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In case you’re just tuning in, stocks are back at record highs following better-than-expected numbers from a company that makes things hardly anyone understands but everyone apparently needs.
Nasdaq 100 futures are up 2 per cent at pixel time, with Nvidia gaining an entire HSBC in value overnight. To Marko Kolanovic, chief global markets strategist at JPMorgan, all this rampant asset price inflation is beginning to look quite inflation-y:
In the last 3 years, narratives for the macro regime went from the ‘roaring 20s’ post-pandemic secular recovery, to imminent recession, to the current goldilocks and best of all worlds when it comes to growth, inflation and monetary easing. Optimism now is quite high and some describe the current regime as ‘parabolic stock markets’ and ‘platinum-locks’ (an even more desirable version of goldilocks). A recent market theory is that stocks should trade higher because r-star (the neutral rate of interest) is making financial conditions easier. This sounds to us like a stretch, and consumers who can’t afford the new mortgage rate or a car loan payment are not deciding based on theoretical changes in r-star. We find current markets developments odd ; for instance the UK, Japan, and Germany being in a technical recession while Europe and Japan stock markets are moving to all-time highs, and various far-fetched applications of AI being fully priced in related stocks and expected to boost to the economy near term.
The increase of CPI and PPI last week and some weaker economic data from the US and abroad cast some shadows on the most optimistic scenarios. With the Nasdaq index rallying ~70% in a year, tight labor markets, and high immigration and government fiscal spending, it wouldn’t be a surprise that inflation may stop declining or move higher. Can one get inflation under control with stock and crypto markets adding trillions of paper wealth, and tightening aspects of QT neutralized by treasury issuance? For instance, just one tech company’s recent gains added the equivalent of the market capitalization of the bottom 100 companies in the S&P 500, and the size of the crypto market doubled since last fall. Can the Fed lower inflation with these developments that are loosening monetary conditions?
Momentum is the only show in town right now because volatility is low, risk is in fashion, Mag7 earnings growth looks unstoppable, and megacap concentration makes equity easy to overweight. It doesn’t matter (yet) that between October and January the expected Fed cuts for 2024 went from two to seven, and have since come down to maybe three, but equities remain more than 25 per cent higher.
The big risk, Kolanovic says, is that macro bites back:
We believe that there is a risk of the narrative turning back from goldilocks towards something like 1970s stagflation, with significant implications for asset allocation.
What were the main market features of the 1970s? Perhaps the most important is high inflation that came in 3 separate waves, all in some ways related to geopolitical developments. Geopolitical developments of that era were significant proxy wars in Southeast Asia (Vietnam), several wars and revolutions in the Middle East, oil embargos resulting in energy crises, shipping disruptions, and an increase of deficit spending. Deficit spending and the rise in interest payments (on government, corporate and consumer debt) were a significant drag on the economies in the 1970s. Equity markets were essentially flat from 1967 to 1980 in nominal terms, and bonds and credit outperformed significantly.
The world in 2024 has war in Eastern Europe, the Middle East and potentially the South China Sea, in addition to elections nearly everywhere. There are shipping disruptions and an energy crisis that only the most optimistic of commentators believe has played out. Deficits in the West are unsustainable and China is trying to ease its way out of a deflationary spiral. Something’s got to give, Kolanovic says:
By far the largest risk is tensions or a trade war with China that would have a much bigger impact on the global economy and would lead to a significant second wave of inflation and market selloff. [ . . . ] This trend may be a reversion of period from the late 1980s to 2000s when the west was enjoying positive feedback loops from the “peace dividend” and is now getting undone into a regime that may be burdened by a “conflict tax or conflict inflation.”
How did this peace dividend feedback loop work? It is essentially a positive feedback loop between improved global geopolitical stability, opening of command economies, and an increase in global trade (goods, services, commodities), resulting in declining inflation and interest rates, thus reinforcing the growth, credit-worthiness and asset valuations across economies. It is easy to see this feedback loop going into reverse, de-coupling of global trade, supply chains and economies that is leading to higher inflation, possible energy and trade disruptions or even hot wars, and growing fiscal deficits, leading to higher interest rates, economic slowdown, and lower asset valuations.
If such a negative feedback loop were to take hold (as it did in the 1970s), investors would move out of equities and into fixed income assets – i.e. seek to receive elevated yields that companies and governments need to pay to fund, rather than more elusive equity growth in a stagflationary regime. Equities were flat from 1967-1980, and with yields averaging above 7%, bonds significantly outperformed stocks.
It’s going to take a lot of graphics card sales to counteract all that.
