Tough To Embrace From Here, But Won’t Fight It
The stock market rally continued to roll along last week with the Dow (+1.1%), S&P 500 (+1.2%), Nasdaq (+2.2%), and the Russell 2000 (+2.2%), all reaching record highs. From the early April interim lows, the S&P 500 has added +$15 trillion of market cap, or the equivalent of a half-year’s worth of GDP, recorded 27 fresh all-time highs, and surged some +34% over the past five months. Further frustrating the bears is that breadth has been expanding, which has even filtered over into the corporate credit market. The spread between investment-grade corporates and Treasuries has narrowed to less than +80 basis points, the tightest it has been since 1998.
It’s not just the U.S. indices participating in this melt-up. The MSCI All Country World Index, which tracks stocks across developed and emerging economies, has also hit an all-time high. Emerging market stocks, shunned by investors in recent years, have outstripped the global index in 2025, in a sign of stepped-up risk-taking which has also been underscored by the stellar performance of small caps of late. One area that had flown under the radar, until recently, has been the massive outperformance of Chinese Tech stocks, with the narrative shifting from regulatory constraints to some major breakthroughs in both AI computing power and Beijing’s push for chip self-sufficiency. The Hang Seng Tech index of the 30 biggest Hong Kong-listed technology companies has soared +40.0% year-to-date compared with a +17.0% gain in the Nasdaq.
While we have some exposure via companies in the tech sector to the AI arms race playing out, we have equally enjoyed participating in this theme through areas in the energy/power supply industries where we see visibility, capacity constraints, and pricing power. Along these lines, it comes as no surprise to us when we come across stories pointing out the stress this data center boom is putting on the electrical grid, where average U.S. prices have shot up by +7.0% in the residential sector and by +5.0% in the commercial sector just over the past three months. Until we see significant sources of new capacity come online, supply-demand imbalances in certain commodities shift, or a material change in the theme, we remain comfortable with the view that the world is going to need every molecule of energy that can be produced for the foreseeable future. That means all hands on deck in the nuclear, natural gas, fossil fuels, and even renewable energy markets are going to be needed to power the transformational AI revolution underway.
Getting back to the capital markets, at face value, U.S. equities are exhibiting characteristics of froth and bubble-like behavior, which should come as little surprise with global equities at record highs and credit spreads compressed to 1998 levels. A very sound and grounded argument can be made that equities have already priced in a near-perfect backdrop amid a deteriorating economy: valuations at cycle highs, sentiment heavily skewed toward the bull camp, positioning nearing historic peaks, and while technicals are constructive, they are registering extreme overbought conditions. These are factors that make it difficult to embrace further gains from current levels, without some sort of cleansing and/or reset of the short-term extremes.
However – and here’s where I talk out of the other side of my mouth without it coming off as a complete contradiction – supportive dynamics in other major macro factors are acting as tailwinds.
Monetary policy is moving towards more accommodation.
Fiscal policy, on the margin, is more expansionary (OBBBA, deregulation, capex tax incentives…) than contractionary (immigration reform, tariffs, increased deficits – although this can be argued both ways).
Liquidity via lowered financial conditions is improving and set to improve further.
Investor positioning – this is the only one of these factors that is set up to not improve much or worsen in the future relative to what it is today
The good news for investors is that the positioning cycle is not a catalyst in and of itself. Rather, it merely acts as an accelerant when developments in one or more of the other macro cycles cause the momentum and dispersion within and across asset markets to change. This is the conundrum investors are facing at the moment, which makes it difficult to fully embrace a further melt-up from here, but perhaps even more painful to not participate or even try to fight it. Keep in mind, this administration and President Trump look at the stock market and asset prices as their report card on policy. It’s not a great risk/reward setup to fight a Fed shifting to an accommodative posture and an administration committed to seeing stock prices move higher. That doesn’t mean that I am of the view that we are on a one-way street to higher levels over the next 3-12 months (there will be corrections), but until I see a material degradation in our models mapping and measuring the major macro cycles, you have to retain enough exposure to maintain your standard of living in what I see playing out as a global debasement trade.
Moving on to the bond market and interest rates, what is catching my eye is that while the 10-year T-note yield backed up by +7 basis points last week (to a two-week high of 4.13%) and by +13 basis points since the immediate aftermath of the Wednesday Fed press statement, the average yield in the investment-grade corporate bond market barely budged (4.75%). Even more interesting is how tight investment-grade credit spreads have gotten with some analysts arguing corporate bonds are becoming the ‘new safe asset’ instead of U.S. Treasuries. With one month left in the U.S. fiscal year, we learned that the 2025 fiscal deficit is outpacing where it was at this time in 2024 (through August) by $75 billion, and this is inclusive of the increase in tariff revenue:
This thesis does deserve some merit when you consider that the government debt-to-GDP ratio is in excess of 120% and at record levels (see chart below) at the same time that the debt-to-equity ratio in the non-financial business sector has fallen to an all-time low of 17.3%. In aggregate, corporate balance sheets have never looked stronger, driven of course by MegaCap Tech. We already have several corporates in France that now trade at a yield discount to French government bonds, and there is nothing to stop that from happening in the U.S. The mantra was always that Uncle Sam has taxing power while the corporate sector does not – but going back to Trump's first term, we’ve seen both parties completely abdicate fiscal responsibility. We’ve gotten to such a point where it's legitimate to question whether U.S. leaders in the future will ever be able to raise taxes without being voted out immediately (look at the political disarray in France right now as the government tries to push through even moderate fiscal restraint).
Let me close up this week with a couple of thoughts on the economy and labor market. I must admit that making sense of the totality of the data in the interest of conveying a simple and clear narrative is impossible at the moment. Some data series show an economy already in a recession, some show an economy in expansion, some show an economy on the cusp of a reacceleration, some illustrate deceleration… to put it plainly, it's messy. That’s why economics is considered a social science, not a natural science. The consensus view is one where recessionary odds have all but been removed and most economists are moving to upgrade their GDP growth projections, along with what the Federal Reserve did in their SEP’s at last week’s meeting. There is a broadening acceptance that the economy is now heading into a growth re-acceleration. Never mind that the most important market for the economy, that being the labor market, is in the process of contracting outright. On Friday, we received the state-by-state employment data, which showed a net decline of -45,582 in August after declining by -46,680 in July. In other words, as bad as the nonfarm payroll report was, things in the jobs market were even worse than the headline suggested. We haven’t seen back-to-back slumps like this since March-April of 2020, and before COVID-19, November-December of 2009. Look at the chart below from Rosenberg Research and you’ll see that declines like this in the state-level employment data are infrequent, but when they do occur, they do so in or around economic recessions.
Yet, the consensus narrative is that of economic re-acceleration, which only really makes sense if the bulk of the recession is already in the rearview mirror. Could we have had an economic recession that the stock market, outside of some fleeting moments of downside volatility, looked right through? Yes, it’s entirely possible – given the level of concentration in the S&P 500 and Nasdaq of monopolistic and economically insensitive tech giants – that we’re able to hold up the market as a whole while various industries went through a series of rolling recessions. I don’t know, it's plausible, yet inconsistent with history, but I’ve learned the hard way not to lack imagination in this business. Things change, and it’s imperative to be flexible with one's view in order to be successful at the craft of investing over time.
As for the week ahead, we will get additional clarity from the Fed with various Fed speakers on tap, including the San Francisco Fed’s President Mary Daly and the New York Fed’s President John Williams — these could be important insofar as the central bank wants to refine its “risk management” message from last week. As far as the data goes, everything will take a back seat to Friday’s core PCE deflator (for August). We will also be paying attention to the shenanigans in Washington, as we approach the rising prospect of seeing a partial government shutdown by the end of the month. In the event that it occurs, it is doubtful that the VIX will stay at 15 for much longer, and maybe this will represent the catalyst to take some of the froth out of risk assets while creating a nice refresh that acts as a springboard into year-end.
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