing AI. They also attract top AI talent by offering the most competitive salaries, research freedom and the opportunity to work on the most significant projects. US tech giants are now using AI to enhance their core products, improve efficiency, reduce costs and even drive innovation through new AI-related ventures.
Those arguments explain the excellent performance of mega-cap tech, which has driven US-market returns this year. It is difficult for Portfolio Managers to underweight these tech giants, as their success and dominance have made them staple elements in portfolios. Last week was no different, as tech was up 6%, real estate was higher, and the performance of any other sector was underwhelming as investors concentrated on big tech.