Investment Newsletter – April 2024
Higher long-term yields will lead to the government having to borrow yet more to pay its spiraling interest-bill on its outstanding debt. But that points to fewer reserves and falling reserve velocity, effectively undoing the work of the Yellen pivot and leaving the stock market in a precarious spot. The Fed is thus likely to cut rates in a quid pro quo with the Treasury. This would not only help the government fulfill its borrowing requirements at a non-usurious cost, it also helps the Fed with its responsibility for financial stability by taking the pressure off risk assets and reducing the likelihood of a funding squeeze. Even though such a move would be unwise, it doesn’t mean it won’t happen. Cutting rates before inflation has been snuffed out threatens to intensify structural risks for price growth. But in the heat of liquidity drying up, funding risks rising, markets on increasingly shaky ground, and the government locked in an issuance doom-loop as its interest costs soar, the Fed is likely to cut rates as an easy first move to ease the pressure, an outcome made even more likely with an election looming.
The largest firms in the US are unsurpassably pulling ahead of their smaller rivals by earning more, investing more, holding more cash and buying back more of their stock. The widening leadership that the largest firms already enjoy extends beyond the monopolies or oligopolies that benefit many of them. They are also bolstering their financials and investing in the future in such a way that they are leaving their smaller brethren in the dust, rendering their lead invulnerable. The bull market is thus likely to remain historically lackluster and less robust as smaller companies continue to lag their bigger counterparts.
Under the expectation of interest rate cuts, if combined with looser global financial conditions, global equity markets will likely rise. Since 2000, if global central banks successively “inject liquidity” under the global economy “relative difference” logic, similar to the periods from November 2006 to May 2007 and from January 2019 to July 2019, it will lead to a decline in the OFR Global Financial Stress Index. This signifies abundant global liquidity, remaining idle in the financial markets, thereby boosting the valuation expansion and rise of global equity assets. During this time, the MSCI Emerging Markets Index averaged a gain of 11.6%, significantly outperforming the MSCI Developed Markets Index at 7.6%.
Interest rate cuts combined with the U.S. “Liquidity Trap” will likely lead to a correction in global equity markets. Two scenarios are observed: (1) A soft landing, where the U.S. economy maintains rapid growth during the interest rate cut period, such as in 1995, 1998, and 2019, during which global equity markets rose, with the MSCI Developed Markets (average 14.4%) outperforming the MSCI Emerging Markets (average 8.4%). (2) A hard landing, where the U.S. economy declines during the interest rate cut period, such as in 1990, 2000, 2006, and 2020, during which global equity markets fell, with the MSCI Developed Markets (average -12.8%) underperforming the MSCI Emerging Markets (average -6.7%).
With the resolution of the U.S. “Liquidity Trap,” the MSCI Emerging Markets will likely increase significantly. Once the U.S. “liquidity trap” is resolved, the excess currency created in the next six months will naturally flow into emerging market countries, boosting equity markets with better fundamentals. Even if developed countries still undergo a “hard landing,” the MSCI Emerging Markets’ average gain can reach about 14%, only slightly lower than the average level of about 18% in a “soft landing” scenario.
With the conclusion of the U.S. interest rate cut cycle, the MSCI Emerging Markets will also increase significantly. Once the U.S. interest rate cut cycle ends, developed economies will recover in the next six months, while emerging markets will exhibit greater resilience in fundamentals. Therefore, the MSCI Emerging Markets Index achieves an average return of up to 16% in this interval. Notably, if the U.S. economy previously experienced a “hard landing,” the fundamentals change logic will be stronger and more flexible, resulting in the MSCI Emerging Markets gaining up to 27%. Conversely, if it was a “soft landing,” the result is less impressive, with only about a 2% increase.
