Markets and macros | It’s an upside-down world!

May 7, 2024

Welcome to ‘Markets and Macros’, our attempt to bring to you all the random, disconnected, interesting things we come across, but don’t otherwise share or write about. Here’s all that we’ve picked up over the last month. 

Cognitive dissonance

This week, the US Federal Reserve decided to keep rates at 5.5% because US inflation has proven more sticky than it would’ve liked. When inflation spiked in advanced economies during the pandemic-era reopening, there were loud debates among economists and other macro watchers. One camp argued that the inflation was being caused by supply issues that would work themselves out, and so, it would be transitory. The other argued that the era of low and stable inflation was over and we had entered a world where inflation, and by extension interest rates, would be higher for longer. In reality, though, we got Schrodinger’s inflation: some transitory, some permanent, and no way of knowing which is which.

Either way, inflation soared. Interest rates rose. Under Finance 101, higher interest rates are bad for stocks. True to this math, in 2022, the S&P 500 fell 19.4% and Nasdaq 100 fell 33%, even while the Nifty 50 was up 4%. Most of this carnage was in the most speculative and growth-y segments of the markets, like tech stocks, venture capital, penny stocks, and crypto.

But then, something peculiar happened. Even as central banks, including the Fed, continued hiking interest rates, stocks rallied. In fact, equities in both India and the US are almost near their lifetime highs.

GLD: SPDR Gold Shares ETF | TLT: iShares 20+ Year Treasury Bond ETF | IN24: India 20 year bond yields

Back in 2021 and 2022, the prevailing narrative was that the entire last decade was some sort of extended anomaly which could only exist amidst a “zero interest rate phenomenon”. As soon as rates rose, the madness would end. Well, rates rose and yet here we are. Leaving bonds aside, everything from equities to crypto, to options volumes, to gold are at lifetime highs?

What explains this?

I like Joe Wisenthal’s idea: everything we assumed was just… wrong.

The main thing I’m thinking about is that we need to go back and rethink everything that we called a “ZIRP Phenomenon” a few years ago. So many aspects of speculative excess were chalked up to low rates, and yet here we are and all this is happening with rates over 5%. Seriously, it’s time for some revisionism.

What would a normal world look like? Here’s some wacky (if not scary) math from The Economist. Today, there’s no difference between the S&P 500 earnings yield (that’s the inverse of its PE ratio) and the yield on US 10 year Treasury bonds.

Take a moment and think about this: what a company earns, when compared to the price of its stock, is like its ‘yield’ – much like the yield of a bond. Ideally, for one to invest in a stock, its yield should be higher than what most bonds offer, because its a riskier investment. Historically, the gap between these two – the ‘risk premium’ – averaged ~4%. Today, it is zero. For the gap to revert to normal, the S&P 500 will have to fall by ~29%. If it is to revert to its 10 year average, the numbers are even scarier:

A reversion to the average, which is around four percentage points, would entail share prices dropping by 29% at current bond yields. It seems improbable, however, that investors’ risk appetites would still be average immediately after such a large drop. For much of the 2010s the yield gap hovered around six percentage points; in the traumatic years following the financial crisis of 2007-09, it was more like eight. A return to those levels would require share-price crashes of 47% and 57%, respectively.

That’s a Zerohedge-level prediction.

Crystal ball-gazing

In the last edition, I had mentioned the CAPE ratio. Basically, the ratio looks at how stocks are valued, over time, compared to how much companies earn — a smoothened out PE ratio, if you will. Recently, I came across a few charts that will make you go WTF, especially if you invest only in India:

Just look where India sits. Interestingly, such high valuations were par for the course before the global financial crisis:

By 2009, however, the party was over:

Source for all three

Right now, among major markets, India is the most overvalued market. Now, as I wrote in the previous post, a higher CAPE doesn’t necessarily mean an impending crash. What it does means, however, is that there’s a higher probability of lower expected future returns.

Don’t bet on this bull market and its easy returns lasting forever

See also: CAPE charts broken by EM and DMs

Glittering gold

I’ve been reading a lot about gold over the last couple of weeks. A lot of weird things are happening to this shiny metal that some people call a “pet rock.”

Historically, there was an inverse correlation between real interest rates (that’s nominal interest rates minus inflation) and gold prices. Why? See, gold doesn’t pay you any dividends or interest. When real interest rates are positive, you’d prefer an instrument that pays interest over gold. And so, the two are usually correlated negatively. Off late, though, this seems to have broken down.

The same goes for the relationship between gold and the dollar. Historically, there was a negative correlation between the two, but that has now broken down.

What does this tell us? For one, correlations aren’t static! They change.

Why these changes, though? Could be many things:

  • Gold and real rates have always moved together during rate hike cycles.
  • The world is currently a dangerous place with geopolitical conflicts everywhere. Gold has always been an insurance against this kind of uncertainty.
  • Central banks are buying record amounts of gold and are pumping the price.

Take your pick.

BTW, here’s an interesting chart on what gold is used for:


As an aside, the correlation between the dollar and commodities has flipped as well.


It’s an upside down world.

China needs an economic plot-twist

The Financial Times has an interesting piece on China’s economic woes. China’s economy is investment-led, with investments making for 42% of its GDP — the highest among major economies. But this investment-led model seems to have hit its natural limits. You must have read about all the pointless roads, airports and ghost cities in China. That’s all investment made to no end. The standard economic prescription to this issue has been that China should reduce its reliance on investment and instead stimulate consumption growth like the US and other advanced economies.


To shift from investment led growth to consumption led growth, you need both the willingness and ability to change. While the Chinese government may have the ability, they certainly don’t have the willingness to change.

Joe Leahy had a good piece in the FT on China’s growth conundrum:

Greater consumption would also necessarily mean reducing the role of manufacturing or investment in the economy. This could be done by unwinding China’s intricate system of subsidies to producers, which includes government infrastructure investment, access to cheap labour, land and other credit, says Pettis.

But if that was done in a big bang fashion, the share of household consumption to GDP would increase while overall GDP would contract as manufacturers suffered. This was obviously not a politically preferable option for Xi.

“They are locked into this system,” Pettis says.

Also check out these comments by Micheal Pettis, one of the most sensible China watchers who’s also been quoted in the FT piece.

BTW, Pranav had written a brilliant three-part series on China’s troubles. Part I looks at China’s obsession with investment, Part II details its consumption woes and Part III examines its recent troubles with real estate and debt. Check them out!

Financial analyst and researcher at Zerodha

Post a comment

  1. Karan Jain says:

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