We Got Our First Big Call Wrong and We’re Pretty Demure About It
Authors: Andres Larios, Jay Sahaym
Story of the Week: Caroline Yee
Intro:
Welcome to the Weekly BluRB, a newsletter catered to students and professionals to get the latest news and insights on global markets. Get prepared for the week by reading four weekly stories circulating equity markets, macro trends, geopolitics, and new business developments. And the best part: we’ll give you an informed view about where we think prices, policy, and trends are moving in the near future. The content in these writings is for informational purposes only and does not constitute financial or investing advice.
Last Week’s Calls:
Oracle Stock Overweight – Up 1.87% in past 5 days
25 bp Fed rate cut – 50 bp cut on Wednesday
Bank of England Holds Rates – Unchanged rates on Thursday
Equity Markets: Stock Market Reacts to Rate Cuts and Firms Go Nuclear
After the Fed Cut Rates on Wednesday, the stock market rallied to record highs throughout the end of the week. A 50 basis point cut represents a signal and an effect to investors. The immediate stock market reaction to the cuts was a dovish signal; particularly that more cuts should be expected and considered when investing in the future. Of course, Chair Powell quelled that sentiment during his Wednesday remarks, but the sentiment still stands.
As mentioned last week, rate cuts are positive for companies because the cost of equity falls, and for public companies who have issued lots of debt (like Oracle from our call last week), this represents a reduced financial strain on paying back lenders and an added commitment on financing projects with added cash flow.
However, as the stock market powers through an increasingly complex macroeconomic environment, we fear (alongside many Wall Street economists) that equities are not reflecting any probability at all of a recession. Of course, we believe that we are still on course for a soft landing, however, if the market is projecting economic health in a time of uncertainty for many, this could cause shocks in the near future to hurt investors more than it should. In other news, although the S&P 500 and the Russell 2000 are at record high values, so is gold, an asset whose value is historically inversely correlated with improving economic conditions.
When we pitched Oracle last week, we did so due to the big promises that Chairman and CTO, Larry Ellison made regarding using nuclear power to power Oracle’s growing AI hardware investments. While we were skeptical about this promise, we saw the potential in this actually becoming a reality. In the past week, two major tech companies and many top banks have declared their endorsements (through investments) of nuclear power.
Recently, Microsoft has signed an agreement to reopen the Three Mile Island nuclear plant (yes, that one) to fuel its data centers. Amazon (Web Services) is now hiring nuclear scientists after keeping their investment in Talen Energy on the down low since March. A group of American banks are now vocally supporting nuclear power investments as energy supply becomes a top priority to ensure that households, schools, and municipalities can keep their air conditioning going, while scientists and innovators can continue to push the frontiers of science.
Our advice? After seeing MAG-7 stocks slump in the past few weeks, these bullish signals for nuclear power should re-invigorate the AI trade as well as the financial health of the capital-intensive companies that provide nuclear power. Talen Energy (who are selling to AWS), for example, filed for bankruptcy in 2021 and is now getting a buy rating from top equity researchers. Keep an eye out for industries tangential to the growing need to fund AI operations.
US Macro: Why We Got Our Fed Call Wrong and Is Unemployment the Right Metric to Look At?
On Wednesday, September 18th, the Board of Governors of the US Federal Reserve announced a 50 basis point rate cut, as opposed to our 25 bp call. The Fed Funds Rate target range is now 4.75-5.00 percentage points. This marked a historic cut because of its aggressiveness and because of granular data points that seem out of consensus with the Fed’s forward guidance. While listening to Chair Powell’s speech following the decision, we were surprised by the 50 bp cut because of the Fed’s data-driven, patient approach to policy-making with regards to inflation, which we thought was swept under the rug now that recent employment numbers have looked shaky. Secondly, we were surprised by Governor Bowman’s dissent of the decision, (the first time this has happened since 2005) as she opted for a 25 bp cut.
Chart 1: Shows the Board of Governors’ Projections for the Target Fed Funds Rate at EOY
Chart 1 shows that most Fed Governors expect at least one more rate cut this year, in the wake of a policy decision that says neither inflation nor employment are completely under control. In Governor Bowman’s statement after her dissent, she stated how the labor market’s cooling is in line with bringing “wage growth down to a pace consistent with 2 percent inflation”, as well as “I see the risk that the Committee’s larger policy action could be interpreted as a premature declaration of victory on our price stability mandate.” Thus, she believed a 50 bp cut was a misleading signal to markets regarding the Fed’s policy focus going forward. On the other hand, industry veterans like Mohammed El-Erian voiced his concern for the Fed being “late in its policy reactions”, and compensating for not having cut by 25 bp in July.
Chart 2: US Treasury Yield Curve over the Course of Last Week
Chart 3: American Consumer 30d+ Delinquency Rate by Debt Type
The yield curve reacted to this policy change by further uninverting. Yields for the 2-year decreased over the week, while yields for the 10-year increased. In line with our comment on the housing market from last week’s Weekly BluRB, we don’t see the housing market getting any more comfortable soon because the longer-dated yields are being pushed upwards due to the current Fed policy and the yield curve’s uninverting process during a rate cutting cycle. Furthermore, auto loans and credit card debt delinquency rates have been inching upwards since the Fed’s rate hiking cycle of 2022. Although employment numbers are still relatively good, we question whether or not the cost of living of the average American is underestimated due to these indicators. As the back-end of the yield curve is still high, keeping auto loan rates and mortgage rates high, it is hard to properly address the economy’s health and the purchasing power of the average American.
We recognize that the Federal Reserve is in a tough position due to COVID-19, but believe they are equally focused on maximum employment and stable prices. For this reason, we predict a 25 basis point rate cut in the November meeting.
Global Macro: What’s Wrong with China?
The Bank of England held rates at 5.00% and the Bank of Japan held rates at 0.25% this past week.
In our first Weekly BluRB, we talked about how slumping economic data in China and the US was impacting demand for oil. Here, we’re going to discuss why China’s demand has faltered and the fiscal and monetary policy measures the country has been debating to avoid an economic crisis.
To start, China’s housing market entered crisis mode after property developer Evergrande defaulted on its debt in 2021. The company borrowed more than $300 billion dollars but after a Chinese law regulating how much money real estate firms could owe was put in place, they sold many properties at outrageous discounts, while at the same rate having increasing troubles paying their interest payments. This event has caused a whirlwind of policies aimed at solving the property crisis, to little avail. Instead, the seriousness of the problem is undermining China’s yearly goal of 5% GDP growth.
Secondly, youth unemployment in China is hovering at around 18%. Last year, youth unemployment numbers peaked at 21.3%, before the metric was pulled from publishing and its methodology was changed to exclude students. Now, 16-24 year olds who are not in school are still struggling to find a job. The property crisis has caused slowdowns in the finance and IT sectors as well, hurting urban citizens the hardest.
Chart 4: Chinese Youth Unemployment
China has definitely been trying to keep these issues away from international investors’ ears. However, as the problem gets worse, they are now having to reckon with policy that can fix this problem before it causes a recession. While it is too complicated to explain the differences between the PBOC (China’s Fed) and the US Fed (we recommend ChatGPTing this prompt), there are many monetary policy tools that are being hotly debated in China right now. Recently, they have cut their 14-day reverse repurchase rate by 10 basis points, and there is heavy speculation of RRR, MLF, and mortgage rate cuts in the weeks to come. Furthermore, PBOC Governor Pan Gongsheng, and two other economic experts are expected to brief Chinese officials on economic development this week.
Lastly, fiscal stimulus may be needed as well. Liu Shijin, who fulfills a similar role to Mario Draghi in Europe, has called for a $1.42 trillion stimulus package to revive economic momentum. He states the funding should come from ultra long-term bonds and should help boost consumption, stabilizing growth and mitigating risks associated with the looming property crisis. With all of these factors being discussed in Beijing, investors are reducing new flows to the country. China are definitely far from a recession, but if they can’t control slumping demand and household cash hoarding in the near term, then we might see the world’s second largest economy falter in the coming years.
Story of the Week: Fighting Wildfires with Innovation:
The area burned by forest fires globally has doubled over the past two decades, now accounting for approximately 33% of global tree cover loss. Climate change is a leading culprit behind this increase: hotter days and months dry out our environments, leaving them more susceptible to rapid ignition and the spread of fires. The economic consequences of wildfires are growing increasingly severe as well. Los Angeles alone faces a property value loss of over $1.2 trillion this year due to high wildfire risks.
For years we have fought these fires in a prescriptive manner: Once a fire starts to burn, just put it out. However, there has been growing reliance in the past few decades on prescribed burning, a more diagnostic approach that could be the key to preventing and not just mitigating these destructive environmental and economic disasters. It is a practice that has long been used in Indigenous communities, and Silicon Valley innovators are only just catching on.
Image 1: “A skidder at work in the Stanislaus National Forest, clearing out woods that are vulnerable to fast-moving fires,” New York Times, August 30, 2024
Kodama Systems aims to address the shortage of human labor required for prescribed burning by using remote-controlled skidders–semi-autonomous machines that can be operated from miles away–to reduce forest density, remove flammable debris, and create controlled burns, making forest treatment more efficient. This technological shift, supported by millions of dollars in venture capital, marks a promising step towards using advanced machinery to implement proactive forest management and reduce the risks of devastating wildfires in the future.
As technology becomes a tool to combat wildfires, there is hope for a more sustainable approach to forest management. Kodama and other similar startups are proof that traditional practices and modern solutions can work hand in hand, fostering healthier ecosystems and protecting communities at risk.
Make sure to tune in next week for more market updates and global insights!