Going To Run Hot
Equity markets are coming off a strong week as investors look through near-term weakness on the tariff file while focusing on positives from investment commitments, progress on a procyclical budget bill, and the administration's shift towards deregulation. On the week, the S&P 500 ripped +5.33% (+19% over the past 27 trading days) and is now within 3% of its all-time high. The Nasdaq Composite surged +7% on the week, with high beta equities trouncing low beta equities as investors rushed to buy back all the exposure they sold in the plunge following the Liberation Day announcement.
For the time being, investors have adopted a belief that the entire tariff file is going to fade into the background while providing a convenient excuse to dismiss any near-term weakness in yet-to-be-reported Q2 data. I somewhat agree with this stance, but I am a little more skeptical and expect to see some side effects as we progress through the year. Yes, the peak tariff rate of 28% has retreated to 18% as per Yale’s Budget Lab, but this is still well above the pre-2025 level of 2.5% and the highest since 1934. This is an impactful cost (tax) on the global financial system that someone will bear as the proceeds flow into Uncle Sam’s piggy bank – simply stated, this is a net drain on liquidity. But markets are disinterested in pricing in much of any downside at the moment. Ergo, investors are betting on a further unwinding in the tariff file. Okay, but what about the baseline 10% tariff rate? Is that going away? Unlikely given the ‘one big beautiful bill’ needs revenue offsets to placate the budget hawks.
In a nutshell, the markets are focusing on the move in average tariffs from 34% to 18%, not the move from 2.5% to 18%. This is how markets see the world — are things getting “less bad,” not if they are “good.” And they see things as being “less bad” and that is how positive momentum is built.
Fast forward to this morning, where the focus is squarely on the US fiscal position after Moody’s downgraded the U.S. credit rating to Aa1, citing “significant economic and financial strengths [that] no longer offset deteriorating fiscal metrics.” Moody’s is now aligned with S&P and Fitch, who downgraded the US to AA+ in Aug-11 and Aug-23, respectively. This isn’t as big a deal as the weekend headlines suggest, in that this was Moody’s simply catching up with the other two rating agencies. Ratings downgrades are typically lagging indicators: they don’t give markets any new information. Moreover, this has long been in the cards as political leaders in the U.S. have figured out that the ‘kick the can’ strategy on fiscal policy is a surer path to re-election.
The question now is whether this downgrade will motivate Congressional Republicans to pivot to a more fiscally responsible package with the current budget bill they are hammering out, with smaller or less front-loaded tax cuts, and/or more spending cuts. Such a pivot would be worse for growth in the near term, but better for the US’s long-term fiscal health. But in my view, the more likely scenario is that we still get an expansionary tax package. This is a view espoused by Treasury Secretary Bessant from his interview with CNN’s Jake Tapper on Sunday. I included the video of the full interview below (12 minutes and worth your time), but the first two minutes spells out the path this administration is choosing of ‘growing our way out' of our over-indebtedness problem. Loud sigh from me, in that this signifies more of the same of what we’ve been doing since the GFC, where we learned that voters found austerity to be unpalatable, and politicians figured out that there was very little near-term downside from markets or voters for recklessly legislating unfunded spending.
Ceterus paribus, this is structurally bullish for hard assets and stocks while being structurally bearish for Treasury Bonds and the U.S. dollar. However, eventually the bond market and interest rates will take the punch bowl away from leaders who are unwilling to rein in the fiscal largesse. Long-end Treasury yields have been incrementally pricing in an unsustainable path for years, and are continuing in that direction as we progress through 2025. The yield on the 10-year T-note pushed up to 4.55% this morning and is looking like it wants to test the recent highs up at the 4.70% level.
Further out on the curve, the 30-year T-bond is already at recent highs as it pushes up against 5.0%. This is the highest rate on this tenure going back to 2008, and a sustained breakout of this level should start to act as a restraint on further upside for the equity markets.
Make no mistake, while the Moody’s downgrade doesn’t tell us anything new, anyone who can do basic math already knows the level of outstanding U.S. debt and the trajectory of ongoing deficits are at the point of causing problems for the financial system should they remain unchecked. Higher interest rates only exacerbate debt servicing costs, which will continue to spook investors (including foreign investors) from committing capital to an asset that is almost assured to underperform on a real return basis.
This brings me to gold. What we’ve seen transpire in markets in 2025 goes a long way toward explaining why gold is up +23% year-to-date. While I think the near-term upside for gold is limited, the long-term benefits of holding a strategic allocation to the yellow metal remain supportive if policy continues to be carried out as it has for the past twenty-five years. The table below catalogues gold's calendar year performance in various currencies going back to the start of the century. I bet it will surprise many readers to learn that gold has compounded at a 10% annual rate since 2000 (second column ‘USD’ in the table).
This next table also comes from the experts at Incrementum, who put together the annual “In Gold We Trust Report” where in one chart they capture the essence of what represents a scarce asset vs. an abundant asset. The chart goes back to 1910 and compares the annual increase in the level of above-ground gold stock vs. the year-over-year increase in U.S. money supply. Distilling down all the numbers shows that the annual stock of gold increases about 1.7% per year over the past 100 years, while the average annual increase in the money supply is roughly 6%. This is a major driver of why gold has retained its purchasing power over time versus fiat currencies – a scarce asset versus an abundant asset. A similar philosophy can be applied to Bitcoin and real estate, which also have ‘scarce’ attributes
Turning back to markets and my thoughts as I round out this week’s missive. While the developments on the policy front have turned from horrible to less bad, and incoming data (economic and earnings reports) remain resilient, that doesn’t mean investors are in the clear. Sometimes, a subtle shift from bad to less bad is all it takes to shift a trend, especially when market positioning is as bearish as it was a little more than a month ago. That said, investors seem once again to be throwing caution to the wind as if the setup for risk assets today is demonstrably better than where it was at the turn of the year. While I’ve checked out of the bear camp as the left tail risks have come in dramatically over the past five weeks, I don’t share the same level of complacency being priced into equities with the S&P 500 at 5,960.
The broad stock market, within a couple of percent of all-time highs has almost entirely priced out a U.S. recession. I don’t take much issue with this view, especially if this administration succeeds in passing its ‘one big beautiful bill’, which almost assures that the economy runs ‘hot’ through 2026. Not saying an exogenous shock couldn’t derail this path, but that is what it would take when you slap more fiscal stimulus onto an economy where nominal GDP is already running north of 6%. But an S&P 500 trading just under 6,000 with analysts forecasting 2025 earnings at $270/share (+10% growth on last year) puts the broad market at a 22x P/E multiple, which is 30% above historical norms. That’s a rich valuation even during the best of times, let alone a period where the President of the free world wants to restructure the global world order as we knew it.
But, as we’ve learned over the past decade, the passive bid into equities from flows, algorithmic trading, and factor investing pushes trends to extremes in both directions. And these only reverse when forced to, and often in a violent and volatile way. Not to mention a VIX dipping below 18, a level it hadn’t seen since pre-Liberation Day. Then we have sentiment, which has finally started to flip with this latest push higher in equities. The Investors Intelligence poll now shows the bulls overtaking the bears — the former seeing its share expand in the past week to 35.8% from 32.1%; and the bear camp down to 30.2% from 33.9%. And would you look at the chart below — the CNN Fear-Greed Index is now fast approaching “extreme greed” after hitting “extreme fear” of a mere 3 just six weeks ago.
Back at the April 8th market lows, it didn’t take much to eradicate the negative mood. But now we are back very close to valuations prevailing near the mid-February peak, which means that reality has to live up to ramped-up expectations to ratify this current giddy mood. The pendulum swung in an extreme fashion in both directions, and the reality in today’s fast-moving marketplace is that news gets digested more quickly than it ever has in the past. As such, asset prices are much more prone to hit extreme levels in both directions. A dream for day traders; for investors, I suggest sticking with well-established secular themes that can withstand the noise that is dominating so much attention in the here and now. This is why patience, discipline, idea generation, and non-correlated strategies will remain in vogue.
** Due to travel and the Memorial Day holiday, I will not be penning a missive next week. Enjoy the holiday for those who celebrate it, and stay safe.
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