As a child I was fascinated and terrified by tales of the Bermuda Triangle, an area between Florida, Puerto Rico and Bermuda where ships and planes disappeared without warning, allegedly. Legend had it that a mysterious magnetic field around the Sargasso Sea drew vessels to perdition, or that even darker forces were behind the disappearance of the crew of the Mary Celeste.
Without stretching the analogy too far, my feeling is that financial markets have entered a logical Bermuda Triangle, or even Trilemma. Data, models, rules and indicators go in, but come out logically impaired. In particular, there is an unreal sense from at least three asset classes that are at historically extreme levels, each apparently contradicting the other. They cannot all be right.
In one corner, the US has, for the first time since 2007, issued long-term debt (30 years maturity) at a yield of 5%. Then, US stock market valuations are at an all-time high since 1929 and, as we stressed in last week’s note, semiconductor stocks are in a speculative frenzy. In another corner of the triangle, oil prices are pushing the highs of the last two decades.
This trio of market signals leaves investing logic in a grey zone — a Bermuda Triangle-like make-believe world. This stretched logic suggests that the prosperity and productivity of AI-related capital expenditure will rescue the world from both high inflation and a debt crisis, and will also prove powerful enough to compensate for the effects of a momentary energy crisis. I am not sure.
The confluence of these three indicators is interesting because each one points to a long-term trend that investors and policymakers cannot ignore, but equally, each one rests on a short-run vulnerability.
Rising bond yields in Europe, the UK, Japan and the US are an early warning of a debt crisis, or debt purgatory, to come. In the very short term, they signal that inflation is creeping higher whilst a number of policymakers — notably on the Fed’s FOMC — appear complacent about this development.
Equities are trading at record high levels and valuations, mostly because earnings and business cycles are strong. But a very small number of stocks has pushed the market higher, caused in part by the fact that sectors like semiconductors are heavily financialised. What I mean by this is that the deployment of exchange-traded funds and options has surcharged the prices of semiconductor stocks, and likely driven them well above long-term fundamental valuations.
In my view, Intel’s ability to treble in value since the end of March (from USD 41 to USD 129 last week) has less to do with the fundamentals of the company, and more to do with speculation. In support of this, a recent Goldman Sachs note shows that retail investors now account for around 20% of US stock market trading.
Energy prices remind us that in a multipolar world, commodities — or rather their supply and refinement — acquire a premium, and that a number of countries will have to address shortcomings in industrial supply chains. For example, last week Willie Walsh, the former airline chief executive, warned that the UK has scant jet fuel refining capacity. As such, energy infrastructure will be an area for future investment.
In the short term, however, supply pressure may be more acute: oil inventories are being drawn sharply lower. Unless there is a full and speedy resolution to the Iran War, estimates from JP Morgan point to world oil inventories dropping to 6.8 billion barrels by September — just enough to keep refineries operating worldwide.
So, like the Sargasso Sea, market compasses are spinning in different directions, and it is difficult to discern a clear narrative. The confusion arises from the changing geopolitical nature of the world, the fast shift in industrial structure away from ‘bits’ and towards ‘atoms’, shortages of refined oil and compute, and the intense financialisation of specialised sub-industries such as semiconductors and commodities.
Given the disagreement between markets, the obvious question is: which one is right? A ‘two-handed’ economist might argue that the stock, commodity and bond markets are all correct, but on different time frames.
In my experience, the bond market is the most consequential, because when it worries, it imposes a cost on other markets and on political actors. The overused but apt quote from President Clinton’s adviser James Carville in the mid-1990s captures it well: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
So, the ‘market triangle’ or trilemma is resolved by bonds showing their displeasure at high oil and inflation, slowing the economy and walloping the over-bought sections of the stock market.
From a policy angle, bond markets are highlighting the urgent need for policymakers to calm inflation — through rate rises from central banks, and an early test for incoming Fed Chair Kevin Warsh — for governments to reduce debt, and for greater policy clarity in countries like the UK. The silver lining is that credit markets are so far well behaved, signalling that the healthy business cycle should allow for these policy actions to be made now, before it is too late.
Have a great week ahead, Mike
The Levelling 