Populism, higher rates and AI: How the market cycle is shaping up

Welcome to Beyond the Benchmark, the EFG podcast with Moz Afzal.

Moz Afzal:

Hi everyone. So we have a very special podcast yet again with Jason Trennert. So Jason, welcome.

Jason Trennert:

Thanks for having me. Good to be here.

Moz Afzal:

Yep. Jason, for those of you who don't know Jason, Jason is the founder and the managing partner and chief investment strategist of Strategas Research Partners. Jason, I think last time you came on was a good two or three years ago, actually. I think three years ago. So great to have you on again. And we were just discussing just before the podcast started that we've known each other since probably around 1997, 1998. So we've known each other for coming up for 30 odd years. And obviously what you've done with Strategas coming up to the 20th anniversary has been very impressive. So congratulations to you and to the rest of the team. Okay. So let's get straight to it. And for those who don't know, Jason produces every month a market balance sheet. So maybe we start there, Jason, in terms of the US stock market. Where do you see the asset and liabilities on the balance sheet for the markets at the moment?

Jason Trennert:

Yeah. I mean, listen, so we've been doing this just as a check on our assumptions and we're trying to make sure that we're as intellectually honest with ourselves as we can. So every month, as you point out, we have 16 building blocks that are valuation, economic growth, profit growth, all of those things. And we either put them into assets or liabilities. And it's just like a balance sheet of a company, we have to mark to market that idea every month. So as an example, like liquidity was a month ago at the end of March, early April, we had that as a liability because credit spreads were widening out and the cost of equity capital was clearly getting higher. And then this month we actually put it back to an asset because credit spreads are tight and clearly the cost of equity capital is getting cheaper.

But it doesn't bounce around a lot. And right now though, I would say it is weakening at the margin. And one of the main drivers of that is just concerns about inflation and price stability because it does seem to be clear that inflationary pressures are building, that there is a pipeline of inflation being created by the increase in oil prices that's showing up in the numbers. And it also affects our expectations as far as the Fed is concerned. I would argue that monetary policy is still largely accommodative, but it's not as accommodative as we thought it would be clearly before the war started. So generally speaking, there are more liabilities than assets. The assets are meaningful though, because we weigh these various items and profit growth and margins really are just, and the technical picture really couldn't be much better. So profit growth has been kind of the amazing story of particularly first quarter earnings, just blown everybody away.

Moz Afzal:

Yeah. And I guess this pattern we've seen over the last few years, right? Where earnings expectations, we're always used to watching those graphs where analysts start very optimistic and basically downgrade the earnings throughout the whole course of the year. But over the last two or three years, it's been the complete opposite, right? We've seen earnings generally trending upwards. And so there seems to be this sort of a constant bearishness about earnings within those expectations. Anything kind of systematically wrong, do you think with that?

Jason Trennert:

Well, I mean, first of all, just to strengthen your point, it looks like earnings for the first quarter in the S&P 500. I mean, we're close to done, but it looks like they're going to be up something like 27 or 28% with 10% revenue growth, which is just remarkable given the fact that we're not exactly early cycle, although it does feel early cycle with AI. And I know it's cliche, but I do think clearly AI is changing everything because the companies, the hyperscalers, they have tonnes of liquidity, tonnes of cashflow, don't really need to tap the bond markets and can continue to spend on CapEx with reckless abandon. And I think there are also starting to emerge slowly maturely some really strong use cases for the technology as well, particularly on the cost side. So to me, that's one of the main reasons why people are kind of getting it wrong, that you have really what is, it sounds a little too hyperbolic, but you just have this really do have an ethical change in the technology of the way businesses and people operate and it's being reflected in higher and higher earnings. So in many ways, the multiple, as you know, is just kind of remaining, even though the market's going up pretty dramatically, actually the market multiple is pretty stable and interest rates are quite stable.

Moz Afzal:

So one question I have, which is a question that you maybe can call it philosophical, but it certainly has real world implications, certainly around the Mag7 and the free cash flow that they've generated over the last, call it decade or so. And now we've gone to another extreme where they're actually finding opportunities to invest that cash and their free cash flows have dropped to close to zero if they're spending all this money and we kind of know they can just stop spending and that free cash flow will come back, right? It's not going to go away. So what's kind of your viewpoint around that?

Jason Trennert:

Yeah, I'm kind of with you. I see it first. I think if you're running one of those companies too, to just take it down in a very practical matter, you don't really have a choice because I think your chances of being fired as an executive at one of those companies is far greater if you don't invest in this technology as opposed to investing and losing some money. And you're also, as you point out, I mean, some of these companies have operating margins that are 40, 50%. So you may be lighting money on fire, but the optionality that you get certainly versus your peers by keeping up with these investments I think is truly necessary that you have to be there. And so I don't see it as a bad use of funds with those companies that are so large that you almost need a technology of this magnitude for them to use the cash efficiently because otherwise you're really just kind of playing around the margins unless you're just going to focus on acquisitions, which is one way of doing it, I guess. But it seems to me this is a potentially much better use of the cash.

Moz Afzal:

So let's talk a little bit about this, I guess, equity leadership we're seeing with AI. What are your thoughts around that? What sort of cracks are you looking for to kind of say, "Well, this trade is now over."

Jason Trennert:

Yeah, well, so I think personally that the thing I'm focused most on really is long-term interest rates because the earnings growth is there, right? The spending is there and there's not a lot of signs that that's going to stop anytime soon, especially given again, the growth and earnings that you're seeing. The only thing that could potentially stop it, it seems to me, is significantly higher interest rates to the extent to which some of the companies that are buying these products as opposed to investing in them are very long duration stocks and they are very long duration companies who need lower interest rates to sustain themselves. So to me, that is one of the biggest drivers of a continuation of this trade.

Now, there's no two ways about it. There is enormous concentration risk. The top 10 stocks in the US are about 40% of the S&P 500. Now, if you look at the tech sector alone, there's broad earning support for the sector, which is to say that the sector is 35% of the index and the earnings are 35% of the indexes earnings. So that's a pretty strong indication, very different than 99 or 2000. I do think semiconductors in some ways are a little bit ... I view it as almost the new transportation index. I like to see the NASDAQ being validated by the semiconductor index, just like I like to see the industrials validated by transportation and I think one leads the other. And right now, even though the semi industry looks a little overheated, I think it is in many ways just reflecting the reality of the fact that everyone almost feels like they're too late on this technology and that they have ... It's an imperative for them to spend more money. The other thing I'm watching is for AI in general is regulation because it's becoming such a big part of the economy, it's becoming political to a certain extent and that always worries me.

Moz Afzal:

Yeah. No, it's a good point. Certainly state by state, there seems to be sort of coming together on that as well and so far the narrative has been, well, we need to compete with China, we need to compete globally. And so regulating now means danger in a sense of just giving the lead to someone else and you've got to balance that at some point with regulation because it could be, as we've seen with methos and Anthropic throwing things out every week, that some of these things could be quite dangerous. So let's move on to, I guess within the same vein is sort of deglobalization or populism, what are your thoughts of that? I know you have some interesting thoughts around that.

Jason Trennert:

Yeah, this is something, and again, this is a ... I'm going to apologise to your listeners. This is a very American view as an American, but I think that the reason why, in my opinion, populism is winning, let's say, or Donald Trump winning to me wasn't as surprising as it seemed to be for a lot of people, because it goes back to kind of what the average person thinks, not what the elite think. And I think the international rules-based order that provided the baseline for policy globally since the end of World War II, I think there's obviously just been a lot of questions about how good it's been for the average person in the middle of the country that doesn't really benefit from globalisation directly, might benefit from cheaper cost of goods, but has given some back in terms of jobs. And I think there's been a lot of other things from both the left and the right where the elites told regular people that it would be good for them and it didn't wind up being good for them.

In the United States, we're seeing the extremes on both sides win some of these local elections. I live in New York City and the mayor of this town is a vowed and unapologetic socialist and is singling out people like Ken Griffin and all the rest of it. So there's that. And so I think that deglobalization, again, is one of these things that's generally seen as being good for people that are very well educated and part of the knowledge economy and not so good for the rest of us. And so I think also there's another idea within the United States is that maybe other countries have been free riding on America's willingness to foot the bill for security and so there is that populists are not really known for being fiscally responsible and that's either on the left or the right. They just spend money on different certainly they don't have on different things.

So one of the things about populism that I worry about is that from a longer term perspective, it could be an underlying theme for inflation and higher long-term interest rates. And so also I think in terms of defence spending is another way in which you're going to see strains, continued strains on budgets. So higher interest rates and perhaps more of a bid for hard assets than we've seen in a long time.

Moz Afzal:

Obviously we've seen that already reflected in some certain metals prices and I guess oil prices slightly unique in that respect. So you're saying you see this sort of playing out into higher inflation. I guess the other way to look at it is when you do have big deficits, the US has, UK has, France here in Europe as well is actually having a bit of extra inflation and stronger economic growth is actually not a bad thing. You can deflate away that debt very quickly.

Jason Trennert:

True. Although it does raise the cost of living for, again, people that don't benefit necessarily. But I do think in the US there is a chance ... I mean, there's the famous quote that US tends to do the right thing after they try everything else, right? And US tends to get remarkably lucky I think. Now luck could be the residue of design, but right now the one big beautiful bill that President Trump passed, which greatly encourages capital spending along with the capital spending you already have on AI, there is a chance that that offsets, that sterilises some of these inflationary pressures through productivity. And there is, and I'm not so sure enough time has been spent on the potential benefits of all of this CapEx spending that where you could in some ways have your cake and eat it too. You could have pretty strong fiscal spending and by the same token have relatively low inflation.

And so that is a distinct possibility in the US. And the question really is what comes first? There is a little bit of a sense in which I think there's a race between productivity gains and inflation, which is to say if you get the productivity gains in time, actually everything can continue as it is. If inflation shows up before you get the productivity gains, then it puts the Fed in a very difficult position and would put some pressure clearly on the financial markets, but as I see it right now, people are largely ignoring some of these worries about higher inflation because they do feel that this is going to be a revolutionary technology where the US is leading, but that's where we stand on that. Again, I think people should spend more time on what could go right as opposed to what could go wrong, recognising the risks political and otherwise.

Moz Afzal:

Yeah, no, certainly. So obviously we have a new chairman appearing in the Federal Reserve and obviously it's going to usher in maybe a new regime and we've already started to see glimmers of what that might look like, both from power and from Warsh interesting enough within their sort of respective species more recently. Why don't you sort of give us the puts and take of Kevin Warsh and what do you think would change under a Warsh governorship over power?

Jason Trennert:

Well, I've been lucky enough to know Kevin for, I don't know, 25 years and I have to say that I was pleasantly shocked at being very honest that he was chosen by President Trump because he has a strong mind of his own, he's an intellectual and it's not necessarily going to be, in my opinion, a rubber stamp of President Trump or any other president. So I think that's a good thing. He has a lot of credibility coming in. He was a former governor, worked at the White House under the Bush administration. So he's got a lot of experience.

I would say that the biggest change is likely the idea that he is going to rely more on interest rates to set monetary policy, the Fed funds rate, as opposed to the use of the balance sheet. And he believes, as I do, there have been a lot of negative unintended consequences of QE forever. I don't think anyone disagrees with the idea that QE in the context of the global financial crisis was the right thing to do. It was really the continued use of quantitative easing for another 14 years that created some of these distortions and misallocation of capital. It also I think fits in this idea of populism because the benefits, in my opinion, were clearly skewed over that period of time towards people with means, people with financial assets, whereas someone living on a fixed income largely got kneecapped in terms of lower interest rates.

So I think that's a good thing. I think at the margin, that probably means that there's probably going to be a little bit more volatility in the markets if you're not always indemnifying people for bad decisions. And not dramatic. I don't think he's going to throw things into reverse, but at the margin he's going to be much more circumspect about using the Fed's power to really shape the outcomes of what happens in the economy. What the Fed is really there to do is to create a condition in which there isn't necessarily an angle in terms of where capital should flow, that there really should be, you should really just create a level playing field in which companies can compete and allocate capital appropriately.

Moz Afzal:

So thinking about maybe kind of flipping back to the market, we obviously have SpaceX coming up for IPO in the next few weeks. Any thoughts on that?

Jason Trennert:

Listen, I think it's ... Now I have to say, this is very fortunate timing because we just had in the United States the Artemis two launch. So there's a fair amount of, just to begin with, there's a fair amount of excitement about space that I haven't seen personally in a while. So you have that. I do think the sector ... SpaceX is creating a lot of interest in the sector at large, right? So you have certain companies that are already public like Rocket Labs or ... And so that have done extraordinarily well, but here, I mean, SpaceX will probably be the largest IPO in history. The thing that also will create some excitement, it seems to me, is that despite the fact that it's a huge IPO, the float is going to be very small. Float is really going to be only, it looks like, something like three to 5% of the market capitalization, which means that there's going to be probably 75 billion will be public, but 1.5 trillion will be private and over time they're going to issue ... It's going to create an artificial shortage of demand for the company. So it's hard not to see that going up meaningfully in the aftermarket, but I do think that there's a general recognition that it ... And I think artificial intelligence has kind of allowed this to happen, that people's imaginations are more engaged now than they've been in a while, which is to say people ... Some of the stuff seems like magic, at least to me. And you say," How is this even possible? "But people are coming to the idea that a lot of things are possible that we never thought were possible before. So there's a fair amount of optimism out there. I don't think it's like a bubble, I really don't, but that may come, but I don't think right now you could make that case.

So I'm quite optimistic on SpaceX, where it's going to land in the sector. In the sectors, no one really quite knows yet, because there are elements of industrials, tech, communications, just in one company. So it'll be hard to figure out until we know, until they tell us what sector it's going to land in. Yeah.

Moz Afzal:

Well, hopefully it comes into the industrials kind of broaden out the market a little bit

Jason Trennert:

I hope so too.

Moz Afzal:

Then just tech. I guess on that point and obviously the further deals coming out, Anthropic probably OpenAI at some point, Anthropic looks like it might squeeze in later this year and obviously we have OpenAI, we have Databricks, we have some really big IPOs coming up in the calendar. I kind of want to get your thoughts on what the dilution impact would be on the broader market because we're talking about, I don't know, just those three or four will be $3 trillion maybe or three and a half trillion dollars of market cap. Do we sell everything before those come into the indices? And obviously I said a small float is probably significant, but it'd be interesting to hear your thoughts.

Jason Trennert:

I wish I had a better answer on that. I have to say right now in the US there's about $8 trillion in money market funds. There is a fair amount of dry powder and I think it's also interesting that these companies are going to come public in the larger mega cap part of the market. Most IPOs come in the small cap and mid cap area where you clearly have to sell something else to buy relatively large IPOs. This, I'm not so sure. And again, I don't want to be overly Pollyannish about it, but just given the sentiment right now, I don't get the sense that a lot of people are going to view these as binary types of trades, which is to say that they have to sell something else in order to buy SpaceX or OpenAI. I mean, that's the sense I'm getting right now, which is just to say that the asset allocations will probably reflect just a greater allocation to equities as opposed to some dilution within the equity allocation itself. Again, I hate to be almost embarrassed to be so optimistic, but that's just the sense I'm getting by looking at what's going on in the markets right now.

Moz Afzal:

I was going to say the other correlate to that is that the US equity weight within say MSCI world or of the global indices will get even more concentrated and that certainly becomes a much more of a challenge certainly in Europe and Asia and other parts of the market. I hear a lot more companies telling us, "Well, we have some really important ones from the UK listing or relisting in the United States." You can't keep thinking that there's only going to be one market left that's actually going to matter and the US market because everyone lists even European companies there or international companies. And so yeah, for me, it certainly has some very interesting implications for the global money management industry as we move forward. Well, Jason, our time is up, I'm afraid, but it was a fascinating and interesting conversation as ever. Anyway, very good to see you after some time. Hopefully I get out to the States and meet you. And of course, I know you're coming out later this year, so we look forward to seeing you then.

Jason Trennert:

Yeah, I can't wait. I miss London. I miss you guys. Look forward to seeing you in your offices, hopefully sometime this fall. So thanks a lot.

Moz Afzal:

Thank you. So that wraps us up for the podcast today. You're listening to Beyond the Benchmark, the EFG podcast, and my name is Moz Afzal. Thank you very much for listening.

 

 

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