Crypto News: Inflation holds the key

A theme has taken hold in markets lately, with stocks taking their cue from bonds.
Usually, it's the outlook for the economy and, therefore, earnings that drive stock prices. Yet, as we begin another quarterly earnings season, it's the bond market dominating the conversation, even when talking about stocks.

What's going on? In a word, inflation. I think investing in 2025 will be won or lost on that score.

Basically, the Fed shouted "Mission Accomplished" on inflation when policymakers started lowering the fed funds rate last year. But it turns out, there may be more work to do. Central bankers' 2024 worry, the job market, is doing just fine as evidenced by the latest US jobs report. It's actually inflation and inflation expectations that are the sticky wicket.

What that means for your portfolio is pretty simple. If inflation resumes its downward trend, the Fed will have been proved right and can continue cutting interest rates, helping to curtail an incipient strike on "duration," a fear about the value of long-lived assets. That's bullish. But if inflation continues to boil over as I suspect, then the thinking from last newsletter's edition about rising term premiums are what I think is in store — and that's bearish.

Let's break this down using the following points:

The strike on duration has been revealed to be inflation fears
If you can calm those fears, the equity market can go higher still
But valuations do look stretched — and that's mostly about extrapolating the present into the future
That says the risks are now skewed to the downside — even before policy uncertainty enters the picture

Inflation is the wild card for markets

The story I told you last week was that the Fed had raised the fed funds rate after the pandemic to create enough financial strictures to slow the economy and bring down inflation. Fearful of a recession, though, they reversed course at almost precisely the wrong time, with economic data surprising to the upside since September, including inflation.

Inflation fears became so pronounced that people started asking for a premium to hold longer-term US government debt. And the rate at which premium was rising started to destabilize other markets. If it rises any further, the whole bull market will unravel — and quite violently, given the overly optimistic premises upon which it is now built.

You can see inflation expectations becoming potentially unanchored. The last University of Michigan Consumer Sentiment Survey showed long-term inflation expectations higher than anything we've seen since the 1990s, outside of a blip during the financial crisis.

Fast forward to this week, and what we see is producer and consumer price data calming fears of inflation. After core CPI rose less than expected, we saw a big rally in Treasury bonds bringing yields down as much as 15 basis points along the curve in some places. In essence, the whole uptick in term premiums, this whole strike against holding long-lived assets, was about inflation fears.

If lower inflation data can calm those fears, then long-term bond yields will continue to retreat. And if those yields retreat, equity investors can go back to worrying about earnings instead of inflation. That gives the bull market more scope to continue — even as skeptical of this rally as I have now become.

How to think about the US market rally

One way to look at this is through the prism of alternatives. Rob Armstrong did just that over at the FT when asking whether British stocks were cheap. As he put it, "US big-cap stocks' valuation premium over UK stocks has exploded since 2021." We're talking a PE premium over 100% now. His conclusion? "The same sort of company with a similar growth rate carries a similar valuation." Basically, the recent US earnings multiple expansion and its premium to other markets is all about growth.

Earnings per share in S&P 500 companies are projected to grow at double the rate of UK FTSE 100 companies over the next two years, for example. It's no wonder, then, that you have a premium on US stocks when other countries like Germany saw their economy contract in 2024. Still, for that 100% US-to-UK premium to work, Armstrong says we're talking about growth differential estimates over the next two years only, not the next 10.

So-called US exceptionalism is real because the US is growing more than other countries. A lot of that growth is tied to large capitalization technology companies. And that explains why they have been driving the market. Nevertheless, investors seem to be extrapolating the present forward. If US exceptionalism falters in any way, watch out.

Faltering is about the inflation story

To think about what comes next, let's go back to the inflation story. That's the Achilles heel of the US market rally. What the past week has shown, with a mini-correction in US shares, is that inflation fears had grown enough to dent the market's upward trajectory.

We have a few things to worry about on the inflation front. For one, the Fed's rate cuts haven't been fully absorbed. Monetary policy always acts with a lag. Second, the US government is deficit-spending as if there was a recession. According to the Congressional Budget Office, "in 2024, the deficit was equal to 6.4 percent of the nation's gross domestic product (GDP), an increase from 6.2 percent of GDP in 2023." That's in a high-growth environment, which would mean something like 8% deficits in a recession as tax receipts decline and automatic stabilizers kick in. And then, there are the inflationary policies around taxes, trade and immigration likely coming online with Donald Trump. No one knows to what extent they will push inflation higher.

My own view is that the Fed erred in cutting the fed funds rate so aggressively in 2024. Look at how real interest rates, the term premium and nominal yields went up in lockstep after the Fed started cutting in September.

The uptick in nominal yields on long-term bonds has been driven to a large degree by an increase in real yields, which in turn has been driven by the premium investors are extracting for the risk of holding longer-maturity bonds.

And then at the same time, inflation expectations have been rising too, making the rise in bond yields even greater in nominal terms than they have been in real inflation-adjusted terms.

What that's telling you is that, instead of offering the market a security blanket, rate cuts may have increased uncertainty. The Fed's cuts may have caused investors to reassess their appetite for taking the risk of holding longer-maturity assets. The combination of sticky inflation and a wrong-footed Fed mean any further rise in inflation will tighten policy as duration fears in the bond market bleed into other markets — just as we started to see this past week.

My optimism has faded a touch here

I'd like this to end on a feel-good note but I think the US equity market has become too wedded to a view that extrapolates US exceptionalism forward. And that's happening against a dangerous geopolitical backdrop. While I am heartened by the more benign inflation numbers. they may be just one-offs. Given the risks facing a US equity market priced only for the best of times, I would say downside equity risks now outweigh upside opportunities. In all of this, inflation will be the big wild card.

Things on my radar

The Israel-Hamas deal tells you not all geopolitical risks are negative ones. That's good for oil prices and inflation, which need good news
Despite the relief rally in bonds, categories that matter most to US households show some pretty price level increases
Fed officials like Williams and Goolsbee are not to be dissuaded. They are optimistic about inflation