December sixteenth, two thousand twenty-four

I. Foundation

resistance to change and hence greater dependability for the results shown in the past.

II. Insights

Our Viewpoints and ideas on market.

On late-cycle trading: not a new cycle, but an extension of the current one

Fed rate cuts and stable business-cycle indicators will drive more balanced growth and performance across the U.S. equity market in 2025, but this balanced growth may be concentrated more in Large Caps than in small caps. Historical experience shows that sustained small-cap outperformance usually occurs in an Early Cycle Environment, accompanied by the end of the labor cycle and rate cuts totaling several hundred basis points. The current environment does not have these characteristics.

The pace of earnings growth is an important clue for determining which stage of the business cycle we are in

S&P 500’s EPS Growth typically bottoms at one of two levels, near 0%, or between -15% and -25%; small caps have a wider range of volatility, with more pronounced movements in troughs and peaks.

Chart: The current Earnings Growth Picking Up began at 0, a feature of a late-cycle extension

The key to determining which kind of bottom forms is whether the labor cycle shocks the economy

When the labor cycle goes through a period of rising unemployment, earnings bottoms, shown by the dashed circles in the chart above, are usually deeper. If the labor market experiences no material shock (solid circles), the bottom is shallower.

The current Inflection Point (the turning point in earnings growth) has rebounded from near the zero line, meaning it has not been dragged down by the unemployment cycle and indicating that the current economic cycle has not ended but has continued along its expansion path. In other words, This is Growth Acceleration after a “soft landing.”

However, it is worth noting that, because the labor market remains tight, this renewed acceleration in earnings growth today may be a typical Late Cycle Extension, that is, a late-cycle continuation.

Historically, earnings growth accelerations of this kind in the late cycle have usually been determined by the unique drivers of a particular cycle

The overheating of technology equipment spending in the late 1990s boosted earnings growth but failed to persist as it spread through the economy; the rebound after the earnings trough in 2015 benefited from a global growth recovery driven by China’s massive fiscal stimulus and a boost from U.S. tax reform in 2017.

In the current cycle, the recovery in earnings growth depends more on a small group of Large Cap, Quality Names, these companies benefit from AI capital expenditure, cost reductions, and improved operating efficiency.

Chart: Reposting the chart from yesterday’s Weekly Wrap

The ratio of the S&P 500 equal-weighted index to its market-cap-weighted index is a typical snapshot of this trend, this ratio has consistently reflected late-cycle market characteristics over the past few years. Although the market rebounded this summer from its “recession scare” lows, the ratio has recently started to decline again, suggesting that a broadening of earnings growth may be more a 2025 story than something achievable in the fourth quarter of 2024.

Chart: No sustained growth in equal-weighted relative performance

Forward-looking indicators of earnings growth show that EPS growth among small caps and lower-quality companies (Lower Quality Areas) has also bottomed, but its rebound has been clearly weaker than that of the S&P 500. This This further confirms that we are still in a late-cycle environment:

At this stage, profits are harder to come by for lower-quality companies, higher price levels, persistent labor-cost pressures, and rising real interest rates leave a core question to answer: can relative earnings growth for ordinary companies accelerate again?

Most likely yes, but the center of gravity for earnings growth will still lean toward Large Caps, and this growth may be more Idiosyncratic than the market consensus expects, meaning it is better to focus on cyclical stocks with higher earnings quality (Quality Cyclicals) than to chase lower-quality cyclical stocks，The performance of the latter often depends on larger adjustments in interest rates and labor costs, conditions that are not yet fully in place in the current macro environment.

The broadening of earnings growth across the market is still at an early stage. In the short term, the main drivers of earnings recovery remain concentrated in high-quality companies with advantages in pricing power, cost control, and efficiency gains. Be alert to the relative disadvantages of lower-quality companies caused by structural constraints such as high costs and access to capital, and prioritize allocating resources to companies that can generate excess returns through innovation and operating leverage in the current environment. This divergence is a typical feature of the late cycle.

The Weekly Wrap for last week, published yesterday (if you haven’t read it, you definitely should!!)It also discussed our concerns about current market breadth. A late-cycle environment means that large caps will certainly be the first to benefit as participation broadens, If nothing new emerges, the small-cap trade may be just about over once this Trump-driven wave has played out.

2024.12.16

The historic rally in Chinese government bonds

Since 12, Chinese government bonds have become a global focus and staged a historic rally.

The 10-year government bond yield (CGB 10y) rapidly broke below key support, falling successively below 2.0% and 1.8% and heading straight for 1.7%; the 30-year government bond yield also fell below the 2% threshold last Friday.

Chart: Entering 12, CGB yields and Repo IRS broke through key levels, with a powerful rally

The major rally began with the announcement of the interest-rate self-regulatory mechanism, the policy signal clearly indicated that monetary policy would shift toward “moderate easing,” and subsequent Politburo and economic-work conferences further confirmed this tone, We pointed out before the meetings: rather than focusing on policy texts, it is better to keep an eye on the bond market as it resumes a one-way trend.

Importantly, this rally differs in many ways from the one in 9.

In September, the market still had high hopes for fiscal policy, focusing mainly on fiscal stimulus, which led to a bear steepening of the curve (long-end yields rose). This time, the move is driven solely by monetary policy, and expectations for 2025 7d OMO rates and RRR 50bps cuts have become fully established in the market.

Chart: The comparison between the 10-year CGB yield and the 7D OMO rate shows that the market expects more rate cuts to come

Another interesting development occurred from the end of 11 to the beginning of 12.

At the time, the CNH DF curve corrected significantly. In particular, after Trump’s election victory, the front end DF failed to break above its annual highs convincingly.On 12 10, buying emerged during the London session and pushed the curve higher. T/N (Tom Next, or overnight swap) rose rapidly in particular, and on 12 11 there was an unusually sharp price move.

Chart: Front end DF failed to substantially break YTD highs

The market’s unusual volatility triggered widespread buying interest.

This move was amplified by rumors:It was said that Chinese policymakers were considering allowing the renminbi to depreciate in 2025 in response to the resumption of Trump tariffs. The news immediately sent USDCNH (the offshore renminbi-U.S. dollar exchange rate) soaring to 7.29, pushed T/N prices all the way up to +2, and drove the implied yield on short-term 1-month funding up 80bps to 3.2%.

Put simply, what this means is Over these few days, concerns about renminbi depreciation triggered urgent defensive hedging by the market, renminbi funding became scarce, pushing up short-term funding costs (that is, T/N).

That evening, an outlet affiliated with the central bank published a denial, stressing that “the renminbi exchange rate has a stable foundation.” The USDCNH exchange rate then fell back, but the DF curve remained firm.On 12 12 and 13, the front-end curve tested its annual highs twice but failed to break through either time. Profit-taking then emerged, and the curve quickly corrected.

Chart: Offshore-onshore 1y swap has widened to April highs

However, T/N remained firm, touching +12 at one point during the London session, reflecting growing market divergence over near-term renminbi funding conditions And T/N’s rise was driven more by the boost from the Politburo meeting; its positive signals attracted overseas capital into Chinese equities.

But as Chinese equities weakened after the Central Economic Work Conference, sentiment turned, capital flows slowed, and T/N fell back to around +0.5; the DF curve also moved lower.

T/N fluctuations reflect short-term changes in supply and demand in the renminbi funding market. This episode, however, was driven not only by currency rumors but also closely linked to capital flows in Chinese equities. When expectations of renminbi weakness emerge and inflows into equities slow, T/N can fluctuate sharply, reflecting rapid shifts in market sentiment.

The final question is whether the rates market has rallied too far. How should we view the outlook?

The point of disagreement in the market is this:On the one hand, bond-market yields have fallen rapidly over a short period20-30bps and are already near historical lows. Some investors are beginning to worry that the PBoC will suppress a one-way rally (as it did this summer). On the other hand, the low-rate policy stance is clear, and room for further rate cuts remains.

Historically, the spread between the 10-year CGB yield and the 7-day OMO rate has typically been around 50bps.

If the 7-day OMO rate is indeed cut by 50bps in 2025, then CGB in 10 still has some room to fall, but the risk-reward at current levels is no longer as attractive as before.The bond market still has some room to rise, but its short-term rally has been too rapid and pressure to take profits is building. Chasing the rally at current levels calls for greater caution; wait for a better entry point.

2024.12.17

U.S. equities are overvalued from a macro perspective

S&P 500 has risen 27% this year YTD; both its absolute level and its macro-consistent valuation are relatively close to historical highs.

Macro valuation (a measure of whether equity valuations are high or low relative to macroeconomic drivers) is more useful than a simple valuation metric, because everyone has a different idea of value, whereas the spread is plain to see.

GS previously introduced a macro valuation model (Macro and Equity Valuations: Tailwinds Behind, Headwinds Ahead) (also posted in the community) showing that The three core variables—10Y Treasury yield, unemployment rate, and core inflation—plus a slowly changing demographic variable, explain S&P 500 valuation trends well, with current valuations deviating significantly from the model’s expectations, exceeded only by the internet bubble at the end of the 90s.

Chart: The model’s forecast based on GS shows that U.S. equities are in fact overvalued relative to the macroeconomic backdrop

The market may be pricing in productivity growth driven by AI ahead of time, but this rationale has not yet shown up in clear earnings growth. Excluding this optimistic assumption, current valuations remain overstretched.Even under a positive macro scenario in which bond yields fall, core inflation eases, and the unemployment rate remains low over the next 12 months, the model attributes only about 4% of improvement in real returns to these factors, while high valuations would be a drag of 7%.

This means nominal returns in 2025 may be only around 4%, leaving little room for further beta expansion.

High valuations alone are not the problem, the key is that in this situation, any negative effects will be amplified during an economic downturn:

Chart: High valuations make the market more vulnerable to cyclical deterioration

History shows that high valuations have a more pronounced negative impact on the market when the economy deteriorates.

2025 is a year of considerable uncertainty, particularly around risks related to policies the new administration may introduce. Broad tariffs are one of the biggest tail risks; if implemented, they could significantly push up core inflation, weigh on GDP growth, and raise the unemployment rate.

According to the model, in this scenario U.S. equities could face a high-single-digit decline. Even if bond yields fall under pressure, the hedging effect would be limited.

Chart: Implied volatility in DM equities and some currencies is near the bottom of its historical range

Implied volatility in developed-market equities has fallen back to the lower end of its historical range, reflecting reduced market expectations of short-term volatility risk. Implied volatility in some major currency pairs shows a similar trend, especially for currencies supported by policy stability and macroeconomic factors.This low-volatility environment may make markets more sensitive to unexpected events; if an external shock occurs, volatility could rebound rapidly.

The market has already revised US growth upward to some extent over the cycle, but the economy’s proximity to “full capacity” means there is limited room for further upside. Although the macro outlook supports the baseline case for being long US equities, we want our community members to pay attention to the downside tail risks from valuation overstretch.

This is especially true when the market challenges the prevailing optimistic macro outlook (for example, because of policy risks or deteriorating growth expectations); if such risks emerge, the market correction could be more severe.

USD can serve as a bet on US growth outperformance while also providing a natural hedge against potential policy tail risks (such as tariffs or higher US rates).

2024.12.18

III. Market Pulse

Our latest Comments on the economic and market environment

Russell 2k Futures: Demand fails to support a rebound

At the start of 12, futures demand unexpectedly recovered even as the Russell 2k index remained persistently weak.

According to Commitment of Traders (COT) data, net purchases totaled 21 hundred million dollars between 3 and 10 12, driven mainly by new long positions. This demand extended the 7.15 hundred million dollars in position growth from the previous week.However, as prices fall further, these newly established long positions face a risk of deeper unrealized losses and urgently need support from the Fed or market sentiment to prevent further deterioration.

Specifically, from 3 to 10 12, the Russell 2k fell -1.4%, underperforming the S&P 500 (-0.2%) and Nasdaq (+0.7%). Despite this, long positioning increased significantly: Asset Managers (6.4 hundred million dollars), Hedge Funds (10 hundred million dollars), and other categories (4.6 hundred million dollars) were all net buyers; only Non-Reportable accounts modestly reduced positions by 3500 ten thousand dollars. This inflow is consistent with the relative change in the funding differential. Over the same period, Russell 2k funding costs maintained a discount advantage over the S&P 500.

But demand failed to translate into price support.From 10 to 17 12, the Russell 2k fell a further -2%, continuing to underperform the S&P (+0.3%) and Nasdaq (+3%).Notably, although capital flows remained fairly steady during this period, actual performance failed to follow through, suggesting a subtle shift in market sentiment.

Before 12 16, Russell 2k funding performance improved steadily on both an absolute and relative-to-benchmark basis, with its discount at one point reaching a high not seen in more than 1 years. But this advantage reversed sharply on 12 17; the one-day drop was among the largest since 2024, partly because of liquidity fluctuations from the quarterly futures roll.

At this stage, recently established long positions face significant challenges Without further macroeconomic tailwinds or Fed support, these positions could fall further underwater.As of now, the funding discount of Russell 2k versus the S&P 500 remains about 20bps higher than at the start of the month. Together with recent capital flows and basis changes, Market expectations for the Russell 2k to remain weak may take longer to adjust.

We also discussed how the various market indices are performing in our U.S. equities community:

Original discussion link:View note

Chart: Russell 2k 3 Month Funding vs Fed Funds

Chart: Russell 2k vs S&P Funding