Market Update - September 16, 2024 PDF

Market Update – September 16, 2024 SLIDE 193 I. Last Week A. Stocks 1. Nasdaq +5.95%; Russell 2000 +4.36%; S&P 500 +4.02%; DJIA +2.60% SLIDE 194 a. The S&P 500 and Nasdaq rose all five days b. Big tech h...

Market Update – September 16, 2024 SLIDE 193 I. Last Week A. Stocks 1. Nasdaq +5.95%; Russell 2000 +4.36%; S&P 500 +4.02%; DJIA +2.60% SLIDE 194 a. The S&P 500 and Nasdaq rose all five days b. Big tech had strongest week since Nov. 2023 (NVDA +15.8%) c. S&P 500 now within 1% of its July record close SLIDE 195 d. UST yields: 3-mo. 4.97% (-16 bps); 2-yr 3.57% (-9 bps); 10-yr 3.66% (-6 bps) S 196 2. What happened? a. Tech helped by headlines from GS conference and ORCL’s earnings b. Continued debate over whether Fed will cut 25 or 50 bps (discussed later) i. Market currently pricing in a 100% likelihood that the FOMC will cut rates 25 bps and a 44% chance of an additional 25 bps. (CME) SLIDE 197 ii. Market is pricing in 4.5 rate cuts by the end of this year (4.16%) iii. Market is pricing in a 2.89% Fed funds rate by the end of 2025 c. CPI – core CPI slightly higher than expected, but broader disinflationary trend still in play (discussed later) 3. Still have concerns about negative seasonality, waning buyback support in second half of September, growth risks, election uncertainty, yen strength. Other concerns: a. Positioning (bullish positioning is considered bearish!) i. BofA says most of its clients have ~63% of portfolios in equities, up from 60% earlier this year and above the long-term average of 56% 1. Historically, mid-60s is where clients stop adding exposure a. Early 2022 was exception and it was followed by bear market ii. BofA even calls hedge fund positioning “bullish” – loaded up on stocks b. Valuation i. S&P 500 trading at 21.1X forward earnings 1. This level has been a ceiling recently; if it goes much higher, it could be an excuse to take profits – especially w/ slowing growth ii. Earnings estimates are very optimistic – 15% growth for 2025 (at same time that market thinks the Fed should consider a 50-bp rate cut?) (Barron’s) FactSet 19 B. CPI 1. Headline CPI +2.5% YoY (down from 2.9%);.2% MoM SLIDE 198 a. Core CPI held steady at 3.2% YoY; +.3% MoM (most in four months) i. Three-month annualized: 2.1% (up from 1.6%) SLIDE 199 2. Inflation is coming from services (not goods) SLIDE 200 a. Core goods prices fell.2% (has declined 14 of last 15 months) b. Core services excluding housing (“supercore”) rose.4% (up from.3%). i. Increases: airfares, daycare and preschool, car insurance 3. Shelter inflation continued to be strong: +5.2% YoY; +.5% MoM (up from.4%) SLIDE 201 a. OER +.5%; rent +.4% b. Shelter is ~40% of core CPI and accounts for ~70% of the YoY increase 4. Disinflation is slowing down. a. The spike in goods, food and energy is over. We’ve received disinflationary benefit. i. Food and energy is showing deflation. SLIDE 202 b. Services inflation remains high. i. Shelter inflation is proving stubborn 1. Seems to be correlated with Zillow index on 17-month lag. SL 203 (WSJ) (FT) (Bloomberg) (Barron’s) (FT) (Bloomberg) C. JunkVIX 1. While the VIX is at relatively moderate levels (16.56), Societe Generale says that this is not a good predictive model. It doesn’t differentiate constituent firms by their financial strength or their fundamentals. 2. They think it’s better to focus on the performance and volatility of the weakest segment of the equity market for signs of stress (rather than looking at the aggregate market). a. When you look at the aggregate market, this is biased towards the biggest, most profitable and usually better-financed firms. 3. In 2018, SocGen developed their Junk Equity Vol Index (“JunkVIX”). a. This looks at the relative volatility of the low-quality, sub-segment of the market composed of poor-quality, often over-levered firms with weak balance sheets. 4. The idea is that if there is systemic distress in the market, an early warning sign should manifest itself in this most vulnerable market segment of highly-levered and highly- volatile stocks before the entire market is affected. 5. In the 2020 – 2024 period, high readings (top 1/3) have resulted in annualized returns of -20%+. Past spikes foreshadowed the Feb. 2018 “Volmageddon,” the tightening-related market corrections later that year, the 2022 market slump, and even the early 2020 pandemic crisis. SLIDE 204, 205 6. Currently, the index is extremely high. (MarketWatch) SLIDE 206 20 II. Looking Ahead to the FOMC Meeting A. Arguments for 25 bps 1. The economy is fundamentally fine. GDP is above trend. Atlanta Fed’s GDPNow is forecasting 2.5% growth for Q3. a. Univ. of Michigan’s consumer sentiment for September hit a four-month high. 2. Core CPI was still too high and housing costs were up.5% MoM. It’s not appropriate to cut 50 bps. 3. Labor market is not weak – payroll growth improved in August, unemployment is low, layoffs are low, jobless claims are at the same low level as one year ago. a. Wage growth increased to.4% MoM. 4. A 50-bp cut may communicate alarm about the economy or lead to expectations of higher cuts in the future. a. A 50-bp cut could be seen as political. b. A 50-bp cut could also push stocks higher and fuel inflation. 5. The FOMC likes to act by consensus and 25-bps may be the easiest path. B. Arguments for 50-bp cut 1. Cutting 50-bps is the FOMC’s best chance at a soft landing. a. Higher rates are cooling spending, investment and hiring. b. Businesses and financial firms that cater to low- and middle-income consumers are pointing to signs of greater strain, and the personal savings rate fell to 2.9% in July, near its lowest level since 2007. c. Global economies are cooling (notably China). Commodity prices are falling. 2. Inflation is cooling. As a result, the real Fed funds rate is very restrictive. a. Inflation expectations are low. 3. Labor market is weakening (so the Fed needs to get ahead of this). a. Hiring over the past three months is at the lowest since mid-2020. Job openings declined. Layoffs rose. Anecdotally, employers are saying that they’re more selective in hiring. 4. If the risks are truly balanced between inflation and the labor market, the Fed funds rate should be closer to neutral. 5. Every time the two-year UST yield has fallen this far below the Fed funds rate over the past 60 years, a recession has followed. SLIDE 207 (Bloomberg) (WSJ) (FT) (Bloomberg) (Bloomberg) (Barron’s) 21 III. Will Lower Interest Rates Make Housing More Affordable? 1. According to the NAR, housing affordability declined almost 30% since Dec. 2021.S 208 a. Housing affordability is a function of: i. The median home price relative to the median income ii. The mortgage rate 2. Home affordability has been low because of both factors: SLIDE 209 a. Home prices relative to income: since 2020, home prices are up ~50% while average weekly earnings are up ~22% i. Low supply (~33% lower than pre-pandemic level) of homes has impacted prices 1. Mortgage lock – resulting in fewer sellers 2. Limited construction b/c of: SLIDE 210 a. High interest rates, high labor cost, more expensive materials, and regulations that limit the pace of building b. High mortgage rates i. The 30-year fixed-rate mortgage increased from ~3% in Dec. 2021 to ~7.75% two years later. 3. It would seem that low mortgage rates would make home prices more affordable by lowering a buyer’s mortgage payment and by allowing for more construction a. But lower mortgage rates also result in higher demand b. Lower rates don’t fix the supply deficit issue – we probably have 3MM too few homes i. Although low rates do encourage more construction 4. In the near-term, lower rates are likely to increase demand faster than supply a. The supply of existing homes was 3.5 months in April vs. 4.2 months pre- pandemic, but this 3.5 would be much lower if monthly sales were higher b. Right now, the average time for a new housing project to get from permit stage to start of construction as well as the time from start of construction to completion are both at record highs SLIDE 211 c. The average homeowner will still experience mortgage lock SLIDE 212 i. Average mortgage rate was 3.8% in March vs. 7.4% on new mortgages in that month (current 30-year mortgage rate is 6.20%) ii. Even if existing homeowners sell, most will buy a new house 5. Holding prices constant (a huge assumption) for the median income household ($74,580) to afford the median income home ($422,600) with a 30-year mortgage (putting 20% down): a. If rates drop to 5.25%, this would use 30% of your income b. Need 3.6% rate to use only 25% of income (so you can stay near 30% after paying insurance, taxes, homeowners association fees, and maintenance) (Dallas Fed) (Richmond Fed) (NYT) (Reuters) (Barron’s) 22 IV. “Has the Recession Started?” by Pascal Michaillat and Emmanuel Saez (Aug. 2024) (researchgate.net) A. The Rule 1. The authors have created a “new Sahm” rule – trying to make it better 2. The rule takes the minimum of: a. Sahm rule i. The difference between the 3-month moving average of the unemployment rate and its minimum over the past 12 months b. Job vacancy rate rule i. The difference between the maximum 3-month moving average of the vacancy rate over the past 12 months and the current 3-month moving average. 3. Two-sided recession rule: a. When indicator reaches.3%, a recession may have started (no false positives) b. When indicator reaches.8%, a recession has definitely started (no false negatives) B. The Intuition 1. The big picture: job vacancies start falling rapidly in a recession, when unemployment starts rising. SLIDE 213 a. Requiring that both indicators rise gives a more accurate and (counterintuitively) more rapid signal. 2. The Sahm rule threshold of.5 works perfectly from 1960 – 2023: a. No false positives (predicted recessions that are not actual recessions) b. No false negatives (actual recessions that are not predicted recessions) 3. With this new rule, we can lower the minimum threshold to.3 and there are no false positive or false negatives. C. The Findings 1. This rule gives earlier notice and is more accurate a. On average, it detects recessions 1.4 months after they’ve started (while Sahm rule detects them 2.6 months after they’ve started) b. New rule perfectly identifies all recessions since 1930 (while Sahm rule breaks down before 1960) 2. Using a threshold of.3, the minimum indicator identifies the 15 recessions of the 1930 – 2024 period without any false positives. a. The highest possible threshold that does not produce any false negatives is.6. i. If.6 is used, the probability that we’re in recession is 67%. 1. This is (.5 -.3) / (.6 -.3) 3. The authors use.8 as the upper threshold (to be conservative). a. With July 2024 data, new indicator is at.5%, so the probability that the US is now in recession is 40%. Calculation = (.5 -.3) / (.8 -.3) = 40% 23 V. Other Interesting News and Data 1. From Aug. 1, 2014 through Aug. 1, 2024, the Russell 2000 has compounded at 8.91% vs. 15% for the S&P 500. (WSJ) SLIDE 214 2. Federal interest expense is now running at more than $1T, exceeding the military budget. It’s hard for a country to stay great when they spend more on interest than they spend on their military (per Niall Ferguson). (Barron’s) 3. Lower-rated (CCC) bonds represented 24% of the high-yield bond issuance from 2004 – 2007. In the last 18 months, they only accounted for 6% of issuance. The overall junk market is looking more like investment-grade debt. Risky companies have turned to private credit. (FT) 4. According to the employment report’s household survey, full-time jobs peaked 14 months ago at 134.8MM and has now dropped by 1.5MM. During these 14 months, we have added 2MM part-time jobs. This is consistent with the story of adding largely lower-paid, part-time jobs and is losing full-time, well-paid jobs. SLIDE 215 a. Since mid-2023, workers classified as “part-time for economic reasons” increased by 600K to 4.8MM. The 4.8MM is low, but the trend matters). SL 216 b. In addition, the percentage of Americans holding multiple jobs is 5.3% (another increasing trend, but nowhere near the record). (MarketWatch) SLIDE 217 5. In August, 11.1% of workers worked from home all of the time and another 11.7% worked from home some of the time. Office occupancy last week was 49.3%. (MW) 6. JPM gives young bankers a protected window from Friday at 6 PM to Saturday at noon with exceptions! They also guarantee one full weekend off every three months. (WSJ) 7. Real median household income was $80,610 in 2023 (+4% YoY). It was not statistically different than 2019’s record high income. SLIDE 218, 219 a. It was ~$113K for Asian HHs, $89K for white HHs, $65.5K for Hispanic HHs, and $56.5 for Black HHs. SLIDE 220 b. To be in the top 10%, a HH needed ~$235K of income. (WSJ) SLIDE 221 8. As a rule, housing becomes unaffordable when it takes up more than 30% of your income. Since 2000, the average household income has doubled but the average price for Zillow listings has tripled to $360K. Over that period, the time it takes to save for a 20% downpayment has risen by nearly half to 11 years. And the share of income that goes to mortgage and insurance payments has risen to ~35%. (FT) 9. The GAO estimates that ~10MM student loan borrowers (more than 25% of the total) were behind on payments as of January. (Bloomberg) a. ~2/3 of them were more than three months late (“seriously delinquent”) 10. Trump promised 100% tariffs on imports from countries that were moving away from using the dollar. The dollar’s global role has stemmed from the fact that countries voluntarily choose to use it. (FT) 11. Donald Trump suggested starting a sovereign wealth fund. The problem is that you need money to do that. A SWF is usually the result of a budget surplus and/or having some state-owned resource (such as a state-owned oil company). (Bl.) SLIDE 222 12. China is struggling with increased possibility of deflation. Entry level salaries are 10% lower than the 2022 peak. Economists suggest that China needs to spend $1.4T in stimulus to reflate its economy. The Q2 savings rate is ~31%.(Bl.) (FT) SLIDE 223 24 Unit 5: Bond Basics SLIDE 224 A. Key Concepts That You Should Already Know SLIDE 225 B. The Yield Curve 1. Shape of the Yield Curve a. Yield curve: shows interest rate for different maturities (Richmond Fed) SL 226 b. Three descriptions of the yield curve SLIDE 227 2. Explaining the Yield Curve a. Three observations about the yield curve SLIDE 228 b. Two theories to explain the yield curve i. Expectations hypothesis SLIDE 229 ii. Liquidity premium theory SLIDE 230,231 C. Forward Rates (based on expectations hypothesis) 1. Introduction to forward rates SLIDE 232,233 2. The intuition of forward rates SLIDE 234 3. Calculating the forward rate SLIDE 235 4. What forward rates tell us SLIDE 236 a. Greenspan on forward rates SLIDE 237 5. Liquidity premium is a better explanation of the yield curve SLIDE 238,239 D. What Moves Rates 1. 2-yr UST moves with Fed funds rate (St. Louis Fed) SLIDE 240 2. Longer rates don’t necessarily move w/ Fed funds rate (St. Louis Fed) SLIDE 241 a. 10-yr UST is highly correlated with nominal growth (St. Louis Fed) SLIDE 242 E. Treasury Inflation Protected Securities (TIPs) 1. The reason for TIPs SLIDE 243 2. How TIPs work SLIDE 244 3. Two reasons why TIPs are important SLIDE 245 a. A simple example of TIPs vs. nominal UST SLIDE 246 4. Calculating breakeven inflation and forward inflation rate a. Ten-year breakeven inflation rate (St. Louis Fed) SLIDE 247,248 b. Five-year breakeven inflation rate (St. Louis Fed) SLIDE 249,250 c. Five-year, five-year forward breakeven inflation rate (St. Louis Fed)SLIDE 251 d. Problems with calculating breakeven inflation SLIDE 252 25 F. Building Up an Interest Rate: Benchmark Rate + Risk Premium 1. Benchmark rate SLIDE 253 a. “On-the-run” vs. “off-the-run” SLIDE 254 2. Factors explaining yield differences SLIDE 255 a. Risk premium (Richmond Fed) SLIDE 256 i. Key idea about the risk premium SLIDE 257 b. Taxability i. After-tax yield vs. tax-exempt yield SLIDE 258 c. Liquidity d. Options SLIDE 259 G. Credit Rating Agencies (CRA) 1. Bond ratings SLIDE 260 2. Examples of ratings performance a. One-year migration SLIDE 261 i. Shows percentage of bonds with a particular rating end up with a rating in the next year (number in parentheses is standard deviation). E.g., 7.26% of bonds that were AA are rated “A” one year later ii. Notice that lower-rated bonds are much more volatile b. Average cumulative default rates SLIDE 262 i. E.g., 1.13% of AA rated bonds default within 12 years ii. Notice the huge percentage of bonds rated “B” or lower that default c. Cumulative (number of) defaulters from original rating SLIDE 263 i. CCC-rated bonds do poorly quickly ii. B-rated bonds eventually have problems d. Time to default SLIDE 264 i. Lower-rated bonds default sooner e. Ratings prior to default SLIDE 265 i. Bonds tend to retain their ratings and then get downgraded quickly prior to default. In other words, bond rating agencies don’t give us much warning f. Cyclical nature of defaults SLIDE 266 i. More defaults occur when the economy is weak g. Recovery rates SLIDE 267 i. The key idea here is that a default does not necessarily mean that you have lost 100% of your investment; there is often a recovery 26