Economy & Markets

The Rasputin Effect: Global resilience to higher rates

  • Scientists investigating the history of the Tsar's family examine photographs of Grigori Rasputin, Moscow, 1990

The Rasputin Effect: Explaining global economic and equity market resilience in the face of the fastest central bank hiking cycle on record; China reopening flops due to housing overhang

Legend has it that Rasputin was poisoned, shot twice, beaten and then drowned before finally succumbing to Russian nobles trying to end his sway over the Czar. I’m reminded of this (probably false) account when looking at global resilience. Despite 400-500 basis points of rapid policy tightening in the US and Europe (since 2021 ~95% of the world’s central banks have raised rates, even more than during the 1970’s inflation shock), and despite a very tepid Chinese recovery, global Q3 GDP growth is still projected to be ~2% and the MSCI World Equity Index is up 18% this year.

How can we explain this? The obvious place to start: the decline in inflation surprises and in related measures (core, trimmed, sticky and median measures of consumer price inflation; NY Fed underlying inflation gauge; “truflation”; the Global Supply Chain Pressure Index, the jobs-workers gap, etc).  But there are 6 other factors worth reviewing as well, which is the subject of this month’s note.

Line chart compares the percent change in forecasted global GDP for Q1 through Q3 2023. The line chart shows that GDP for each quarter is projected above 1%, with Q3 still projected to be ~2%.
Line chart shows the inflation surprise index for the US and World since 2018. The line chart illustrates that the decline in inflation has been much lower than expected, with accompanying measures falling rapidly.
[1] The “inverted yield curve -> recession” argument is premature. Yes, inverted yield curves tend to precede recessions as shown on the left.  But why was it such a consistent signal?  Before prior recessions (other than COVID), yield curve inversion reflected policy rates that were restrictive in real terms (i.e., relative to inflation).  This time, policy tightening in the US is barely restrictive at all, as shown on the right.  And while a simple read of the yield curve points to recession, the health of the US corporate sector does not: the corporate sector financial balance is still in surplus, a condition which has never preceded a recession (see chart below).
Line chart shows the spread between the 10-year and 3-month yield since 1967. The line chart shows that an inverted yield curve tends to precede recessions.
Line chart shows the difference between the Fed Funds rate and Core CPI since 1957. The line chart shows that the difference, or “real interest rates”, is around 0%. This means that policy rates are barely restrictive.
[2] Central banks have only removed around one third of the $11 trillion in global liquidity they created in 2020/2021. In other words when considering points #1 and #2, there’s still plenty of liquidity in the system and the cost of money is not prohibitive.
Line chart shows the total assets of various countries since 2007. The line chart shows that ~$11 trillion of global liquidity was created in 2020 and 2021. However, only about one-third of that liquidity has been removed.
Line chart shows the financial balance of the US non-financial corporate sector since 1960. The line chart shows that prior/during most recessions, the financial balance of the corporate sector has been negative. Currently, however, the corporate sector is still in a surplus.
[3] Biden’s industrial and fiscal policies offset part of the drag from higher policy rates. The charts below show the construction bounce in the manufacturing sector, and the direct government spending and tax incentives associated with semiconductor, infrastructure and energy bills. And don’t look now, but US fiscal policy has become very loose again: the latest fiscal deficit is not far off the peak deficit during the financial crisis of 2009. A recent note from our economist colleagues goes into the details1.
Line chart shows the total amount of spending on manufacturing construction since 2005. The line chart shows a large increase in spending at the exact time the CHIPS Act and IRA were signed in 2022.
Bar chart shows the total amount of direct government spending and tax expenditures for the CHIPS Act, IRA, and Infrastructure Bill. The bar chart shows the US government is set to spend ~$800 billion on industrial policy, and an additional ~$500 billion in tax expenditures.
Bar chart shows the direct and indirect subsidies for semidconductors and batteries from 2023 to 2031. The bar chart shows that the investment and credits are ~$500 billion.
Line chart shows the US and Eurozone surplus / deficit as a percent of GDP since 1969. The line chart shows the latest fiscal deficit is nearing the peak deficit level during the financial crisis in 2009.

Bidenomics, opioids and the Third Man. I’ve got questions on the long-term inflationary impact of Bidenomics. Two examples: the ultimate cost of US semiconductor production compared to Taiwan, and the cost of energy systems with large amounts of renewable power that also require substantial backup thermal power and/or energy storage.   Also, the notion that hiring IRS agents will raise enough money to finance the energy bill and reduce the deficit is to me totally implausible.  But there’s one thing to be optimistic about: the potential for industrial policy to partially revitalize US manufacturing communities that were left in the dust by China’s entry into the World Trade Organization.  I’ve written before on the connection between post-WTO Chinese FX intervention, US manufacturing job losses and US opioid addiction rates (see Eye on the Market 7/13/2021).  The “battery belt” that will stretch from Michigan to Georgia through Ohio, Kentucky and Tennessee will be welcome news in many communities.

I never do media appearances but I did accept an invitation in July to speak on a video podcast called The Compound which is moderated by money manager Josh Brown.  The reason I accepted: it’s a long form 90-minute show that allows for in-depth discussion and debate that does not occur in any other media I’ve seen.  Anyway, they end the show by asking for a book and movie recommendation.  I mentioned “Empire of Pain” by Patrick Keefe on the family behind the opioid crisis, and the 1949 film The Third ManThe connection: the ferris wheel scene in which Orson Welles describes to Joseph Cotton how he rationalizes his tainted penicillin scheme.

[4] Rising interest rates will take time to flow through to profit margins and household balance sheets. In contrast to some US banks that made extremely poor decisions to extend asset duration at the lows in rates2, many US and European companies extended liability duration and enjoy the lowest levels of interest expense to cash flow in decades. As shown below, for the first time on record, corporate interest expense is falling as the Fed is hiking rates. US household debt service costs are also low. One reason: the average coupon on outstanding residential mortgages is ~3.5%, immunizing many homeowners from the spike in mortgage rates to ~7%. Credit card and auto delinquencies are rising, but from low levels and are now back at 2010-2020 averages.
Line chart compares the Fed Funds rate and corporate net interest payments as a percent of after-tax profits since 1970. The line chart shows that for the first time on record, corporate interest expense is declining as the Fed hikes rates.
Line chart shows both the household debt service to disposable income and average rate on outstanding mortgages since 1980. The line chart shows that debt service costs are incredibly low, one reason being the average coupon on outstanding residential mortgages is ~3.5%.
While higher interest rates hit US housing pretty hard, the lowest housing inventory in decades3 offsets what might have been an even sharper decline in home prices, permits and starts. Also: tight US labor markets have sustained personal income and spending. While goods spending is weakening, services spending and auto spending are holding up. Note how the timing and magnitude of the expected consumer slowdown has changed since January. Tech layoffs have declined by 50%-75% from peak levels according to Challenger data; the AI frenzy came just in time for some.
Line chart shows the months supply of existing single family homes since 1982. The line chart illustrates the lowest level of housing inventory in decades, which offset what might have been a sharper decline in prices, permits, and starts.
Line chart compares the PCE forecasts of sell-side economists from January 2023 to January 2025. The report shows that economists project sustained personal income and spending, with the Q/Q percent change at ~2% in 2025.

Note that the US government is not nearly as immune from rising interest rates as households or companies.  Net interest payments to GDP have already risen from a post-war low of 1.2% in 2015 to 1.9%, and are heading to 3.2% by 2029 which would match the post-1960 high last seen in 1991.  See our American Gothic piece from January for more on the long-term unsustainability of US Federal debt, entitlement spending and interest.

[5] Just wait, economic weakness is coming later this year or in early 2024. Monetary policy tightening works with a lag and is occurring after a period of unprecedented stimulus. Excess US household savings are projected to run out sometime in 2024, and while current economic indicators are robust, there’s weakness in Conference Board leading indicators. 

Line chart compares the estimates of US household excess savings by JP Morgan’s Economics Team, Private Bank, and Investment Bank since 2020. The chart shows that excess US household savings are projected to run out sometime in 2024.
Line chart compares the Conference Board coincident and leading economic indicators index since 1970. The line chart shows that coincident economic indicators are robust, but there is weakness in the leading economic indicators.
We also monitor the longer-dated indicators shown in the table. The overall pulse does not point to a significant contraction, just to modestly weaker US conditions in 6-9 months. Furthermore, new orders less inventories (#5) has improved three months in a row. We watch this metric closely given its leading signal on the PMI index, a useful predictor of economic growth and stock market returns over the long run.
Table of monitored leading indicators.

[6] YTD US equity returns have been substantially boosted by rising valuations of a few mega-cap stocks, most of which have not seen their earnings projections grow at all this year.  We covered this issue in June, and J.P. Morgan’s Global Markets Strategy team wrote on the topic as well4.

  • While NVDA and META earnings projections are rising for 2023 and 2024, they are flat for MSFT, GOOGL, AMZN and AAPL.  Even so, the latter 4 stocks are up 40%-60% this year.  TSLA, whose earnings are projected to decline by ~30% from 2022, has risen by over 100% this year
  • Market cap concentration in a handful of stocks is at its highest level since the early 1970’s, even narrower leadership than during the 2000 TMT Bubble.  Also: the increase in market cap concentration just reached its highest level in 60 years
  • Six mega-cap stocks (MSFT, GOOGL, AMZN, META, NVDA, CRM) explain 51% of S&P 500 performance and 54% of the Nasdaq 100
  • Crowding in growth factor investing has reached the 97th percentile, eclipsed only in early 2000
  • A steep rise in concentration and narrow market leadership has historically reversed with the S&P 500 equal-weighted index outperforming the market-cap weighted index
Line chart shows the market cap of the largest 7 companies as a percentage of total large-cap market capitalization from 1990 to the present. The largest 7 companies increased their share of market cap significantly since 2020 and now account for almost 25% of total large-cap market cap (up from ~15% in 2019).
Scatter chart plots historic MSCI World equity return through July of each year on the y-axis against the trailing 12 month change in Fed Funds rate on the x-axis. 2023 is in the upper right quadrant, exhibiting strong equity returns against increases in rates.
Line graph shows the evolution of 2023 earnings expectations for 7 stocks (NVIDIA, Meta, Google, Microsoft, Apple, Amazon, and Tesla). These are indexed to their December 2022 levels. The earnings expectations for NVIDIA and Meta have increased dramatically since then. The earnings expectations for Tesla have fallen. The earnings expectations for the other stocks are relatively close to their December 2022 levels

The bottom line: risk appetite is back, courtesy of immaculate disinflation and plenty of liquidity

The equity rally can be justified on the grounds that the Fed’s “immaculate disinflation” was not expected by many investors, some of whom added risk this year after conservative positioning in 2022.  But: rising valuations account for 90%+ of the gain in the S&P 500 this year, with earnings growth accounting for the rest.  Multiple expansion has occurred despite the lack of a rebound in long term earnings growth expectations.  As shown on the left, this is unusual.  In other words, there’s a lot of good news priced in at current levels and little room for any negative developments in the Russia-Ukraine war and global energy/food prices next winter.

More signs of investor optimism:

  • market sentiment is in the 95th percentile of bullishness
  • the cost of a one-year 95 strike put on the S&P 500 is in the 85th percentile of cheapness since 20085
  • the Dow Jones Index rallied for 13 consecutive days through July 26, the longest streak since 1987
  • don’t look now, but the YUCs (young unprofitable companies) are rising again. The rally in electric aviation company JOBY is a prime example…see our energy paper on the dubious prospects for electrified aviation

The equity rally is also taking place when fixed income is competitive with equities from a yield perspective for the first time since 2002, as shown on the right. For risk-averse investors, some fixed income opportunities offer compelling risk-reward compared to equity counterparts6.

Line chart displays S&P 500 Price / 12m forward earnings and S&P 500 earnings forecasts from 1985 to the present. P/E ratios have risen this year while long-term earnings forecasts have dropped; rising valuations account for most of the gain in the S&P 500.
Line chart shows the convergence of yields across three assets from 2000 through the present: S&P 500 12m forward earnings yield, US corporate investment grade bonds, and the US three-month treasury rate. All three assets have converged for the first time since 2002.
Line graph shows the young unprofitable companies as a % of equity market capitalization from 1990 through current date. The % of total market cap is beginning to increase again, following a decline in 2021-2022.

After the Flop, waiting for the Turn: China’s reopening fizzles due to real estate overhang

After Strange World, Lightyear, Amsterdam and Babylon flopped in 2022, China’s grand reopening did the same in 2023. The latest problem with China’s economy stems more from misallocated investment in residential real estate than from excess industrial capacity. China’s home ownership rate is ~90% (a figure unheard of in the US even during the most feverish attempts by the FHFA to unsustainably inflate it), and 20% of Chinese households own more than one home. Vacant properties amount to 2+ years of sales, and consumer confidence remains low despite low mortgage rates designed to boost leverage and homebuying.

As discussed in our April piece on the dollar as the world’s reserve currency, China relies on large amounts of trapped domestic savings to finance itself.   Rather than a balance of payments or banking crisis, the housing situation in China has resulted in a period of slower growth and an equity market that trades at 10-12x earnings, a steep discount to the developed world.  The Chinese Politburo appears to have announced intentions to provide more stimulus, but the timing and amounts are unclear.

Line chart shows the weighted average of 10 monthly indicators to track the strength of economic activity in China from 2015 to current. There was a drop in activity at the beginning of 2020, followed by a very large spike in 2021. Since the spike in 2021, the index has declined to below historical trend.
Line chart shows the y/y growth of China’s residential floor space of newly started houses. It also shows the y/y growth of China state-owned land use right transfer revenue. Both have declined notably to negative 20-30%.
Line chart shows the China consumer confidence index since 1996. The index was at very high levels from 2018-2021. More recently, the index has seen a drastic drop-off.
Table shows the housing comparison of China and the US. It compares the value of housing stock relative to personal consumption, real estate activities as a share of GDP, home price to income ratios, and home ownership rate. China is much higher than the US in all of these metrics.

 

1The Curious Case of the 2023 Fiscal Expansion”, JP Morgan North America Economic Research, M. Feroli, July 26 2023

2What happened to the US banking crisis?  The perception of a blanket FDIC guarantee of uninsured deposits after SIVB and new Fed borrowing facilities has led to a sharp slowdown in bank deposit outflows, despite the ongoing gap between money market rates at ~5.0%, 1-year CDs at 1.8%-2.6% and deposit rates at ~0.5%.

3New homes are selling at roughly the same price as existing homes for the first time since the late 1960’s.  Most likely reason: very low levels of existing supply.

4Steepest Rise in Concentration, Narrowest Leadership, ML Application of Crowding to Predict Market Returns”, J.P. Morgan Global Market Strategy, July 21, 2023, Dubravko Lakos-Bujas and Marko Kolanovic

5Some press reports cite put options as being cheaper than at any time since 2008, but this is a little misleading.  Option premiums incorporate short term interest rates and as rates rise, premiums get cheaper.  When analyzing put option premiums struck based on S&P 500 forward prices (which effectively incorporates rate changes), they’re still cheap but not quite as much as when looking at premiums based on S&P 500 spot prices.

6Another example: the yield on investment grade REIT debt is roughly the same as REIT cap rates (5.8%)

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