Depending on which data you look at, the U.S. economy is either in really good shape or it’s facing some serious obstacles. Andy Constan, the CEO of Damped Spring, which specializes in macro research, has been in the game since he started as a trader at Salomon Brothers in 1986. He joins the ETF Think Tank to discuss the latest goings-on with the Treasury and the Fed as well as where he sees the cracks and opportunities in the current economy.
To provide some background, Constan says that a lot of government liquidity has contributed to the current rally in equities. During the era of zero interest rates, the Fed began buying financial assets in the absence of dropping rates and that helped take duration out of the market. Investors with all that cash on hand kept trading up to the next riskier asset – Treasuries to corporate bonds to stocks to meme stocks to crypto. This is a big reason why QE stimulated financial assets. Ultimately, that contributed to the inflationary pulse that started in 2021 and still lingers today.
Constan has also been following the quarterly refunding announcements, which essentially state how the government is going to fund its deficit, for years. He says it used to not be important, but today it is. For example, the government stopped issuing coupon bonds around the debt ceiling and moved to issue T-bills instead. Once that deadline passed, the government would finally return to 80% bond issuance. Those changes had implications for risk asset markets. Risk asset prices fell at first, but then rallied in Q4 once T-bill liquidity was available. It lifted crypto and even gold prices with the lack of supply in risky assets.
Constan says he views elevated inflation and ultra-low credit spreads as not a major problem for the financial markets. Right now, we’ve got higher growth with inflation remaining above target. He thinks that’s not necessarily a terrible place for equities or spreads, although it’s tough for bonds. Even though high yield spreads are as tight as they’ve been in a long time, they’re happening in an environment where the VIX is also very low. Spreads are just sticking with equity volatility. We’re in a good place for corporates to be able to make their debt payments and refinancing is cheap. There’s less value in equities & spreads, but there isn’t a red flag.
What’s the outlook for artificial intelligence? Constan sees a significant demand for chips and a wage demand for those folks. Currently, we’re in a phase of robust spending & large demand for certain sectors/people and that generally causes an inflationary pulse. Eventually, it’ll be deflationary. For the aggregate economy, prices will fall, but for the person who is displaced by AI, they’ll have no income. Then you run into questions, such as “does the government step in in this situation” and whether we should consider things like universal basic income. Without a doubt, it’s had a very concentrated impact on stock prices.
How should investors and advisors navigate the current landscape? Constan believes it’s important to recognize what you’re trying to do and that’s trying to build long-term wealth. The best way to do this is to accept the returns that come with taking risks. Stay invested all the time in something that’s passive and diversified. Never look at it. Contribute what you can. Own diversified beta. It’s important to do it at low cost and in a cost efficient way. He believes that alpha exists, but it’s way more difficult to capture than people think.
Other key takeaways:
- The reverse repo facility, which had grown to about $2.5 trillion, has since come down, but that was due to the debt ceiling. The Treasury general account got drawn down to zero and the government needed the funding to pay its debts.
- If you’re looking for indicators, a reverse repo facility drawdown is something you can consider from a liquidity perspective.
- Constan thinks the reverse repo facility will last a lot longer than people think and QT will last a lot longer than people think. People will need an incentive to buy bonds and that’ll be a headwind. They will taper, but it won’t be nearly as quickly as people expect.
- Constan doesn’t see evidence of an imminent recession. He thinks we need to see meaningful job demand destruction before that happens.
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