December sixteenth, two thousand twenty-four to December nineteenth, two thousand twenty-four

I. Foundation

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

On the migration of debt on and off the balance sheet

As a way to reduce debt, shifting it on or off the balance sheet can help to some extent, but its substantive impact is indirect.

Shifting debt between on- and off-balance-sheet treatment can help reduce debt to some extent because, in general, the interest cost of off-balance-sheet debt is higher than that of on-balance-sheet debt. Thus, even if this shift does not reduce total debt, it lowers debt costs and can free up some cash flow during the debt-reduction cycle to pay current wages or expenses.

On the other hand, the substantive impact of shifting debt between on- and off-balance-sheet treatment is not very significant. First, the actual interest-cost savings are small relative to the total amount of debt; in an economy with an aggregate size of 123 trillion, the annual savings from this component would be less than 800 billion. Second, low interest rates are not cost-free in themselves, because the creditors of the debt are mainly the banking system within the economy. Lowering the debt-service cost of off-balance-sheet debt therefore reduces the banking system’s income accordingly.。

If the banking system is capitalized independently, this shift represents an actual transfer of funds from the banking system to the entity reducing its debt.

But if the banking system itself also needs a capital injection, the result is this: on one hand, the entity reducing its debt saves some money; on the other, those savings are almost entirely offset by the funds that must be injected into the banking system, leaving no fundamental change in the economy.

2024.12.19

II. Insights

Our Viewpoints and ideas on market.

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

Federal Reserve rate cuts and the stabilization of business-cycle indicators will support more balanced growth and performance across the U.S. stock 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 typically 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 characteristics.

The pace of earnings growth is an important clue to where we are in the business cycle.

S&P 500’s EPS Growth typically bottoms at one of two levels— near 0%, or between -15% and -25%. Small caps have greater volatility, with more pronounced swings in troughs and peaks.

Chart: The current pickup in earnings growth began at 0, a characteristic of a late-cycle extension

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

When the labor cycle includes a rise in unemployment, as shown by the dashed circles above, the earnings trough is usually deeper. If the labor market experiences no material shock, as shown by the solid circles, the trough is shallower.

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

However, it is worth noting that, given the continued tightness of the labor market, this renewed acceleration in earnings growth today may be a typical Late Cycle Extension, or post-cycle extension.

Historically, accelerations in earnings growth during this kind of late-cycle phase have usually been driven by forces unique to the particular cycle.

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

In the current cycle, the recovery in earnings growth relies more on a small group of large-cap, high-quality companies; these companies benefit from AI capital expenditures, cost cutting, and improved operating efficiency.

Chart: Reuse 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 classic illustration of this trend; this ratio has consistently reflected late-cycle market characteristics in recent years. Although the market rebounded this summer from its “recession scare” lows, the ratio has recently started falling 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: No sustainable growth in equal-weighted relative performance

Leading indicators of earnings growth suggest that EPS growth among small caps and lower-quality companies has also bottomed, but the rebound has been clearly weaker than for the S&P 500. 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; given higher price levels, persistent labor-cost pressures, and rising real interest rates, the key question is whether earnings growth at ordinary companies can reaccelerate.

Probably, but the center of gravity for earnings growth will still favor large caps, and this growth may be more idiosyncratic than the market consensus suggests, meaning it is better to focus on high-quality cyclicals than to chase low-quality cyclicals，The latter’s performance often depends on larger adjustments in interest rates and labor costs, conditions that are not yet fully in place in the current macroeconomic environment.

The broadening of earnings growth across the market is still in its early stages. 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. Be wary of the relative disadvantages low-quality companies face due to structural constraints such as high costs and access to capital. Prioritize companies that can generate excess returns in the current environment through innovation and operating leverage. This divergence is a typical late-cycle characteristic.

Yesterday’s Weekly Wrap on last week (if you haven’t read it, you definitely should!)also discussed our concerns about current market breadth. A late-cycle environment means large caps are still bound to benefit first as market breadth expands, If nothing else new emerges, the small-cap trade may be about done after this Trump wave.

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 government bond yield (CGB 10y) rapidly broke below key support, successively falling 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: As we enter 12, CGB yields and Repo IRS have broken through key levels, with a powerful rally

The sharp rally began with the announcement by the interest-rate self-regulatory mechanism; the policy signal clearly indicated that monetary policy would shift toward “moderately accommodative,” and subsequent Politburo and Central Economic Work Conference meetings further confirmed this stance, We pointed out before the meetings that, instead of focusing on the policy texts, it was better to keep a close eye on the bond market, which was starting to resume its 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, focusing mainly on fiscal stimulus, which led to a bear steepening of the curve (long-term yields rising). This time, the move is driven solely by monetary policy; market expectations for 2025-year 7d OMO rates and a RRR cut of 50bps have fully taken shape.

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

Another interesting development occurred between the end of 11 and the beginning of 12.

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

Chart: Front end DF failed to substantially break YTD highs

The market’s unusual volatility sparked broad buying interest.

This move was amplified by rumors:Chinese policymakers were reportedly considering allowing the renminbi to depreciate in 2025 in response to the resumption of Trump’s tariffs. The news immediately sent USDCNH (the offshore renminbi exchange rate against the U.S. dollar) surging to 7.29. T/N prices were pushed all the way up to +2, and the implied yield on the short-term 1-month tenor jumped 80bps to 3.2%.

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

That evening, an official channel affiliated with the central bank issued a denial, stressing that “the renminbi exchange rate has a stable foundation.” The USDCNH exchange rate subsequently retreated, but the DF curve remained firm.On 12 12 and 13, the front-end curve tested the annual highs twice but failed to break through either time. 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, reaching +12 at one point during the London session, reflecting widening market disagreement over near-term renminbi funding conditions; T/N’s rise was driven more by the Politburo meeting, whose positive signals 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 fluctuations reflect short-term supply and demand in the renminbi funding market. This episode was influenced not only by currency rumors but also closely linked to capital flows in Chinese equities. When expectations of renminbi weakness emerge and equity inflows slow, T/N can fluctuate significantly, reflecting rapid shifts in market sentiment.

The final question is whether the rally in the interest-rate market has gone too far, and how should we view the outlook?

The market is divided over one point:On one hand, bond yields have fallen rapidly in the short term by 20-30bps and are already near historical lows. Some investors are beginning to worry that the PBoC will suppress a one-way market move, as it did this summer. On the other hand, the low-interest-rate policy stance is clear, and room for further rate cuts remains.

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

If 2025-year 7d OMO really is cut by 50bps, then 10-year CGB 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 upside, but its short-term rally has been too rapid and pressure from profit-taking is building. Chasing the market at current levels calls for greater caution; wait for a better entry point.

2024.12.17

The U.S. stock market is overvalued from a macro perspective

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

Macroeconomic valuation—that is, a measure of whether stock valuations are high or low relative to macroeconomic drivers—is more useful than valuation metrics alone, because everyone has a different answer to what something is worth, whereas price spreads are obvious.

GS previously introduced a macro valuation model (Macro and Equity Valuations: Tailwinds Behind, Headwinds Ahead) (also posted in the community), which showed that the 10Y Treasury yield, unemployment rate, and core inflation—the three key variables, plus a slowly changing demographic variable—can explain the valuation trend of the S&P 500 quite well; current valuations deviate 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. stock market is in fact overvalued relative to the macroeconomic backdrop

The market may be pricing in productivity growth driven by AI in advance, but this thesis has not yet shown up in clear earnings growth. Excluding this optimistic assumption, current valuations remain overstretched.Even under a favorable macroeconomic scenario in which bond yields fall, core inflation declines, and the unemployment rate remains low over the next 12 months, these factors add only about 4% to real returns in the model, while high valuations impose 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 actually a problem, the key is that in this situation any negative effects are amplified during an economic downturn:

Chart: High valuations leave 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 faces considerable uncertainty, particularly risks related to policies that may be introduced by the incoming administration. Broad-based tariffs are one of the largest tail risks; if implemented, they could significantly push up core inflation, put GDP growth under pressure, and raise the unemployment rate.

Model projections suggest that, 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 stocks and some foreign exchange pairs is near the lower end of its historical range

Implied volatility in 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 in some major foreign exchange pairs shows a similar trend, especially for currencies supported by policy stability and macroeconomic factors.This low-volatility environment may increase the market’s sensitivity 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 our friends in the Sphere community to watch for downside tail risks from stretched valuations.

This risk could make a market correction more severe, especially when the market challenges the current optimistic macroeconomic outlook, for example because of policy risks or a deterioration in growth expectations.

USD can serve as a bet on the outperformance of US growth 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 the Pullback

At the beginning of 12, futures demand unexpectedly rebounded despite the continued weakness of the Russell 2k Index.

According to Commitment of Traders (COT) data, net buying between 3 and 10 12 reached 21 hundred million dollars, driven mainly by new long positions. This demand extended the position increase of 7.15 hundred million dollars in the previous week.However, as prices fall further, these newly established long positions face the 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 the 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, the Russell 2k's funding cost showed a persistent discount to 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 the Nasdaq (+3%).Notably, despite relatively steady fund flows during this period, realized performance failed to materialize, indicating a subtle shift in market sentiment.

Before 16 12, the Russell 2k's funding performance improved steadily on both an absolute basis and relative to its benchmark, with its discount briefly reaching a level not seen in over 1 years. But this advantage reversed sharply on 12 17, with one of the largest single-day declines since 2024, partly due to liquidity volatility associated with the quarterly futures roll.

At this stage, recently established long positions face significant challenges Without further macroeconomic tailwinds or support from the Fed, these positions could fall further underwater.So far, the funding discount of the Russell 2k relative to the S&P 500 remains about 20bps higher than at the start of the month. Given recent fund flows and changes in the basis, Market expectations for the Russell 2k to underperform may take longer to adjust.

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

Original discussion link:View 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 the curves bear-steepened. U.S. equities weakened across the board, with Bitcoin Sensitive sectors suffering the steepest declines (-11.29%), while Non-Profitable Tech fell 6.38%. VIX rose to 19, credit spreads widened, and market expectations for FED rate cuts in 2024 were revised down further, with fewer than two cuts now priced in (-31.5bps).

Two statements from the meeting were particularly important:

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…”

When preparing new economic projections, some Federal Reserve officials took preliminary steps to include the potential effects of certain policies on the economy in their forecasts. These estimates are highly conditional, indicating substantial uncertainty in the projections, with the specific effects depending on how the policies are actually implemented and how the economy responds.

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 deteriorate: the Fed raised its PCE forecast for 2025 from 2.1% to 2.5%, while lowering its unemployment-rate forecast (U3) to 4.3% (previously 4.4%). This suggests that policy tightening may persist longer than the market expects.

2) Policy retains a “high bar”: the statement specifically mentioned “the extent and timing of additional adjustments,” suggesting that the policy path 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 in 2024 (-31.5bps),Powell emphasized the word “restrictive” as many as 10 times, further dampening expectations of monetary easing.

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

Two direct market consequences.

1) U.S. Treasury yields surge:The curves bear-steepened at both the short and long ends. Yields on 10-year and 30-year Treasuries broke above their post-election highs, becoming a major obstacle to further gains in equities. The front-end adjustment (Dec SOFR) is nearing its end, but rising long-term yields are putting pressure on high valuations.

2) The Santa Rally is impeded:The market had expected a “Santa Rally” at year-end, but this hawkish shift has significantly made it harder for the rally to continue. Current SPX valuations of 22x require a combination of accommodative policy and a strong economy for support, while the adjustment in FOMC has weakened that possibility.

Overall, although technical factors remain supportive (inflows + long gamma), and subsequent stabilization in VIX could favor a short-term rebound, The likelihood of the market reaching new highs has declined substantially.With the Federal Reserve continuing to emphasize that fighting inflation takes priority, further gains may require stronger economic and policy catalysts. After a strong year of performance, a more cautious stance should be considered.