Talk Your Book: The Bubble Will Get Bigger

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0:16Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:45Welcome to Animal Spirits with Michael and Ben. On today's show, we are joined by Michael Aroni, who is the Chief Investment Strategist and Managing Director at State Street Investment Management. Ben, this year has been all about the Mike. Well, actually, that's not true. That's not true. That's not true. First quarter, Liberation Day, that was definitely a macro headline trading environment. But man, that feels like a long time ago. AI has just eaten everything since then, right? Eventually, investors will care about those sort of headlines again. And you know what? I don't miss it. I don't think anybody misses it.

1:16That is not a fun environment. Well, no, of course. A bubble is more fun than a bear market, obviously. Maybe not as exciting. You get more adrenaline from a bear market. But a bubble is, you know, I think debating this stuff, the reason is, and I stole this from someone, I can't remember who, you always know when you're in a crisis. Everyone knows it. Oh, that's so true. But you never really know for sure when you're in a bubble. There isn't a checklist, because you've been trying to define this lately. There's no checklist you can say, check this, check this, check this, yep, it's a bubble. No one knows in real time.

1:51Because you always think like, well, yeah, but what about this and what about that? And so that's why the discussion is so interesting with AI, because there are no definitive answers. Not to nitpick, but I feel like the meme stock mania, you knew that eventually that was unsustainable, right? Yeah, that's true. That's fair. But like, you're right. The stock market to know in real time that you're smarter than everybody else and everybody is pushing these prices up and you're the only one who sees the truth in the future. Come on now, you're fooling yourself. Now, I think we all agree that stocks aren't cheap.

2:26But so what? Why should they be cheap? We're in a revolution of compute power, margins, all-time highs. I mean, all the usual tropes that we talk about. But yeah, that's what makes it fun and exciting. We talked to Micaroni today from State Street. And it's funny. We talked to him the last time in 2020. So it just feels like a world ago to that. Jeez. I know you said that on the show, but it's – But his take is, listen, yeah, I think this is a bubble. I think the bubble is going to get bigger. And he listed off all the reasons, the Fed cutting rates, deregulation, tax cuts, all these things. And honestly, when you lay it out that way, because I think what you think like, hey, listen, I've identified a bubble.

3:05It's going to pop tomorrow. I think a lot of people have that in the back of their mind. Like, listen, of course, the bubble's there. It's going to pop. His point is, yeah, I think this is kind of a bubble, and I think it's going to get much bigger. NVIDIA's gone to$10 trillion. I mean, at this point, would that surprise you? Of course not. What do you mean? I just said it. It would not surprise me. All right. So you're... No, not tugging in cheek. NVIDIA's going to 10 trillion. All right. You heard it here first. Do I own it? No, I don't. Wait, you sold from the Lowe's? Yeah, I made like 80%.

3:34Well, I don't know if I made 80%. Did I make 80 %? I made a lot of percent. Surprising. I'm diamond hands in it here. I'm not going to sell into an AI bubble. Oh, I bought a house. Come on. Give me a break. Fair. Okay, so we got into a ton of stuff with AI. We talked about taxes. We talked about government spending. all this stuff with Mike Aroni, who is the Chief Investment Strategist at State Street Investment Management. Here's our talk with Mike.

3:58Michael, welcome to the show. Hey, it's great to be back. Good to be here with both of you and Michael, Ben. So I looked, the last time we talked to you was in 2020, and the world was a much different place back then. And it's funny, I looked at just a short bullet point of the things we talked about, and one of them was government spending, do deficits matter, is the government ever going to be able to slow its spending. And it's kind of funny that we're still having those same conversations today. You wrote a piece on your uncommon sense that just talked about the government spending. And I think this whole debasement idea has been a big trend this year.

4:33Maybe you could just kind of talk about why deficits can be so important to the stock market. Well, I think that what's happened here this century and for a while now is that the one-two punch of both easy monetary policy and permanent fiscal deficits has been a tailwind for risk assets. And I think that that ultimately could repeat itself again. So we're on the verge of the one big beautiful bill act actually providing both consumer and business stimulus, not only now, but in 2026. And it has been an important tailwind. The question is, is when does it matter? We chatted in 2020. It didn't matter then.

5:14We have much bigger deficits and much bigger challenges now, and it doesn't seem to matter. The governments that spend the most, the risk assets do pretty well. In 2022, the only thing that mattered for investors were macro stories, primarily inflation and the hiking cycle. And now it really seems like nobody cares. That's not true. But people care way less about the future of interest rates. They care. It's all about AI. It's very much like the micro is dominating the news flow. Matter of fact, I saw a chart recently that showed the size of the Fed's balance sheet. And that has been trending lower in a meaningful way.

5:57And it's like nobody talks about it because OpenAI and the announcements that they're making on a daily basis are sucking up all of the oxygen from the investors like mine. Like we just can't focus on too many things at once. But that would have been a huge story back in the day. And in fact, I'm like, I guess the macro tourist that I am, I'm surprised. I thought that that would matter. Why hasn't the runoff on the Fed's balance sheet hit risk assets? Is it just because we happen to be in an AI explosion? Like, what do you think? Well, I think there's a few things here. I think that ultimately consumers and businesses were effectively able to lock in lower interest rates, long-term interest rates.

6:35So when the Fed was raising rates, we never did hit that maturity wall. And so I think that's been a part of it. I certainly think that there's been some powerful fiscal policy that has offset some of the decline in the Fed's balance sheet. And Michael, as you know, I think, and Ben was kind enough to mention on Common Sense, in my last article, I wrote about this idea that there's a whole host of reasons the Fed would have to cut rates. Some of it had to do with the fact that the standard overnight financing rate was creeping higher than the effective funds rate. The kind of repo facility that was created out of the pandemic, the last time we chatted, is now drained.

7:12We're moving from kind of abundant reserves to ample reserves, meaning that bank reserves are now creeping lower, about 10 % of GDP. And what happened? Chairman Powell signaled the end to quantitative tightening. And sure enough, the Fed suggested just last week at the last FOMC meeting that quantitative tightening would be end. And so I don't know if we should be kind of congratulating the Fed for shrinking the balance sheet from$9 trillion to$7 trillion. It's still pretty big, and it's still pretty stimulating. So I have this theory that the collective we and the market only has room for one worry at a time, right?

7:49We worry about one thing, we focus all our attention on it, and then another worry comes on, then we move to that. And for a while there, it was government debt. And the spending that we did in 2020 was astronomical. and I think people just keep saying, just wait until the toll comes due, right? Just wait, it's gonna happen. And some people are of the mind that, well, listen, nothing's gonna stop this train at this point. Neither party has any will to take the medicine and take the pain and slow government debt. So we're just gonna keep continuing debt. And maybe that means inflation is 3 % in the future instead of 2%.

8:24Does the debt actually worry you at all? Because most of the time, my thinking is, what is the actual outcome here besides just higher inflation? What are the actual worries that people could have from this? Well, I do think that with increased supply of treasuries and now competition from the German government is issuing far more supply and others are issuing far more fiscal spending that has to be financed by sovereign debt. Now you have a global increase of supply. At the same time, you basically have some appetite that's saturated, if you will, or sated, I guess would be the word here. And that you might not see as great a pickup of demand.

9:04And ultimately, I think the worry is that long-term rates will rise. And ultimately, when we look at this, we know that any investment, real estate, bonds, stock, it's the present value of the future cash flow is discounted to discount rate. If long-term treasury yields are the proxy for that discount rate and it's creeping higher, eventually that will matter. We saw a little bit of this in August of 2023 to the end of October 2023. So what happened? So just as we're chatting, we're going to get the Treasury quarterly refunding. Back then, Treasury Secretary Yellen for the first time in years suggested that she would kind of increase the amount of longer dated coupons.

9:43And 10 years breached 5 % for the first time since 2007, and the market fell out of bed. I think ultimately that is the risk that we face, that long-term rates could creep higher. And it's our expectation that long-term rates and inflation are likely a little bit higher, a little bit more volatile, and a little bit stickier than at least it has been in the last 25 years. And that could matter. Does it surprise you that the 10-year went back to 4 % essentially then? Because I know a lot of people were worried when it hit 5%, and then rates went right back down. So why are rates falling this year?

10:17Well, I do think that growth expectations have declined. Some, Chairman Powell and others have cited the fact that last year, the US economy grew at, let's call it around 2.5%, I think it was 2.4%. In the first half of this year, when we exclude the impacts from trade, inventory stocking and concerns about tariffs, the US economy grew closer to 1.2%. So it was cooling. So yields are just growth expectations, inflation expectations, and term premium. And I would suggest that growth expectations were likely more muted and term premium and inflation were a little bit stickier. Now, again, I do think that there is some concern that as we head to the fourth quarter, and we don't really have this data, that we could have a bit of a kind of a slowdown in the US economy.

11:02And I think that's putting downward pressure on long-term yields. But Ben, you have noticed that each time they breach that 4%, they did when the Fed cut rates in September, they don't stay there very long. They start creeping back up. Today, we're at 4.11. Now, I'm not chicken little. I'm not saying that rates where they are today are problematic for markets. They're not. And the bias is for the Fed to cut rates further. I think this will be stimulative. I think the risk, right, like you said, is if we get myopic and we focus on what could cause a problem, higher long-term rates, kind of in that 475 to 5 % range, that could be problematic.

11:40We're not there. I'm not sure we'll get there, but that is a risk. Is there anything inside the system that is cause for concern today? And maybe it's just lack of concern, I guess. I don't know if that's a lazy answer, but what might be out there that you are going, hmm, aside from the obvious spending on data centers and all that sort of stuff? Well, like I said, I do think headed into this kind of period now where the Fed cut rates again. The standard overnight financing rate was creeping higher than the effective Fed's funds rate, and they were both rising. As I said, the kind of the repo facility that was created out of COVID is essentially drained.

12:17So you had a number of indicators to suggest that monetary policy conditions were tightening. And I think the Fed and the Treasury took notice, and they're taking a number of steps to ultimately try to put some downward pressure on those rates. And again, they were successful a little bit. We got below 4 % on 10 years back in September, but we started to creep a little bit higher. So I do think that there were some underlying conditions in capital markets that started to raise some alarms, but they got to it early. Now, Michael, I think the other thing from my perspective is the following. I do think there is a risk that the economy and the labor market are doing better than feared.

13:00And if that's the case, and now you have the Fed cutting aggressively at a time when inflation is notably above the target, I do think that markets could take notice of this. And to Ben's kind of what I'm chatting with Ben, right? I think that ultimately the way this reflects itself is in higher long-term rates. I do think that could be a risk next year. Maybe not a high probability risk, but one I'm keeping an eye on. So what's the contrarian view on the labor market? Because everyone is so concerned about AI and the impact that it's going to have on the labor market. And any slowness is immediately blamed on that.

13:33But let's say it's just a cyclical thing. What is the contrarian view that the labor market is actually doing better than most people think? So here's the thing. I think that ultimately, when we look at this, the labor market, as Chairman Powell describes, is in a curious kind of balance. What is that balance? Both the supply of labor and the demand for it are slowing at the same time. That's highly unusual. So Ben, what's the problem? I think the problem is threefold. Immigration reform, far fewer immigrants entering the labor force, demographics, we're all getting a bit older, and AI. So the conclusion here is that I think is fascinating, is that you do not need as many new jobs to keep the unemployment rate low because of that curious kind of balance.

14:17So to me, that's the contrarian opinion. The labor market is undergoing a structural transformation that's really interesting right now. And at the heart of it are those three things, immigration, AI, and demographics. You don't need as many new jobs. In fact, you may be able to get zero and still keep the unemployment rate low. On Friday, October 10th, there was another flare up in potential tariff. There was some heated rhetoric out of the White House in Beijing on what that was going to look like. And you saw, looking at volume for SPY, which just celebrated its what anniversary? So it's 1993.

14:57So we're more than 32 years. I was about to say it's 30th, but I guess that was two years ago. Wow, time is going too fast. That was two years ago. Time flies, Michael. Unbelievable. All right. So on that day, there was a volume spike in SPY and everything else. People fired first and asked questions later, as they always do. Are you surprised at both how calm markets are and also how quickly news gets people seemingly all bowled up, all bared up in record time? I don't know if I'm surprised. I think we now live in a day and age with 24-7 kind of news and information, 24-7 trading practically.

15:36specifically the retail investor has become a huge component in terms of trading volume and flows and their impact on and momentum. So I'm not sure that I'm surprised by all this in terms of the calmness. I mean, why would we be calm every time there's a market problem? You have the plunge protection team steps in to protect us all and save the day. Right. So whether it's treasury, whether it's the central bank, why would I why would I be nervous every time there's a problem. They step in and either issue checks or massive fiscal spending, or they start rebuilding the balance sheet. It starts expanding and lowering rates.

16:13I mean, what's there to be worried about? And I think markets complacency reflects that. It is funny when you hear people talking about like, oh, the game is right. That's it. It's like, well, yeah, obviously. And now that you know that, now that you know that the powers that be will do everything to prevent bear markets. And why would you do anything else but, you know, responsibly own stocks? I think, all right, whatever. Anyway. I guess the good news, Michael, is that, hey, it's rigged in investors' favor. And that, I think, is a reflection of that complacency. My thesis is the stock market is just so much more important now.

16:48If you look back at, like, everything I think kind of traces back to the Great Depression. There was really no social safety net. There was no, the Fed didn't know what they were doing. We learn a little bit more each time. And I think even the great financial crisis in 2008, we never would have had the response in 2020 had 2008 never happened. Right. And so every time we have one of these crises, they do learn a little bit more and take a little bit more of the left tail off. It doesn't mean bear markets can't happen because we've had what almost three this this decade, if you count April. So you can't take the declines off of the table.

17:17I think what you can take off the table is the the length of the declines. Is that fair enough to say that? Like they just aren't going to last as long if the government is willing to step in every time. I think that that is true. I think that ultimately you will have this kind of downside volatility. I mean, this is investing. You are taking risk and stocks can be volatile. So you should expect corrections along the way and even that occasional bear market. So I do think that that exists, but I do think that they are probably a bit sharper and shorter lived relative to history. And Ben, to your point, In this market rally since the lows back in kind of early April, essentially what's happened is the S &P 500 has kind of increased by about half of the U.S.

18:00economy's GDP. So it underscores your point that the market has become a major kind of influence on the U.S. economy, on sentiment, both from consumers and businesses, and it's not going away. Michael, I'd like to get your take on credit markets. spreads are tight as they should be, given the backdrop that we just described. If they weren't, there'd be a very bizarre disconnect and buyers would come in to tighten them. But there's some chatter, and you probably have a better sense of the data than I do, that one of the reasons why high yield market spreads appear tighter or healthier than they have historically is because a lot of the lower quality companies are moving to different sources of financing.

18:45Is there any truth to that, that those companies are now accessing money via the private credit? Or is that just something that people are saying without really any verifiable data? Or am I saying that they're saying it? Is anybody even saying this? No, I think I've heard this notion that private credit markets have distorted credit markets. They have increased fourfold in the last decade in terms of the assets kind of in private credit. I think they're upwards of 1.5. Some estimates is close to 2 trillion. And that's a fourfold increase over the last decade. And so certainly, again, I think as Ben was highlighting, kind of post the 2008 environment, kind of regulation came in, traditional lenders of credit exited many of the different businesses or increased kind of the credit conditions or kind of what you needed to lend to.

19:37They left those businesses, but with low and zero rates, in some instances, negative rates on sovereign debt, that money flowed somewhere and it flowed to private credit markets. Overall, I think those markets have provided an interesting stimulus to markets, to private equity, to the AI phenomenon that has been healthy. I do worry that as more entrants come in, as you move down in credit quality, you do have to wonder about some of the lending that's going on. But some of the big players, the Aries, the KKRs, the Apollos, the Blackstones, I'm not so worried about their books at this point. And I'm not sure there's been a major distortion to listed credit markets.

20:15I think the last time there was some real credit problems, of course, 2008, 2009, which created a good opportunity for investors, perhaps the last fat pitch that we got in terms of high yield credit investing there. But the other thing you might recall is kind of the shale boom and subsequent unwind. And a lot of the triple C credits in below and high yield were in the energy space. Well, these energy companies are in far better shape today. And I think that's more to do with it. I think when I look at it, earnings are growing, profit margins are high, interest coverage ratios are fine, and default rates are low.

20:48I think that has to do with the kind of compression in credit. One final thing here is, Would you rather lend to the United States government or to some of these companies, given some of the rates here, or some other sovereign from that perspective? I think that's also shifting. And we talked about that in terms of the term premium that investors will require to invest in long-dated US government debt. So Michael and I were talking earlier today about the whole AI phenomenon. It's impossible to ignore this point. I think the downside is pretty easy to lay out, right? These companies spend too much money.

21:21The expectations get taken too far. And then eventually there's a comeuppance because there's not a quick baton handoff to, you know, investment into ROI. Right. I think people can we can look at history and see that happen many times of innovations like this. What is like the best case scenario here where these companies are making all this investment and it doesn't lead to a bubble bursting that people are kind of waiting for? The best case scenario is this general purpose technology gets widely adopted by consumers and businesses that many different businesses and consumers come across and find different ways to utilize the technology.

21:59And that elusive return on investment begins to manifest itself, begins to reveal itself. That is the best outcome. Now, it might be the rosiest outcome. And to your point, I think that the way that I viewed this is that for really the last year, we've been encouraging investors to think beyond the mag seven. But within tech, we like the earnings growth. We like the AI phenomenon. But here's the thing. In the last seven decades, even in technology, the companies that spend the most aren't always, they don't always perform the best going forward. And in fact, to your point, in these historical cycles, what happens is that all that excess capacity ends up really having the bubble burst eventually, almost through higher interest rates eventually down the line.

22:45But what happens next is all businesses or consumers come in and sop up that excess capacity and find a better way to use it, a more interesting way to use it, a cheaper way to use it. And I think that'll happen again. So I'm not sure I'd be loading up on the hyperscalers, but boy, I'm long on technology and bullish on the potential for technology. I'm just not sure that all of the spending will pay off over the long term, but it's going to lay the foundation for the next line of businesses. The most recent example of this, of course, is the TMT bubble bursting. Remember, guys, we used to get the Netflix used to send you CDs in the mail, but all this excess broadband capacity led to streaming.

23:26And now it's a trillion-dollar company, whatever it is. So to me, these guys are laying the foundation for the next wave. And I want to be thinking about the next wave. Now, I'm not a stock picker. I wish I was. But I think that that's ultimately kind of where we're headed. And that's the scenario that I think most likely happens. So you mentioned the hyperscalers and investors. Unless you are really doing something wacky with your portfolio, you're there. You're invested. I guess I'll plug SPY again. It is now the S &P 500 has, what is it, 40 % of the market cap is in the pot, is in the max seven, whatever it is.

24:04Whether it's 35 or 40, who cares? It's a lot. It is a large percentage of your asset allocation, even if the S &P 500 or the US stock market is whatever it is, 30 % of your portfolio, whatever it is, you're all the way there. What are you hearing from investors about like, hey, I don't want to like bail because it's a core holding, but how should I think about diversifying outside of just the MAG-7? Right. So to your point, about 38%, well, it's a couple of percent among friends. That means 62 % of the S &P 500 is in something other than the MAG-7. And so I do think there's opportunities here.