Dec 5, 2023

Dislocation remains a frustrating theme for financial markets.

For instance, the benchmark S&P 500 has rallied almost 20% year to date with much of the performance attributed to a handful technology behemoths while both the average and median stocks within the index lag meaningfully. The outsized performance of this technology sliver manifests in the Nasdaq 100 Index which is up nearly 45% year to date.

Much of this year's constructive economic resilience carried with it the hope that a broader market recovery would spread from the technology leaders and into the smaller cap names of the Russell 2000 and the more economically sensitive Dow Jones Industrials. These broader measures are only up about 5% and 9%, respectively, on the year.

Interestingly, this performance disparity remains even with the recent year-end rally which is largely underpinned by the expectation of lower interest rates and an economic soft-landing. Thus, we see a tremendous dislocation between the over-owned technology kings and the forgotten stocks of nearly every other index that is not the Nasdaq100.

A soft-landing should be the tide that lifts all boats. Yet, the market continues to find safe harbor in just a few large cap tech shares even though the market is bought all in on early rate cuts and a soft-landing kick save by the Federal Reserve.

While we cannot call the concentration in tech irrationality, we do observe similar instances tend not to sustain and often end with meaningful asset re-pricings when the party is over. Were the market to rotate out of its few winners and into the many laggards, such a rotation would likely be one of the most opportunistic "fat pitches" in recent memory. Despite the market re-pricing a more benign interest rate outlook, this rotation has failed to take hold. Failure to do so suggests the market remains skeptical of the economic resilience and soft-landing narratives of the consensus. Thus, the dislocation has failed to resolve so we must ask why.

The failure to resolve suggests the safety trade in big tech reflects a higher probability of systemic risk into 2024. Earlier this year, much of the forecasting consensus penned in a '23 recession as the lag effects of interest rate hikes did their work. The cycle was likely to resolve with a recovery starting later in 2024 which the market would discount favorably by a few months so the pain trade of '23 would be a buy sometime in '24.

Instead, the recession calls failed thanks to an unexpected fiscal splurge of pro-cyclical deficits and a liquidity surprise engineered by the US Treasury and the Federal Reserve - all of which more than offset the monetary policy tightening. Markets correctly re-priced for this surprising stimulus, however, markets were selective.

While Treasury markets improved in recent weeks, their risk profile measured via term premiums reflects fiscal concerns. Thus, the bond market has pushed back on the fiscal profligacy and the equity markets remain narrow, suggesting the fiscal largesse is not spreading to the rest of the economy, leaving smaller stocks and many industries currently out of the market's favor.

Could such a dislocation be sustained in coming months? Sure. Does such a dislocation suggest markets see fiscal risks rising in the next year? We think so and would note the recent

fiscal borrowing of 2023 largely came from excess funds in money markets which bid short-dated treasury bills.

To be fair this source of funds remains around $800 billion, but it is down from $2.5 trillion. If this drains to zero, Treasury financing runs the risk of sourcing from longer-duration money pools and excess reserves of the private sector. The risk of "crowding out" by government spending out may explain some of the equity market dislocation. So we will be watching the situation closely as the short-term funding pool continues to drain.

While this drain is a risk, imaginably the monetary authorities tend to maintain the financial plumbing at all costs. The main tool for such maintenance is Quantitative Easing which indirectly underwrites the fiscal debt servicing and provides market stability as private debts, regardless of interest rates, find a supply of currency to refinance their debts.

Financial assets tend to rally on QE however, the lift stems from a redenomination that makes real returns less favorable given the monetary inflation. Moreover, such inflation is contained to asset markets and unable to leak into the broader economy - thus the big tech vs the rest dislocation reflects the realization of policy distortion.

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