Markets Repricing Increased Uncertainty
One of, if not the, most challenging aspects of investing isn’t the math (while very difficult at times), but rather trying to price the sociology or behavioral dynamics at play in markets. All too often, investors read a piece of research or watch an interview on financial television where the content is presented with such conviction and confidence that a less sophisticated financial mind, more often than not, assumes it is right. After all, these guys or girls are experts, and must know more than I do, otherwise they wouldn’t be on TV. What gets lost in the well-articulated and polished presentation are all the assumptions, factors that could change, and how the author would course-correct to a changing set of circumstances. Most good analysts spend a lot of time evaluating an investment thesis, see the whole field better than a casual observer, and therefore understand what needs to occur for their thesis to be on track or what would cause it to go off the rails.
A permanent factor in pretty much all investment analysis is standard error and uncertainty. It’s this uncertainty factor that is most often mispriced, and typically gets mispriced the most at bullish or bearish extremes. It’s this increase in ‘uncertainty’ on several fronts that I think is getting repriced in markets over the last six weeks: growing skepticism on funding the AI theme, an extremely divided Federal Reserve on the direction of monetary policy going forward, the vulnerability of the K-shaped U.S. consumer via a stagnating labor market, and an ongoing affordability crisis. Not to mention the U.S. restructuring its place and objectives in the post-WWII Rules-Based Order.
Let’s start with what happened in markets last week and then branch out into some thoughts on these other items. U.S. equities experienced some additional fissures in the AI theme that has lifted both the economy and stock market for the better part of 2025. It started on Wednesday after the close when Oracle narrowly missed its revenue estimates while disclosing greater-than-expected capital expenditures. On the week, Oracle’s stock was hammered by -13%, and as I type its stock has almost been cut in half ($345 to $182) since its announcement with Open AI for a 5-year, $300 billion cloud computing contract. The day of the announcement, Oracle stock added nearly $300 billion in market cap, but questions about how this deal will be paid for have haunted the stock ever since, to which they have yet to provide anything to halt investors from selling its stock.
Next up was chip designer Broadcom, which provided more information on this file, as it reported on Thursday. Margin compression concerns and the huge commitment from OpenAI outweighed a record $18 billion in sales and strong profit growth. As a result, even with stellar earnings (which are in the rear-view mirror), Broadcom still emerged as one of the worst performers in the S&P 500 last week. This is what happens when super-inflated expectations in the investor space start to receive some doubts. Experienced investors know that it's not the results that matter as much as the stock's reaction to the results. In this case, there is enough doubt setting in about the future growth of the AI theme that investors are actively taking some profits and reducing what is a very large overweight in many portfolios. As is always the case in these interconnected themes, the domino effect caused Nvidia to falter by -4% last week and AMD by more than -3%.
As for the major averages, the Nasdaq fell -1.6% for the week and suffered its fourth weekly decline in the past six weeks. The S&P 500, after a brief flirtation at a new record high, also dropped by -0.61% on the week, snapping a two-week winning streak in the process. The Dow has held in relatively well because it only has a 20% weighting in Tech/Communication Services (on a cap-weighted basis), compared to a 45% share for the S&P 500 and about 70% for the Nasdaq. The AI theme is far from dead, but the air is clearly coming out of the balloon. Investors have become much more discerning over the past two months, with viable concerns over cash-flow drain, massive debt issuance, all of the circular arrangements, and now, apparent delays of hundreds of billions of dollars in pledged spending on data centers due to labor and material shortages.
We also had a Fed meeting last week, where they cut the fed funds rate to a range of 3.50% – 3.75% with FOMC members highly divided on whether inflation or the labor market is a bigger concern for the economy at the moment. That debate will not be solved with the coming week’s barrage of lagged economic data (it was this lack of information, as we found out on Friday, that caused Chicago FRB President Austan Goolsbee to dissent for the first time, though he admitted that he had one of the lowest interest rate “dots” for 2026).
The most attention-grabbing bit of the press conference was when Powell mentioned more than once that the official Employment Situation report was likely overstating job creation by an estimated 60,000 positions/month.
“We think there’s an overstatement in these numbers.” - Fed Chairman Jay Powell
If his math is correct, this would imply that the average of +40,000 jobs added per month since April could actually be -20,000/month after all the revisions are announced next year. I don’t imagine Powell made that comment without fully understanding the implications of it; such a string of payroll declines has never happened without the economy either heading into a recession, already in a recession, or crawling out of a recession. I interpret this as the Fed realizing that the combination of the information from the QCEW, ADP small-business employment, and the skew from the Birth-Death model has actually resulted in an environment where employment is not cooling at all but is contracting. This begs the question: Are investors being too complacent about the labor market?
Such a weak backdrop in the labor market (which isn’t borne out in the official data) is consistent with the ugly readings coming out of the University of Michigan consumer sentiment index, which just rang in at one of the lowest levels on record in the 70-year-old survey (even if it did improve mildly from the prior month). Dave Rosenberg summed it up well in one of his daily missives last week:
“It does say something about the state of consumer psychology – it is now so damaged that the sentiment gauge is lower than it was at the onset of all past recessions as they headed into their first month, and -36% below the average. Looking at the worst month for all recessions, the current level of sentiment is -23% lower today than the average. Only the deepest part of the 1980 recession was weaker. And it is also quite the message here when one considers that the UMich index is lower today than it was at the lows we saw in the aftermath of 9/11 and the collapse of the Financial sector in the fall of 2008. There may not be a recession evident in the so-called “hard data,” but there surely is across the gamut of “soft data”… and the “soft data” lead and are subject to far fewer revisions.”
During the press conference, Powell also made it a point to acknowledge that the Fed Funds rate is now within the band of what most economists and FOMC members consider neutral, the level which neither stimulates nor constrains the US economy over the medium term (1 – 3 years). This leaves the committee “well positioned”, in Powell’s words, to wait and see how the U.S. economy develops. The Chair noted that the Fed has cut rates by 75 basis points this year (since Sept) and 175 bps since the start of the current easing cycle (Sept 2024). In short, the FOMC can now afford to wait and see how those reductions filter through into the real economy. This is key for capital markets in that it clearly puts the burden of proof for more rate cuts higher in 2026 than it was throughout 2025.
The big news coming out of last week's meeting was the announcement that the Fed will return to expanding its balance sheet by buying short-term Treasury securities to manage the level of reserves in the financial system. Starting last Friday, the Fed intends to buy $40 billion in T-bills per month for the next several months and then reassess the amount of bond buying on an ongoing basis. Powell took pains to explain that this was not “quantitative easing” (bond buying to suppress long-term rates), but rather an effort to make sure the short-term funding market has sufficient liquidity through year-end 2025 and into next year’s tax season.
Final thought: Powell concluded the press conference by saying he was focused on delivering a strong American economy to his successor, a noble sentiment that also suggests he will be upbeat for the remainder of his term. That’s just the sort of backdrop equity markets like, and one more reason to remain bullish on US stocks. The new SEP’s message of faster economic growth, lower inflation, and stable labor markets is welcome, which is why equity markets' initial response was favorable. The Fed’s projections may not be any more accurate than anyone else’s, but it is comforting to see such an upbeat forecast from the US central bank as we head into a new year.
With respect to the bond market, we are living through history. The 10-year T-note yield has risen to 4.19% from 4.14% since the last Fed rate cut. Since the first easing in September 2024, it has risen by +50 basis points, which has never before happened at this juncture of any Fed rate-cutting cycle in the past. Normally, once the Fed has cut by a cumulative -175 basis points, the 10-year is down by an average of more than -40 basis points. This speaks to a market deeply suspicious of the Administration’s commitment to price stability because even with all the deregulation, the fiscal largess being implemented and the tariff hikes have caused the term premium embedded in the Treasury market to firm back up.
The last item I want to touch on in this fog of uncertainty that is seeping into the outlook for 2026 is the National Security Strategy report released last week. The contents of this report were not a surprise or new, but I do find it fascinating to observe the blunt delivery of this administration admitting it is looking to restructure the post-WWII Global World Order:
“After the end of the Cold War, American foreign policy elites convinced themselves that permanent American domination of the entire world was in the best interests of our country. Yet the affairs of other countries are our concern only if their activities directly threaten our interests.
Our elites badly miscalculated America’s willingness to shoulder forever global burdens to which the American people saw no connection to the national interest. They overestimated America’s ability to fund, simultaneously, a massive welfare regulatory-administrative state alongside a massive military, diplomatic, intelligence, and foreign aid complex.
They placed hugely misguided and destructive bets on globalism and so-called “free trade” that hollowed out the very middle class and industrial base on which American economic and military preeminence depend. They allowed allies and partners to offload the cost of their defense onto the American people, and sometimes to suck us into conflicts and controversies central to their interests but peripheral or irrelevant to our own.
And they lashed American policy to a network of international institutions, some of which are driven by outright anti-Americanism and many by a transnationalism that explicitly seeks to dissolve individual state sovereignty. In sum, not only did our elites pursue a fundamentally undesirable and impossible goal, in doing so they undermined the very means necessary to achieve that goal: the character of our nation upon which its power, wealth, and decency were built.”
Some might read this and be saddened by the U.S. stepping away from the “Pax Americana” framework that has governed major power conflicts and shaped international relations since WWII. Others will read this and welcome such a development after seeing the U.S. expend $8 trillion on wars in the Mideast with nothing to show for it other than an increased debt burden and a hollowed-out industrial base. Which side you fall on is less relevant than understanding the implications of the fallout from this transition that is underway. Couple this with the rise of China’s influence on the global stage, its ascension up the quality spectrum as a competitive threat in many key industries, and the U.S.’s pivot to reshoring its industrial base, not to mention the role this has played in fueling the affordability crisis playing out in the U.S., and you’ll start to scratch the surface of the significance of the tectonic shifts underway.
Below is a chart plotting gross Federal debt as a % of gross domestic product, which, after peaking at 119% following WWII, then bottomed at 31% in 1974, has steadily increased back to the post-WWII all-time high.
The challenge facing Uncle Sam today is that we don’t have the revenue or stomach to pay down this debt through organic means (increased taxes, austerity, growth…). Sure, we could try any of these options (some of which we have), but none would succeed without a significant degree of financial pain for the U.S. economy. You see, the U.S. economy, as great as it is (and don’t kid yourself, it still is great), has an Achilles heel in that it has become ‘hyperfinancialized’ over the past 25 years. The chart below plots household net worth as a % of disposable income (wealth to income) going back to 1950. For almost 50 years (green shading), this ratio was stable around 5x, then from the mid-90s to 2011(just after the GFC), it increased by about 10% (just before the GFC meltdown, it had increased by roughly 25%). But it was this post-GFC era where we introduced QE, ZIRP, late-cycle tax cuts (2017), and a tsunami of fiscal stimulus during Covid that this ratio exploded by more than 40%.
It’s been such an increase in wealth relative to the rest of the world that it has come to be known as “U.S. exceptionalism”. But what was also going on in the background was that the rest of the world was recycling its current account surpluses back into U.S. assets. However, since roughly 2014, the rest of the world shifted where they were allocating their surpluses – from U.S. government debt to U.S. equities (the chart below plots foreigners' holdings as a % of marketable US govt. debt and MSCI US equity market/MSCI world).
Okay, no big deal, foreign investors made a prudent decision to redirect new capital into stocks instead of bonds, which has worked out well for them and anyone owning stocks over the past fifteen years. However, keep in mind a simple illustration of international trade flows – Japan, Germany, or China… sell the U.S. goods, the U.S. pays for the goods with dollars, the trade partner sends some of those dollars home for local purposes, and any excess they leave in the U.S. to invest in assets. This balance of how much foreigners own of U.S. assets relative to how much the U.S. owns foreign assets is known as the Net International Investment Position, and it looks like this (stable until about 2007, start of GFC, and then a steady decline ever since):
Now, let's go back to the National Security Strategy Report:
“America First diplomacy seeks to rebalance global trade relationships. We have made clear to our allies that America’s current account deficit is unsustainable. We must encourage Europe, Japan, Korea, Australia, Canada, Mexico, and other prominent nations in adopting trade policies that help rebalance China’s economy toward household consumption, because Southeast Asia, Latin America, and the Middle East cannot alone absorb China’s enormous excess capacity. The exporting nations of Europe and Asia can also look to middle-income countries as a limited but growing market for their exports.
China’s state-led and state-backed companies excel in building physical and digital infrastructure, and China has recycled perhaps $1.3 trillion of its trade surpluses into loans to its trading partners. America and its allies have not yet formulated, much less executed, a joint plan for the so-called “Global South,” but together possess tremendous resources. Europe, Japan, South Korea, and others hold net foreign assets of $7 trillion.
International financial institutions, including the multilateral development banks, possess combined assets of $1.5 trillion. While mission creep has undermined some of these institutions’ effectiveness, this administration is dedicated to using its leadership position to implement reforms that ensure they serve American interests.”
Let me do my best to translate this for you on how it relates to markets. This document admits that “America’s current account deficit is unsustainable” (we buy more widgets from foreigners than we sell them). If America’s current account deficit is unsustainable, then America’s capital account (the money foreigners invest in the U.S. relative to what we invest overseas) is unsustainable. As illustrated above, the U.S. economy has become ‘hyperfinancialized’ where stocks are the key driver of the upper-end of the K-shaped economies' consumption habits and a major source of Uncle Sam’s tax receipts. If U.S. policy is serious about reshoring jobs, revitalizing industrial policy, and eliminating national security vulnerabilities with trading partners, then investors need to be aware of the potential consequences – foreigners won’t be selling as much stuff to us, which means they won’t be able to buy as much U.S. assets, and they likely will have to sell U.S. assets to bring money home given their revenue will be weakened by the U.S. not buying as much of their stuff.
This isn’t an Armageddon situation for investors, as U.S. policymakers are well aware of this vulnerability, and it isn’t in America’s best interest, nor the rest of the world's, for U.S. asset prices to crater due to global liquidations. But the world is changing, as we’re seeing with the NSS report. Leaders from around the world are reacting, as they should, to secure their own national interests. This likely means the U.S. dollar continues to weaken over time, not dramatically, but in a gradual and persistent fashion. You’d also suspect inflationary pressures remain sticky to the upside, as there is a reason a lot of industrial policy was outsourced to other regions around the world – it was more cost-effective, and they became good at doing it. Altering these supply chains and production hubs to new regions takes time and money – that’s either lower profits or enhanced productivity. Enhanced productivity is a fancy economic term for more output with less input – typically less labor input (downward pressure on the labor market).
In a nutshell, how a macro thinker would expect this multi-year transition to play out in markets is consistent with what we’ve seen happen in various asset classes this year:
Real assets (scarcity – gold, gold miners, copper, uranium, domestic and foreign stocks) outperforming financial assets (abundance – sovereign debt, U.S. treasuries, and currencies, i.e. US dollar). Please don’t extrapolate these trends, as a lot of these asset classes (like gold, silver, and the miners) have rightfully repriced for this reality. And while I do expect this general trend to persist going forward, it will do so in fits and starts. Many of these asset classes are more volatile than broad stock indices, so sizing their weighting in a portfolio is important for you to withstand a meaningful correction and not be shaken out. Lastly, it's important for all investors to be aware that equity valuations around the world are rich relative to their respective histories, and that’s a vulnerable setup with potential big disruptive structural shifts at play. Perhaps valuations are pushing higher because of these structural winds. The most important thing you can do is maintain discipline, prudence, and humility. Overconfidence and conviction in one’s ability to predict the future are a recipe for disaster.
The week ahead is packed with economic data that will help to shed some light on the health of the economy, inflation, the labor market, and where policy might be headed in the future.
Tuesday: October retail sales (consensus at +0.1% MoM) and November nonfarm payrolls (consensus at +50k) – October will be released as well (but no unemployment rate for that month)
Thursday: November CPI and December Philly Fed manufacturing index
Friday: November existing home sales (consensus at 4.15 million units from 4.10 million in October)
I’m not sure if I’ll be able to squeeze out another missive before the Christmas holiday. If I’m unable to get one out next week, we’d like to wish everyone a safe Holiday Season, and a Merry Christmas to those that celebrate.
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