In our previous market update we highlighted the key drivers of the transitory risk-off inflation market regime which occurred in January and February, those being:
- Persistent dollar strength.
- Inflation Fears
- The Feds pivot from asymmetrically dovish to neutral.
- High economic uncertainty and the wide distribution of probable economic outcomes.
Additionally, we dove into our moderate expectations that US Growth and subsequently dollar strength would likely slow over the medium-term, driven by a wider distribution economic outcomes and the likely event of foreign investors leaning towards caution, i.e., being quick to sell US risk assets.
Since then, on a global scale markets have shifted from pricing in mild stagflation to pricing in risk-on inflation, however, the US markets have made a pretty aggressive shift to pricing in a more deflationary environment.
Stagflation is characterized by:
- Dollar up,
- Yields up,
- Commodities up,
- Bonds down,
- Equities down,
- Crypto down.
Deflation is characterized by:
- Equities down
- Crypto down,
- Dollar down,
- Yields down,
- Commodities down,
- Bonds up.
We expect that this aggressive shift in the US is likely to back up a bit with yields and oil moving higher in the short-term. That being said, the medium-term – while considerably uncertain – could put the US into a continued deflationary environment orchestrated by the new administration’s policies.
Unpacking The Economic Data
As we’ve consistently stated in previous notes, the implications of a new and aggressive administration is a much wider distribution of probable outcomes for the economy, which is now being reflected in the accelerating economic policy uncertainty index.
What we’re also seeing is that the high expectations for the Trump economy have been forced to reconcile with reality as shown in the Citi economic surprises index, which has been in a negative trend since November and is nearing levels from summer 2024.
Looking at actual growth data, what we’re seeing is the ISM manufacturing index has finally made it back above 50, however, the services PMI is trending lower following a peak in late 2024.
Something that confuses many investors is that many of the popular indicators of the business cycle, such as the Conference Board leading Economic Index or the ISM manufacturing PMI, are mostly just indicators for the manufacturing side of the economy.
However, roughly 70% of the US economy is services, which means that many of the same investors who were off sides waiting for manufacturing production to pickup, are now thinking its time to take on a lot of risk, which is not necessarily the case when we look at indicators of the services economy.
US Liquidity
US net liquidity has been among the key drivers of asset markets since 2008. China has been picking up the slack since 2022, however, since early December, neither China nor the US have been very stimulative, which is one of the factors weighing on risk assets.
On a positive note, the TGA is finally getting spent down, which is a positive impulse for US Net liquidity – admittedly we have been dead wrong on how long it would take for this to play out.
Global Liquidity
Global liquidity has begun to reaccelerate in recent months, reaching its previous all-time high as the weaker dollar has provided cover for foreign countries to once again become much more aggressive with fiscal and monetary stimulus, similar to what we saw in August of 2024. One example of this is the European Central Bank ECB cutting its policy rate by 50 basis points in its most recent meeting.
The Crucial Liquidity Situation
In 2020 record amounts of debt were borrowed globally by governments and corporations at extremely low interest rates, which drove a massive influx of liquidity.
This felt great while it lasted, everything was up, but at some point all of that debt has to get refinanced, and that time is coming up.
A significant portion of the money borrowed in 2020 was termed out 4 to 5 years, which means that now, a lot of that debt is coming due and that means the demand for refinancing on a global scale is rising.
Unless there is a significant increase in liquidity (supply of money) to meet that demand for money, liquidity will be sucked out of asset markets – beginning with riskier assets like crypto.
The best analogy for this is an air pocket, there is currently a significant gap between supply and demand for liquidity and unless there is a significant acceleration in liquidity growth, that gap will naturally suck liquidity out of riskier assets first.
Trumps Economic Agenda
At the risk of getting political, in order to understand where we think the economy and markets may be heading, we have to take a brief look into what we think the new administration is attempting to do.
The below chart might be the best characterization of the current economy, and the demand for populism that got Trump elected. It illustrates corporate profits and employee compensations’ respective shares of gross domestic income.
Many of the people who voted for Trump are in the cohort of the economy represented by the red line (this is also the majority of the country). This is the middle and lower class and their incomes come from labor. High inflation and interest rates have a substantial negative impact on the lifestyles of this cohort.
Whether you agree or disagree with his policy execution, Trump’s key stated objectives are to bring down interest rates and inflation, and flip the economy from one driven by deficit spending, to one driven much more by the private sector – which benefits those represented by the red line.
What we are likely witnessing is the Trump administration attempting to tank the economy and sacrifice asset prices and the blue line in an effort to force yields and inflation lower to benefit the bulk of his voters (blue collar, middle class etc.).
Our Outlook
In our view, there are two scenarios which have the highest probabilities of playing out:
1. The Bearish Scenario:
1A: The new administration’s efforts to flip the regime, end up causing too much economic distress, pushing the US economy into a recession.
1B: There isn’t a sufficient acceleration in liquidity on the backend of this growth scare to make up for the acceleration in debt refinancing demand in 2025.
Any combination of the characteristics of this bearish scenario would likely mean that we see a significant decline in risk-assets in 2025, followed by a longer recovery than the current consensus expectations.
2. The Bullish Scenario:
2A. Trump’s plan drives a surprise deceleration in inflation, and a substantial decline in yields without forcing a recession, followed by a strong economic recovery driven by factors such as deregulation.
2B. The substantial weakening of the US economy and the dollar provide cover for significant acceleration in liquidity from the US, Eurozone, and China.
This best case scenario would likely mean short-term pain for risk-assets, with a very positive medium to long-term outlook.
While crypto and US markets have faced major headwinds for the better part of 3 months, EU and Chinese equities along with gold and gold stocks have been performing well, as is often typical of risk-on inflation market regimes.
We are still in an environment of high uncertainty with a wide distribution of outcomes, which is why we are not trying to make any big predictions or take on a lot of risk at the current juncture.
As always – especially in these uncertain environments – it’s important that we stick to our process, manage our risk, and take opportunities as they present themselves. Our systems are going to do a much better job at helping us navigate these uncertain markets than we ever could by trying to guess or predict future outcomes.