Monetary Debasement On Full Display
U.S. equity markets continued to power higher last week with the S&P 500 gaining +0.6% and the tech-heavy Nasdaq adding +1.25%, while the Dow and Russell 2000 ended the week little changed (-0.07% for the former and +0.23% for the latter). Prior to Friday’s modest down day, the Nasdaq registered four record closes in a row, and the S&P 500 logged its ninth record closing high since the start of the year. What most investors likely are not aware of is that it’s been 925 trading days since the small-cap Russell 2000 index closed at an all-time high. This is the longest streak on record where the Russell 2000 has not joined the S&P 500 in seeing a record high.
I’d argue this is the result of a combination of structural (lack of smaller IPOs, Private Equity, oligopolistic dynamics within industries) and cyclical headwinds (higher interest rates for longer, inflation, and labor costs). All of this has resulted in earnings for this index having contracted for three consecutive years, rendering it an inferior place for investors to allocate capital relative to large-cap indices.
Another thing that sets the Nasdaq and S&P 500 apart from all the other major global equity indices is the level of concentration they have achieved, where the top five stocks in the Nasdaq 100 comprise 52% of the index, and the top two stocks (Nvidia & Microsoft) represent 27% of the index. As for the S&P 500, the top five stocks comprise nearly 28% of the index, with the same two, NVDA and MSFT, making up nearly 15%. It goes without saying that had these companies, along with a handful of others, not been as dominant and successful as they are, then we would not have the concentration we do. Where superior operational efficiency, appropriate product mix, and large addressable markets, combined with structural changes in capital markets (passive flows), have created a winner-take-all environment that reinforces the divide between the ‘haves and have-nots’.
Putting aside the structural setup for a moment, the near-term tactical setup is less constructive. We’ve come a long way since the early-April lows with sentiment, positioning, and the technical backdrop now shifted decisively back into the bull-camp. Moreover, the Nasdaq is now nearly 7% above its 50-day moving average (a level where a pullback or pause starts to become more likely), while the S&P 500 is nearly 5% above its comparable moving average. Furthermore, breadth, while okay, hasn’t kept pace with recent gains, and internals are starting to roll over as signs of buyer exhaustion sets in. It’s also worth mentioning that vol-control funds are closing in on their max exposures while the monstrous bid from CTA’s is nearing exhaustion. Good thing the corporate buyback window is about to reopen as we work through earnings season.
That being said, other factors have also contributed to this risk-asset rally beyond just fundamental improvements. I’d argue that this rally has been driven mainly by removing worst-case outcomes rather than delivering best-case results. Markets tend to react to “better” or “worse”, not just “good” or “bad”. The positive aspects of the market come from reduced fears of a global trade war, diminished hostilities between Iran and Israel, the early passage of the Big Beautiful Bill (with no one worrying about $2 trillion annual deficits anymore), nobody taking the White House threats to fire Jay Powell seriously, the ongoing deregulation that’s bullish for financials and crypto, no signs of inflation accelerating (likely delayed rather than halted), some progress on trade with China, a widespread belief that tariffs are more beneficial than harmful (boosting government revenue, attracting direct investment, and opening more markets for U.S. exporters), an earnings season that has so far exceeded expectations (after a significant lowering of the bar since late March), and U.S. economic indicators beginning to consistently surpass consensus forecasts this month – with the Citigroup economic surprise index reaching its highest point in seven weeks.
While the major large-cap U.S. indices are reaching overextended levels, one area that has experienced a healthy period of consolidation is equity markets outside the U.S. Over the past three months, U.S. stocks as measured by the Vanguard Total Stock Market Index (VTI) have significantly outperformed the Vanguard FTSE All-World ex-U.S. index (VEU), as shown in the chart below. It’s not a coincidence that the U.S. dollar has managed to establish a near-term bottom at the same time, rising by +1% over this period. I’ll discuss more of this below, but my analysis suggests it's time to start increasing foreign equity exposure.
One area in the U.S. equity market that is being left for dead is the healthcare sector (worst-performing sector YTD)—call it pressure from every direction (legislation, pricing, tariffs, and a lack of innovation). However, when an entire sector has historically low valuations relative to the market (0th percentile), it should compel even the most casual market observer to do some work and tip over a couple of rocks (table from Goldman Sachs).
As for bonds, 4.5% on the 10-year T-note yield and 5.0% on the long bond are proving (as has been the case for a long while) to be ceilings and attractive re-entry points. The impediment has mostly been shifting expectations on Fed rate decisions, as highlighted by the swaps market going this month from pricing in 65 basis points of rate cuts by year-end to -45 basis points currently — even with Governor Waller voicing his intent to vote for an easing at the next FOMC meeting (not likely to happen, but dissension is growing). A 4.25%-4.5% cost of carry does indeed put a floor under the 10-year T-note, which is trading near 4.5%, because rallying into an inversion will obviously require more than just benign inflation data but also a clear-cut decay in the labor market.
Which brings me to the economy, where my work doesn’t show much of a growth impulse. It’s not that the economy is extremely weak or on the verge of slipping into a recession, but I have issues with anyone who claims it's strong. Perhaps the best way to describe it is that it's muddling along, and the fact that worst-case outcomes haven't materialized is a huge relief. The latest estimates from various Nowcast models for Q2 real growth—Atlanta Fed (+2.6%), New York Fed (+1.7%), and St. Louis Fed (+1.6%)—average out to +2.0%. This means first-half growth is at +0.75%, compared to +2.3% in the same period of 2024 and +2.7% in 2023.
This is rather a feeble rate of growth for the first half of 2025, but thank goodness economic growth no longer correlates strongly with the S&P 500 or corporate profits. Yes, there is a positive correlation, but not to the degree it has been in the past. Looking forward, the consensus is at barely more than +1% growth in both Q3 and Q4, which would be a performance that leaves average annual real GDP growth at around +1.0% in 2025, down from +2.8% in 2024 and even weaker than the “recession-scare” year of 2022 when the economy managed to expand +2.5% on average. Before 2020, you have to go back to 2009 to see the last time the economy sputtered so badly. Yet, the narrative is one of a strong economy. Perception and reality are at odds with each other.
This brings me to a structural investment view that investors seem to be embracing at the moment – whether they understand it or not – the debasement trade. Sure, the S&P 500 and Nasdaq get all the attention with year-to-date performance at +8% and +9% respectively. But these marks pale in comparison to International Developed market equities (ACWX) +17%, Emerging Market equities (IEMG) +18%, Bitcoin +26%, gold +29%, silver +31%, uranium miners (URA) +53%, gold miners +56%, and platinum +58% year-to-date. Without question, these returns are aided and abetted by a weaker dollar, which is down 10% from its recent high, but I think we are observing a regime shift playing out in real-time.
While the U.S. dollar remains the world’s reserve currency, and no, I do not think anything else exists around the globe to displace it, we are seeing a change in character for the dollar during recent events. A long-held theory in markets was the “US dollar smile,” which implied that in times of global economic turmoil or times when the US was outpacing other economies, the dollar would rise (dollar does well at each tail of a distribution, hence the smile analogy). The dollar would underperform when economies around the rest of the world were outperforming the US, and no major stress events were occurring. However, what we’ve seen recently is that in times of market stress, the US dollar has gone down. For the first time in a long, long while, the risk-off reaction function of the US dollar has changed.
There is suddenly a US-centric crisis scenario that drags down the US dollar that was previously unimaginable. There are a multitude of forces at work here: over-indebtedness, fiscal irresponsibility, the Trump administration rewriting the global trade framework, breakdown of trust and confidence in global institutions…but a at the end of the day it’s the ‘what’ is happening that matters more than the ‘why’ – at least to this humble analyst. And the ‘what’ here is that the flipping of the correlation between the US dollar and US stocks over the last six months is ominous. For the first time in decades, there was a point in the post-Liberation Day trading that US stocks, US bonds, and the US dollar all declined together. This was extremely unusual and reflected the fact that capital was flowing out of the US. We’ve seen similar episodes in the post-COVID period, following the sanctioning of Russia's reserves by the US and EU, but never to the degree we’ve been witnessing in the last four months.
In the past, European and other non-US domiciled investors were comforted by the fact that the US dollar was negatively correlated to their US stock market holdings. Fund managers could take more risk with US stocks because when things went badly, the US dollar usually rose. This negative correlation meant that US stocks in Euro or Yen terms were usually less volatile. However, that relationship has completely flipped. During the last half-year, the US dollar has gone down at the same time US stocks sold off.
For a US investor (or one that has hedged the US dollars), the S&P 500 is up 7% year-to-date. But for a European investor that’s failed to hedge, the S&P 500 is down 5% in Euro terms.
An objective analyst has to consider the possibility that this is nothing more than an intermittent spasm in a long-term trend, which could be the case. Or we could be finally reaching the point in US dollar hegemony where the following charts showcasing the dire position of the US’s fiscal standing are starting to matter. No analyst I know has penned more ink on this subject than Luke Gromen, and the comments and charts below are from his note this weekend:
“US Interest payments as a % of receipts is near 50-year highs, and near 50-year wides relative to global mean interest expense (ex-US) as a % of receipts. The US fiscal and debt situation IS among the worst in the world, and among the most acute (what interest expense as a % of receipts denotes.)
We will keep this simple: When the chart below happened in 1985, the US government implemented policies (Plaza Accord, etc.) that drove the USD (DXY) down by nearly 50% over the ensuing 2+ years.“
“Importantly, raising taxes is not a real option, as the chart below shows: The US can set top marginal tax rate wherever they want, but they only ever get ~19% of GDP in receipts…and we are just about there.”
And so with US receipts at all-time highs (blue, below), and with DOGE’s attempt to cut outlays having already failed miserably for both economic AND political reasons…
…and US tax receipts already near 80-year highs as a % of GDP (blue line below)…
…there’s only one way out: Devalue the USD to boost nominal GDP growth, aided by having the Fed cap UST yields to prevent the bond market from undoing the reduction of debt/GDP (like the Fed did 2020-21 under Biden, via QE.)
This has always been the inevitable outcome of the US running up $31 trillion in debt since 2000 on negative economic value-added projects (wars, bank bailouts, COVID stimmy’s)…
…but the US interest as a % of receipts chart above and western sovereign bond problems means “inevitable” is becoming more “imminent” by the week.
To be fair, the US isn’t the only nation that has been ignoring fiscal prudence, but we are the biggest and most important in the realm of global financial markets. All of this simplifies to two inevitable outcomes: 1) politicians have a change of heart and implement extreme austerity measures that will bring about widespread pain and hardship to everyone (in which investors would only want to own cash, Treasuries, and defensive equities) or 2) politicians continue to take the path of least resistance (try to grow and/or print our way out of it). There are other variations that combine these two simplified versions, but they entail some combination of the above. At the end of the day, I’m most confident that the second option will be pursued, which for investors means you need to favor exposure to real assets over financial assets in your portfolio allocation. This isn’t an exposure that will work through thick and thin, and I’m confident there will be difficult times for any and all strategies with where we’re heading, but on a long-term basis investors need to overweight scarce assets (gold, real estate, high quality stocks, Bitcoin, commodities…) and underweight abundant assets (sovereign bonds and currencies). This is what the currency debasement trade is all about – cash buys you less of things over time: it buys you less house, less of the equity market, less gold… part of investors' jobs going forward is being sure to preserve the purchasing power of their capital.
There are many boxes being checked on the global financial system entering a debt doom loop. I know this sounds ominous and scary, and my intention isn’t to be dramatic but rather to educate readers so they can be proactive in engineering a strategy to navigate this possible outcome.
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