Higher for Not Much Longer?

0:00Hi, I'm Raoul Pal, CEO and co-founder of Real Vision. Alongside brilliant minds like Edward Snowden, Benedict Evans and Balaji, I'll be on stage exploring the extraordinary potential of AI and the profound change it represents, not just for financial markets, but also for the world as we know it. With over 5 ,000 attendees and over 150 side events, Singapore will become a vibrant hub for a full week from the 3rd to the 9th of June. Visit superai.com to register and join me with 20 % off tickets with the code REALVISION. Link in the description. Thanks.

0:47The death of inflation, but not the death of growth. Is that a feasible scenario? Not really, if you ask me. Welcome to this live edition of Steno Signals. I'm Andreas Steno, your weekly host on this show at Real Vision. And this week, I will show you a part of my slide deck that I've traveled hedge funds with throughout this week. So allow me to be a bit technical and allow me to look at all sorts of regions across the world when I assess this question on whether inflation is gone at the same time as growth is rebounding. Is that really a feasible scenario? Maybe for one region and one region only, but we'll get back to that.

1:27Because before we get to that discussion on inflation versus growth, I think it's worthwhile revisiting so-called financial conditions. If we bring up the slide with the quote from Jay Powell's last press conference, where he basically introduced the new feedback loop or the new reaction function from the Federal Reserve that was very linked to market-based gauges of financial conditions. Powell referred to long bond yields rising through the autumn as a feedback loop that allowed the Federal Reserve not to hike interest rates to the same extent as they had otherwise planned to do. So the big question now that we are less than a couple of weeks away from the last meeting of the year at the Federal Reserve is whether this feedback loop still holds true.

2:20So if we look at the next page with a more or less live update of these financial conditions, we've seen a tremendous move towards easier financial conditions in the US since this press conference and since this very famous quote by Jay Powell. If we look at the light blue line in the chart, we have the US financial conditions index and then the dark blue is the European equivalent. And first of all, it's very noteworthy how big a gap we have right now between the two indices, basically showing that financial conditions are much tighter in Europe relative to the US. But if you look at the US index, we've seen an easing equivalent to 100 basis points.

3:04So basically, you can read the y-axis as a measure of basis points in financial conditions. And since that press conference, we've seen an easing of what's equivalent to four interest rate cuts, just because of easier credit spreads, higher multiples in equity space, and all of that. So that actually leaves the US in a better spot than a month ago, if you believe that these financial conditions can guide the economy or can forecast the economy. And I think there's some merit to that view, while Europe is still stuck in the abyss, basically, with much tighter financial condition compared to the US.

3:50And when we look at financial conditions as an indicator for future growth and future inflation, What's worth reminding ourselves of here is that easier financial conditions lead to better growth, but also higher inflation. Those are the patterns you get if you try to use these financial conditions indices to forecast the developments ahead. So it basically means that it's much more likely that U.S. inflation will not return to target compared to European inflation. But it also means that the US will likely outgrow peers across the globe because of easier financial conditions. And it leads me to talk about the dollar market.

4:32So I'll jump to the conclusions that are extremely important for the short-term outlook for the US economy. And one of the things that I noticed ahead of 2024 is that we have another strong seasonality upcoming because of automatic adjustments driven by inflation this year. So the so-called COLA adjustments will once again be relevant from the 1st of January of 2024. So what do I mean when I say COLA adjustments? The first chart here is a chart showing the running tax receipts of the US federal government. And by 1st of Jan, the tax brackets will be moved up nominally with the change to the cost of living seen over the past 12 months, roughly 5.4%, meaning that basically already from January, the average taxpayer will pay less in taxes compared to in December.

5:33That is, first of all, stimulus. It's also something that will allow the U.S. economy to run on fumes for even longer. and it allows the consumer to gain a bit of breathing space after a tricky couple of quarters. And if we look at the social security benefits and the COLA adjustments to them, on the next page we can see that also here we'll get an adjustment of roughly 5.5 % to these social security benefits. Again, actual money leaving the coffers of the federal state and instead giving households a better opportunity to spend. And I think this is very relevant for the short-term outlook for the US.

6:20And I also think it's one of the reasons why we continue to see strong performance in equity markets, that the upbeat sentiment into next year could be driven by these adjustments to spending behavior already because of people in the know spending ahead of these adjustments, allowing them to. And it ultimately rhymes with a very tricky path to 2 % for the Federal Reserve. If you look at the price plans among small and medium-sized companies, they basically tell you why inflation is not going to get to 2 % easily. The chart on NFIB price plans relative to the core inflation index here has shown sign of reacceleration over the course of the past three, four months.

7:13So basically, a survey among small and medium sized companies, they're asked whether they plan on hiking prices over the next three to six months. And NetNet, much more of the survey, is inclined to hike prices for the next quarter or two. it's typically a very strong leading indicator of actual inflation trends. And in this current environment, I kind of see it as a sign that small and medium-sized companies are trying to hike prices on lower volumes because sales are down among these companies while they're now trying to get more from the same volume of sales. Whether they will succeed is a different question, but it's pretty clear that they will give it a decent try into next year.

8:01And that's why I still find it tricky to believe that US inflation will get to 2 % easily, leaving a tricky task for the Federal Reserve ahead. And pairing this with what we've seen in interest rate space the last six to eight weeks, interest rate cuts for next year are being priced in right, left and center across the dollar curve, across the euro curve, across the sterling curve, across the Brazilian curve, no matter where you look. The market is starting to convince itself that inflation is done. And at the same time, a scenario where growth will be revived at some point during the first or second quarter of next year.

8:41And that cocktail is obviously very bullish. And if you pair that with the recent liquidity trends in the US market, We have a pretty decent cocktail for a year-end rally still. Not to the extent seen in November, but a pretty decent cocktail still for the remainder of the year. We're going to take a quick break and be right back with more of today's top analysis on the Real Vision Daily Briefing.

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10:11Looking at dollar liquidity on page 14, we have the issuance of T-bills relative to the usage of the overnight reverse repo facility at the Federal Reserve. And note that the left-hand axis is reversed here so that you see the overnight reverse repo facility with a reverse relationship to the issuance of T-bills. Why is this so important for the dollar liquidity momentum right now? Well, we have an issuance net-net of a couple of hundreds of billions a month in T-bills. And that volume or that amount of dollars is automatically withdrawn from the overnight reverse repo facility, maybe even with the multiplier of 1.5.

10:59If when dollars leave the overnight reverse repo facility, it means that a money market fund, for example, pulls out the dollar from that repo facility to buy a T-bill. When that money market fund pulls out that dollar and buys a T-bill, a deposit in the banking system will be created because there will be a seller of that T-bill, at least on a net basis. Ultimately, that increases liquidity in the money market. It increases liquidity in financial markets overall. And it's good news for everything interest rate sensitive and liquidity sensitive, such as technology, crypto, you name it. So how long can this trend last?

11:42Because the overnight reverse repo facility is obviously not an endless facility. We have ish 700 billion left, meaning that at this pace, 200 a month. will get a depletion around the end of the first quarter next year. And if the depletion pace is, say, a couple of hundred billions a month, maybe even 300 billions a month, as we've seen over the past couple of months, then this will clearly overshadow the quantitative tightening effects from the Federal Reserve. The QT program runs at a little less than 95 billion a month. And if this overnight reverse repo frees up a couple of hundred billions a month, net-net, we have a positive liquidity landscape.

12:27And running our models ahead of December and January, we still expect that decent liquidity landscape to remain intact. The issue I have with how markets currently see this is that it's very tricky not to, at the same time, forecast a rebound in inflation if liquidity is improving, if money markets are improving, if credit is improving, because it typically fuels the inflation cycle if all of these parameters are positive. And when we look at the money growth in the private sector in the US, as the last chart of the US part of the slide deck here today, we can also see that the money creation in the lighter blue is way above trend still.

13:14We can also see that the trend has already turned from a couple of drawdowns during the pandemic. and unless the Federal Reserve regains control of this liquidity narrative, there's no reason to expect liquidity to shrink. Is that an issue if you're trying to get inflation back to 2 %? Oh dear, yes it is. Ultimately, the Federal Reserve probably holds hopes and prays that this repo facility at the Fed will be sort of depleted fully, which will allow them to regain control of the liquidity development maintenance on a monthly basis. But we're still at least a couple or three months away from that point in time.

13:57What does that mean for your portfolio? I think for now it's good news. Once this accelerating, re-accelerating inflation picture into next year is more pronounced or is more visible, then I'd argue that the bond rally that we've seen lately will come to a sudden stop. But that's a discussion for next year. On the other hand, in Europe, let me show you a few charts on why everything is basically upside down here in many ways when it comes to liquidity trends, when it comes to price trends, and when it comes to growth trends. In Europe, growth and inflation will be gone soon if both are not already gone as per now.

14:41If we look at price trends in Germany, basically equivalent surveys of the one I showed among SMEs in the US. We see a slide in price expectations or price plans from companies within the auto sector, within the chemical industry, within manufacturing, all of that. Remember that the European economy is less service-driven than the US economy. So ultimately, what I'm saying here is that price plans point in a much clearer direction in Europe than they do in the US now. likely as the growth picture is weaker, likely as financial conditions are tighter, and likely also because of the liquidity situation being much less benign in Europe.

15:25So let's have a look at the liquidity situation in Europe to compare it to what I just showed in the US. If we look at the private money growth, a couple of slides ahead, in Europe, we see a clear lower than trend growth, even though we have seen growth in private credit. But from an inflation perspective, it matters whether we have above or below trend growth in liquidity and credit. And in sharp contrast to the US, we have clearly below trend growth in Europe while we see the opposite in dollar markets. And that's why I hold the view that if you want to truly bet on inflation being gone as a theme, you should do so in Europe, maybe even in European bonds.

16:15But not all bonds, because the final chart I want to show you on the European landscape, before I move on to a couple of charts in the UK, is the chart on the Italian contribution to the money developments in the Eurozone. We've known Italy as a problem child of the Euro landscape for quite a while. Even though I love Italy, it's not always a financially stable unit. And recently, we've seen a clear decline in the credit trends in Italy and much sharper than those seen elsewhere in the region. Italian inflation is already running below target. It's at 0.7 year over year. We see really high rejection rates in the Italian banking system.

17:02So basically, clients asking for loans being rejected. We see signs of unemployment on the rise in Italy now for the first time in a couple of years. And it doesn't really rhyme with a stable situation for the Italian government budget. So what you have on the chart here is the Italian contribution to money growth in Europe. It's declining fast. And in dark blue, you have the spread between Italian sovereign bonds and German sovereign bonds reversed. So if the dark blue drops, it means that Italy gets more expensive from an interest rate perspective. This is one to watch because an Italian debt crisis or an Italian political crisis is typically something that will weaken the euro area as a whole.

17:50And I think we are on the verge of something that could turn out to be ugly in Italy. Again, if you look at the trends, looking for potential triggers, I'm following a couple of the Italian banks very closely in CDS space. to see whether the market gets scared of the liquidity situation within the banks because this is very driven by a lack of liquidity in Europe from the European Central Bank to the Italian banking system. So ultimately what I'm saying here is Europe might be a better spot for bets on inflation disappearing, but those bets are probably smartest to take in core sovereign bonds in countries with a better credit rating than Italy.

18:32While I struggle to see how the euro should perform well in this scenario, I struggle to see how European equities can continue to perform well as they've done lately compared to the US into next year in such a scenario. I find more value among SMEs in the US compared to Europe given this. We're going to take another quick break and be right back with more of today's top analysis on the Real Vision Daily Briefing. Hi, I'm Raoul Pal, CEO and co-founder of Real Vision. Alongside brilliant minds like Edward Snowden, Bendict Evans and Balaji, I'll be on stage exploring the extraordinary potential of AI and the profound change it represents, not just for financial markets, but also for the world as we know it.

19:15With over 5 ,000 attendees and over 150 side events, Singapore will become a vibrant hub for a full week from the 3rd to the 9th of June. Visit superai.com to register and join me with 20 % off tickets with the code REALVISION. Link in the description. Thanks. And then we have sterling markets as the final thing I wanted to touch upon before going to the questions. The European inflation printed at negative levels in November. It's not out of the ordinary from a seasonal perspective, but it was a big surprise on the low side from an inflation perspective. We have likely close to outright deflation in Europe right now from a momentum perspective.

20:02And we're yet to get to the same conclusion in the UK, but I think we will get there very soon. If you look at the inflation print in November in the UK, I have a whole table of the main components of the CPI basket and also the monthly trend six, seven months back. Interestingly, we have a clear, what I call head fake, in the developments in clothing and footwear. So prices increased through September and October. We have a clear head fake in recreation and culture. It includes package holidays, airline tickets, all of that. compared to a landslide in these prices in November through the black week, but also due to seasonal weakness in the demand for travel activities and all of that.

20:57My best guess is that the report from the UK, which is released a couple of weeks after the Eurozone equivalent, will showcase deflation as well on a monthly basis, that is. And it is yet to sort of be a market consensus that the UK will be able to cut interest rates as fast as their peers across the channel. So that's a very interesting trade as well, because I think the GILDS market could prove to be a very decent buy here. If I'm right, that deflation will also slowly but surely kick in the UK ahead of New Year's. And visualizing this via the sort of PPI versus CPI chart that I love the most, we have a strong PPI trend in the UK compared to peers now.

21:46So basically producer prices or input costs falling off a cliff relative to what we see elsewhere. And typically producer prices lead consumer prices by a couple of months, which will allow for a surprise on the very low side in the UK. And I think the report is released the 20th of December. Oh, sorry, December. And finally, Chad, I wanted to show you, we obviously also use very corn-driven setups to try and forecast inflation. And when we look at inflation in the UK relative to the Google search activity on inflation in the UK, we have a very strong pattern here as the last chart of the deck with a clear sign that inflation is no longer at the forefront of people's worries.

22:39It is no longer sought after as a theme in the press, and therefore, the Google search activity is basically declining rapidly here. I would see that as a pretty decent early indicator that inflation is actually gone. So let's see how it plays out. Again, the US will struggle to get back to 2 % inflation, but those trends are much more benign in Europe and in the Eurozone and in the UK. meaning that interest rate sensitive stocks could likely perform still, but dollar liquidity trends are much better than they are across the pond, allowing for, I think, a better performance in US markets compared to peers into year end and into the early innings of next year.

23:29Back to the first question I asked today after all of this, is it feasible that inflation veins fast without growth also veining? The answer to that question is most likely no. In the UK and in the Eurozone, inflation and growth is on the decline, while in the US, I see signs of inflation re-accelerating next year, which basically rhymes with a better growth outlook. Not a pretty growth outlook, but a better growth outlook than peers in Europe. With those words, I'll look at the questions. and we had a couple of questions coming in already ahead of the show here, one from Alexander. And I really like this question because Alexander is asking me, if the ECB starts a cutting cycle soon, I think they will already in March next year, do you expect them to keep the bottoms higher long-term and the new highs higher in a new hiking cycle?

24:28So basically, is this an uptrending global rates environment also in Europe? And I hold a lot of sympathy for that view, given some of the structural changes we saw through the pandemic. It's fairly tricky to trade that view as of today, given how strong a trend there is towards lower prices and lower rates in Europe right now. But I'll make sure to update you on forward-looking evidence of whether inflation will also re-accelerate in Europe into maybe the latter parts of 2024 and early 2025. because you could make the case that credit flows easier now. You could make the case that the labor market has changed.

25:10I think there is some merit to that, allowing for higher lows and higher highs in the interest rate cycle from here. I would, by the way, also support that notion in dollar markets, maybe to a larger extent than I would for euro markets. So a great question. And Vlad is asking me in relation to all of this, how do you view treasury inflation protected securities as an investment vehicle over say the next couple of years. In full transparency I'm already long TIPS as they're called and the reason is that real interest rates are relatively high from a historical standard. The entry point is therefore good in TIPS trades because you basically bet on low real rates and not lower nominally interest rates.

26:01And I think from a trend perspective, it's a very intriguing case. Also, since the reacceleration of inflation trends in the US that I find likely for next year will likely not be met by instant monetary policy tightening. Thereby, they will allow real interest rates to go up. Also, when inflation starts to go up right now, they allow both to go down on the same time, so to speak. So very good observation, Vlad, and I truly support that idea. Sebastian is asking me, lots of people seem to see weakness in risk assets into next year. What do you expect and what do you watch? So I'll try and answer that question very short and sweet, basically.

26:48The overnight reverse repo facility is key to everything that's ongoing right now because it allows liquidity to be pushed into the system again. When the overnight reverse repo facility is empty, it's time to watch out. My best guess on the timing would be late Q1 right now. So I have some sympathy for the view that risk-gas will struggle next year, but we have a pretty decent liquidity market ahead of us the next couple of months here. Tom is asking me, what's the market consensus missing? And at what price does oil become appealing? And I think it's fair that I get questions on oil because I've been too bullish, just to put it straight out there.

27:35I always use oil as a counterweight to technology in my portfolio. And when technology performs, you typically don't get strong returns in oil space. There is a case to be made now that Joe Biden is close to pulling the trigger on refilling the SPR. That's at least the best argument that I can find right now for an underpinning of oil trends. Technically speaking, it also looks very compelling down here. We had quite a few support areas, just above 70 in the springtime this year. So technically speaking, also with Biden potentially buying up, it looks like a decent entry point. But as I said, I typically use it as a counterweight against technology.

28:21But I like the trade tactically speaking here, even though I have admittedly been too bullish on that oil trade lately. I 100 % agree. I'll leave it at that for this week's edition of Stenos Signals. Remember that this is window into my thinking. macro-wise, I cannot guarantee that you have the same risk appetite or the same risk horizon. But what I can guarantee is that we'll continue to update you on the macro signals here in the show on Real Vision. If you like what you saw or what you heard, then you can visit the link on the screen now to gain the exclusive offer for the Real Vision community to join my live portfolios, my live thoughts on portfolio construction given the ever-changing macro landscape.

29:09Thank you very much for watching. I'm Andreas Deno from Real Vision. And on behalf of the entire team, have a great evening.

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