Regime Shift

Animal Spirits: The market is all in on the Trump election victory as stocks soar and credit spreads tighten. Valuations and cash flows mean little currently, as FOMO rules the day. This will be much like the Tech bro, Reddit run-up we had in Covid; however, meme stocks should play a smaller role. Silicon Valley names, crypto and private equity will do very well, as the funding of the election that came from there should expect some payback via deregulation. The longer-term aspects of tariffs and protectionism, which have historically led to inflation, more costly goods, and reduced global revenue, are a problem down the road. We could easily see another 3 to 5% up in the market going into the inauguration.  While this market can reverse at any time, fighting current trends could prove to be a very expensive proposition. 

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Druckenmiller is Worried

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In the long run, we are all dead, but focusing on the short run is not the solution. Stan Druckenmiller’s investment philosophy to never invest in the present is something that everyone, including Jerome Powell, needs to take to heart. The legendary investor stresses the importance of looking out 18-24 months to envision the economic situation and set your portfolio for that scenario. With that philosophy, it is no surprise that he sees U.S. monetary policy’s main problem as Chairman Powell’s obsession with data dependency and near-term conditions. We have been long-standing critics of the Fed’s short-sighted approach. Paradoxically, they combine this fixation on the most recent economic data with a stubbornness to change direction. They have tended to hold tightly to their forward guidance, eliminating any discussion of reversing course. They do not change their mind as circumstances change. Lack of flexibility is the road to failure for investors and central bankers.

Druckenmiller is especially concerned about the Fed’s mindset because he thinks the central bank may repeat the mistakes of the 1970s. As a macro investor, he is overlaying a pattern from 50 years ago when inflation fell from 8% to 3%, and it looks eerily similar to our present drop in price indices. That suggests we face a renewed inflationary phase if this analogy plays out. Because he fears the central bank “has declared victory too early,” as dissenting voter Michelle Bowman put it after the aggressive 50-basis point cut in September, the Fed may be too slow to raise rates if inflation does rise. He contends that stocks at record highs and narrow credit spreads were warning that monetary policy was already accommodative before they cut rates.

Trump’s win has added rocket fuel to the stock rally as investors are pricing in the likelihood of major deregulation and easier fiscal policy, making conditions even more accommodative. Furthermore, the new administration will introduce inflationary tariffs, compounding the Fed’s worries. Add a gaping budget deficit approaching 7% of GDP while the country is not in a recession, and you have a recipe for major policy mistakes.

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Econ 101

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We are back to Reagan’s classic trickle-down theory that George Bush decried as “voodoo economics.” It can work, but only when lower consumption/higher savings generate higher investment. Tariffs will increase the amount people spend on their everyday purchases, hurting lower-income consumers, and extending the 2017 tax law, plus lowering corporate taxes, will increase the income of wealthy consumers. This is designed to increase savings by shifting income from lower-income, low-savers to high-income, high-savers, and corporations. The hope is that overall investment increases and everyone benefits over time. The drag from lower consumer spending is offset by increased business spending that increases productivity. The rise in economic activity then feeds back into higher demand. The only way that happens is if investment activity rises.

Problems arise, however, if lower consumption does not generate an escalation in investment. If companies forecast lower demand, the only way they embark on capital spending is if investment has been depressed, which was the case when Trump assumed the presidency in 2017. However, capex has been rising since the pandemic lows. Unless the weakening trend in employment reverses, we are left with a savings glut thanks to the wealthy getting wealthier. That excess savings goes into creating asset bubbles, and with households not fully consuming what is produced, investment ends up falling, the opposite result of what was intended. Therefore, investors need to focus on capex growth, which will decide whether we avoid a recession. Investment can occur domestically through a broad adoption toward a massive AI buildout or externally as countries are incentivized to invest in the U.S. to avoid tariffs. The former could be the economy’s savior, but the latter can create imbalances if it is not curbed. 

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Germany and China’s Fiscal Instability

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Global markets got hit with a fiscal barbell last week. Germany must scramble for fiscal stimulus, and China just rolled out an insufficient stimulus package. Somehow, both governments disappointed investors, a glaring contrast to the flying optimism in the U.S.

German Chancellor Olaf Scholz blew up his governing coalition when he fired his fiscally conservative Finance Minister Christian Lindner because Scholz wanted budget increases to support Ukraine. Lindner happens to be the head of the Free Democrats and immediately withdrew from the coalition, leaving Scholz leading a minority government of his Social Democrats and the Green Party. Scholz is forced into a snap election but prefers to delay it until January. However, Friedrich Merz of former Chancellor Angela Merkel’s Christian Democrats is currently leading in polls and wants an election this week. There is a need for two actions: 

·   Releasing the “fiscal brake” in Germany that was put into the constitution in 2009 that limits the federal deficit to only 0.35% of gross domestic product.

·   Finalizing an election to stabilize the government and pass fiscal stimulus.

Until then, Germany’s economy will be rudderless. That is an untenable situation given the approach of a new Trump administration that will end Ukraine support and complicate trade flows with the U.S.

China did announce a 5-year fiscal support package of $1.4 trillion on Friday, but it fell far short of facing the real problem of weak consumer and business demand. It helps local governments by allowing them to issue bonds over the next 5 years to pay down a mountain of debt they took on with private companies. Local governments have had a major cash flow crisis caused by reduced revenues caused by the real estate crisis. Friday’s measure falls short in two ways:

·   It does help lower their interest costs, but even with this debt swap, local governments still have over $7 trillion in remaining obligations to private lenders.

·   There is no money directed to boost growth.

We had warned a month ago in our Q4 Outlook that until Beijing takes steps to stimulate demand, their efforts will fall short of investor demands. The Trump tariffs will certainly pressure China’s industrial base and add to their overcapacity problem, intensifying deflation that weighs down demand. China will probably wait to see how severe the tariffs are before taking the necessary step: fiscal stimulus directed at the consumer. Until then, expect subdued relative performance out of Chinese stocks.

What to Look for This Week

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1. Tuesday, November 12 at 10:00 a.m. E.S.T. the Fed Senior Loan Officer Survey Managers Index for Q4 is released. The Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Large and Middle-Market Firms is still restrictive but has fallen from 51% to 8% in a year. Any move to easier net standards would be bullish risk assets.

2. Wednesday, November 13 at 8:30 a.m. E.S.T. October Consumer Price Index. September core CPI ticked back up to June’s 3.3% reading after spending two months at 3.2%. The Cleveland Fed is forecasting October and November core CPI to stay at 3.3%, contrary to Jerome Powell’s statement that the Fed’s confidence has increased that they will reach their 2% inflation target. If there is an upward surprise, that will upset the stock market rally.

3. Thursday, November 14 at 9:00 p.m. E.S.T. Chinese October data for Unemployment, Industrial Production, Retail Sales, and Fixed Asset Investment. The National Bureau of Statistics (NBS) holds a press conference upon the release of those economic numbers. The data will be scrutinized after the market’s disappointment over their major stimulus package that was just announced Friday.

Fed Speakers: Tuesday, November 12 at 10:00 a.m. E.S.T. Fed Governor Christopher Waller speaks. That same day, Richmond Fed Governor Tom Barkin and Minneapolis Fed Governor Neel Kashkari speak. In Waller’s last speech in October, he said that labor supply and demand have come into balance, but the November Fed statement described labor conditions as easing. We are looking for any pushback to the dovish comments from Chairman Powell’s press conference last week. Powell Speaks Thursday, November 14 at 3:00 p.m. E.S.T. and NY Fed President John Williams speaks shortly afterwards at 4:15 p.m.