Macro Matters - it's all about inflation

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Speaker B: Welcome everyone to another edition of the Macro Matters podcast for the CFA Society of Chicago. I am Rich Excel. I'm once again lucky to be joined by co host Jessica Noviscus and Tony Zhang. Jessica, Tony, welcome. Welcome back. It's been a couple weeks. You know, a lot of people are on vacation but there's a little bit going on in the market still, so probably worth getting together.

Speaker C: Well, definitely. So good to see both of you uh, Rich and Jessica, um, ah, as people spending the time on vacation and we definitely watch a lot of the factors driving behind of the macroeconomic including I think the uh, crude oil which actually having a huge impact over people spending nature. Something that I think uh, look forward to discuss with all of you.

Speaker D: Yeah, and July proved to be sort of a nothing month. We got earnings. Uh, they did not have sort of the impact I think that I was anticipating. But there's a lot of other moving pieces. So as we move out of the summer I think folks are going to be more focused on what's to come.

Speaker B: Yeah, it's always tough to get a read on things in August knowing that half the world is on vacation. But um, but let's start to think about maybe set up the uh, you know, the, the landscape for what people will coming back to. And so with that, um, we'll talk you through some slides. Of course we want to start with a disclaimer that these views are the views of us individually and not the views of uh, any anyone's particular firm. Um, and with that, what this. I saw this headline on Bloomberg today when I was scrolling through, talked about how there's a US bond sale today. It was the costliest one in terms of yield since 2001. And is it, is it, are investors warning. Uh, Treasury Secretary Besant who we've talked before about how um, he himself has said use the bond market as his gauge of success. Is the bond market telling Secretary Bessant he's not doing a good job. I have here here the 30 year bond yield which we see came in at 5.21% where, where the uh, the bond sale went. Um, that and that is, that's uh, quite elevated. And we've talked about this before. So maybe Jessica, I'll give you the first shot at this one. Is it, you know, is the bond market telling the administration that they need to kind of change some policies here?

Speaker D: Yeah, I think what we're seeing is a uh, continuation of what we started talking about two weeks ago. Right. That was right after the uh, Fed came out, uh, with no rate movement. They had the press conference, we discussed the different interpretations of what war had said and the bond markets responded by taking longer, longer term yields up pretty significantly. And I think that makes sense. I think that it's fair to, to think that inflation is not fully under control and Warsh has come out and said that 2% is the target and we will get there. I think he hasn't really offered too much in terms of what that looks like. And so the market is not willing to sort of give him that W at this point. And then you've got all the other longer term concerns. And I'm very much an equity girl, so I'm always looking at equity markets. But equity markets have not been at all pricing in some of the longer term risks. And I think that right as a product of earnings have been good. The near term things have been good. They've been so good. So it's hard to factor in fiscal deficits and geopolitical tensions and the changing in the world order and trade relationships and all that. It's very hard to factor in those longer term, sort of obscure risks. And I think that's what the bond market is starting to do now.

Speaker B: And when we look at this, um, I'm going to go on a limb and say the 30 year bond market is kind of the purview more of insurance companies, endowments, foundations, et cetera, and not the retired baby boomer who might want to lock in a juicy yield. Um, Tony, what is your take? As Jessica says, is the bond market. We always hear the bond market smarter than the stock market. Is the bond market telling us that there's a lot of problems and stocks at all time highs are completely missing the point?

Speaker C: Well, not necessarily. I actually agree with what uh, Jessica, just comment. So if we actually read, um, overall about the Bond Market is 30 years is definitely macro driven. So what's the major macro here? As what we continuously um, emphasize again, again and again the background, the content is how are we going to deal with the $39 trillion national debt here? The way to actually compensate the investors continue to invest into um, the national debt or treasury right over here is to actually have to raise the high. Give the higher rate to compensate additional uh appetite for debt. So that's why right now the 30 um years uh remain to be yield to be super uh high and very high over here. That cannot last longer. Um what's really telling us is the longer that it's going to take apparently the cost that from the national level is going to increase, increase significantly and the snowball cannot continue uh to roll uh until something really happened. So here definitely um, we look at from that perspective like all the sales like a store and the coolers and simultaneously we have to compensate the investor to do that. Well if we actually do not lower the interest rate at moment the short term rate. So Federal Reserve or both Federal Reserve. I think that uh the Treasury Department would have a difficulty to roll over their ah, short period of sale um with low interest like a um, treasury bond or treasury bill over here then actually would add additional pressure to what we continue to see that the interest payment from the um, central government uh here. So that's how I interpret this. Apparently um, Jessica pointed out that equity markets hasn't really pricing this well. This is um. I sort of just feel that equity market sink slightly. Um, it's a little bit shorter side. Okay. Not like a longer term, it's a shorter side. So the shorter side play right now here we actually sold it. We, we see actually two things. One thing is from the recent number that I think we might cover is that the rate height odds might actually decrease. My, this is. People anticipated that my attitude degree. So this is what uh, I see the divergence here but I think we are going to cover that. So we, yeah, save this for later.

Speaker B: Yeah, we'll get to that. We'll definitely want to talk more about the equity markets but just kind of trying to stay focused on the bond market right now. I mean this week we've gotten CPI and PPI data. Right. Everyone's been waiting for the inflation data. Um, go on to your favorite X.com account and you'll see a lot of debate out there about whether or not this is um, the you know, the bond bulls will tell you inflation's cooling. Just look at the data. Inflation's cooling. It's all getting better. All the people that were Chicken Littles that were saying that inflation was a problem, that would be me too. Um, you know, are wrong and inflation's going to come back. Um, the, the bond bears will say, you know this, there's a lot of noise in this data. There's a lot of other things and, and, and um, and, and so, um, the trend is still looks clearly higher. I, the, the data I have on here is, I have the, the PPI final demand, um, which, which leads the pce, you know, by, by about, you know, a couple weeks to a month. Usually you get, get a pretty decent read on what PCE will come out. And of course the Fed, the Fed cares more about the PCE than it does other inflation measures though it looks at all of them and if you look at that the PPI is, you know, in fact it had spiked earlier this year around the, you know, the supply shocks and now is really starting to cool off. Maybe this exogenous shock is working its way through the system and we're going to start to see PCE falling back towards Target and the bond market is going to um, feel a bit more comfortable about that. Is that a fair interpretation? Jessica, are you still a little skeptical that PC is going to gently fall back? It's still well above 2% for sure.

Speaker D: It is still well above 2%. And really I think that is the most important thing is sort of the level right now. Um, we always thought we could see oil prices coming down, gasoline prices coming down. Gasoline is nowhere near where it was pre war, but it has come down. And so the market has, has sort of. Right, the, the, the recent high was gasoline and we've moved past that. So the market is really willing to move past that heightened period. But the way that Warsh has been speaking, he has taken such a strong line on 2% is the number we are taking it to 2%. I think that's where we've sort of seen this change in narrative where, where it is now was fine relative to where it had been, but it's not fine versus that 2%. And that's sort of been the focus since Warsh has come on board as chairman.

Speaker B: Tony, do you think 2%? I mean you've been a bit more of an inflation dove here where you. I think that is going to continue to drive it down. Um, we have seen the price of compute maybe falling a little bit, etc. Um, but what we look like relative to trend and why we shouldn't be worried about a still elevated inflation number.

Speaker C: Well, we definitely should be worried about the inflation number. This is no doubt about that. The PPI still well above the 2%. Yes. But um, the most important thing here we actually had to derive if the PPI continues to actually go higher. This is something that what we need to check is whether the PCE by actually go go size that actually are telling us like a two sides of two sides of a story. One is from the uh, uh supply side and while on the other hand from the demand side the higher at the PPI apparently from the supply side basically uh telling us that definitely the cost from the inflation would actually making the uh production cost much much higher. But if we are ah able to continue to uh, like company are uh able to actually pass through the high cost to the end consumer that probably uh might not be such a major issue from what we actually from the investors are thinking for instance like a, if Apple can successfully just pass through the high cost from the memory chip ah to the end consumer by raising the price and uh this is uncertain yet um then probably we can actually see this might not be transferred uh to the equity investor instantaneously. Oh of course eventually it might take a ah huge impact once we see the growth rate slowing down. But from the analyst perspective so far they continue to project that the uh corporate earning uh will grow at a very much healthy rate so that giving the room to corporate Americas to adjust to higher PPI data. However this is I could always emphasize I think the deflationary nature of the AI is going to accelerate and based on what we have seen recently we started seeing the force, the trend actually pick up the momentum much faster than we actually anticipated.

Speaker B: Uh yeah, I mean if even if the Apple tries to pass on that cost. First of all I don't, I don't know, I don't see a lot of people with uh, going after the new iPhone myself. I see a lot of cracked iPhones out there. But um, but I also think that from a, from a CPI perspective that actually might be deflation because of the hedonic adjustments that we do. But get me started on CPI and hedonic adjustments. But I think um, you know inflation obviously PCE inflation CPI is one, one part of the Fed's mandate, dual mandate of course. The other part is the job market. The labor market also looks like it's getting better. Right. The jobless claims has been kind of gently coming back down here. The unemployment rate follows that. Um, you know I know that you've been a little, you talking a little bit about the labor market getting disrupted again because of AI Tony. So maybe I'll let you start on this one. Don't see it in the data. Um yeah, maybe white collar jobs are getting disrupted but there's plenty of other jobs out there that uh, you used to say maybe not as high paying but I'm um, going to Guess an electrician is getting this paid as much as you know starting financial analyst on Wall street these days. So yes, I don't know what's a high paying job and what's a low paying job anymore. It looks to me though that jobs are jobs in the job data looks pretty good relative to where it was at the end of last year and pretty good relative to where it has been historically too. So where's this, where's this AI job decimation story? Because I don't see it in the data.

Speaker C: Uh great question, great question. Um, so far here as what you say here we haven't really seen the uh AI disruption over some labor intensive jobs such as plumbers technician which actually requires the licensing apparently so far government hasn't really issued any AI or robot license to actually do that type of job so far. But that kind of job might be good. But for most of the jobs out there, especially the white uh, uh color uh job that most of the graduates or especially recent graduates might actually look like look for. That's definitely not a good news over there. If we actually look at the job data um latest not from payroll. Where we actually have seen is we always see the job growth at the service sector, the service sector, healthcare service sector and we don't even see any like uh job growth in traditional uh Wall street type of job financial analysts and even it uh continues to see the company laying off significant amount of employee over there. So that transfer whenever the financial sectors and also the IT sector which are uh the dominant the support for the US Economy actually are uh weakening. That would actually sever the foundation or any effort to do like for instance re industrialization and also having the huge impact later on the service labor like Russia service. The number remains strong uh over the past uh few months just because of the world uh Cup. But after the World cup we suddenly see the huge decline over the uh job growth in the service, restaurant service or I think hotel service sector. Significantly we will continue to see the deterioration over the next couple um of months. This is something that really bother me and really concern me. Um, so um, how can we actually identify the issue? I think the government would need to take this very serious. But from the investor's point of view that we continue to see two different performance uh over the sector like from software semiconductor uh sector which actually showed really reflect what had been uh going on. But I still want to hear what Rebecca and uh. Richard your thought about this?

Speaker B: Yeah, well I kind of think that the administration might uh say that we're pretty happy to lose financial analysts and hire electricians because Secretary Besson said all along it's time to focus on Main street and less on Wall Street. So I think that narrative probably suits quite well. But, um, Jessica, maybe, um, all those coal miners that President Biden wanted to convert into coders have to go back to working in data centers. Perhaps. But we know, we know labor data, especially unemployment rate, um, I mean, nonvarped, is going to get revised multiple times. So let's, let's not worry about that. Last month's number, the unemployment rate, which has been trending better. You know, labor, you know, a lot of. A lot of boomers leaving the labor market, etc. Um, you know what? It's. What's the.

Speaker C: What.

Speaker B: What's the other read you can have on this? I mean, to me, if you're just the Federal Reserve and you're looking at inflation, which is starting to fall a little bit lower, not back to where it needs to be, etcetera, but you're looking at the labor market improving, Maybe there's pockets of weakness, maybe there's pockets of strength. The aggregate number looks okay. It's kind of hard to argue that we need aggressively higher rates at this point. But what would, what would be the other take on that?

Speaker D: Yeah, it's interesting you just said aggregate number rich, because I think that's been something that has been a factor for the last few years. If you look at growth, if you look at the strength of the consumer, it's hard to see beyond that aggregate number. And I think what these numbers show, it. It looks stable, it looks balanced, it looks good improving. But it's, to me, a reflection of this no hire, no fire environment that we've been in. And as you mentioned, the labor participation rate has come down. Once you segment that by age, it is mostly, uh, folks retiring out of the labor force. Immigration has been down. That's been a factor of it. But if you look at what that means for the real underlying health of a labor market, low hiring, that's not. Great point. That. That's. You're gonna, you're gonna. The retirees are gonna be gone. Immigration is gonna do what it's gonna do, and the supply side of that is what, flatlining or at least sort of static. And then you've got this low demand, right. That doesn't really point to a lot of success or strength underlying. Real, stable, sturdy strength in the labor market. And so that's. I feel like I say this every time we talk is like everything Looks good, but I'm so afraid of what is lurking underneath and it's again sort of hidden by those aggr. Is that really an accurate read on how the everyday consumer feels?

Speaker B: That's a fair point. Go ahead.

Speaker C: Yeah, the magic in the US is here. Like almost every single data that uh, we saw or we have seen, uh, after release will be subjected to revise later on. We continue.

Speaker B: That's why, I mean, but jobless, that's why I put jobless pins on there too because that's real time. That comes out every week. Um, and that's much more reliable indicator of the strength because that's people. Ah, you know that, you know, that's not your, that's a real data point you can take. That's real time, not subject to revisions. Um, so I think, you know, you're looking at both is we can look at, we can look at other labor market data. We can look at the job opening, the labor turnover survey. We could look at things like that. There's a lot of other data points. We look at the ISM employment data that came out, um, you know, last week and it all looked, you know, it was all fine, uh, solid and certainly above in expansion, not in bull market, but it was, it was, it was fine. So I mean, I guess the question though really comes down to, you know, the, the odds of a, just this week, the odds of a rate hike have come down a little bit. Um, and I know we're still looking out a month, but the short term interest rate market still thinks we're going to get. There's a third of a chance or 35% of a chance that we're going to get a hike, which is surprising given that we haven't seen anything, is a hike, would a hike be a good thing if we got a hike? Because you guys are maybe talking the story of, you know, prices staying high, labor market looking weak. It sounds like stagflation. And I don't know if hiking rates into stagflation is the answer key, but someone in the bond market seems to be way more worried about inflation and prices than they are about jobs right now. Jessica, I'll give you the first shot at it then. And then, uh, I'll let Tony go.

Speaker D: Yeah, the way that I'm interpreting this, uh, inflation is above 2%. That means at some point, right. There's really no outlook to getting down to 2% on its own. I think that we can talk about if it, you know, the pace that Wash is looking for that he thinks Maybe is acceptable to the folks as they see the macro data come in. But I think it's highly unlikely that anyone thinks we're getting back down to 2% without Fed intervention. They've taken a hard line. That means at some point a rate, a rate hike is coming and I think that's sort of what we see here. Right. We're never really seeing two rate hikes priced in through next year. The market is sort of, this isn't like strong opinions in my opinion reading this warp data. Um, September I think is off the table. I think where the labor market is and where CPI came in, I think they can easily take September off the table. October I think is in play. November is in play. At some point if war keeps kicking the can down the road, I do think you threaten additional credibility loss just given that we are not at or directed towards that 2%. And so at some point it's got to come. I think the market's sort of right here on expectations but I don't think that there is, I don't think we're going to see anything in September.

Speaker B: I'll take the other side and say the market, this short term interest rate market is wrong. They've been wrong a lot lately to be honest with you. Remember the rate cuts they priced in earlier this year that didn't work so well. Um and I think October is definitely off the table. It's way too close to the election to see um, the FOMC is as split and partisan as it is right now. I think that that's a, that's a tough call December but I mean December, that's really where the action is really where there's a little bit more focus on that. Um Tony, you know we've talked about this for a long time going back and forth about the short term interest rate market. Where you know is the bond market right To Jessica's point I mean we're still not work Chairman uh, Warsh wants to be in. Price stability is definitely one of the key mandates they're going for. So is the rate hike what we're going to look to see and what does that mean for growth?

Speaker C: Well yes, definitely. If we actually look at the bond yield apparently long term, uh 20 years, 30 years. That's exactly what we just discussed that need to be that it needs to stay high to compensate for investors who continue to show the appetite to buy the uh, US uh long term uh treasury bond. So that's necessary. Now here we actually the other way to actually compensate to uh, make that successful is how do we actually lower the interest payment from the uh, Treasury Departments on the short term and simultaneously let the investors to buy the treasury bond for the long term. That's the only step. I think the only move for the next step is to lower the rate, lower the real interest rate in the short term. So my bet will be Federal bank or Federal Reserve might have a rate cut in September next month. Uh, even against what we actually saw, what we have seen right over here. Again this is against all the odds here. I think the central bank might actually take a rate cut uh, apparently out of surprise of nowhere. We would like to actually take a look and see if that will be the case. This is my bet because without lowering the interest rate um, or real rate then we might actually see the national debt continue to roll over, increase much higher than anticipated. This is something that not any actually ah, bond investor would like to actually see however. Well this is I think the central bank especially from the new chairman Wash would like to see, like to actually do not lower the frequency um, of transparency over the market. This is something what we um, say is lower the manipulation or lower the guidance over the market so that people, what the investor might actually have to see, what that really means. What that really means is it's actually going to create um, um, the imagination or anticipation that Federal Reserve might hike the interest rate without materially hiking the interest rate. What that means is I can actually keep the interest rate high so the appetite for the bond investor remain high but without actually taking real money out from the pocket. The longer the central bank can do this, this is something that will be in favor of the uh, Treasury Department I think Ben and also uh, President Trump. This will definitely serve the national interest. Mike Quantumville so again uh, as what Rich and uh, Jessica, you can see I'm always very dovish about the Federal Central Bank's action or activity next rate card. I think it will be in September. We'll see.

Speaker B: So Jessica, maybe back to you. If, if we get a rate cut in September, what do you think the bond market reaction is going to be? I'm going to guess you Gail curve is going to get a heck of a lot steeper. I hear where you're coming from Tony, but I don't know if uh, I don't, I mean in a world of, of no community forward communication, I don't know if the first surprise could be that big. That, that would certainly cause a little concern for all markets I would think. But Jessica, what do you think?

Speaker D: I think The August air is getting to Tony. There's a cut coming in September. I think Warsh would blow his credibility. I think the curve would go to like a record steep. I, no, I can't even entertain this thought anymore.

Speaker B: I mean, you know what if you just play for uh, for rate hikes going to zero between now and October, there's still some juice in the curve if you look at the sofa market. So you don't have to bet on cuts. If you just bet on do nothing for a couple meetings, you can still make a little m. Still make a little money. Yeah. Don't get me wrong, I don't think they're going to hike, but cuts would be aggressive. It would be to make a statement for sure. But I think I will make one point though, and I think it may be too early for it in September, that I think you could actually plausibly make the case for a rate cut if you also talk about aggressive quantitative tightening that we know is going to tighten policy. And I think you could have to do it though hand in hand and it brings in the whole question of ample reserves. And there's a whole bunch of other Fed market plumbing that you have to worry about. And it's going to take a while, I think, because we've got that committee. But I have here the Fed balance sheet, both in white. I have the actual numbers, which are just under $7 trillion down off the peak of 9 trillion in 2022. Um, and then as a percent of GDP, which is at about 22% again, the peak was around 40%. But of course if we go back to pre financial crisis, we were around 5% forever. So the balance sheet is still quite large on an absolute basis and relative to the economy. Um, and this is clearly one thing that Warsh has wanted to focus on. He's, one of his committees is going to focus on there. So, so maybe this is what you're thinking, Tony, this is what you're thinking. They're going to, they're going to cut rates, but they're going to aggressively tighten. Quantitative tightening. Is that. Am I onto something there or.

Speaker C: Yes, Rich, I think we are, uh, aligned on this perspective. Yeah. The way they can actually do the uh, quantitative, uh, tightening right here, apparently it's lower, lower the interest rate. The reason for that, uh, we know that lots of banks actually have a deposit, uh, over the central bank after the last financial crisis to really earn the, the high, higher interest rate, the real, uh, risk of free rate without actually, uh, investing externally. So that being said, if they can actually get 3.75% risk free, what's the point? To actually to lend this money to other um corporation with a high risk or default regardless of whether it's real estate or it's ah, um, uh, other manufacturing, uh, industries and so on. So the bank's reluctance actually to move this kind of balance of the Federal Reserve's balance sheet. So even this is something that what um, new chairman, working group or task force intended to do. That is this probably might be something that is being cooked right here and right now. And if you actually continue to look at what ah, Chairman um Walsh is doing is setting up multiple task force and there's a couple reasons to set up the uh. The task force apparently would need to actually find some kind of a justification for the action that he intend to take. He would just, he would just come out and say hey, here. Based on other task, task force research or analysis, this is something pre justified. So just by what the activity or action this like the center B would take. Well now the question is what might happen? Would that be a rate hike or would that be nothing or would that be a rate cut? So it's my bad. That's what I. Again it's rate cut.

Speaker B: So Jessica, I want to point to you because I will say that um, there are, I guess in my discussions there's very few people that support a large Fed balance sheet. However, there's a lot of people that are really worried if the Fed aggressively uh, shrinks its balance sheet just because of the disruptive nature of that. Um, but to Tony's point, I mean prior to the financial crisis we didn't. We operate in a scarce reserves environment. Banks did not have a lot of reserves. They definitely weren't getting interest on those reserves. But we have changed bank regulation and um, so it takes some bank regulation change as well. It seems like, it definitely seems like something that the new chair would like to see ushered in. But I, it seems like that might take a period of time to kind of get to that point. But um. Any, I don't know any, any thoughts on the, on the balance sheet, the size of the balance sheet, the direction of the balance sheet. Um, and, and, and maybe the timing of that.

Speaker D: Yeah, I think, I think Warsh is more of a balance sheet hawk than he is a rate hawk. I think that has been made clear. I agree with that. I think this is again sort of like rates. We never really normalized them after the gfc and if you fast forward that sort of, you know, that's one less tool than in the toolkit the next time you need it. So I'm certainly in favor of tightening up the balance sheet. I think that is what we will see from Warsh. I think that he is smart enough to do it in a measured way. We've already seen sort of a contraction here. I think a continuation of that can be absorbed into this market given where other financial conditions are. And I think that would, that would definitely be the right move. So I hope we see more of it.

Speaker B: Yeah, that definitely seems, I mean just the economy has clearly grown. I mean you could see on a percent of GDP basis we're almost back to where we were pre Covid. Of course it took a massive jump after Covid, but we're still a far cry from where we were pre financial crisis. And so, um, you know, the balance sheet should grow with the economy over time. It's just a question of how much. And then the interesting thing is while it has been coming down, um, quite a bit the last few years, this year it's ticked back higher with some of the treasury policy. But um, I guess $64 trillion question is when will bond market concerns impact the stock market? And I think you were talking about this before, Jessica. We've looked at this before. The 10 year treasury yield at 4.64, the S&P earnings yield at 4.6. There's really no equity risk premium. Um, and there hasn't been for a couple of years. It's the equity markets seeing growth and nothing but growth and the bond market seeing inflation and nothing but inflation. Um, something. This can persist as we saw in the late 90s, of course for a long time. But it does seem like at some point here one of the markets is going to be right. And just a question of what's the catalyst for that.

Speaker D: Yeah, and I sort of think it's uh, the way that I think about it is it's. I don't think this needs to force correct anytime soon. I think it's a reflection of different worries and different concerns and different focuses from bond investors versus equity investors. I think equity investors are so focused on the near term and the earnings growth and the AI story and this is the best way to play it. And I think the bond investors are starting to factor in some of those longer term risks and I do think that's the right thing to do if you can sit tight on a 10 year timeframe. But that's not what equity investors are looking at. And so I don't know if I Expect this chart to force any hands. I um think we're going to see more of the same until we sort of get a crack. And if inflation continues to come down maybe some of those fears in the bond market you know sort of flit away and we see yields come back down. I don't think that's off the table given sort of the direction the macro is going. But otherwise I think that this can sort of persist for a while.

Speaker B: No I agree it doesn't have. It doesn't have to course correct anytime soon but it does seem we do. One of the things we talked about earlier would be um the. The retirees that are leading the labor market etc. And um selling expensive stocks to buy cheap bonds. If that's how you view it isn't a bad idea if you're starting to retire and you're looking at having a fixed income um whether we're at the right levels for that or not. And uh. We'll see. But Tony your thoughts on uh the persistence of this lack uh of equity risk premium.

Speaker C: Well when actually talking about the equity risk of premium really depends on which group of investors are you referring to or you are talking about. And I think m majority of the hedge fund and majority of the retail investor recently has got a significant hit. This is every people have already seen that from the UH semiconductor AI play which UMN actually plummet uh more than like a 50% to almost 60% including Sandesk Nvidia Micron and this is we continue to see this uh like AI or place has received significant hit. So if you look at talking to investors in Deflator group we I already seen the recession just recently didn't pick up from uh eventually until the explosion of situational awareness. Like every people knows about that and every like correct market correction end with one of this kind of a nominal uh hedge fund exploded or liquidated like long term uh capital management uh the one before that is like we recall uh smell when capitals uh over this gamestop you know and this time again it's a citadel coming out to actually buy out every situational awareness. But if you had to look at that group of investors they definitely was taking a huge hit the market already correctly over there. So we haven't which is recently since like I think last week that most of the AI uh play start rebounds which haven't really coming out from the um bearish market at this moment. Even though the overall index look completely different. It's a complete if you look at index oh nothing changed it's like we're still hitting a new high. But if you look at the uh, internal, uh, inside that, definitely we have seen like a structure change and a lot of people, especially retail, um, invest people, uh, on Robinhood don't have show no interest over like Apple, which actually reached the new high. And if you look at that, they just, they, no one actually had appetite over Apple. They just love, um.

Speaker B: Well, to your point though, I mean, I mean, under the hood, we've seen a broadening, certainly of, I mean the positive interpretation is we've seen a broadening of it. I guess the negative interpretation would be we've seen a lot of hedge funds blow up and selling popular longs and covering shorts that they hated. But I mean, Jessica, you mentioned this before. The earnings season has been. We talked about it last time when it was halfway through or whatever. We're almost through at this point and it's pretty spectacular. So if, uh, you're long stocks, there's no reason, there's nothing in the, in the fundamentals saying that I want to sell. You might say it's not sustainable. Um, but this is the best earnings season we've had in, in a couple years easily and more. I mean, it's by orders of magnitude. I mean, is this what all you need to focus on? And this is why the equity market doesn't see risks that the bond market seems to see.

Speaker D: That's definitely what I think that we're seeing and, and I don't know if they're wrong for that.

Speaker C: Right.

Speaker D: We said was it last podcast or two ago, like we're looking forward to earnings season. That's the fundamentals. That's when you bring it back to the fundamentals and the fundamentals are good. I think that there's a lot of debate of, um, can this continue and what's the future look like? I also think it's sort of interesting and there are parallels to the consumer and the AI world. I think companies are spending a lot right now because things are good and have been good. And so what are the risks of investing? I don't think we'd be shocked to see cash balances be sort of driven down from here. Now is the time to make hay while the sun is shining. What does that do in terms of maybe making folks less defensive or sensitive if we do see a crack in AI or in the consumer story or what else? There's always sort of the next layer of this and the second derivative of implications. But yes, I think this is very much what equity investors are focused on. And we've seen this risk on sentiment build in the markets for so long. That's sort of where we're coming from. You pile the best earnings season on top of it and this is what you get.

Speaker C: Yes, I actually agree uh with that. Uh, so it's like uh. We. I recall when we actually discussed about this in the last episode. The fundamental looks uh, chosenly good. So every. Every time it's like this happened again and again over the past 10 years. Every time when investors uh seen their favorite stock uh tank without any change with the fundamental reason and apparently will be those investors who have the patient who have the. The uh currency to actually buy into this kind of a weird um moment this actually will profit. This have been proved again again. So most of the time when it happened from the short term the narrative of the market is actually flushing on like Wall Street Journal. Whatever things they would just say hey analysts would anticipate the earning peak uh this quarter and actually might slow down in next quarter. But underlying the uh. From reality from what we have known as a fact, it was one hedge fund or maybe one hedge fund together with. Coupled with a lot of uh similar tracking hedge fund who just taking extraordinary high leverage and doing the um. The trade which actually is moving against the fundamental. Now here then we actually saw another big group of investors trying to really make this uh. This kind of leveraging back fail. And this has happened in the past when we actually saw the crude oil uh becoming negative price. This is no one actually would anticipate but that happened. You know this is. So this is actually coming down to a very very important point. So whenever we actually saw a strong and solid fundamental from account uh corporations earning but we actually see the huge like price deviation in the short term that actually present a uh great buying opportunity. I think this has just happened again. But every time when uh retail investors reading uh from the Wall Street Journal like a reading goes kind of a very scary narrative about what might actually go wrong. So this is just uh showing just another lesson I would say.

Speaker B: And we know earnings drive the stock market right and the stock market is a leading indicator of the economy. Um this all suggests that the economy is looking rather good right now. And despite all the naysayers that want to talk about the K shaped economy, the only few people are doing well etc. We know, we know from our experience that if companies are making money at some point um, they're going to continue. They'll start hiring a little bit more as well because they're going to be wanting to kind of grow the size of the pie. And we've seen that in the labor data getting better. Now that kind of goes back to maybe the bond market's a little right on inflation. So maybe there isn't a one's right, one's wrong. Maybe we, you know, we're. Faster growth and faster inflation is what we're going to see because the economy could potentially be much stronger than many in the market. Many of the pundits want to give it credit for. Um, am I reading too much into that? But I mean, when I see earnings like this, as you see that this is relative to expectations, no one would suggest this is going to continue. As you see that the surprise numbers are usually pretty consistent in the 5 to 10% range. And so this is way better. But, um, you know, even if it came down to last quarter, which we thought could never be repeated, and you know, this looks like the companies are actually, in spite of all the challenges in the market, doing pretty darn well. And that's usually a pretty good sign for the strength of the economy, which potentially makes Chairman Warsh's job, uh, a little bit harder. So, Jessica, ah, are the bears of the economy just really missing the point here?

Speaker D: I don't know. And you know, I've never fancied myself a bear, but I have been a little more skeptical over the last, I don't know, 12 months. But what you just said, Rich. Right. Companies are growing. That means they're going to hire. I think that's the biggest concern. And I think Tony would, you know, is it different this time with AI? I think one of the important stats that I saw, I think 90% of companies beat revenue, but only about half beat margins. So we are seeing the growth, but we're not necessarily seeing it all flow through to the bottom line. Do companies see that as an opportunity? We're sort of in this testing phase of AI. When do we move to the productivity phase? Or at least when companies are willing to maybe roll the dice on not hiring someone and seeing if they can replace that, or shift people around and rely on AI in a certain. I think that that is such a key factor to seeing how this plays out over the next few years is do we see that hiring increase in labor markets or is this growth more focused on productivity? We see it in company margins, but we don't see it flow through to the consumer. That creates a problem in an economy that is 2/3 driven by consumer spending.

Speaker C: Yeah, certainly, um, the overall economy, Corporate America are doing Better doesn't uh, translated automatically that the normal citizen will be actually doing better. If we actually take China as one great example is we continue to see the uh, China gdp growth at 4%. I mean this is, I'll take the

Speaker B: under on what the actual Chinese GDP growth is just for the record. I'm sure it's posted at 4%.

Speaker C: Okay. You can actually uh, uh argue about whether the nominal or the real. But here is the thing. Similar to uh, in the US is a company like having so high of uh earning growth such as Nvidia or even Meta, but they continue to lay off the people while simultaneously revenue and uh, earning per share keep growing at a double digit number. And this time it's just a completely different. It's like the uh, corporate earning is decoupled from the hiring or recruitment of the corporation. This is what we will continue to see this again again and again. I think um, Chairman Walsh realized this is the case and hopefully that he can actually take action uh to uh, do something but by himself. He needs to actually work with ah, uh, Treasury Secretary they sent and um, current administration to actually solve this out. So this issue that um, the whole society, the whole country need to adapt unfortunately.

Speaker B: Um, maybe I'll try to, I'll try to kind of take the other side of that. I mean the factor performance which we've looked at before and this is on a long short sector neutral basis. You know momentum, had, we talked about that before, had had cratered a fair bit. But it's still up for the year and it seems to be stabilizing here over the last week as um, you know hedge funds got blown out in July and now I think so things are a little more quiet. But what stood out to me on this um, was the year to date performance of value versus growth. You can see value is doing quite well and growth is struggling. I think that kind of hits to what some of what you guys have both been talking about. And if we look at value versus growth um on a factor basis through time and compare it to inflation, there tends to be a pretty good um, correlation or co movement um of these and that there's a intuition for that. Right Value companies by their nature typically have high fixed costs and so higher nominal prices, higher nominal revenues are going to drop to the bottom line a little faster. Whereas technology companies, growth companies, financial services companies, their costs are all human capital. So you know higher inflation is going to squeeze their margins and so they're going to be likely to fire people. So um, when you know what you're talking about with Nvidia, Meta, etc, not the name but the bigger mega cap tech names laying people off as we've seen. You talked about financial, you know, maybe financial services. To me that's just um, growth companies that are highly sensitive to, from a margin standpoint laying people off to hold on to margins while we look at healthcare, energy, etc. Um, you know those, those, the more value oriented industries uh, are doing quite well and that's, and that we see that drop into the bottom line. So is this just another indication of maybe within the equity market saying that inflation is still a problem despite things dripping down a little bit or I don't know. Jessica, what do you, what do you think? Am I reading too much into that?

Speaker D: No, I, I don't think you are. I think it's, I think the equity markets are certainly poised for inflation. I think you see it with the cyclical sectors that have been rallying. I also think that there's just a lot of moving pieces. Energy this year was a huge factor, um, the AI stuff and growth has gotten so concentrated in tech and then you apply leverage to that which even amplifies everything and it's in a high growth period of time. And so that's when you see things get over their skis and see a bit of a pullback and that's amplified by leverage. I think that there is so much that it's sort of hard. I think we're so far removed from the value outperforms when inflation is up because it means the economy is doing well and that's what drives value. So like I just think that there's so many other moving pieces that are sort of skewing this um, but this chart is really interesting. It's, I guess it's cleaner than I thought it would be.

Speaker B: Tony, uh, your thoughts? I know you watch the equity market

Speaker C: a lot Certainly uh, value outperformance growth this year for a couple of reasons. One, the major, one reason is that people is very skeptical about the AI sustainability especially a lot of people or narrative talking about whether Capex spending from the uh, uh, hyperscaler is sustainable. So we discussed about that in the uh, last couple of years of EPSOs and the other narrative will be whether the central bank would actually have to really cut the interest rate given what had been really coming down. So if the actually central bank does uh, cut the rate, ah, typically we will anticipate the value factor especially like a dividend type of stock or sector will actually outperform so that's what have been driving recently, um, at least in the past couple of three quarters. While growth has outperformed value over the past couple of years. This is uh, maybe this year slightly changed uh a little bit. However if we actually look at the question is whether the recent um performance from the value stock the factor would actually last is we have to ask this question is are uh there any fundamental economic reason behind the recent rally in addition to just like a being cheap, relatively cheap. It's the sole reason or whether there will be some. Um.

Speaker B: I think there's a very clear one. There's a very clear one. Earnings revisions Earnings revisions drive stocks more than anything. And value companies see faster earnings revisions. Well when there's inflation you talk about oil prices which you did before. Okay, oil prices have gone up. That means more inflation. It also means energy company earnings go up much faster. It also means material companies earnings go up much faster. So isolate take away their uh oil stuff and just focus on earnings revisions. And that tells you to buy value companies.

Speaker C: But actually if you look at value company typically we categorize as kind of industrial or maybe healthcare or even energy uh stock they actually highly related to the AI or data center's construction here because the cap actually continues to increase. Eventually the cash flow will flow to that um AI related uh manufacturing and infrastructure construction. But so here the people actually think from the factor perspective is the value outperform. But actually indeed not. It's indeed actually this is like they tend to be correlated to the AI uh data uh center construction. It just happened to be this. So uh hope uh people investors uh don't actually look at oh we should actually really have invest into the the uh value factor by itself uh different interpretation underneath similar like a momentum. If we actually look at oh the momentum the year to date momentum factor still actually to be positive. But for most of our investors if they actually they invest into momentum they lost money. If we're looking at year to date actually turn out to be positive uh number but from investor point of view their return on their current account is negative. The reason is simple. A lot of investors don't for investing into the momentum factor. They don't put their money in until they see the strong momentum already. So basically they buy at the top.

Speaker B: Yeah and that's not just retail investors. There's a lot of investors that we

Speaker C: know lots of investors similarly uh from situational awareness even he claimed to be year to date to be 80% but lots of investors regardless whether retail institutional investor holding into the AI Sector lost their money, they see the negative on their account. So even though the factor by itself to say, hey, it's a positive, but dollar amount is negative, uh, certainly for sure. So we actually need to go deeper, uh, underneath the factor this year. So this year is super, um, AI driven apparently.

Speaker B: I think there's a few more things going on besides that too. But, ah, yes, I would definitely acknowledge that AI is a factor and a, is a factor even for the, the energy and industrial companies for sure. But it does seem to me that there's inflation and inflation expectations are really the thread that is weaving through the entire market right now. Um, whether we get a hike or a cut in September, whether we see the bond market as, uh, oversold and attractively priced, or whether we see it as the bond market telling the Treasury Secretary is in trouble, it all seems to hinge on inflation. And maybe even the factor performance in the equity market hinges a little bit on inflation. Um, with that, Tony, maybe I'll ask you for your last words and then Jessica, I'll let you wrap it up for us.

Speaker C: Yes, um, even though we haven't really seen too much of an impact from in depth perspective from the high, uh, treasury yield, um, uh, pass through to the equity market. But we already seen some kind of a warning sign here and there globally, uh, politically. So we definitely need to keep an eye on that. There's underlying flow and once we actually come back next time, we will actually have more to discuss, but definitely taking a cautious step at this moment.

Speaker B: Jessica, any last words for us?

Speaker D: Yeah, I said I'm an equity girl. I really mean that. So it's very painful for me to say that bond yields right now are much more interesting than the stock market. Yet another high. Uh, I think Jackson Hole is in about two weeks. So we've had two press conferences with War. Uh, we're sort of counting our days, I think, when he's going to actually tell us anything. So I'm looking forward to Jackson Hole and seeing what that means. As you said, Rich, everything, everything is being interpreted through the lens of does this, what does this mean for the Fed? Every inflation number, every macro number, every labor market data is does this make it harder or easier to raise rates? And so, um, that's what I'm focused on for the next two weeks.

Speaker B: And perhaps that's, uh, the market doing what Kevin Warsh wants us to do, which is actually set the price and not respond to the Fed. But you're right, Jackson Hole always is, uh, an interesting time for the Fed. To communicate, and other central bankers communicate what they're really kind of focused on and watching. And so we will look forward to that. So, for those who are listening, if you made it this far, please reach out to our CFA Society staff and get your continuing education credits so you can, you know, sign that with confidence at the, uh, when you go to pay your dues next year. Um, uh, Jessica, Tony, thanks again for joining me. Look forward to talking to you guys in a couple weeks, um, and see, maybe we'll wait for Jackson Holt and see what we hear, uh, from Jackson Hole before we meet, uh, to talk again.

Speaker C: Sounds good. Yeah. Look forward to our next discussion.

Speaker D: Good talking to you guys.

Speaker A: Thank you for listening to this presentation of the CFA Society Chicago Podcast. Tune in to hear society members pick the brains of more leading industry professionals@cfachicago.org podcast and to attend one of our upcoming events, please visit cfachicago.org thank you. And we'll see you next time on the CFA Society Chicago Podcast.