Cool markets, hot takes

0:05Pushkin. US markets finished December with a bang and are starting January with a whimper. Stocks are down just about 1 % in the few trading days we've had so far in 2024, with big tech leading the way down. Apple, for one, is down 5 % after getting downgraded by some analysts. And the bond market is falling too. Yields have risen 12 basis points on the long end so far. Today on the show, we've got thoughts. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu here in my mother's closet in Sacramento, California. And on the other end of the line, all the way from New York, which I miss dearly, one financial commentator, Robert Armstrong.

0:53What are you looking at right now? What's she got in the closet, Ethan? Is it like linen? Is it like sheets? Or is it women's clothing? Or what are you looking at? It's mostly women's clothing. My mom likes reds and blacks, I think, just judging by the color spectrum in the closet. Right on. I'm sure she's a woman of immaculate taste. Absolutely. Absolutely. Absolutely. I am, I think, contractually and cosmically obligated to agree with that. How was your New Year's? I had the most New York possible New Year's Day. Is that right? Yeah. I went to Coney Island. I did the polar plunge with my kids.

1:28And then I went to Nathan's Hot Dogs and consumed a chili cheese dog. And then I rode the cyclone roller coaster. Then you get your official I'm a New Yorker card after you do that trifecta. Wow. Did you have any moments where you felt like you were going to throw up on the roller coaster? Almost the entire time in all three steps, but that's irrelevant. It was a good kind of nausea. Speaking of things that are plunging and or puking, stocks, Rob. Yes, stocks. It's been just over two trading days here in the US and stocks are down. Yesterday, it looked like they were going to be down about 2%.

2:07Today, they've gone up a bit, more like 1%. But I think any way you cut it, it's been a bit of a damp squib so far this year, led especially by some of the big tech stocks. Apple so far this year down more than 5%. Not a great showing for Apple and for big tech. At the same time, bond yields nudging up a bit. We closed out 2023 with the 10-year yield falling. Now we're closer to 4%, up about 12 bps so far this year. I don't think it's quite the start that market participants were expecting. It's got us thinking about what should we be looking for in these markets to try to answer some of the questions we were left with in 2023.

2:44Okay. So a little tightening in the cost of long-term money. And I think that's going to be a huge theme for the year. Obviously, it's come down from its kind of near 5 % highs. And while much of our attention and the attention of the market has been on the short end of the curve on what the Fed is going to do with its official policy rate. I think a lot of what happens in weeks to come and indeed for the rest of 2024 is going to revolve around what we see at the long end at 10 years and longer. Yeah. I mean, there was a period last year where I felt like most market participants had like a coordinated long-term yields freak out where everyone was talking about, look at the deficit, Look how huge it is.

3:29Inflation, it's not coming down easily. And then we crossed 5 % one day on the 10-year yield, which was like a holy shit moment, right? And we've retraced more than a full percentage point from that point crossing 5%. I hear you. But the other thing to remember, though, is how far we are. So inflation, and I say this with mild exaggeration, is now back at its target ish, right? The 10 year yield is still two to 3 % higher than it was in the pre-pandemic period, the post-financial crisis pre-pandemic period. So part of what is going on there at the long end is not captured in the discussion of inflation and the Fed's policy rate.

4:19There's something else there that we have to talk about. That's a really important point, that if we continue to get good inflation news for the rest of the year and the Fed declares victory and starts cutting, it's not clear that the tenure has that much more to fall. Maybe a little bit, but we're pretty close to target here. The latest inflation report, I think, had a lot of people looking at soft landing on a six-month annualized basis. Core PCE inflation, which is the Fed's preferred target, it's at 1.9%. That's quite good. I mean, that's on target, essentially. More and more people are just saying, this is the soft landing.

4:55A month ago, people were saying, it looks like we're there. Now, I'm talking to more and more people who say, here we are, soft landing, done, it's in, which makes the higher 10-year all the more interesting. There's another factor that goes into long yields, which got a lot of discussion last year, which is the fiscal outlook, right? What is government spending doing? Obviously, bonds are issued by the government. They're pretty sensitive to what's going on with tax policy and government spending. And as the US government is borrowing more and more at these record peacetime fiscal deficits, that, some argue, has pushed the long year up as investors demand more return for investing in government debt that's swelling in supply.

5:35Yeah. I mean, I think that's the right way. Supply is the key term here. The prosaic way to understand this, I think the correct way to understand this in terms of supply and demand, higher government deficits equals more issuance of government bonds versus what all else being equal is a stable demand for said bonds. The price has to fall for those two to match, as it were. Yeah. And that means yields have to rise because, as we often have to write in our business, prices and yields move in opposite directions. But here's the weird thing that I don't know if I totally get, Rob, is last year, again, at this peak moment of fiscal freak out, there was a big increase on what's called the term premium, which is how much additional yield does a long-term bond have to pay versus maybe a shorter-term bond.

6:26And that grew pretty large a couple months ago last year, again, when we were all talking about deficits. But the term premium has basically totally vanished. And it's been so remarkable that it actually got mentioned in the Federal Reserve meeting minutes that were published just the other day. You know, because all the Fed governors were like writing and talking about this, again, mere months ago. And now it's totally vanished. I'll give you a theory, which we heard yesterday. We spoke with Bob McKell, who's the co-CIO of J.P. Morgan Asset Management, and he is kind of the biggest fixed income guru there at J.P.

7:08Morgan. And his view is everybody is in a complete panic because the government spent a lot of money during the pandemic, as it should have, by the way. But if you think back to prior historical episodes, the ability of the U.S. government to get back on solid fiscal footing is pretty impressive. He's been in the business for a long time. And he was talking about when he came in in the early 80s, he came into the business. Everybody said, the U.S. government is never going to pay single digit yields on its debt ever again, because the fiscal situation is a disaster. We're never going to have another balanced budget.

7:48Cats and dogs living together. It is chaos. But 10 years later or 15 years later, yields had collapsed. It was the Clinton administration. And by God, we had a balanced budget. So all the gloom and doom about the U.S. fiscal situation and the attendant hysteria about long-term bond yields may be a bit overstated. Rob, in this vein, talking about the fiscal picture and inflation affecting long-term yields, there's a related question that I think is very much live in these markets, which is the correlation between bonds and equities. And this is, I think, as close to a fundamental market relationship as you can get.

8:31Do bonds and equities travel together or do they travel in the opposite direction? And we want them, and importantly, we want them to travel in opposite directions, right? Because then the two parts of our portfolio, the bond part and the equity part, hedge each other nicely. So we can sleep well at night, knowing that if our equity portfolio stinks, our bond portfolio will be doing well and vice versa. Yeah. And so it helps us reach the efficient frontier and maximize returns over time and lets us sleep better. Exactly. And if it's not true, if the correlation is positive, that entire investment formula is kind of defunct.

9:06And that's what we saw in 2022 when bond equity correlation started to trend in a positive direction. And over the span of 23, we saw some concerning correlations pop up. There's a million measures of this, and we can argue about which one to look at. But one that we looked at in the unhedged newsletter was rolling two-year returns between the S &P 500 and long-dated treasuries. So that's a very slow measure of correlation. It takes 500 trading days into account. And that turned positive for the first time in November 22 and stayed positive for most of 23. And again, the concern there is if the returns on your bonds are doing badly at the same time returns on stocks are, that's not great.

9:52Nobody had very much fun in 2022. I think it's important to emphasize that the key factor in this relationship, usually, and there's always confounding factors, but usually the key factor is inflation. And to simplify, neither bonds nor stocks particularly like high inflation. So when inflation is high or the risk of inflation is at the forefront of investors' minds, the probability that neither asset class will perform well rises dramatically. So the question we're facing right now is inflation at or close to target again, are we going to see that correlation go negative again in the way we want it to?

10:37One thing we've learned in the last year, right, is that when we were thinking about inflation and what it was going to do and how long it was going to last, we thought way too much about the 70s and early 80s and how inflation was very persistent then and how it was very unstable then and went up and down and hung around. And it may just be that the pandemic related inflationary incident is not like that huge inflationary incident in the seventies and early eighties that captures so much of our imagination, right? That we think about so constantly. Maybe we ought to get rid of that model and realize this was the burp as you put it.

11:21and inflation anxiety is going to die down, bond stock correlation is going to go negative, and we can be happy with our 60-40 or 70-30 portfolio again. Yeah. That's the optimistic view anyway, and it's something we'll definitely be looking at in these markets. So far though, to begin the year, stocks down, bonds down. Pretty simple. Yes. Well, I did mention at the top, Apple's been one of the big losers so far in the few trading days we've had this year. Mag-7 generally, right? They haven't behaved well at all. No, it's not been a great start to the year for most of the Mag-7. And I think there's, we came into 2024 having in recent years seen both sides of the Mag-7.

12:05We saw in 2020 and 2021 during the go-go mania of the immediate lockdown era where everyone's at home and has stimulus checks. The back seven went absolutely crazy alongside most of the market, but it was led very much by these tech stocks. Then the second that interest rates started to go up or that threat began to materialize, they got absolutely crushed. Meadow was down 70 % at the absolute worst. Then we entered a weirder era as inflation and interest rates began to level off a bit. Big tech became defensive. It became the place that you would go when you weren't totally sure about things.

12:43And that was clearest after Silicon Valley Bank failed. Big tech outperformed the market and continued to do so for some amount of time, despite the uncertainty in the broader economy. I mean, these are all kind of very different profiles for these stocks. I mean, I think a great question for the year to come is this. What exactly are the Magnificent Seven? Not thinking about them individually, what their businesses are, what differentiating factors there are among them. But as an asset class, which is clearly how Wall Street treats them at this point, what are they? Growth stocks? Are they a momentum play?

13:19Are they defensive? Are they an interest rate play? We all know these stocks are tremendously important. We all know they've delivered a disproportionate amount of returns of the total stock market return over recent years. But what are these things? What are they in their essence? I want to ask, hearkening back to my training in graduate school in philosophy? What are they in themselves? And I really don't know the answer to that question. I mean, the weird thing about them, right, is that in general, the stocks that have a lot of growth potential in 10 years are not supposed to be very profitable today.

13:56And that is not the case with most of the MAG-7. These stocks have the one-two punch of being both ridiculously, absurdly profitable today and also having totally plausible double-digit growth potential for years and years to come. That is just like a feature you don't see in most stocks. Although we've had a couple of analysts downgrades of Apple this week, people saying maybe the growth picture isn't so rosy. On the other hand, though, to channel our colleague Elaine Moore, how many times have people predicted peak smartphone saturation and it just never comes and Apple's rolling out the sexy new VR headsets?

14:32If Apple smartphone sales finally peak and start to roll over, my prediction from about 2014 will finally be correct and I will be vindicated. Not wrong, just early. Just early. I was just 10 years early. On the Unhedge podcast, we aim to be both wrong and early. It's the hardest thing to do, actually. It's harder than being right. On that note, we'll be back in just a second with Long Short. Welcome back. This is Long Short, that part of the show where we go long a thing we love, short a thing we hate. Rob, I'm feeling short commercial real estate. And unlike most of the market - Now that calls late.

15:21You should have been short commercial real estate three years ago. You had made a bundle. I know. I know. And here's how I feel, right? In 2023, the market, I would say, was like drastically, drastically short commercial real estate. A bunch of real estate ETFs sold off like crazy. People were freaking out and some people thought it could be a potential crisis catalyst. And we were really in the camp that this doesn't look like a crisis in the making. There's a lot of structural features that insulate the broader economy from problems in commercial real estate. And in the meantime, the market has kind of changed its tune and you're seeing regional banks and real estate ETFs bounce back, I think that may be overdone potentially.

16:00And there could be a market correction in the wrong direction at this point. Because the problems in commercial real estate are, they're not catastrophic. It's not going to bring down the economy, I think, but they're real problems, right? Remote work remains a feature of the way that we do business. Higher interest rates are still around. We're not going back to zero, we're at 4 % on the 10-year. And people built way too many apartments in certain markets right after the COVID boom, especially in places like Miami and the Sunbelt. Those are going to come home to roost and they're going to be investors taking losses.

16:33I think you're going to see more of that start to materialize this year, even again, if it's not a catastrophe for the whole economy. Yeah. Well, I have an extremely tentative long. I looked yesterday for yesterday's newsletter, I looked at Alibaba, which for a long time was a, you know, a darling global company. It was the leader in Chinese e-commerce, a bit like China's Amazon, although their business models are slightly different. Uh, and it has had a horrible couple of years. The stock price fallen like 75%. They had a reorganization plan to simplify what had become an extremely sprawling business.

17:13That seems to have come off the rails. Of course, we know that the Chinese Communist Party has not taken a very friendly attitude towards tech companies within China. The story of Jack Ma, the founder's sort of public shaming is well known at this point. But I wonder if now it's all been a bit overdone. If the company operationally can't get back on the rails and perhaps equally importantly, the party softens its view towards the tech industry a little bit in the year to come. Is it possible that it is the exact moment of maximum darkness for Alibaba and a tiny bit of light about its future might come through?

18:04And at those moments, stocks can really move. Yeah, for sure. Well, Rob, thanks for being here. We'll have you back very soon. And listeners, we'll be back in your feed on Tuesday with another episode of Unhedged. Catch you then.

18:35Special thanks to Laura Clark, Alistair Mackey, Jacob Weisberg, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

19:06We'll be right back.