Did Gershwin Have It Right?? - Global market update

As the old song goes (but somewhat altered), summertime and the livin’ is easy; corporate profits are jumping, and the markets are high; oh, investors are rich and everything is good looking; so, hush little baby, don’t you cry! Given the fact that we in Ireland are also enjoying some good weather this summer – which we normally look on at in jealousy to neighbours near and far – the feel-good factor could lull us into thinking that there is not a care in the world right now. But high temperatures are not the only thing that could see investors get burned!

Back in the early 1990s, political strategist James Carville famously said that if he was reincarnate, he would “want to come back as the bond market – you can intimidate everybody”. And while various US administrations over the years have placated the so-called bond vigilantes and their concerns on government deficits, inflation and borrowing, to the point where it felt that Carville’s observation reflected a quaint anachronism of an earlier, simpler time, these days, it feels as fresh and relevant as ever. It’s hard not to see a link between the highest long-bond auction yield since 2001 (coming last Thursday) and an ugly July federal budget statement that produced the fourth-largest monthly deficit on record. 

Let’s not forget that the US Treasury’s net interest burden has now comfortably exceeded $1 trillion over the past year, and that metric is only going one way. Even if the Federal Reserve (Fed) doesn’t hike rates – though the market still believes it will – the underlying pressure on the average interest rate of Treasury securities is to the upside as low-coupon debt is retired in favour of higher-yielding bonds, notes and bills.

The problem is that interest costs as a percentage of federal revenues have surged to nearly 20%, an all-time high. Granted, it’s still not miles away from where we were in the early 1990s, but back then there was a legitimate appetite to take on and solve the problem. Today, that desire seems absent in the political psyche. Small wonder, then, that people are talking about the potential for an explosive rise in long-end yields as the bond vigilantes take out nearly 30 years of frustration.

This must all be a disappointment for Scott Bessent as the Treasury Secretary has made no secret of his desire to dampen bond yields and rein in the federal government’s borrowing costs. While things can still change, through one prism at least he has helped oversee an historically poor performance for the bond market. Despite 0.75% of Fed rate cuts, yields at the long end of the curve are higher than they were when the current administration took office. 

This is due in no small part because the government has failed to deliver on his 3-3-3 plan – 3% real GDP growth, a budget deficit of 3% of GDP and increasing oil production by 3 million barrels per day. A little more than a year-and-a-half into the current administration, the scoreboard reads an ugly 0 for 3 on the plan, which probably explains some of the bond market’s angst. There are still nearly two-and-a-half years to turn it around, but it’s a little hard not to see that some of the bond market’s current travails are a function of policy own goals, particularly vis-a-vis oil/gasoline prices.

Virtually nothing matters more to markets at present than the AI (artificial intelligence) buildout. It’s such a sudden and massive stimulus for the US that it has shifted macroeconomic data. But today’s debt-financed buildout will be heavily reliant on a compliant bond market. Credit markets have a habit of registering doubt before broader markets and should be heeded. Spreads revealed mounting strain long before newspapers declared a financial panic in the past, and they are performing much the same function today. The main AI players’ credit spreads have risen sharply in recent weeks, though it’s not clear whether this is temporary or the start of something consequential. 

The recent increase in bond yields and widening in spreads suggest that debt investors are demanding greater compensation when it comes to financing both the government and the AI buildout – so, should other investors take note?

Equities, meanwhile, continue to do their own thing. The S&P stands at or near all-time highs even after the weaker payroll numbers, fiscal deficit and in-line inflation data. Yet you wouldn’t know it with a casual glance at index prices, but this has been the most volatile summer earnings season in 15 years. While the chart of the S&P may say that everything is calm and quiet, its individual members are whipping around like crazy. It’s true that earnings have been strong and expectations robust but, by the same token, it’s hard to argue that that hasn’t been fully priced. 

We have just passed the 15-year anniversary of the US sovereign downgrade trade, which saw single-stock volatility pop markedly, but in the current earnings season it is above that observed at this time of year at any point since 2012. As a reminder, history only rhymes rather than repeats, and the structure of the equity market has changed quite a bit over the last 20 years or so, and there are arguably more localized volatility dampeners now than there were back then. 

In a sense, the “stock market” doesn’t exist at the moment, at least as a monolithic asset reflecting macro input factors. Much of its performance is dictated by a handful of cheerleader stocks. So, if investors use it as their lullaby in isolation, they might be in for a rude awakening!!