October ended with slight declines in all markets. After the gains seen in September, the market took a breather.
• S&P 500: -0.99% • Nasdaq: -0.85% • Stoxx Europe: -3.35% • All Country World Index EUR: +0.92%[1] • Global Fixed Income Index EUR: -0.65%
The market was in a kind of “tense calm,” awaiting the U.S. elections in November, with results that were generating and would continue to generate high uncertainty. There are significant differences in the priorities and approaches of both candidates’ programs, but they do agree on one thing: increasing spending.
Can a state spend ad infinitum? According to the proponents of Modern Monetary Theory (MMT), the answer is yes or almost. They argue that a country with control over its currency (like the United States) can increase the deficit to achieve full employment, as long as it doesn’t face high and persistent inflation. And who decides if inflation is high and persistent? The politician in charge.
If you recall, in September, the Federal Reserve (the U.S. Central Bank) lowered rates by 0.50%, a significant reduction considering inflation was still above 2%. This decision was made due to the perceived deterioration in the economic situation, especially in the labor market, with the aim of reducing public spending both now and in the future.
However, following the Fed’s 0.50% rate cut, the 10-year bond yield increased by 0.70%. It seems the Fed didn’t achieve the desired effect… This movement reflects investor sentiment and expectations, which is crucial as it gives us insight into possible market trends in the coming months.
Let’s start at the beginning. The yield curve, which represents interest rates across various debt maturities (1 year, 2, 5, 10, 20…), was inverted. Short-term rates were higher than long-term rates, which is illogical since lending over the long term should, in theory, involve higher interest due to greater uncertainty. So, why does the curve invert? One explanation that makes sense to me is that economic agents are requesting short-term credit to finance their working capital due to insufficient liquidity from lower sales. Many companies, anticipating an increase in inflation and a rise in rates, stock up to avoid higher future prices; if they haven’t done so, they reduce their purchasing budgets. This increase in short-term credit demand drives up interest rates.
On the other hand, long-term rates hold steady or might even decrease, as investors anticipate higher inflation and lower economic growth. Historically, this type of inverted curve has been a recession indicator, although that hasn’t been the case so far.
In simple terms, short-term rates are adjusted based on the Fed’s decisions. When the Fed lowered rates, short-term yields also dropped, but long-term yields, from five years and up, increased. This is because investors believe the Fed has “thrown in the towel” on fighting inflation, prioritizing the labor market instead. This sounds like Modern Monetary Theory (MMT), doesn’t it?
The latest labor market data show signs of weakness. In October, only 12,000 jobs were added month-over-month, the slowest growth in four years. What’s more concerning is that private sector jobs dropped by 28,000 while the public sector rose by 40,000. In other words, if it weren’t for public spending, total employment would have fallen. Moreover, the main type of employment being created is temporary. At first glance, it may seem that the state is doing a great job compensating for the private sector, but beware: “the devil is in the details.”
Why are investors expecting higher inflation?
Fossil fuels (oil, coal, and natural gas).
Investment in oil-related infrastructure fluctuates with prices. If demand increases, prices rise, making oil projects more attractive, thus boosting investment. However, this infrastructure isn’t immediately operational, so it can’t meet demand automatically, leading to further price increases. Often, supply overshoots and eventually exceeds demand, causing an oversupply and prices to fall. We are currently in a low-investment cycle, further strained by regulated energy transitions, where a politically motivated agenda has resulted in less investment in fossil fuels, though 81.5% of global energy consumption still depends on them[2], especially in emerging countries. Rising demand from sectors like artificial intelligence [3]and China’s growth, combined with reduced supply due to geopolitical events, could lead to sharp increases in oil prices and inflation.
Fiscal deficit.
The U.S. government projects a cumulative deficit of $22 trillion over the next ten years, excluding possible recessions or events requiring additional spending, as was the case during the COVID-19 pandemic.
U.S. debt today exceeds $35 trillion, representing 123% of GDP. Federal spending constitutes 37% of GDP, and, more importantly for our analysis, interest payments make up the second-largest federal expense, surpassed only by social security and greater than defense[4] spending. Based on government projections, it’s likely that interest expenses will surpass the social security budget.
How to finance this spending? By raising taxes, increasing debt, and/or printing money. All of these methods, in some way, are inflationary.
Rate cuts.
Regardless of the Fed’s motivation for lowering interest rates, a possible consequence is an increase in credit and consumption, which, in turn, puts upward pressure on prices.
What’s the conclusion of all this?
• As I mentioned in last month’s commentary, the Fed and other central banks around the world may lose their independence and serve only the state in its spending programs. I’m not saying that many of these expenditures are unnecessary, like subsidies in healthcare, education, defense, justice, and especially in emergencies like the recent DANA in Valencia. However, if there’s excessive spending on superfluous matters, resources for more necessary objectives decrease.
• The curve inversion. As you can see below, the curve inversion has already begun, but there is still more ground to cover. On the X-axis are debt maturities, from 1 month to 10 years, and on the Y-axis are interest rates. The brown line represents the yield curve as of December 31, 2023, and the green line, the same curve as of October 31 of this year. In the December 2023 curve, maturities from 1 month to 4 years were higher than those for 10 years. Currently, the curve has inverted significantly, with the 10-year rate exceeding all previous maturities up to one year. It’s noticeable that sub-year maturities have higher rates, but they are more sensitive to central bank cuts.
The interpretation, as mentioned before, is that the Fed will fight to avoid worsening employment, meaning it will lower interest rates so companies keep hiring, putting inflation on hold for now, as it’s near the 2% target.
What does this imply for investment?
• Having a greater exposure to short-term fixed-income bonds. Short-term interest rates are higher, and if central banks continue to cut rates, the prices of these bonds would rise (remember, prices move inversely to rates).[5]
• Lower exposure to long-term maturities. If long-term rates rise, driven more by the market, this would negatively impact long-term bond prices.
• Regarding equities, they are generally a good asset against inflation because the assets on their balance sheets are real assets that inherently reflect price increases.
• If public spending increases, helped by lower interest rates, inflation is likely to rise. Therefore, it’s preferable to have certain assets that protect against inflation, like gold.
I would like to include a brief comment on the election outcome and its possible impact on financial markets.
Donald Trump secured the majority in the Presidency, Senate, and House of Representatives. From an economic perspective, these are the most relevant points in his electoral program:
• Tariffs: Imposing tariffs on various products, especially those from China, with rates potentially reaching up to 60%.
• Fiscal Deficit: Increasing spending and cutting taxes, so the deficit will continue to grow.
• Labor Market: Restricting illegal immigration, affecting the labor market, decreasing supply, and raising wages.
One of the long-term consequences of this economic program is the greater likelihood of rising prices, so I believe that the election results have not altered the conclusions regarding the financial assets discussed above.
[1] The increase in this index is due to the rise of the dollar against the euro of 2.17% in the month.
[5] If I buy a bond at 100 with a coupon of 5%, at maturity, let’s assume 1 year, I will get back 100 and my profitability will be equal to the coupon, that is, 5%. But if the price of the bond falls in the market for whatever circumstances and I can buy it at 90 for example, my return will no longer be 5%, it will be higher because in addition to the coupon, I get a rise in price at maturity of 10 because I get 100 back.
Altum Faithful Investing EAF, SL, a financial advisory company financial advisory company with registration number 219 with the Comisión Nacional del Mercado Securities Market.
We have been recognized as part of the International Network of accredited Social Enterprises.
Altum Faithful Investing EAF. SL. in the framework of the Icex Next Programme, has been supported by ICEX and co-financed by the European ERDF fund, to contribute to the international development of the company.
October Market Review
October ended with slight declines in all markets. After the gains seen in September, the market took a breather.
• S&P 500: -0.99%
• Nasdaq: -0.85%
• Stoxx Europe: -3.35%
• All Country World Index EUR: +0.92%[1]
• Global Fixed Income Index EUR: -0.65%
The market was in a kind of “tense calm,” awaiting the U.S. elections in November, with results that were generating and would continue to generate high uncertainty. There are significant differences in the priorities and approaches of both candidates’ programs, but they do agree on one thing: increasing spending.
Can a state spend ad infinitum? According to the proponents of Modern Monetary Theory (MMT), the answer is yes or almost. They argue that a country with control over its currency (like the United States) can increase the deficit to achieve full employment, as long as it doesn’t face high and persistent inflation. And who decides if inflation is high and persistent? The politician in charge.
If you recall, in September, the Federal Reserve (the U.S. Central Bank) lowered rates by 0.50%, a significant reduction considering inflation was still above 2%. This decision was made due to the perceived deterioration in the economic situation, especially in the labor market, with the aim of reducing public spending both now and in the future.
However, following the Fed’s 0.50% rate cut, the 10-year bond yield increased by 0.70%. It seems the Fed didn’t achieve the desired effect… This movement reflects investor sentiment and expectations, which is crucial as it gives us insight into possible market trends in the coming months.
Let’s start at the beginning. The yield curve, which represents interest rates across various debt maturities (1 year, 2, 5, 10, 20…), was inverted. Short-term rates were higher than long-term rates, which is illogical since lending over the long term should, in theory, involve higher interest due to greater uncertainty. So, why does the curve invert? One explanation that makes sense to me is that economic agents are requesting short-term credit to finance their working capital due to insufficient liquidity from lower sales. Many companies, anticipating an increase in inflation and a rise in rates, stock up to avoid higher future prices; if they haven’t done so, they reduce their purchasing budgets. This increase in short-term credit demand drives up interest rates.
On the other hand, long-term rates hold steady or might even decrease, as investors anticipate higher inflation and lower economic growth. Historically, this type of inverted curve has been a recession indicator, although that hasn’t been the case so far.
In simple terms, short-term rates are adjusted based on the Fed’s decisions. When the Fed lowered rates, short-term yields also dropped, but long-term yields, from five years and up, increased. This is because investors believe the Fed has “thrown in the towel” on fighting inflation, prioritizing the labor market instead. This sounds like Modern Monetary Theory (MMT), doesn’t it?
The latest labor market data show signs of weakness. In October, only 12,000 jobs were added month-over-month, the slowest growth in four years. What’s more concerning is that private sector jobs dropped by 28,000 while the public sector rose by 40,000. In other words, if it weren’t for public spending, total employment would have fallen. Moreover, the main type of employment being created is temporary. At first glance, it may seem that the state is doing a great job compensating for the private sector, but beware: “the devil is in the details.”
Why are investors expecting higher inflation?
Investment in oil-related infrastructure fluctuates with prices. If demand increases, prices rise, making oil projects more attractive, thus boosting investment. However, this infrastructure isn’t immediately operational, so it can’t meet demand automatically, leading to further price increases. Often, supply overshoots and eventually exceeds demand, causing an oversupply and prices to fall. We are currently in a low-investment cycle, further strained by regulated energy transitions, where a politically motivated agenda has resulted in less investment in fossil fuels, though 81.5% of global energy consumption still depends on them[2], especially in emerging countries. Rising demand from sectors like artificial intelligence [3]and China’s growth, combined with reduced supply due to geopolitical events, could lead to sharp increases in oil prices and inflation.
The U.S. government projects a cumulative deficit of $22 trillion over the next ten years, excluding possible recessions or events requiring additional spending, as was the case during the COVID-19 pandemic.
U.S. debt today exceeds $35 trillion, representing 123% of GDP. Federal spending constitutes 37% of GDP, and, more importantly for our analysis, interest payments make up the second-largest federal expense, surpassed only by social security and greater than defense[4] spending. Based on government projections, it’s likely that interest expenses will surpass the social security budget.
How to finance this spending? By raising taxes, increasing debt, and/or printing money. All of these methods, in some way, are inflationary.
Regardless of the Fed’s motivation for lowering interest rates, a possible consequence is an increase in credit and consumption, which, in turn, puts upward pressure on prices.
What’s the conclusion of all this?
• As I mentioned in last month’s commentary, the Fed and other central banks around the world may lose their independence and serve only the state in its spending programs. I’m not saying that many of these expenditures are unnecessary, like subsidies in healthcare, education, defense, justice, and especially in emergencies like the recent DANA in Valencia. However, if there’s excessive spending on superfluous matters, resources for more necessary objectives decrease.
• The curve inversion. As you can see below, the curve inversion has already begun, but there is still more ground to cover. On the X-axis are debt maturities, from 1 month to 10 years, and on the Y-axis are interest rates. The brown line represents the yield curve as of December 31, 2023, and the green line, the same curve as of October 31 of this year. In the December 2023 curve, maturities from 1 month to 4 years were higher than those for 10 years. Currently, the curve has inverted significantly, with the 10-year rate exceeding all previous maturities up to one year. It’s noticeable that sub-year maturities have higher rates, but they are more sensitive to central bank cuts.
The interpretation, as mentioned before, is that the Fed will fight to avoid worsening employment, meaning it will lower interest rates so companies keep hiring, putting inflation on hold for now, as it’s near the 2% target.
What does this imply for investment?
• Having a greater exposure to short-term fixed-income bonds. Short-term interest rates are higher, and if central banks continue to cut rates, the prices of these bonds would rise (remember, prices move inversely to rates).[5]
• Lower exposure to long-term maturities. If long-term rates rise, driven more by the market, this would negatively impact long-term bond prices.
• Regarding equities, they are generally a good asset against inflation because the assets on their balance sheets are real assets that inherently reflect price increases.
• If public spending increases, helped by lower interest rates, inflation is likely to rise. Therefore, it’s preferable to have certain assets that protect against inflation, like gold.
I would like to include a brief comment on the election outcome and its possible impact on financial markets.
Donald Trump secured the majority in the Presidency, Senate, and House of Representatives. From an economic perspective, these are the most relevant points in his electoral program:
• Tariffs: Imposing tariffs on various products, especially those from China, with rates potentially reaching up to 60%.
• Fiscal Deficit: Increasing spending and cutting taxes, so the deficit will continue to grow.
• Labor Market: Restricting illegal immigration, affecting the labor market, decreasing supply, and raising wages.
One of the long-term consequences of this economic program is the greater likelihood of rising prices, so I believe that the election results have not altered the conclusions regarding the financial assets discussed above.
[1] The increase in this index is due to the rise of the dollar against the euro of 2.17% in the month.
[2] Statistical Review of World Energy.pdf
[3] Demand for electricity is growing so much with AI that the International Energy Agency has convened a global summit
[4] Nick Giambruno: Is the Dollar Collapsing? 7 Key Indicators You Can’t Ignore
[5] If I buy a bond at 100 with a coupon of 5%, at maturity, let’s assume 1 year, I will get back 100 and my profitability will be equal to the coupon, that is, 5%. But if the price of the bond falls in the market for whatever circumstances and I can buy it at 90 for example, my return will no longer be 5%, it will be higher because in addition to the coupon, I get a rise in price at maturity of 10 because I get 100 back.
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Altum Faithful Investing EAF, SL, a financial advisory company financial advisory company with registration number 219 with the Comisión Nacional del Mercado Securities Market.
We have been recognized as part of the International Network of accredited Social Enterprises.
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Altum Faithful Investing EAF. SL. in the framework of the Icex Next Programme, has been supported by ICEX and co-financed by the European ERDF fund, to contribute to the international development of the company.