Over the last year I have gradually been turning more negative about markets. A year ago, my rationale was the state of government finances and the reliance on Quantitative Easing (“QE”). I argued that economic growth would inevitably be low, and as a result of QE ultimately inflation would be higher. As bond yields rose to reflect the latter, I thought equity valuations must be impacted.
The new world of low growth
Twelve months later in many ways we are in a new world. Economic growth has indeed slowed further to what are very low levels by recent historic standards. But the new direction of U.S. policy and the speed with which it has been enacted has taken markets by surprise.
A year ago the U.S.A. was the one major western country still showing above trend growth. The cynics would say this was partly due to a covert pre-election boost in liquidity expansion to try and assist a Biden/Harris victory. There has indeed been a sharp retraction in money creation since the new Administration took power. Together with the immediate impact of Trump’s tariffs, it is already causing talk of recession.
Some cling to the hope that higher defence spending will sustain growth. However, public spending has eventually to be paid for by taxation, so at some point in the future it will be offset by lower private sector spending or investment. Trump’s Department of Government Efficiency may put more money back into private hands by reducing taxation. But it will also put people out of work. Overall, I doubt whether changes in public spending, whether increases or reductions, will have much of an impact on overall growth in the short or long term.
A change in policy and repo spread volatility
Bond yields have reached new highs and put more pressure on government financing and refinancing. Under Janet Yellen, the U.S. Treasury used short-term T-bills to finance the Government’s debt while keeping a lid on bond yields bills. According to my friends at CrossBorder Capital, over the last 27 months an astonishing 57% of total issuance has been in the form of short-term-bills. As I have argued before, this is QE without the pretence of issuing longer term debt and then buying it back again.
The new Administration is likely to change this. Scott Bessent, Yellen’s successor, is known as a ‘sound money’ man, and it is Trump’s middle America supporters who have been most damaged by QE over the past 25 years. They don’t own the assets whose prices have skyrocketed, while their salaries have been ground down.
According to CrossBorder, most of this pre-election stimulus has now been withdrawn. Under the liquidity-based prism they view the world through, this tightening explains why global growth is falling. The dilemma the Federal Reserve and the U.S. Treasury face is that the economy and perhaps even more importantly the fragile U.S. financial system urgently needs more liquidity, while the politics suggests less.
As so often, investors need to keep an eye firmly on repo spreads over overnight rates. They have shown substantially more spikes in the last six months – further evidence of tensions in the repo markets. The canary in the mine has not yet fallen off its perch, but it is not singing very happily.
A return to a form of gold standard?
Bessent still has to solve the headache he inherited: the combination of substantial fiscal deficits, the rising cost of finance, and massive refinancing needs. CrossBorder Capital make an intriguing suggestion that his solution may be a return to some form of gold standard, abandoned in 1971.
New liquidity creation would be controlled by linking it in some way to a finite asset. Could it be gold? Could it be bitcoin? At the moment that seems unimaginable, but it does fit with the surge of gold imports into the U.S., and Bessent can pull a trillion dollar rabbit out of the hat by revaluing gold deposits from the $42.22 book price (the price in 1973) to the current price of $3,000.
I believe that the politics of middle America will trump economics, that the Federal Reserve will be reluctant to take its foot off the brakes, and the U.S. will go into some form of recession. The uncertainty round Trump’s on-off trade policies and the imposition of tariffs must be unhelpful. And higher bond yields will not help companies needing finance any more than it helps the government.
The impact on equity valuations….
I will end this article by looking at the impact on equity valuations, and on some of the longer-term implications. U.S. valuations, even if measured in conservative ways, were at least until recently as high as or above even those at the peak of the 2000 dotcom bubble. The difference is that unlike then in 2025 there is real earnings growth. However, the companies are now so large that even without anti-trust legislation it is not possible for them in aggregate to generate the levels of growth which they have historically. Some will, but at the cost of others.
The consensus today is probably that bond yields will continue to rise on the back of supply and demand and worries about inflation, or even stagflation. If that does prove to be the case, it is another potential hit to the stock prices of large growth companies such as the Magnificent Seven. My own view is that the U.S. cannot afford to let bond yields rise much further and will take actions, whether suppression or something more radical, to keep them down.
We have seen non-U.S. equity markets outperform the U.S. this year, probably as a response to some of these issues. The risk for international investors is the dominance of the U.S. (70% approximately) and the top 10 stocks (22%) in global indices. So any strategy, active or passive, where allocations are made on the basis of the global index is vulnerable to a fall in prices, whether from earnings disappointments or whether from lower valuations.
…..and long-term inflation expectations
Finally, if Bessent does earn his place in history by deflating the QE bubble without causing catastrophe, there will be beneficial implications for the long-term inflation outlook. As regular readers will know, I have been of the view over the past five years that we are inevitably off to the magic money tree. Another possible scenario is slowly emerging from the mists of the future.
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