The K-shaped economy - Wall Street versus Main Street

 

I normally hate the comments about the difference between Main Street and Wall Street. Usually, it is a false dichotomy, but the current environment suggests that the average consumer or wage-earner is having a harder time than wealth-holders. This is what happens when we are in a more inflationary environment. Yes, inflation is off its highs, but the average inflation for this century is closer to 4% than the 2% Fed target. 

The labor markets are looking weak and confidence is weak, yet the stock market is higher based on strong earnings from those economies that have network effects and represent the tech industry. Two-income households may be doing well, but the rest of the country is trying to hang on and deal with recurring price increases that do not appear in the CPI indexes. 

A strong stock market may pull the economy higher, but that is unlikely. The higher stock market is likely the result of too much money chasing existing assets. The good markets may not be seeing all of the inflation, but the financial markets are seeing "asset inflation.

Is there a story for small caps?

 

If you look at the Shiller CAPE P/E values, the large-cap market looks expensive. If you look at small-cap stocks excluding the largest Mag 7 stocks, the market seems better positioned. Now that the small-cap risk premium has fallen, some have questioned its validity, but the number suggests a closer look.

If we just look at the 493 SPX stocks outside the Mag & there seems to be more value broadening investor focus. Of course, earnings for the Mag 7 have been higher, which justifies holding these stocks. Additionally, small-cap value and growth have not been rewarded. To hold these smaller-cap names, you truly have to believe that current P/E valuations are a strong predictor of short-term stock performance. Perhaps that is the case over the next five years, but it is a stretch for the next year.

Gold central bank holdings - Saying no to fiat money

The perception of the gold market has changed radically since the Great Financial Crisis (GFC). During the first 10 years of the century, central banks sold gold. Who wants gold when you can have dollars, euros, or yen? Who wants a real asset with no yield when you can have a financial asset with a yield? Who wants a real asset when inflation was under control and less than 2%?  

Now, we know who wants these assets - central banks. These institutions create fiat money, and they don't want it from their peers. Of course, rates were set to zero and, in many cases, moved to negative values during the period of QE. If financial assets can yield negative returns, a hard asset with zero yield looks pretty good. If government debt reaches a new high well beyond GDP, we can suspect it will not be paid with taxes, and governments will have to default on the debt or inflate their economies. The pandemic suggested that governments will go to any lengths to boost the economy with new money. 

The central banks are acting rationally and not telling the public what they really think. Fiat money is out, and hard assets are in. 

JGB rates starting to matter to the rest of the world

Japanese 10-year JGB yields are now 2.34, the highest this century. An end to loose monetary policy, continued loose fiscal policy with the expectation of a tax cut, the "Takaichi Trade", and persistent inflation that is currently at 2.9% means that there is a strong reason to see yields move even higher. The rising JGB rate is having an impact worldwide as money starts to flow back to Japan. Now, it is hard to say this is a complete reversal when real rates are still negative, but the global financial landscape is changing, putting pressure on Treasuries and rates in other countries.