The Silver Bullet - No. 10

Buy the Tails

Keep your eye on one thing and one thing only: how much government is spending, because that's the true tax. There is no such thing as an unbalanced Federal budget: you are paying for it. If you are not paying for it in the form of explicit tax, you're paying for it indirectly in the form of inflation.
- Milton Friedman

Buy the Tails

September 2024

An emergency cut without an emergency. The Fed shifted its reaction function to the extreme dovish side, as it cut in the face of stable jobless claims, and near record market valuations.

Investors cheered the Fed reaction, as valuations increased further. The logical conclusion is: if the Fed cuts 50bps during good times, that means they are ready to support markets during the bad.

Put simply: the goldilocks party is on, and everyone’s invited. The problem is, the party’s a bit crowded and the music might stop, eventually. A soft landing is the consensus view amongst nearly 80% of investors and is now nearly fully priced into risk assets. What’s mispriced are the tails.

Starting from the current situation of a soft landing, with disinflation and resilient growth, the scenarios for the next year can be widely divergent. On the one tail, both Democrats and Republicans have promised to keep spending. A Republican sweep could deliver a rapid fiscal boost to the US economy, boosting inflation together with tariffs on imports. But the Democrats, too, are likely to continue fiscal handouts to the poorest consumers, which have proven to be more inflationary than tax cuts. On the other tail, a divided Congress could fail to deliver enough stimulus to extend the cycle, pushing growth lower and increasing the probability of a recession.

In today’s new geopolitical environment, low inflation and solid growth are a fragile equilibrium that will be tested over the coming months. The clock is ticking.