The onset of the Iranian crisis has unleashed a litany of dire prognostications surrounding the likely course of the price of financial assets.
Yet US equity markets are close to record highs.
What gives?
The favoured explanation among the commentariat is that markets are complacent – perhaps even “irrationally exuberant” – and a day of reckoning is nigh. Viewed through a macroeconomic prism, that explanation has some appeal.
Even if hostilities in the Middle East are about to be dialled down, it is difficult to see oil prices return to their pre-conflict levels. Re-engineering of energy supply chains, a greater tendency to “just-in-case” rather than “just-in-time” oil inventory management and an ongoing risk premium attaching to the price of oil may see an extended period of elevated oil prices.
Inflation was “sticky” prior to the surge in oil prices. Furthermore, structural global inflation suppressants that had operated since the late 1980s up until the onset of the pandemic are in clear abeyance (think declining skilled migration flows from the former Eastern Bloc, China and India; the retreat of globalisation of goods markets; increasing labour and goods market regulation; and declining baby boomer workforce participation).
Those waning structural inflation suppressants and now the surge in oil prices have meant that central banks, including the US Federal Reserve, are required to be more attuned to upside inflation risks than they may have been in the three or so decades leading up to the pandemic. It has also meant that an anticipated decline in bond yields has not eventuated.
There is a view that current bond yields are “elevated” by some historical standard. That notion, however, doesn’t bear scrutiny.
Between 2008 and 2022 (the period covering from the GFC to the pandemic), US 10-year bond yields averaged around 2.4 per cent. That was a period of extraordinarily low yields by historical standards. Yet it is etched in the minds of a number of market participants as some benchmark of ‘normality’.
Between 2000 and 2007, the average US 10-year bond yield was around 4.7 per cent. That is a way north of where the current US 10-year bond yield is trading.
The latter is arguably a better benchmark (albeit one that is far from perfect). Interestingly, the average through the 1960s was also around 4.7 per cent.
In other words, current bond yields are not “high” by historical standards. The corollary of that notion is that in the current period of relatively strong inflationary tailwinds, the forces preventing any substantial decline in global and US bond yields are formidable. That would imply ongoing headwinds to economic activity growth and equity market performance.
So why are US equity markets at close to record highs?
For one thing, the macro data is yet to show any substantial slowing in economic activity growth. However, it has also yet to reflect fully the fallout from the Iranian conflict. But more importantly, the answer is that equity markets reflect a whole lot more than the macroeconomy.
Global markets are currently wrestling with huge economic structural shifts that are arguably more important than conventional macro metrics in driving equity market performance. At the forefront of these changes is the rapidity of technological advances. The incorporation of AI into economic life will likely see massive productivity growth that can mitigate any adverse macro influences. Moreover, there is an element of US exceptionalism that attaches to AI and consequent productivity growth.
The US is at the epicentre of AI developments, and there are signs that it is already reaping outsized rewards from that circumstance. US productivity growth has averaged 1.7 per cent per annum since the end of 2021. The equivalent Australian figure is -1 per cent. To put it more starkly, US productivity has grown by almost 7 per cent in that time; Australia’s productivity has fallen by 4 per cent. (Australia’s experience is reflected more or less in the rest of the developed world outside the US).
That might in part explain why US equity markets are at record highs (despite an adverse prospective macro environment), and that is, to some extent, dragging the laggards with it.
An important investment dimension arising from the foregoing is that it is likely to result in a greater dispersion of individual stock returns. That being the case, the returns from “good” active management are accordingly higher compared with passively managed index funds.
So yes, the macro environment is a challenging one and likely to stay that way as bond yields remain at current levels or go higher. And that should make investors wary. But equity markets (particularly the US) can benefit from harnessing important structural mega-trends that can propel ongoing strong equity performance despite that adverse macro environment.
The RBA: where to next?
I had canvassed the possibility that the RBA might ‘pause and reflect’ at this week’s RBA Monetary Policy Board (MPB) meeting.
That was not intended as a prescriptive statement but more as a descriptive sense of what the RBA may deliver under the new arrangements that accompanied the An RBA Fit for the Future review initiated by Treasurer Chalmers.
That didn’t eventuate, but I think the RBA MPB made the right call.
Inflation was already both too high and broad-based ahead of the Iran shock, even if the March quarter CPI outcome was slightly less than feared.
And despite that ‘better than feared’ March quarter outcome, newly issued RBA forecasts show a path for trimmed-mean inflation higher than forecast back in February. For this calendar year, trimmed-mean inflation is expected to come in at 3.5 per cent (compared with 3.2 per cent forecast back in February).
For what it is worth, I think on balance the current environment is one that argues for further insurance against inflation expectations becoming unanchored, and that should see a further tightening at some stage this year.
Both the Federal and State governments appear to be reticent to abandon politically expedient but ultimately counter-productive spending measures. In large part, the result is higher policy rates.
This is also the product of an almost egregious inattention of past and present governments (both State and Federal, Labor and Coalition) to policies that might ease structural constraints on inflation. In most instances, this involves “unintended consequences” of regulatory creep in labour and goods markets.
The foregoing is emblematic of a particular inflation proclivity in the Australian economy. That is on top of structural global inflation suppressants that had operated from the late 1980s up until the onset of the pandemic, now being in clear abeyance. The foregoing suggests that the RBA might still need to reload later in the year.
Coming up: US non-farm payrolls is unlikely to move the dial for the Fed despite the Warsh ascendancy.
The last meeting of the US Federal Reserve appeared to indicate the Fed was some way from easing policy rates. At this juncture, it is difficult to see that changing even as Kevin Warsh assumes the Chair’s position, presumably later this month.
Warsh conjectures that disinflation in the US will follow from tremendous (largely AI-motivated) investment. In Warsh’s view, that investment has wrought a productivity dividend that (other things equal) has raised the US economy’s ‘speed limit’. In other words, the US economy can grow at a faster rate before igniting inflationary pressures.
That is a credible – if eminently debatable – position. And there have been glimpses of that phenomenon in some of the less “noisy” inflation measures.
For example, the Dallas Fed‘s trimmed mean core PCE measure was 2.4 per cent in March, minusculely above the February reading, which was the lowest since August 2021, and comes despite broad-based price pressures emanating from the Trump tariff agenda. That said, progress toward the 2 per cent target, even on the Dallas Fed measure, has been excruciatingly slow.
Judging by their commentary, most members of the Fed’s rate-setting Federal Open Market Committee (FOMC) remain concerned about the potential for the recent oil price surge to unanchor inflation expectations.
And it remains the case that the Fed’s favoured inflation measure, the core private consumption expenditures (PCE) price index, at 3.2 per cent in March, is well above the target 2 per cent and was the highest read since November 2023.
So, absent some sharp deterioration in the labour market, the incoming Fed Chair might be hard-pressed to convince his fellow FOMC members of the case for cutting the policy rate.
Today, of course, brings the April non-farm payrolls report. Indications are that the labour market remains in satisfactory condition.
The ADP April payrolls report was more robust than anticipated, showing a gain of 109k (versus the 85k increase expected). The ADP report is sometimes dismissed (too easily in my view) because of its poor record in foreshadowing month-to-month movements in the Bureau of Labor Statistics payrolls measure. However, it is just as good a measure of the state of the labour market as the payroll report.
The March Job Openings and Labor Turnover survey (JOLTs) report saw openings remain at a satisfactory 6.9 million.
The April Institute of Supply Management (ISM) manufacturing index (PMI) released on Monday paints a reasonably satisfactory picture of the US manufacturing sector: the index came in unchanged at 52.7. The employment component slipped to 46.4, which is a little on the soft side and consistent with some manufacturing job losses (50.0 is the neutral point between expansion and contraction). The prices component, meanwhile, increased to an elevated 84.6 (ringing clear alarm bells around accelerating inflation in the sector).
The April ISM services index also paints a satisfactory picture, with the overall index remaining consistent with expansion at 53.6. The employment component improved a little to 48.0 from 45.2, although it remains consistent with some modest cooling in the non-manufacturing labour market. The price component remains elevated at 70.7 (again consistent with worrying acceleration in inflation).
A consensus outcome for payrolls of a circa 180k increase in employment and an unemployment rate unchanged at 4.3 per cent, with average earnings growth of 3.5 per cent, is unlikely to move the dial for remaining Fed members.
If Kevin Warsh does, in fact, wish to cut the policy rate, he has his work cut out.
Stephen Miller is an Investment Strategist with GSFM. The views expressed are his own and do not consider the circumstances of any investor.
