From December sixteenth, two thousand twenty-four to December twentieth, two thousand twenty-four

I. Foundation 

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

On- and off-balance-sheet migration of debt

As a way to resolve debt, moving it on or off the balance sheet can have some effect, but its substantive impact is not direct.

Moving debt between on- and off-balance-sheet items can help resolve debt to some extent because, in general, the interest cost of off-balance-sheet debt is higher than that of on-balance-sheet debt. Therefore, even if this migration does not reduce total debt, it lowers debt costs and can thereby release some cash flow during the debt-resolution cycle for current payroll or expense payments.

On the other hand, the substantive impact of moving debt between on- and off-balance-sheet items is not very significant. First, the actual amount saved through lower interest costs is small relative to total debt, and in an economy with a total size of 123 trillion, the annual savings from this component are less than 800 hundred million. Second, low interest rates are not cost-free in themselves, because The creditors for this debt are mainly the banking system within the economy, so reducing the cost of servicing off-balance-sheet debt correspondingly reduces the banking system’s revenue.。

If the banking system is capitalized independently, this transfer means an actual transfer of funds from the banking system to the entity responsible for debt resolution.

If the banking system itself also needs a capital injection, the result will be that the entity responsible for debt resolution saves some funds, while almost the same amount of those savings is offset by the funds that need to be injected into the banking system, leaving the economy without any substantive fundamental change.

2024.12.19

II. Insights 

Our Viewpoints and ideas on market.

Post-cycle trading: not a new cycle, but an extension of the current cycle

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 of several hundred basis points. The current environment does not have these features.

The pace of earnings growth is an important clue for determining where the business cycle stands.

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 fluctuation, with more pronounced swings in their troughs and peaks.

Chart: The current pickup in earnings growth 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.

During labor cycles accompanied by rising unemployment, shown by the dashed circles in the chart above, earnings troughs are usually deeper. When the labor market has not experienced a material shock (solid circles), the troughs are shallower.

The current Inflection Point (earnings growth turning point) is rebounding 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 continuation of the late cycle.

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

The late-cycle boom in technology equipment spending in the 1990s drove earnings growth but did not 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 large-scale 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, and these companies benefit from AI capital expenditure, cost reductions, and improved operating efficiency.

Chart: Repost the chart from yesterday’s Weekly Wrap

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

Chart: Relative performance of equal-weighted indices has not shown sustainable growth

Looking at forward-looking indicators of earnings growth, the EPS growth of small caps and lower-quality companies (Lower Quality Areas) has also bottomed, but its rebound has been noticeably weaker than that of the S&P 500. This further confirms that the current environment is still in the late cycle:

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

Probably, but the center of gravity for earnings growth will still tilt toward Large Caps, and this growth may be more Idiosyncratic than the market consensus suggests, which means it is better to focus on higher-earnings-quality cyclical stocks (Quality Cyclicals) than to chase lower-quality cyclicals，The latter’s performance often depends on larger adjustments in interest rates and labor costs, and these conditions are not yet fully in place in the current macro environment.

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

Yesterday’s Weekly Wrap for last week (if you haven’t read it, you definitely should!)also discussed our concerns about the current market breadth. The late-cycle setting means that large caps will undoubtedly be the first to benefit as participation broadens, If nothing else new emerges, the small-cap trade may have run its course after this Trump-driven rally.

2024.12.16

A historic rally in Chinese government bonds

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

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

 Chart: As 12 begins, CGB yields and Repo IRS break through key levels, with a powerful rally

The sharp rally began with the announcement of the interest-rate self-discipline mechanism, with policy signals clearly indicating that monetary policy would shift toward “moderately accommodative.” The subsequent Politburo meeting and Central Economic Work Conference further confirmed this stance, We said before the meetings that rather than keeping our eyes on policy texts, we should watch the bond market, which was beginning another sustained one-way move.

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

In September, the market still had high hopes for fiscal policy and focused mainly on fiscal stimulus, leading to a bear steepening of the curve (long-end yields rose). This time, the move is driven purely by monetary policy, and expectations for 2025-year 7d OMO rates and a RRR cut of 50bps are now fully priced in.

 Chart: The comparison between CGB yields at 10 years and 7D OMO rates indicates that the market expects more rate cuts

Another interesting event occurred from late 11 to early 12.

At the time, the CNH DF curve corrected significantly. In particular, after Trump’s election victory, the front-end DF failed to break convincingly above its annual high.On 12 10, buying emerged during the London session and pushed the curve higher. T/N (Tom Next, or overnight swap) rose particularly quickly, and 12 11 saw an unusual price move.

 Chart: The front end DF failed to break decisively above YTD highs 

The market’s unusual volatility sparked broad buying interest.

The move was amplified by rumors:Chinese policymakers were reportedly considering allowing the renminbi to depreciate in 2025 to respond to the resumption of Trump tariffs. The news immediately sent USDCNH (the offshore renminbi exchange rate against the U.S. dollar) surging to 7.29, pushed T/N prices up to +2, and drove short-term implied yields for 1 months up 80bps to 3.2%.

Put simply, this means Over these few days, concerns about renminbi depreciation triggered urgent hedging operations, making renminbi funding scarce and pushing up short-term funding costs (that is, T/N).

That evening, a media outlet affiliated with the central bank issued 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 high twice but failed to break through. Profit-taking then emerged, and the curve corrected rapidly.

Chart: The offshore-onshore 1y swap spread has widened to its April highs

However, T/N remained firm, at one point reaching +12 during the London session, reflecting a widening divergence in market views on short-term renminbi funding conditions, while the rise in T/N was driven more by the Politburo meeting. The positive signals from the meeting attracted overseas capital into Chinese equities.

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

T/N volatility reflects short-term changes in supply and demand in the renminbi funding market. This episode, however, was influenced not only by exchange-rate rumors but also closely linked to capital flows in Chinese equities. Whenever expectations of renminbi weakness emerge and inflows into equities slow, T/N fluctuates significantly, reflecting rapid shifts in market sentiment.

The final question is whether the rates market has rallied too far, and how should we view what comes next?

The market’s point of divergence is:On one hand, bond-market yields have fallen rapidly in the short term by 20-30bps and are already close to historical lows. Some investors are beginning to worry that the PBoC will suppress the one-way rally, as it did this summer. On the other hand, the low-rate policy stance is now clear, and there is still room for future rate cuts.

Historically, the spread between the CGB yield at 10 years and the OMO rate at 7d is usually around 50bps.

If OMO at 7d is indeed cut by 50bps in 2025, then CGB at 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 rally, but the short-term rise has been too rapid and pressure from profit-taking is increasing. Chasing the rally at current levels calls for greater caution and waiting for a better entry point.

2024.12.17

U.S. equities are overvalued from a macro perspective

The S&P 500 has risen YTD by 27% this year, and is relatively close to historical highs both in absolute terms and in terms of macro-consistent valuation.

Macro valuation (that is, a measure of whether equity valuations are high or low relative to macroeconomic drivers) is more useful than valuation metrics alone, because everyone has a different idea of value, whereas spreads are plainly observable.

GS previously introduced a macro valuation model (Macro and Equity Valuations: Tailwinds Behind, Headwinds Ahead) (also posted to our community), which showed that the 10Y Treasury yield, the unemployment rate, and core inflation—the three key variables, along with a slowly changing demographic variable—can explain the valuation trend of the S&P 500 well, and current valuations diverge significantly from the model’s expectations, surpassed only by the internet bubble of the late 90s.

Chart: According to GS's model, the U.S. equity market is actually overvalued relative to the macro 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 favorable macro scenario in which bond yields fall over the next 12 months, core inflation declines, and the unemployment rate remains low, these factors would add only about 4% to real returns in the model, while high valuations would be a drag of 7%.

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

High valuations alone are not really 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 the negative impact of high valuations on the market is more pronounced when the economy deteriorates.

2025 is marked by high uncertainty, particularly risks related to policies that may be introduced by the incoming administration. A comprehensive tariff policy is one of the biggest tail risks; if implemented, it could significantly push up core inflation, weigh on GDP growth, and raise the unemployment rate.

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

Chart: Implied volatility on DM stocks and some foreign exchange pairs is near the low end of its historical range

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

The market has already made some cyclical upward revisions to US growth, 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 members of our community to pay attention to the downside tail risks from valuation overstretch.

Especially when the market challenges the prevailing optimistic macro expectations, such as through policy risks or a deterioration in growth expectations, the emergence of such risks could make the market correction 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 cannot support the pullback

At the start of 12, futures demand unexpectedly recovered despite continued weakness in the Russell 2k index.

According to Commitment of Traders (COT) data, net buying between 3 and 10 12 totaled 21 hundred million dollars, driven mainly by new long positions. This demand extended the 7.15-hundred-million-dollar increase in positioning from the previous week.However, as prices fell further, these newly established long positions faced the risk of deeper unrealized losses and urgently needed support from the Fed or market sentiment to prevent further deterioration.

Specifically, from 12 3 to 10, the Russell 2k fell -1.4%, underperforming the S&P 500 (-0.2%) and Nasdaq (+0.7%). Despite this, long-position additions were significant: 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, while only Non-Reportable accounts trimmed positions slightly, by 3500 ten thousand dollars. This inflow was consistent with the relative change in the funding differential. Over the same period, the Russell 2k’s funding cost showed a persistent discount advantage versus the S&P 500.

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

Before 12 16, Russell 2k funding performance was steadily improving on both an absolute basis and relative to benchmarks, with its discount at one point reaching a level not seen in over 1 years. But this advantage reversed sharply on 12 17, with a one-day drop among the largest since 2024, partly due to liquidity fluctuations from quarterly futures rolls.

At this stage, recently established long positions face significant challenges Without further positive macroeconomic developments or Fed support, these positions could move further underwater.As of now, the Russell 2k funding discount versus the S&P 500 remains about 20bps higher than at the start of the month. Given recent flows and basis changes, The market’s negative outlook for the Russell 2k may take longer to adjust.

We also discussed the performance of the various market indices in our community’s U.S. equities group:

Original discussion link:https://www.meridianresearch.app/notes/dfb3102a-6e96-4576-b33f-25a7238a079cView note

Chart: Russell 2k 3 Month Funding vs Fed Funds

Chart: Russell 2k vs S&P Funding

2024.12.18

What We Are Seeing Post FOMC

Powell’s hawkish stance weighed on markets, yields rose sharply, and curves bear-steepened; U.S. equities weakened across the board, with Bitcoin-sensitive sectors suffering the steepest losses (-11.29%), while Non-Profitable Tech fell 6.38%. VIX rose to 19, credit spreads widened, and expectations for 2024 rate cuts in FED were revised down further; fewer than two cuts are now priced in (-31.5bps).

There were two particularly important points in the meeting:

1. “In developing new projections, ‘some people did take a very preliminary step and start to incorporate highly conditional estimates of economic effects of policies into their forecasts at this meeting,’ Powell said…”

In developing new economic projections, some members of the Federal Reserve took preliminary steps to incorporate the potential effects of certain policies on the economy into their forecasts. These estimates are Highly conditionalThey, indicating that the projections carry considerable uncertainty and that the specific effects depend on the policies’ actual implementation and the economy’s response.

2. ”…of an outlook in which U.S. central bankers anticipated a higher inflation outlook and fewer rate cuts next year.”

Against this backdrop of projections, The Federal Reserve expects inflation to be higher in the future, while the anticipated number of rate cuts may be lower.

Powell sent a clear signal: fighting inflation takes priority over growth.

1) Inflation expectations deteriorated: the Fed raised its forecast for 2025 core PCE from 2.1% to 2.5%, while lowering its unemployment-rate (U3) forecast to 4.3% (previously 4.4%). This suggests that policy may remain restrictive longer than the market expects.

2) Policy maintains a “high bar”: the statement specifically mentioned “the extent and timing of additional adjustments,” suggesting that the policy path ahead may remain unchanged unless inflation or employment data improve significantly.

3) Rate-cut expectations narrow: the market is currently pricing in fewer than two rate cuts for 2024 (-31.5bps),Powell emphasized that policy was “restrictive” as many as 10 times, further curbing expectations of easing.

Chart: After Powell, only 31.5 bps of FED cuts are now priced in for the whole of next year

Two direct market consequences.

1) U.S. Treasury yields surge:The yield curve bear-steepened at both the short and long ends, with the 10-year and 30-year yields breaking post-election highs and becoming a major obstacle to further stock-market gains. The front-end adjustment (Dec SOFR) is nearing its end, but rising long-term yields are putting pressure on high valuations.

2) Santa Rally faces headwinds:The market had previously expected a “Santa Rally” at year-end, but this hawkish turn has significantly raised the bar for the rally to continue. Current SPX valuations of 22x require a combination of easier policy and a strong economy, while the adjustment in FOMC has weakened that possibility.

Overall, although technical factors still provide support (inflows + long gamma), and a subsequent stabilization in VIX could benefit a short-term rebound, but The likelihood of the market reaching new highs has fallen substantially.With the Fed continuing to emphasize that fighting inflation takes priority, further gains may require stronger economic and policy catalysts. After a strong year-to-date performance, a more cautious stance should be adopted.

2024.12.19

BOJ decision: genuinely unexpected

The BoJ’s decision yesterday surprised the market. Recent economic data have been strong, downside risks to the U.S. economy have fallen significantly, and the Fed’s overall stance has shifted. The market broadly expected the Bank of Japan to raise rates at this meeting, but the BoJ ultimately decided to leave rates unchanged.

Ueda emphasized at the press conference that the main reasons for delaying the rate hike were the desire to confirm the momentum in wage growth before next spring’s wage negotiations, as well as uncertainty surrounding the incoming U.S. administration.As for wage growth, the data cannot be confirmed until 3 next year at the earliest, or even later, so this point remains quite vague. Ueda offered no clear path for resolving the uncertainty around the new U.S. administration’s policies, which also leaves the market questioning the forward guidance for future BoJ policy.

He also said the BoJ did not need to wait for specific data to make a decision, but did not further explain the criteria for that judgment or make a clear commitment about the timing of future decisions.

The yen depreciated sharply during the policy meeting, and its accelerating decline at the press conference prompted questions from reporters. Ueda responded that the effects of exchange rates would be considered, particularly their implications for the stability of import prices. Even so, Ueda said current data trends were positive and that “a little more” information was needed before making a rate-hike decision, implying that a hike remains on the way.

Our view has consistently been that a rate hike by BOJ is highly likely to come in January next year. There is considerable uncertainty, but it probably will not be delayed further.From the perspective of policy communication, this BoJ decision will undoubtedly undermine the market’s confidence in its transparency; in effect, it draws down its credibility.

Trading the yen’s continued depreciation is essentially trading this erosion of credibility because the market will have substantial doubts about BOJ from this point onward.

The yen’s one-way depreciation trade has two resistance points. The first is verbal intervention by Japan’s Ministry of Finance (MoF); the second, more than two hours later, is when actual intervention takes place.

Single equities on the Nikkei have barely moved, and yen depreciation has a positive effect on Nikkei trading. The market continues to favor sectors that benefit from the BoJ’s dovish policy, such as real estate, exporters, highly leveraged companies, and tourism. With rate hikes delayed, banks and financial stocks continue to be sold, Before January, trading largely followed this logic: cyclical sectors > defensive sectors, large caps > small and mid caps.

As for the yen, the market’s pricing for January is actually not as high as we expected, which means trades chasing further depreciation will continue to persist. The next target level for intervention from Japan could be around 160.

Note that liquidity in the Japanese market may tighten from next week, especially starting 12 24. Each year, this imbalance coincides with Japan’s repo blackout period (the final 5 trading days of each quarter), which can affect the market’s supply-demand balance and increase short-term volatility risk.

2024.12.20

Note: All content in this article is for reference only, does not constitute investment advice, and is not a basis for any laws, regulations, or regulatory policies. Investors should not use or rely on this information as a basis for their decisions.