15th November 2023
Dear Investor,
Back to reviewing our current investment themes to make sure the rationales are still intact.
Last time we discussed our Hong Kong/China and Energy themes (Commentary #21) and today we will look at the US market and economy.
One of our main theses is that what has worked over the last 10 years will not continue to work over the next ten years. So, buying and holding an index of US stocks, particularly Nasdaq, was not going to generate the same returns as they have done in recent history.
We wrote the below in Commentary #5:
“One of the biggest investment changes in the past 10 to 15 years has been the massive rise of passive investment. By passive investing, we mean where investors just put money into index funds. The strong US stock markets over this period meant that all you needed to do to make money was buy the main US indices and you would outperform most markets and strategies. This created problems for many investors who were stock pickers or ran long/short strategies or macro funds who, on the margin, joined the herding behaviour or lost assets. The continued move to (US dominated) passive investments was a self-perpetuating machine as the performance drew assets to these vehicles and created more buying, pushing up the prices. Rinse and repeat. This also helped create the FANG phenomenon whereby a few mega-cap tech stocks dominated all investment flows. As these indices are market cap weighted, the big stocks got bigger and bigger and dominated the investment landscape. This worked for over 10 years, was supercharged in 2021 post the pandemic and then 2022 happened.
We believe the landscape has changed dramatically and that this is no longer the right strategy. Indeed, in our opinion it is very unlikely that US markets will outperform the rest of the world as it has done over the last 10+ years.”
And in January, we wrote the following:
“So why is the bear market not over given the 20-40% downdrafts in the major US indices? There are many answers to this question, not least of which being you don’t wring out 10 plus years of speculative excess engineered by a zero cost of capital with one run-of-the mill down year.
While the EU and the UK are more advanced through their recessions, the US is likely just starting or close to a recession. The withdrawal of liquidity is the first phase of this bear market and then we move onto phase 2. The US market in my opinion, hasn’t fully discounted the earnings shortfall that is to come from a slowing economy and higher interest rates. So, while PE multiples may have come down, earnings are the next shoe to drop.
Just like in 2000-2002, there will be winners in this environment and stocks which go up or don’t go down. We will expand on this in future commentaries but for any “buy and hold” investor, it is not advised to own the major US indices”.
Since the cycle peak this has been good advice as can be seen in the charts below. First up is the Russell 2000, an index of stocks focused more on the domestic economy. Down 30% over 2 years
We then look at the broader S&P500 index which is down a more respectable 6% over the same time frame.
But as we have noted previously, this doesn’t tell the whole story. As a market cap weighted index, this means that the bigger the market cap of the stock, the more weighting it has in the index. An equal weighted index as shown below is down over double that amount as can be seen below.
This is entirely due to the huge outperformance of US technology stocks, particularly the mega-cap stocks, now dubbed the “Magnificent Seven”. Partly this is due to the massive increase in passive investing seen over the last 20 plus years as we noted above.
This flow in cap-weighted passive investment creates a potentially very dangerous situation in which a reversion in sentiment could become a vicious cycle in the other direction. Beyond passive flows, the other reason these stocks have done well in our opinion is that they are a big, liquid asset which can accommodate large sums of money quickly and with minimal cost. Moving say USD100Billion out of government bonds or European stock markets into these stocks is very mangeable and there are not many vehicles which can accommodate that. We think this is also connected to the strength of the USD as a way to get USD exposure (aside from bonds, which, until recently, provided minimal yields and limited upside optionality).
We also discussed the structure of the US equity markets in Commentary #5 showing there was still a lot of speculative juices flowing with the proliferation of option activity, particularly 0DTEs.
“Options market volume has exploded and is hitting the highest levels ever recorded even more than during the retail meme stock boom of 2021. Not only this, between 40 and 50% of the volume is so-called 0DTE options. This stands for zero days to expiration. So huge amounts of bets are being placed on where stock prices or index levels finish up at the end of the day. This causes the major options dealers to buy stocks to hedge risk and also dampening volatility. Retail participation has boomed in the last month.”
We also included this quote from the great Stan Druckenmiller:
“Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets.”
This has been particularly important during the current “tightening cycle” because as the Federal Reserve was increasing interest rates, it was also providing liquidty to banks due to the issues at various regional lenders (which we discussed in commentary #11) effectively adding liquidity to the markets reversing and QT that had been going on.
Our current view on US markets remains the same as what we wrote last time (Commentary #22)”
“What this means in the short-term is that the pressure on the equity markets from higher bond yields will abate for the moment and together with the sell-off in September and October, means we will likely get a rally into the year end, before economic reality hits next year as the long-awaited US recession finally come home to roost. “
So that’s the current state of the US markets. The average stock is not doing well and a handful of mega caps are holding up the major indices. Now how about the economy? Has the recession hit yet?
We wrote the below in January.
“Rate hikes take time to feed through to the real economy other than in some sectors such as housing. We are only just starting to feel the effects of the initial rate hikes starting in March of 2022. On top of this, we have the Fed removing liquidity via its quantitative tightening (effectively the opposite of what it has been doing since 2009). Once economies slow further, money supply drops more and higher interest rates bite, there will be further casualties in this highly indebted global economy.”
As we noted above, while the QT has been reversed, rate hikes have continued apart from the last 2 Federal Reserve meetings but the economy has proves surprisingly resilient. We have covered some of these previously but a few highlights below:
The US housing market is frozen, with very few transactions happening. From CNBC
The real estate market hasn’t been favorable to buyers recently: Median home prices have shot up 26% since 2020. And 30-year fixed mortgage rates have more than doubled, from an average of 3.72% in January 2020 to 8% as of Oct. 18, 2023.
The US housing market is quite unique in the West by having such long-term fixed rate mortgages (because of, it may be added, the US government’s underwriting of the mortgage market). So, anyone who bought a house prior to rate hikes starting last year is paying between 3-4% for their mortgage. If they were to sell and buy a new house, they would be paying 8% as they cannot take their mortgages with them. Due to limited transactions, prices are not yet declining and construction activity continues. This changes at some point as the US has a very mobile population when it comes to work. It is common for people to move states for work. The housing dynamics playing out in the US can be contrasted with countries like the UK, Canada, and Australia, all countries with high property prices, but with much shorter-term fixed mortgages, which are seeing more marked reductions in prices as mortgage rates bite and hit disposable income. Along with this, transaction volume is declining as sellers do not want to accept lower prices.
UK house prices hit by “pricing realism” but 2023 not as bad as feared
(Alliance News) – UK house prices suffered the chunkiest November loss in five years, numbers on Monday showed, though findings suggest 2023 has not been as tough a year for the sector as predicted.
According to Rightmove, UK house prices declined 1.7% on a monthly basis this month, the worst November fall since 2018.
CBC News
Canadian home sales slumped again in September — and benchmark price went down, too
Canada’s housing market continued to cool last month, new numbers from the Canadian Real Estate Association show Friday, as the number of homes sold has now fallen for three months in a row and benchmark prices slipped lower, too.
“The current level of interest rates and prices don’t mix well. One of the two needs to come down, and it doesn’t look like the Bank of Canada is poised to cut rates any time soon,” he said. “Housing could be in for a rough winter, though as usual, location matters a lot, with some provinces likely to struggle more than others.”
Staykov says the main theme of the housing market right now is a vast disconnect between sellers who are stubbornly trying to get the high prices they have their hopes pinned on, and buyers looking for a bargain.
The other indicator people point to as a sign of strength of the US economy is the labour market. Now it is generally well known that the labour market and unemployment rates especially are lagging indicators of the economy, and this is even more so the case now after the craziness of the pandemic. You had a perfect storm for labour in that a number of people left the workforce for good, and businesses have hoarded labour as they know that it is hard to replace. Over the last year we have seen a bunch of high-profile tech stocks announce layoffs which are headline news, but it must not be forgotten that it is small businesses which actually employ the majority of workers and account for over 2/3 of all job creation. As we have noted previously, small businesses have struggled and continue to struggle.
The NFIB Small Business Optimism Index decreased half of a point in September to 90.8. September’s reading marks the 21st consecutive month below the 49-year average of 98. Twenty-three percent of owners reported that inflation was their single most important problem in operating their business, unchanged from last month and tied with labor quality as the top concern.
The average rate paid on short maturity loans was 9.8 percent, 0.8 of a percentage point above last month.
So small businesses don’t feel confident, their hiring plans are on a downward trend and their interest costs continue to climb. These are not big corporations which have access to the bond market and refinanced their bonds back in 20/21. These businesses depend on the regional banks which are having their own issues. From the NFIB survey commentary:
Inflation remains the top business problem faced by small business owners. They raised labor compensation at record rates to keep workers and fill open positions which are at record high levels. To manage rising labor, energy, and other costs, they raised prices at record high rates and continue to do so, adding to inflation pressures. But they are investing in their firms at historically low rates, primarily because capital spending is financed from the bottom line, and profits have been squeezed by rising input and labor costs and regulatory compliance. Interest rates on their loans have more than doubled and financing is harder to get now.
The labour reports this year have been strong until the report released at the end of October. Payrolls increased by 150K in October vs a consensus of 180k and down from 297K in September. In addition, the previous months were revised down but nearly 350K for this calendar year. Other trends are in a similar direction with hours worked reducing, wage growth slowing and unemployment ticking up.
To be very clear, we are not hoping for people to lose their jobs and unemployment to go up, but we believe the business cycle is alive and well and that means recessions, and that implies job losses and that also means earnings estimates going down and the stock market falling.
A major reason the recession has not officially started is government spending. With the government running a US$2Trillion budget deficit, in the short term at least economic activity tends to keep going, useful and productive or not. GDP numbers will be growing, but at the cost of an increasingly unsustainable government balance sheet. Increasingly, this has other consequences such as we have seen in the bond market, and just as we saw in the summer, we have another warning shot across the bows from another rating agency.
Moody’s turns negative on US credit rating, draws Washington ire
NEW YORK/WASHINGTON, Nov 10 (Reuters) – Moody’s on Friday lowered its outlook on the U.S. credit rating to “negative” from “stable” citing large fiscal deficits and a decline in debt affordability, a move that drew immediate criticism from President Joe Biden’s administration.
The move follows a rating downgrade of the sovereign by another ratings agency, Fitch, this year, which came after months of political brinkmanship around the U.S. debt ceiling.
This surprised us more as Moody’s is owned by Warren Buffett and he is a savvy political operator, so we shall see how this plays out.
US GDP was reported as having risen 4.9% quarter over quarter in Q3 driven by consumer spending and government spending. Can the US consumer continue this way? From CNBC
Even with Covid-era government transfer payments running out, spending has been strong as households draw down savings and ramp up credit card balances. The personal saving rate declined to 3.8% in the third quarter, compared to 5.2% in the previous period. Also, real after-tax income fell 1% in the quarter after increasing 3.5% in Q2.
With student loan repayments starting up again, it seems credit, rather than cash is king. Again, from CNBC:
- The average credit card balance is now more than $6,000, the highest in 10 years, a new report by TransUnion found.
- Total credit card debt also reached a $1.08 trillion record in the latest quarter, the Federal Reserve Bank of New York reported Tuesday.
- Amid persistent inflation, consumers are struggling to afford their everyday expenses, TransUnion’s Charlie Wise says. “They’re trying to keep the house of cards from collapsing.”
It has generally been a losing proposition to bet against the US consumer, but dare we say that this time is different with savings rates running down and interest rates at recent historical highs?
What about government spending? The below from The Conference Board:
Government spending was also a significant contributor to overall economic growth for the quarter, rising 4.6 percent, vs. 3.3 percent in Q2. The acceleration was due to increases in both federal defense and nondefense spending.
Over the last 2 years we have had the Inflation Reduction Act, the CHIPS act and numerous smaller Federal support programs as well of course the War in Ukraine and now also the Middle East. Now, obviously war spending is a net contributor to GDP even though there is nothing productive about war and the parallels with the late 60s, early 70s are more striking given the open ended spending on the Vietnam War while running big fiscal deficits, the unrest in the Middle East leading to oil embargos, so the question is whether the US government can continue to spend like the proverbial “drunken sailor.”
Prior to the 1980s, large deficits came about due to war or recessions. The highest deficit was 4.1% in 1976 due to the 1975/6 recession. The 2001/2 recession caused a deficit of 1.5% which reduced to 1.1% in 2007. Post 2008/9 recession the deficit peaked at 9.8% of GDP, decreasing thereafter as the economy recovered. The covid response caused the deficit to increase again to 5.5% of GDP in 2022. We are currently in a booming economy and the deficit is 6.3% of GDP.
The US government has a lot of refinancing to do over the next 3 to 5 years and, other than the bond market, there is nothing to stop them spending, but continuing fiscal deficits will mean interest rates will remain higher. Chairman of the Federal Reserve, J. Powell has previously said he doesn’t like to comment on fiscal policy as it is not his area, but it seems even he is getting frustrated as his rate hikes are being counterbalanced by increased government spending.
Barron’s 20th October
The overall level of the U.S.’s debt isn’t a problem in itself, the Federal Reserve’s Jerome Powell said Thursday. But when asked about the level of government borrowing relative to the past, the chairman suggested that rapidly rising debt levels could become a problem moving forward.
Powell noted, however, that while the outlook is worrisome, the size of the U.S. debt isn’t something that affects whether the Fed will raise rates in the next six months.
We believe the US is much closer to recession if not already and this will mean earnings and the stock market should fall from here.
The general response to this is that the Fed will cut rates if there is a recession. Now that may be true but with inflation stubbornly high, it may not happen. Even if it does, the comments we made in Commentary #3 still hold true:
“Now, what if the Fed does start cutting interest rates soon, even with inflation still running at 6%. Well, the historical record shows that markets do not bottom until well after rates are cut.
Let’s go back to 2001. The Federal Reserve started cutting rates on January 3rd, 2001, and over the course of that year, cut rates from 6.5% to 1.75%. How did the market do? Please refer back to the chart above showing the peak to trough decline of 60%!
What about 2007/8? The Fed started cutting rates in September 2007 and the market bottomed 1.5 years later and 50% lower.”
In summary, we would seek more profitable investments in other areas than the major US indices.
Until next time,
