Why the Bond Market May Be the Stock Market's Biggest Risk

Analyzing Fed Policy, Bond Market Risks, and Equities Outlook This is the markets. I'm Chris Hussey. And today is Wednesday, September 23rd, and I'm here at the Goldman Sachs trading floor with Tony Pascarello, who is Global Head of hedge fund coverage within Thick and Equities. Tony, thanks so much for joining us. Great. Speaker 2 To be here. Speaker 1 You were with us almost exactly a year ago, and at the time the Fed was actually cutting rates. Oh, what a difference a year makes. Walk us through what you make of both the Fed and the market's reaction and how hedge funds were positioned going in and coming out. Speaker 2 Well, it's interesting, we started the year and the market, the interest rate market expected there be a couple of cuts this year. Looks like there may be certainly a couple of hikes this year. We are one, one hike into that. The strip's telling you that are probably about four hikes maybe touch more when all is said and done. So, so, so we've ended up in a very different place. You know, why is that 66 months above target on inflation? Of course, what's going on in the Middle East has contributed to a rise in oil prices and refined products, but also nominal growth has been very strong. So I don't think it's necessarily all bad in that context. Look, I thought the chair reasserted kind of command of the narrative last week. Ultimately, he hiked. It was a hawkish hike and in the doing, the back end was kind of anchored in inflation break evens were anchored in and I think it kind of came a clearing event for the stock market. And so up until Monday's close, it felt like that was generally speaking viewed as a win by the stock market. As we sit here today, Bonnie's are pushing higher again, 10 year notes kind of making higher highs in yield terms relative to where they've been. So a bit more pressure returning equation, yeah? Speaker 1 You would have expected though, the 10 year not to make higher highs, right? I mean, if they're going to be hiking, you got to think that that's going to slow the economy down. And so people are going to think, OK, they got everything under control. Are you worried that the 10 year making higher highs has got people worrying that they don't have things under control? Speaker 2 If you were to ask me what's the number one kind of clear and present danger for the stock market, I'd say it is the bond market. I would have said that a month or two ago. So this is not new. I do think the debt and deficit narrative which kind of comes in and out of market focus is kind of in market focus right now. And of course we're talking about a lot of bonds coming off the assembly line, not just from sovereigns like the US Treasury, but also of course the fund, the AI CapEx build out and and growth continues to look stronger than expected. And so we're now talking about Q3 GDP growth 3% or better. Remember, the second-half is supposed to be a slow down post the taxed endless. I'm not saying it is all bad, but you can certainly feel on a day like today, again, that kind of pinch coming into the stock market from the bond market. Speaker 1 Tony, that's a great point on growth. Our economists are forecasting 3.3% GDP growth for the third quarter. This is a very strong growth environment still. All right, You've taught me a lot over the years. You're a deep thinker on the markets, but one of your mantras has always been don't fight the Fed. So where do you think equities go from here? Because if I don't want to fight the Fed, don't I sell equities? Speaker 2 I'm a student of market history. Respect the market history book for sure. I feel like in the, you know, section on 1st principles rule #1 is probably don't fight the Fed. I've been doing this for 27 years. If I look back at what has ended bull markets along that path, it usually does involve a tightening of Fed liquidity alongside other factors. And again, if you, if you look at market history, generally speaking, the early innings of a tightening cycle, do CS and P trade lower. Now I think you have to ask the question, is this kind of a mini tightening cycle or something, something bigger? I think the stock market is acutely aware of what the bond market discounts as we sit here today. Again, even with appreciation for a little bit of the pressure that you feel in stocks, I think the stock market knows the strip is telling you they're probably going to go about four times. So like if that is what is delivered or less than that. I don't think this is necessarily a traumatic dynamic for the stock market. But again, you have to watch it carefully and it where it leads me is if one needs to be looking for hedges, looking for bedfellows for the equity risk, then I do think contemplating shorts in the bond market is the right way to go. AI, Fiscal Impulses, and Hedge Fund Positioning Strategies OK. So one of the elements of that, of course, is that, you know, 4 hikes will contain inflation. One of the other differences in markets today though, is that we have this AI structural trade underway. How, what does that change the dynamic of maybe don't Fed the fight the Fed or just what the Fed is doing in general? Is this AI trade going to just continue to drive up inflation because there's so many resources going to this? Speaker 2 I think there's two dynamics in the context of of of countervailing forces to the worry about a fed tightening cycle 1 is exactly that which is the AI kept back cycle. And so if you just look at the hyperscalers, I think in 2023 around hyperscaler CapEx was like 150 billion. Next year that's probably 1.3 trillion. So it is an enormous cyclical impulse that is working its way through the global economy, particularly within the US Look, the second is we have a $2 trillion budget deficit at full employment when we're not really at a, you know, fully a war, if you will. And so I think when you stack those two impulses next to each other, trillions of dollars of AI CapEx spend, trillions of dollars of fiscal deficit per annum simultaneously, then I do think you have a very pro cyclical offset to some of the other things we're worrying about. Not uncomplicated, no. Speaker 1 It's not uncomplicated. And are your hedge fund customers positioned correctly for that you feel or do you feel the hedge fund guys are having to get themselves right way here? Speaker 2 This is a general statement. I think deployment of risk, deployment of leverage is relatively low right now versus various other turns in the year. And again, I've, I've used this word choice every week, certainly every month has been its own little distinct adventure this year on net hedge funds have performed very well. That could be fundamental long short clients that can be systematic longshore clients that can be macro hedge funds. And so they've they've they've done quite well amidst all these twists and turns in the volatility. But I think as we sit here today with a nice P&L reservoir, folks are lower on the risk taking scale. Generally speaking, I think set up for what we're talking about though. So paid rates, positions in the bond market, bias towards flatter curves in the bond markets on the margin, long dollars and I think our people on net long equities for sure. Again though, I think it's kind of on a lower risk setting than where it's been most of the year. Speaker 1 Yeah, it makes sense. S&P 500 Earnings, Japan's Trade, and Final Disclosures What other risks are you and they looking at here beyond AI, beyond the Fed? Speaker 2 Well, as a, as a client who's been there and done that said, you know, the surprise always comes from the place you're not looking. I suppose COVID was probably the best example of that. I think the biggest question is we've enjoyed this incredible earnings boom. So when you take out these one time PE marks, you're talking about 2530% earnings growth for S&P 500 coming off great denominators. So just kind of mind bending earnings growth. And so the open question is can that be sustained? On our view it will slow, but you're slowing from 2530 to more like 11:50, so still generating double digit earnings growth, but a meaningful slowdown. So trying to calibrate how the markets going to treat that second derivative slowdown is I think one of the big open questions. Speaker 1 Yeah, it is. And I guess if it's a slowdown and not a decline in earnings though it you're going to get, you know a pretty good market you would expect though, no, that's. Speaker 2 Where I come out, so we've enjoyed what is tracking to be 4 years of double digit returns in SP 500. That's only happened one other time in modern history and of course that was the very end of the 1990s. So the market has enjoyed this and it's very much been an earnings driven rally. We're sitting here today peas 1819 year ago when we last spoke it would've been 23. So very much driven by the earnings growth we're talking about. And so I think the market has enjoyed that. My guess is where that leads is just a just a lower gradient of return from here, IE as earnings growth slows, the extent to which the market appreciates slows, but on that's still positive. Speaker 1 You said it, so I got to ask you The tail end of the 1990s led to the 2001 tech bubble. Does that concern you that what we're seeing is rhyming? Speaker 2 I think where I come out, where Peter Oppenheimer and our colleagues have come out is there's no doubt the market is highly valued relative to market history. So I think even like that 1819, you're probably still in the 90th percentile of this circle range. But if you do a direct compare to say Weber were coming out of 99 into 2000, the market today is less highly valued. These companies are more profitable and they have better balance sheets. Speaker 1 Yeah, no, it's so true. All right, let's put a bow on it. What's the trade? Speaker 2 I always have a spa spot for the trading rallies in Japan. This has been more than trading rally. This has been a heck of a of a post COVID rally in Japan. I still think there's this bottom up shareholder reform story that's coming through brick by brick day by day. I think if you're a believer in the AI trade, if you're a believer in the reindustrialization and the remilitarization trade, the Japanese stock market offers a lot of these properties that you're seeking and has AI stocks. It has advanced manufacturing as defense contractors and you have long may it run a very pro cyclical government policy, federal policy right now. I think that trade is cleaner than it was three or four months ago. We've seen actually a pretty consistent deleveraging of that trade for our prime brokerage franchise. So if I had to pick one horse to ride for the next phase of the game, I'm going Japanese equities with a bias towards the domestic. Some more of a topics like trade than a Nikkei like trade. Speaker 1 Yeah, of course you have corporate governance modernization taking place there as well. So cool trade. What are you looking out for next week? In the week after SO? Speaker 2 When I, when I started in this business, I started in interest rates and one of the guys I work for said, you know, rule, rule #1 is you can never miss payrolls Friday. You never take that day off. So next Friday brings a payroll number. The labor markets looked pretty solid of late. So jobless claims very low. You know, job creation, not, not, not outsize, but but healthy enough. And so I think both the bond market and then turn the stock market will take your cue from the payroll number next Friday. Speaker 1 Tony, thanks so much for sitting down with us. That does it for this week's episode of the MARKETS. I'm Chris Hussey. Thanks for listening. Speaker 3 The opinions and views expressed herein are as of the date of publication, subject to change without notice, and may not necessarily reflect the institutional views of Goldman Sachs or its affiliates. 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