Note: I will be travelling (Pacific time zone) until August 10. Posting will be irregular and possibly limited by time and equipment constraints.

EARNINGS WATCH

From LSEG IBES:

70 companies in the S&P 500 Index have reported earnings for Q2 2024. Of these companies, 82.9% reported earnings above analyst expectations and 11.4% reported earnings below analyst expectations. In a typical quarter (since 1994), 67% of companies beat estimates and 20% miss estimates. Over the past four quarters, 79% of companies beat the estimates and 16% missed estimates.

In aggregate, companies are reporting earnings that are 5.0% above estimates, which compares to a long-term (since 1994) average surprise factor of 4.2% and the average surprise factor over the prior four quarters of 7.3%.

Of these companies, 57.1% reported revenue above analyst expectations and 42.9% reported revenue below analyst expectations. In a typical quarter (since 2002), 62% of companies beat estimates and 38% miss estimates. Over the past four quarters, 62% of companies beat the estimates and 38% missed estimates.
In aggregate, companies are reporting revenues that are 0.5% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.3% and the average surprise factor over the prior four quarters of 1.2%.

The estimated earnings growth rate for the S&P 500 for 24Q2 is 11.1%. If the energy sector is excluded, the growth rate improves to 12.0%.

The estimated revenue growth rate for the S&P 500 for 24Q2 is 4.5%. If the energy sector is excluded, the growth rate declines to 4.4%.

The estimated earnings growth rate for the S&P 500 for 24Q3 is 7.6%. If the energy sector is excluded, the growth rate improves to 8.8%.

The 70 companies having already reported realized a 16.5% earnings growth rate on a 5.8% revenue gain. Margins keep rising fast!

Trailing EPS are now $230.69. Full year 2024: $243.20e. Forward EPS: $260.30e. 2025e: $278.64.

The combination of rising earnings and declining inflation is keeping the Rule of 20 Fair Value on the rise (yellow line above). Expensive equities are supported by solid fundamentals (rising earnings and slowing inflation).

NBF warns that earnings expectations could be too high:

The frenzy on US stock markets is being fuelled by ambitious earnings expectations, with the consensus forecasting a 13% increase in S&P 500 earnings per share (EPS) over the next 12 months.

But how realistic is this given the current very negative reading of the Bloomberg Economic Surprise Index?

As today’s Hot Chart shows, earnings forecasts have been revised downwards by an average of 7.2% in the three months following a reading of less than -0.5 on the Bloomberg Economic Surprise Index, which is currently the case. As shown, the Energy, Materials and Financials sectors are usually the ones suffering from the biggest downwards revisions, while Health Care, Consumer Staples and Utilities are only marginally reassessed.

Bottom-line: we see a significant downside to the consensus estimates for EPS growth in the coming months.

But the real surprise could be that the economy is not so weak as the surprise factor suggests. Not a moot point considering that equities are often quite susceptible to negative economic surprises:

The initial Atlanta Fed GDPNow estimate for Q2 was +3.9% on April 26. It sank to +1.5%, nearly 40% lower, on July 3rd, heavily weighted down by Personal Income and Outlays data and the very weak ISM PMIs. It has since recovered to +2.7%.

My take on some of the recent crucial stats:

• Real consumer expenditures rose 0.26% in May after –0.13%, +0.8% a.r. in the last 2 months, a sharp slowdown from +1.5% a.r. in Q1. But Wages and Salaries jumped 0.7% in May and are up 5.5% a.r. in the last 2 months with inflation at 2.6% YoY. Absent the rise in the Savings Rate (from 3.5% to 3.9%), real expenditures would have increased 3.7% a.r. in April/May, twice the Q1 growth rate. Strong labor income, higher savings and wealth provide solid spending power going forward.
• Recent ISM data came in very weak but the less widely followed, but more accurate, S&P Global’s PMI surveys were very strong with rising new orders.
• Supporting the stronger S&P Global survey, Industrial Production jumped 0.6% in June following +0.9% in May. Factory output rose 0.4%, in a broad advance that included gains in autos, electrical equipment, appliances and nondurable goods, following May’s upwardly revised 1% increase. Output of consumer goods rose 1% in June, the most in nearly a year. Manufacturing production jumped 0.84% QoQ in Q2, +3.4% annualized, bettering the aggregate of the 5 previous quarters.
• June Retail Sales were much stronger than expected and May’s weak +0.1% originally reported growth rate was revised up to +0.3%. Control Sales rose 0.9% MoM in June after +0.4% in May. Last 4 months: +4.3% annualized with negative inflation.

Overall, the American consumer is in good shape: labor income is strong, inflation is slowing (black), even on “essentials”, and wealth gains have benefitted all income levels.

The Unemployment Rate is up but only because supply has increased. Demand remains solid as S&P Global’s PMIs revealed. Indeed Job Postings have stopped declining since the end of May and even perked up in the first 2 weeks of July.

Economists keep marking down their Q2 GDP forecast, now below +1.8%. The GDPNow, at +2.7%, is above the highest Blue Chip estimate. Barring a major black swan event, the odds are high that economic surprises will surprise on the upside in coming months. Goldman Sachs’ own surprise index has turned up recently.

  

And, for what it’s worth, U.S. leading indicators are also more positive:

@RBAdvisors

If so, earnings growth will likely broaden beyond the Mag 7. Here’s Goldman Sachs’  David Kostin:

AMZN, GOOGL, META, MSFT, and NVDA are collectively expected to grow 2024 profits by 37% compared with 5% for the median S&P 500 stock. But we have previously noted that consensus estimates of sales growth for the five stocks is forecast to slow from 22% year/year in 1Q 2024 to 17% in 2Q, and further decelerate to 16% in 3Q and 14% in 4Q. NVDA sales growth is expected to slow from 262% year/year in 1Q to 111% in 2Q, 73% in 3Q, and 56% in 4Q.

In contrast, sales growth for the median S&P 500 stock will be accelerating, albeit from a slower pace (year/year growth of 2%, 3%, 4% and 5%).

The recent trend of small-cap outperformance will likely persist unless the macro environment changes substantially, or the mega-cap Tech stocks report 2Q results that causes analysts to raise revenue forecasts for the next several quarters.

In our recent report on AI and US Equities, we discussed that investors have become increasingly concerned about the prospect of “overinvestment” in AI, especially among the four hyperscalers (AMZN, META, MSFT, and GOOGL). These firms collectively spent $357 billion on capex and R&D during the past four quarters – fully 23% of the total spending by all S&P 500 companies!

Consensus estimates of 2024 and 2025 capex and R&D spending by the hyperscalers have increased by $65 billion compared with expectations at the start of the year. However, analysts have lifted their sales forecasts for 2025 and 2026 by only $36 billion – a gap of nearly $30 billion. From an earnings perspective, the shortfall is lower but still substantial ($7 billion) given the profit estimates in 2025 and 2026 were raised by $58 billion.

Simply put, these firms during the past six months have dramatically increased their planned spending on AI initiatives but it is not apparent when the return will come – in 2027, 2028, 2029, or perhaps not at all?

In the late 1990s DotCom boom, sales revisions was the key variable to watch because it ultimately signaled when momentum reversal would be sustained. The potential resumption of the AI trade – and by extension a reversal of the recent underperformance of large-caps vs. small-caps – will depend on revenue revisions. S&P 500 outperformance will resume if big Tech beats and raises its forward sales guidance. If not, then small caps will continue to outperform. GOOGL will report on July 23, MSFT on July 30, META on July 31, and AAPL and AMZN on August 1.

  

Playing small caps? Which ones?

Russell 2000 investors should be aware that:

• Trailing 12-months operating margins is 4.7%, 9pp below that of the S&P 500 companies.
• If the Russell were a single company, it would carry a speculative-grade credit rating: Net debt of 4.4 times trailing Ebitda compares to 1.5 times for the S&P 500 (Grant’s)
• Russell 2000 Q2 earnings are seen down 5.6%, the 6th consecutive down quarter.
• On a trailing 12-month basis, 42% of Russell 2000 companies are losing money. Only 6% of the S&P 500 companies lost money last year.

• The Index P/E of 18.4 is only attractive if you don’t know that this P/E calculation excludes losers. In reality, the P/E is 34.0x trailing earnings per LSEG IBES.

The S&P 600 Index P/E is 17.9x trailing and 15.5x forward. No losers are allowed in this index.

Canada: Retail sales stall in Q2

Retail sales data for May were below economists’ expectations, showing a sharp decrease after an expansion in April (+0.6%, revised down from +0.7%). An increase in sales in the motor vehicle and parts industry mitigated the decline, as the contraction excluding that sector came in at 1.3%, its largest decline since July 2022.

The industrial details behind the decline were not encouraging either, with 8 out of 9 industries registering a monthly contraction, the worst diffusion since July 2022.

Adding to the disappointment, the early estimate for June signaled a 0.3% contraction. According to this preliminary estimate, real retail sales contracted 0.7% annualized in the second quarter of the year.

The picture is even gloomier when accounting for strong population growth, as we estimate that real retail sales contracted 3.9% annualized on a per-capita basis. The clear downward trend in real per capita retail sales since the first rate hikes in 2022 clearly demonstrates the negative impact of restrictive monetary policy on the consumer.

We note that the majority of sectors have seen declines since March 2022, with discretionary spending suffering the most, including real estate-related spending (furniture and building materials). Despite the fact that a first rate cut has been announced and more should shortly follow, we think retail sales could remain muted for the coming quarters. Indeed, rate cuts still leave the monetary policy to a restrictive level, meaning that the mortgage renewal payment shock continues. This is likely to prompt caution from the Canadian consumer, especially as the labour market is cooling rapidly.

AI CORNER

While GOOG, MSFT, APPL, META and NVDA were busy acquiring and developing Gen AI and LLM capabilities, AMZN has been rather quiet. It has invested in Anthropic and is reportedly developing its own LLM (“Olympus”). David says the recent hiring of David Luan and his team at Adept is a significant new step for Amazon.

• Amazon Hires Top Executives From AI Startup Adept for AGI Team

Amazon.com Inc. hired top executives and other employees from startup Adept AI Labs Inc., a move by the e-commerce and cloud-computing giant to bolster the development of artificial general intelligence, an advanced version of AI that can think like a human.

David Luan, Adept’s co-founder and former chief executive officer, will join Amazon’s AGI autonomy team, led by Rohit Prasad, according to an internal memo Amazon provided to Bloomberg. Four other co-founders and an unspecified number of other team members will also join Prasad’s group.

Amazon will license Adept’s technology developing agents, or AI tools that can perform tasks autonomously, to help Amazon build products that can automate software work flows, according to the memo. (…)

“David and his team’s expertise in training state-of-the-art multimodal foundational models and building real-world digital agents aligns with our vision to delight consumer and enterprise customers with practical AI solutions.” wrote Prasad in the note to staff. Luan will report to Prasad as the leader of the AGI autonomy team and the automations team, according to the memo. (…)

Unlike some of its big tech peers like Microsoft Corp. and Google, Seattle-based Amazon hasn’t focused as much on developing a broader, more ambitious artificial general intelligence, or AGI, that can perform most intellectual tasks as well or better than humans.

The Adept agreement also comes at a time that technology companies have stepped up hiring from well-funded AI startups that are building costly foundational models. In March, Microsoft hired a large portion of the staff of Inflection AI and arranged a deal to license its technology for $650 million. (…)

David says that “David Luan is an incredibly insightful and visionary individual. His hiring at Amazon is much more significant than the hiring of Suleyman at Microsoft.”

From Perplexity.ai:

• Luan will lead the “AGI Autonomy” team at Amazon. He will oversee the development of digital agents capable of automating software workflows.
• Prior to co-founding Adept, Luan served as the vice president of engineering at OpenAI.
• As part of the deal, Amazon is licensing Adept’s agent technology, multimodal models, and datasets.
• This move is seen as a significant boost to Amazon’s AI capabilities, which have been perceived as lagging behind competitors like Google and Microsoft.
• The FTC’s interest in Amazon’s hiring of Adept executives follows similar inquiries into Microsoft’s recruitment of employees from Inflection AI.
• This hiring move demonstrates Amazon’s commitment to strengthening its position in the competitive AI landscape, particularly in the development of advanced AI agents and automation technologies. However, it also highlights the increasing regulatory attention on such talent acquisitions in the AI industry.

What are David Luan’s view on applications of LLMs?

• Luan is particularly excited about developing AI agents that can assist humans across various professions. At Adept, his company focuses on building multimodal agents designed to work alongside humans in any profession.
• Rather than full automation, Luan believes AI agents should focus on augmenting and enhancing human capabilities. He envisions a future where AI functions almost invisibly below all software we use.
• Luan emphasizes the importance of developing LLMs for real-world, practical use cases. He believes that co-designing AI systems alongside real users and incorporating their feedback is crucial for progress..
• While acknowledging the power of large-scale models, Luan argues that use-case specific fine-tuning is more critical than simply increasing model size for many applications.
• With Adept, Luan is particularly interested in developing reliable and useful agents for enterprise applicationsLuan highlights the significance of training models on diverse, multimodal data, especially data related to knowledge work, rather than just natural images or text.
• He recognizes the current limitations of LLMs, such as their inability to perform real-world actions, and sees opportunities in developing models that can better understand and interact with computer interfaces.
• Luan is aware of the potential risks and biases associated with LLMs and believes these issues need to be carefully addressed as the technology develops.
• Overall, David Luan’s view on LLM applications emphasizes practical, human-centric use cases that augment rather than replace human capabilities, with a focus on developing reliable, multimodal agents for enterprise settings.

The race is on between behemoths to fill all possible application spaces and build as large and solid user bases as possible as rapidly as possible. Once people get used to specific AI apps and to their dedicated virtual butler (LLMs), it will become very difficult to get them to move.

Yes, there will be excess spending for a while but the chips likely won’t be down until 2026.

BTW, Chinese companies are also rushing to develop AI apps that will be made available outside China. Chinese LLMs are all open source and much lower cost than Western peers. Among major Western LLMs, only LLaMA (Meta) and Mistral are open source.

Initial Jobless Claims in US Increase by Most Since Early May

Initial claims increased by 20,000 to 243,000 in the week ended July 13, matching the highest level since August 2023, according to Labor Department data released Thursday. The median forecast in a Bloomberg survey of economists called for 229,000 applications.

The increase also reflected the impact of Hurricane Beryl as claims in Texas jumped by more than 11,500 during the week, the largest advance since March 2021 on an unadjusted basis.

Continuing claims, a proxy for the number of people receiving unemployment benefits, also rose by 20,000 to 1.87 million in the week ended July 6, the highest since November 2021.

The claims data are prone to big weekly swings this time of year, which include holidays such as Independence Day as well as school closures for summer break. In addition, the retooling of auto plants for new models, as well as inclement weather and storms such as Hurricane Beryl, can add to the volatility. (…)

4-week averages:

• Job postings on Indeed have stopped declining (through July 12)

The Wealth Defect

Household Wealth Gains Are a Tailwind to Consumer Spending (Apollo)

The University of Michigan Survey of Consumer Sentiment shows that a record-high 30% of the population has stocks worth more than $500,000, and 37% own a home worth more than $500,000.

It is remarkable that these wealth gains for the household sector have taken place while the Fed was raising interest rates.

The bottom line is that the tailwind to consumer spending for homeowners and equity owners is significant, in particular when combined with record-high cash flows from fixed income.

Source: University of Michigan, Haver Analytics, Apollo Chief Economist

Shipping costs are spiking again

Freight rates have soared by 257 per cent this year, according to an index of eight major shipping routes from Drewry, a maritime consultancy. On one of those routes – Shanghai to Los Angeles – the spot rate for shipping a 40-foot container is roughly US$7,300, up from US$1,965 a year ago. (…)

Shipping costs have risen enough to affect global inflation to a small degree, the Capital Economics report said. But “if rising shipping costs partly reflect a shift in demand towards discounted Chinese goods, then the net boost to consumer prices will be offset by cheaper imports.”

TRUMP 2.0

This is from Evercore ISI:

Markets may view the possibility of a second Trump Administration positively, recalling Trump 1.0 tax cuts and focusing on the deregulatory agenda going forward, especially in sectors like energy and finance. However, it is worth noting that the core of the Trump policy agenda this time – raising tariffs and restricting immigration while largely extending existing tax cuts – points in the direction of lower growth and higher inflation.

Key policy themes impacting markets in a Trump 2.0 Administration:

• Tariffs, immigration, and taxes make up Trump’s “big three” macro policies that collectively imply lower growth and higher inflation. On taxes, the high fiscal cost of continuing the expiring tax cuts leaves relatively little scope for new tax cuts, so the main impact is larger long-term structural deficits. That, combined with more aggressive approaches to tariffs and immigration, would create a far less pro-growth and more inflationary policy mix than Trump 1.0.

• Trump’s deregulatory agenda will provide a boost to profitability for some industries but could negatively impact others. A Trump victory is broadly positive for financials and traditional energy. It is negative for certain health care sectors and creates uncertainty for big tech.

• Geopolitical risks remain high, with Trump representing a new source of uncertainty but also potentially looking to resolve the live conflicts he will inherit in Ukraine and the Middle East. Some U.S. alliances are likely to fray as Trump takes on traditional allies on both economic and security issues. Decoupling from China becomes U.S. policy, driven by an active tariff war but extending into other areas as well.

Across a range of areas, Trump and his team would come into office much more prepared to execute from day one. As his first White House Chief of Staff Reince Priebus said recently, “Whatever Trump wants to do in his agenda, he’s going to have the ability to do it much faster, less clumsy.” Trump 2.0 will also benefit from a more favorable judiciary.

ING:

Donald Trump’s position on the deficit has shifted since he first ran for president in 2016. Back then, the mantra was all about capping the debt and repaying money the country owes. In 2020 he blamed the Democrats for not helping pass spending cuts – but fast forward to today, and there is little mention of reining in the deficit. In fact, the 2024 GOP Platform document fails to mention the fiscal deficit or debt at all!

Should Trump win and Republicans sweep through Congress, the focus will be on a “second phase” of tax cuts in addition to an extension of the 2017 TCJA. This will involve sizeable tax cuts for corporates paid for by spending cuts/efficiency savings and tariffs placed on imported goods. Party officials are also of the view that tax cuts will more than pay for themselves through boosting the size of the economy and lifting revenues, even though the 2017 TCJA failed to achieve this. 

Trade policy is the second major initiative. The imposition of 10% tariffs on all goods imports with 60% levies on Chinese-made products together with a four-year plan for phasing out Chinese imports of electronics, steel and pharmaceuticals. These policies are designed to curb foreign competition, support US domestic manufacturing and employment with additional claims that this will boost national security. This will be accompanied by “de-regulation” aimed at promoting growth in relation to environmental, anti-trust and energy.

Thirdly, there is the prospect of significant controls on net immigration involving more enforcement officers. Proposals also include the forced removal of undocumented workers. This could constrain labour force growth, and at the margin may add a little to wage pressures over the next four years.

Our sense is that this policy proposal mix from Trump could help to support domestic demand via the stimulus of tax cuts, but there are clear upside risks for inflation relative to Biden’s proposals. Tariffs and trade barriers will put up business costs, at least initially, while immigration controls may limit labour supply growth, posing additional challenges for corporate America. This stronger growth, higher inflation environment is likely to mean monetary policy needs to be kept tighter than would otherwise be the case under Biden.

In this regard, we have already seen the Fed revise up its estimate of the neutral federal funds interest rate – believed to be neither expansionary nor contractionary for the economy – from 2.5% to 2.8%. We continue to see that as being too low, and under Trump’s policy mix we could see that “neutral rate” rise towards 3.25%. After all, if expansionary fiscal policy is providing more support for the economy, the Fed could justifiably feel that monetary policy needs to be tighter in order to achieve the 2% inflation target.

Should the Democrats retain control of the Senate, Trump will be forced to make concessions on key policy areas and his efforts to enact additional tax cuts and major immigration controls may be scuppered. Constrained by his ability to push his domestic priorities, Trump would likely focus on trade policy, where he has more autonomy. It would also coincide with a greater focus on foreign policy relating to Russia/Ukraine, China/Taiwan and the Middle East/Israel as a means of exerting influence. This will have more significant economic implications for Europe. (…)

Mandatory spending, or spending mandated by existing laws, represents nearly two-thirds of expenditure. It is predominantly healthcare and social security spending, largely determined by the number of recipients. It has been growing by 0.1-0.2pps as a share of GDP per year historically, driven by demographic trends.

In the past, the growing mandatory outlays were offset by shrinking discretionary spending (voted on in the annual appropriations process). The third and smallest component of government spending is interest expense. Having spiked by 0.5pps in 2023 due to higher interest rates, this reached 2.4% of GDP which is somewhat higher than the 50-year average of 2.0%.

Components of government spending (% of GDP)

Source: Congressional Budget Office, ING

Digging deeper into the structure of discretionary spending, the chart below shows that it’s already close to historical lows in relation to the size of the economy, especially on the defence side, which accounts for just under half of this component. That suggests limited room for reduction, especially given the higher demand for military equipment due to ongoing conflict in the Middle East and Eastern Europe. Non-defence discretionary spending includes federal education, transportation, housing programmes and homeland security amongst others. Cuts are possible, but as with defence, it would mean spending falls to the lowest share of the economy in 50 years.

Discretionary spending 1973-2023

Source: Congressional Budget Office, Macrobond

The components of mandatory spending tell the most important story. With the extra pandemic era support for households having ended, income security programmes returned to normal in 2023, so there is little scope for further reduction and there is upside risk if unemployment rises. Meanwhile, the spending allocated for healthcare (Medicare/Medicaid) and social security is under structural upward pressure due to an ageing population.

Mandatory spending 1973-2023

Source: Congressional Budget Office, Macrobond

The conclusion is that there isn’t as much room to easily cut government spending as meaningfully as some campaign officials seem appear to think. (…)

Under both presidential candidates, the deficit will remain uncomfortably wide, with debt levels continuing to rise rapidly. However, the combination of direct decisions on tax policy and the macro conditions suggest that a Trump/Republican administration could lead to up to 1.2-1.3% GDP wider annual deficits starting in 2027 compared to a Biden/Democrat administration.

ING Forecasts under different scenarios (Full year average)

Source: ING

Implications for US Treasuries and markets

The US Treasury market is not currently being adversely impacted by extra supply being thrown at it from the higher deficit. The term premium implicit in the 10-year yield is close to zero, implicating little to no extra yield being paid to investors to encourage them to hold Treasuries. Simply put, the 10-year yield is being priced as an extrapolation of a rolling one-month T-bills exposure through the decade, with its path based off the fair value market discount for the Fed funds rate. A rolling 1-month T-bills exposure contains no price risk, while a 10-year Treasury holding comes with significant two-way price risk. Yet there is no compensation for that risk – which explains our argument that the market is not currently pricing in fiscal deficit pressure, at least not yet.

There are three reasons for this.

1. First, we’re on the eve of a Fed rate cutting process. It’s not unusual for there to be a minimal term premium at this stage of the cycle, as the price risk is seen to be more biased to the upside, as typically long dated yields fall as the Fed cuts.
2. Second, Treasury Secretary Janet Yellen has managed to curb the effect of the extra issuance by morphing the more significant increases towards shorter maturities, and away from longer maturities (in particular, away from 10 years and longer). The closer maturity issuances are to the Fed funds rate, less is the capacity for significant deviation from it.
3. Third, there is a risk-on market theme out there with equities at record highs, implying the market believes there is little to worry about. That offers a comfort blanket of tranquility – but one that can easily be taken away.

Going forward, a lack of market concern on the size of the deficit can easily pivot to it being top of the list of worries. The transmission mechanism here is a few poor bond auctions that become a trend, requiring the build of a material new issue concession that gets built into structurally higher absolute yields. That could happen slowly, or it could be more abruptly. Our base is for a slow creep. But it’s an impactful one. We see the 10-year yield heading for 5% as a base case in 2025 in consequence. That sounds aggressive, as we barely and briefly touched 5% as the funds rate was rising in 2023 before falling away. But this time, we’re likely to get to that area in a more structural manner, where it would take either a deep recession or a systemic break for it to be coaxed back down.

In fact, a 5% 10-year yield call is a conservative one all things considered. It’s just a 100bp curve to a Fed funds rate that’s been cut to 4%. Under a Trump administration and on the assumption of a higher deficit than under a Biden administration, that 5% call easily becomes a 5% handle, meaning “5-point-something”. And it’s not inconceivable that that could round up to 6%. That said, we’re cognisant that a level like that sits above a generic BBB rate corporate yield curve today and any visit of 6%, if we got there, would therefore likely be fleeting. It would also be damaging for leveraged players of all guises, heightening recession and corporate default risk. That said, just because it’s damaging does not mean we can’t get there. A Biden administration could be better, but not by much. Remember we are currently in one. (…)

In the current environment, where markets are calm, politicians see little threat from the current trajectory of the US’ fiscal position. But that will quickly change if ratings agencies and markets start to see it as an issue. If markets become dysfunctional, it will force governments to take more rapid and painful action. That may not happen in the next four years – but as a minimum, the higher, steeper yield curve we expect will put up costs for households and businesses and prove a headwind for the economy more broadly.

It does not matter… until it does…

The 2024 GOP Platform :”Make America Great Again” lists 20 objectives an eventual Republican government would seek.

#13 is “KEEP THE U.S. DOLLAR AS THE WORLD’S RESERVE CURRENCY”.

Gavekal’s Charles Gave argues that

If the next US administration tries to maintain US monetary preeminence, the US economy is doomed and US power is doomed with it. The world will become a very dangerous place.

First, let’s remind ourselves why the US dollar became the world’s reserve currency. (…) other countries decided that they were more comfortable holding US dollars than other currencies.

This can happen to your currency if you have the right set of characteristics.

• You must be dominant culturally; other countries send their young folk to study in your universities.
• You must be dominant militarily, controlling the sea lanes and therefore world trade.
• You must be dominant scientifically, providing the best environment for Schumpeterian growth driven by creative destruction.
• You must be dominant industrially, producing the best weapons (which can be bought by friendly countries holding an excess of your currency).
• You must be dominant agriculturally, able to feed the populations of friendly countries in the event of natural catastrophe or war.
• You must be dominant financially, allowing other countries to borrow in your markets if they need to.
• You must be dominant legally; assets owned by non-residents must be protected by the rule of law as strictly as if they were owned by your own citizens.

The US had all these characteristics in 1945. It then added another when Saudi Arabia agreed to price its oil in US dollars. This handed the US control over the access to energy for oil-importing countries—that is, most countries outside the Middle East. Since every economy is just energy transformed, this elevated the US to an even more economically dominant position.

It also forced many countries to live below their means in order to run current account surpluses that had to be invested in US dollars. As the French economist Jacques Rueff put it in the 1960s, the US had the imperial privilege of financing its budget deficits with its current account deficits. Or, to put it simply, the US was the only country in the world without a foreign trade constraint. The only times the Federal Reserve had to follow a restrictive policy was when inflation threatened to get out of control, never when the US trade deficit became too large.

All this is well known. But for the last 20 years or so, the US ability to maintain these characteristics has deteriorated to the extent where today the US fulfills only two of the conditions necessary for issuing the world’s reserve currency.

• The US is dominant in creative destruction.
• The US dominates the world’s sea lanes.

US industry has largely disappeared. And the US middle class has disappeared along with it, as the rich have got richer and the poor poorer. Today, no non-American believes he will be treated fairly by the US legal system. And fewer and fewer believe that US universities are still the world’s best. Meanwhile, there has been a huge rise in the US budget deficit to finance the living standards of the new poor, and a huge increase in the US current account deficit to finance the purchase of foreign goods, as goods are no longer produced by factories in the US.

How have these external deficits been financed? By the establishment of huge US oligopolies in the information industries, and by getting foreigners to buy shares in these oligopolies by promoting the insane idea that indexation is the best way to allocate capital.

And how have the budget deficits been financed? The old fashioned way, by the central bank printing money.

And why has there been so little inflation in the US? Because instead of buying US treasuries as they did in the past, the foreign holders of US dollars have bought the shares of these information oligopolies—otherwise known as the Magnificent Seven—so driving massive inflation in the share prices of these companies (the Swiss National Bank’s portfolio is Exhibit A here).

In short, the days of the US dollar as the world’s reserve currency are drawing to a close. However, those in Washington who have benefited most from the US dollar’s reserve currency status do not—or do not want to—recognize this.

If the next president tries to maintain the imperial privilege of the US dollar, the US economy will shrink to the point where it will resemble the British economy in 1945, when economic weakness forced the UK to give up its empire. The same will happen to the US.

The choice is between US imperial privilege and the US economy. The solution will be for the new administration to emulate Theodore Roosevelt and to go after the Magnificent Seven and their like and break them up.

And if these behemoths are broken up into dozens of smaller companies, the US dollar will abruptly depreciate, and the US current account will improve. This will create the conditions necessary for the rebirth of US industry and the revitalization of the US economy, which will retain its Schumpeterian advantage in creative destruction.

Being an eternal optimist, my inclination today is to buy the shares of small US industrial and energy companies. In a few years, they may be big companies. By then the S&P 500 will be much lower—even though the share prices of most “normal” companies will be much higher.

To be honest, I hope that the next US administration will create the mother of all bear markets in indexed portfolios. And I hope this because I love the US.

John Authers yesterday:

More than anything, Donald Trump wanted to convince our interviewers from Bloomberg Businessweek of one thing — that the greatest problem afflicting the US was the strong dollar. The transcript of the interview, available here, is worth reading in full. His opening words were:

I think manufacturing is a big deal, and everybody that runs for office says you’ll never manufacture again. We have currency problems, as you know. Currency. When I was president, I fought very strongly and hard with President Xi and with Shinzo Abe… So we have a big currency problem because the depth of the currency now in terms of strong dollar/weak yen, weak yuan, is massive.

This is strong stuff (…).

Oddly, Mr. Trump’s thinking juxtaposes with a commitment in the Republican platform to “KEEP THE U.S. DOLLAR AS THE WORLD’S RESERVE CURRENCY.” He’s also dead set on tariffs: “You put the tariffs on and now they all come back to the United States and build. And it’s so easy.”

To some extent, a debate over whether Trump is right about this is irrelevant. He wants a weaker dollar and if elected will try to make it happen. (…)

What exactly can a president do to deal with such a situation? The dollar’s position as the world’s reserve currency means people will want to use it and to treat US assets as a shelter. Capital controls are presumably out of the question. Setting up a sovereign wealth fund prepared to sell a pile of dollars might work. Cutting rates, favored by Trump once the election is over, would also help.

More plausible is coordinated intervention, à la Plaza. Foreign exchange is a two-way process, and there may be willing counterparties. Japanese authorities are already trying, strenuously, to strengthen the yen. It’s cost them a lot of money already, and it hasn’t helped. Success has been limited largely because US rates remain high, sucking funds out of Japan. So there may be common cause there, particularly as US rates now appear to be heading down.

Marc Chandler of Bannockburn Global Forex pointed out that this point in the economic cycle, with US rates likely to start falling soon, was propitious: “They could be pushing at an open door. Just verbally talking the dollar down could work, especially with the cyclical adjustment underway.” (…)

Against this, the Trump platform is mutually contradictory. His current economic wish list includes:

Tariffs

Lower interest rates

A weaker dollar

Fiscal expansion

Lower inflation

None of the first four is compatible with the fifth. All things equal, the Republican platform is a list of measures to boost inflation. Tariffs and fiscal expansion would also tend to raise rates and push up the dollar. “The problem that Trump has is that he wants a weaker dollar but the things he wants to do more or less all mean a stronger dollar,” said Jonas Goltermann, deputy markets economist at Capital Economics. “You can’t just say what you want and get it automatically. That’s the nub of the issue.”

#5 says “STOP OUTSOURCING, AND TURN THE UNITED STATES INTO A MANUFACTURING SUPERPOWER”

Here, its Louie Gave, Charles’ son, who discusses

whether the US can reindustrialize while the US dollar remains overvalued by 20-40% on a purchasing power parity basis against the currencies of most other big industrial powers, whether China, Japan, South Korea, Germany or Sweden. The answer is obviously no, which forces investors to mull over two possible scenarios:

• Scenario #1: the US tariffs are an empty gesture by policymakers who want to be seen “doing something” without much thought of longer-term consequences. The tariffs themselves are the “goal”, rather than a “tool” to be used in pursuit of a well-defined goal. As such, over the long term, this will do nothing to enhance US competitiveness and may undercut it. Hence, the new tariffs on Chinese solar panels will be as effective in making the US a global solar panel maker as those of 2012 were.
• Scenario #2: the US tariffs are the first salvo in the implementation of a broader US industrial policy that will now see the US actively weaken the US dollar in a bid to return the US to global industrial leadership.

Today, and by default, most investors will assume that the first scenario plays out. After all, it is more or less what has prevailed over the past decade and so offers the comfort of past experience. But surely the odds of scenario #2 are not zero? If so, this would mean that we move into a world in which the US is actively trying to devalue its currency while, simultaneously, China continues to follow a “strong renminbi” policy in its bid to dedollarize emerging market trade.

In other words, while every other hedge fund waxes lyrical about the impending collapse of the renminbi against the US dollar, both US and Chinese policymakers are gearing up to deliver the precise opposite outcome!

U.S. manufacturers have tripled their investments in new factories since 2022. Yet, new orders and production are flat. Does it take much more than 2 years to get a factory running after construction begins?

Stagflation from Higher Tariffs: 1970s Redux?

• Using a large macroeconomic model, we analyze four scenarios. The “baseline” scenario, in which tariffs are not raised, traces out the path of the economy from 2025 through 2029. We impose a 50% tariff on $18 billion worth of Chinese imports under the “Biden” scenario. In the “Trump” scenario we impose a 60% tariff on imports from China and an across-the-board 10% tariff on other trading partners. In the fourth scenario, we repeat the analysis of the “Trump” scenario but assume that foreign economies retaliate with their own 10% tariff on imports of American-made products.

• The “Biden” scenario is essentially the same as baseline because tariffs on only $18 billion of Chinese imports simply do not move the needle in a $28 trillion economy. Under the “Trump” scenario, GDP growth downshifts significantly in 2025 relative to baseline, which causes the unemployment rate to rise half a percentage point more. Inflation is higher in 2025 under the “Trump” scenario relative to the baseline. If foreign countries retaliate with their own levies, then our projections show that U.S. GDP would contract next year and the jobless rate would move even higher.

• The growth-reducing effects of the tariffs arise from their effects on the Consumer Price Index. Higher prices erode growth in real income, which leads to slower growth in real consumer spending. Monetary policy easing helps to cushion the blow to the real economy from the tariffs. That said, Fed policymakers may place greater weight on deviations of inflation from target than the model assumes. If so, real GDP growth could slow more and the jobless rate could rise higher than our simulation results suggest.

• The so-called “Misery Index,” which is the sum of the CPI inflation rate and the unemployment rate, rose from 9% in 1972 to more than 20% in 1980 due to the oil price shocks of the 1970s. The unemployment rate and the inflation rate would both increase if tariffs rise meaningfully, but the sum of these two variables likely would remain well-below the highs that were reached in the late 70s/early 80s. In short, tariff increases would impart a modest stagflationary shock to the economy.