September has the worst seasonality of any month for Equity Markets and thus traders returning from the beach after Labor day are usually cautious. The fact that this is a US Election year is only adding to that feeling, especially as populist politics are pushing back against Globalism everywhere we look.

With the US Equity Market over 70% of Market Cap - albeit not 70% of opportunities - the US Political Cycle is clearly the dominant short term uncertainty. And with the return on US$ cash still the hurdle rate for markets - and a key driver of the $ - the announcement at Jackson Hole by Jerome Powell that ‘the time has come’ for rate cuts suggests to us that markets are shifting to a period of change - part seasonal, but also we suspect part structural.

Short Term Uncertainties - other people’s leverage, currencies and politics

The dramas of July we documented in our August monthly (it’s supposed to be quiet) delivered a roller coaster August for markets. For those forced to buy at the top or sell at the bottom (as many leveraged traders were) it was the worst August in years. For those able to sit it out, those roasting at the beach or even those frozen in indecision, the bounce back has left them relatively unscathed. But this is not to say that nothing has changed. Traders and asset allocators returning to their desks are likely to be adopting new strategies and tactics for the upcoming Autumn/Winter ‘season’.

The three big anomalies - low volatility, low Yen and high stock concentration have all largely unwound. Which is good.

Chief amongst them will be de-risking, if they haven’t done it already. The early narrative that the sell-off was about economics quickly shifted to our own view that it was largely the Yen Carry trade (see August Analogues). Going into the summer, we saw the undervalued Yen, along with the low levels of implied volatility and the high concentration in a few US Megacap stocks as being one of the three key anomalies in markets and as such are comforted by the fact that much of this has now unwound.

Meanwhile, leaving aside for a moment the serious ongoing conflicts in Ukraine and the Middle East, newer political dramas have played out in the UK, France and the US during the so called quiet summer season and as the population as well as investors return from the beach, greater consideration and scrutiny is being applied. The latest news from Germany, where the East of the country is voting for the ‘far right’ AFD, is reminding investors that the populist revolt against the Globalist narrative continues to grow. The real target is uncontrolled immigration and the ruinously expensive net zero policies coming from the radical centrists and the fact that the far-left coalition put together by Macron to thwart the (actually otherwise socialist) National Rally party of Marine Le Pen can not agree on forming a new government, highlights that the real split is between Globalists and Nationalists.

Rates matter more for the $ than for the economy.

Rates are coming down - not enough to stimulate consumption or to please the Bond markets, but maybe enough to trigger the $

The announcement at Jackson Hole that the Fed would start cutting rates has naturally got the Bond Markets (over) excited, but just as we saw above 5% on the 10 year as ‘the wrong math’ this time a year ago, so we see below 4% as also being so. There was a flight to quality element as well as a scramble down the curve to lock in higher lates for longer, but compared to other assets, notably higher yielding equities, bonds look like something to own only if you have to.

Some indicators don’t tell you what you think they do

Meanwhile, it is worth looking at the time series of the CME Fed Futures model that commentators use to tell us ‘what the market is thinking will happen to rates’. The snapshot below is of expectations/probabilities of December 2024 rates being in various ranges (currently Fed rates are still at 5.25). If we look at the grey line - the expectation that rates will be 50-75bp lower by then, we can see how the ‘predictions’ have lurched over the last 12 months, from 30% in November, to essentially nothing by end of January, to 34% by end of February and back to 3% in May. (Note this is effectively a ‘stacked bar’ type chart, so it is the gap between the lines we are measuring).

This is essentially a chart of the ‘Pivot’ Meme

The CBOE rate expectations are not useful for forecasting

Source CBOE, Historic Expectations for December Fed Funds

A similar graph for the September meeting would have seen rate expectations for rates to be 400-425bp, ie a 100-125bp cut, set at 1% last October, jumping to 58% by December and dropping back to effectively zero in February.

The market probability of a 100bp September cut went from 1% to 58% and back to 3% in a period of 6 months. Hardly helpful.

For us, the Fed is not currently about the economy, or even the bond markets - it is implausible the Fed will cut far enough to invert the yield curve at this point. Rather, it is about the $. The Trade weighted index is back down close to the 100 mark and the uncertainty is around how it will be viewed by a new White House. We remain of the view that Trump would talk the $ down and markets are starting to suspect that a Harris White House might do the same.

‘No Joe’ could mean a shift towards more pragmatic politics

Indeed, we are starting to suspect that the real result of ‘No Joe’ will be a shift away from extreme positions (on Foreign Policy, Green Environmentalism, Culture Wars etc) to a more pragmatic deal oriented approach. Ironically more like Trump. As we said in 2016, it’s important to take Trump seriously but not literally. This remains true. As we discussed in a recent note (Democrat Madmen, the rebranding of Kamala), this looks like a very professional exercise in positioning Harris as the ‘Not Trump’ candidate by appealing to an Obama-era Nostalgia and secretly aping many of his policies.

Medium Term Risks - monopoly earnings and a weaker $

Elon Musk appears to have taken on Trump’s mantle as ‘namer in chief’ such that the label he attached to Britain’s new Prime Minister ‘Two Tier Kier’ has stuck, capturing as it does the rigid, albeit quixotic, attempts at enforcement of ‘approved behaviour’. Indeed, TTK has been a powerful meme in the rapid collapse of his approval rating.

The risk to markets is that policy will shift to blaming large corporates (rather than politicians) for the economic problems, Joe Biden’s shrinkflation and now Kamala Harris talking about price gouging are examples of politicians throwing corporates under the (campaign) bus.

US policy is thus the biggest medium term risk to markets, for the reality is that the large corporates that dominate the US and by extension the Global Market indices do so through their high earnings per share, which are less a testimony to the strength of the US economy in general (though they are presented as such) and more to their ability to generate and maintain monopoly or quasi monopoly levels of operating margin. An important variable we discussed back in March (the three body problem) remains RFK Jnr, the independent candidate who has been polling close to 20% in some states and who announced that he was standing down this week - but only in the swing states. Pippa Malgren (whose Substack is a must read in our view) has a fascinating take on all this, but for investors the thing that stood out is the notion that, should Trump win, RFK jnr might have a powerful role as an ‘anti corruption Tsar’, taking on Healthcare in particular, but also Big Food - and likely big Tech. Indeed, the announcement this week of an antitrust investigation into Nvidia is the symptom of what may be a big change

The anti-Trust investigation into Nvidia is going to be troubling megacap investors

The second key issue, as noted above is the Dollar itself. There are literally $trillions sat in high yielding Money Market accounts, a significant proportion of which are the $ surplus of OPEC and other countries that used to be recycled through the Petro $ machine into US Treasuries and which we suspect have been a source chasing other US$ assets as well. If the world starts to think that the US$ might devalue by, say 10%, then the outflows could be both meaningful and self fulfilling.

Long Term Trends - diversification and yield

We have noted in the past the apparent schizophrenia in markets that declare China ‘uninvestable’ on the basis that they might invade Taiwan and yet hold significant amounts of TSMC and Nvidia, probably the two biggest losers under that scenario (TSMC make all Nvidia’s chips). In reality, this is Fiduciaries being told they can’t own China by their advisors and consultants- effectively a pre self sanction against the risk of an actual sanction. Once again, the risk being managed is the career risk of the manager rather than the actual risk to the underlying investor.

However, if, as we believe, international investors start to diversify their exposure to the US, whether prompted by concerns over the concentration risk in US megacap tech, the structural problems in the US Bond market, or indeed just the US$ itself, then Emerging Markets and China in particular are going to be an increasing part of both debt and equity portfolios. It is interesting that the we are starting to hear again about the concept of the twin deficits, something that was a popular economic meme under the Clinton regime and which came against a background of a weaker $ as the majority of Clinton’s two terms as President saw the DXY traded below 100.

It might seem strange now against the current background of relentless anti China ‘news’ and wishful thinking that the Chinese model will ‘fail’, but the reality is that a shrinking population in China that is still combined with 4% GDP growth boosts GDP per capita, while a population growing through mass migration has the opposite effect. The mote is in our own eye. Meanwhile, the rapidly growing populations of India and, say Nigeria, are causing less social cohesion regardless of being ‘good’ for GDP.

When half your domestic car sales are EVs that reduce your roadside pollution and your country’s dependency on imported hydrocarbons, your population are happier than if they are being told that they not only have to by EVs ‘to save the planet’ but also that the option of a cheap one from China is ruled out ‘to save Stellantis’. China is pursuing a dual circulation model that is dominating its own market, but also offering high quality, relatively low cost exports. So far the US has managed to persuade its ‘allies’ in Europe to also put up trade barriers to protect the US car industry, but they can not do so in the rest of the world in the same way they can’t prevent the rest of the world buying Xaomi or Huawei rather than Apple or Nvidia, or indeed in the case of Xaomi, Porsche.

The Chinese economic model allows profits, but does not allow super normal profits from monopolies, meaning investors used to ‘moat stocks’ will need to focus on the cash flow characteristics for returns rather than multiple expansion due to cheaper discount rates and monopolistic margins. That’s more than a change of the seasons, that is a structural change in the weather.

Model Portfolios

Making predictions and then positioning to benefit is speculation, assessing probabilities and constructing portfolios to have asymetric risk/return is what we prefer. Thus, for example, some diversification away from US assets might under-perform a concentrated US portfolio, but should still generate positive returns and in the event of a sharp drop in the $ would have a significantly better outcome for international investors.

In our model portfolios, we have rebalanced to take our half weight in Japanese Trading companies down to zero and also reduced our exposure to the Robotics and Automation theme. Both Thematics had done very well on the back of not only fundamentals but momentum and a lot of $ hedged (not leveraged) flow into Japan generally. This flow has reversed and we feel that, with the stocks having bounced they will nevertheless trade closer to the lower end of fair value for now. We have similarly reduced our exposure to another long running theme of European Financials, where after strong returns from the normalisation of interest rates we see value now out of line with medium term prospects as well as some increased uncertainties.

By contrast we see better opportunities in Emerging Markets ex China. This thematic has emerged from the ‘China is univestable’ meme and is essentially a BRICS trade as EM with China viewed as a separate risk class. We have China Consumer and Tech as a separate theme - albeit currently zero weighted in the portfolio. By contrast Global Fintech looks more attractive to us now, and of course Gold.

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