Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Markets. I'm your host, Tim Graf, head of macro strategy for Europe. Each week, we talk about the latest insights from our award-winning research, as well as the current thinking from our strategists, traders, business leaders, clients, and other experts from financial markets. If you listen to us and like what you're hearing, please subscribe, leave us a good review, get in touch, it all helps us to improve what we offer. With that, here's what's on our minds this week.

Dan Gerard (DG): I would hate to be a stock picker in this environment still. I think most of the returns continue to come from your asset class allocation and your sector allocation in an unknown world where the winners and losers are still very hard to decipher because of the adoption of this tech and how it's going to unfold. That's really where you want to be, really, and the earnings weighting will take care of it.

TG: Not only is it not a stock picker's market, it's not really much of an asset allocator's market right now either. Just own stocks seems to be the mantra. And really, who can argue with that? I recorded this episode with Dan Gerard, an equity-focused strategist on our team in Boston, with stocks having just hit all-time highs, and on the eve of a Fed decision that's most likely going to bring a cut to interest rates, despite inflation still being above target, perhaps rising once more, with equity markets at all-time highs, with the US labor market normalizing, but not yet contracting, and with the US' Q3 growth outlook starting to look a lot better thanks to a resilient consumer.

Now, my pessimistic side would point to the fact that a record number of surveyed fund managers see equity markets as overvalued. Our own portfolio weight indicators show institutions with an equity allocation that was last exceeded in 2008. But the side of me that has actual skin in the game would note that I haven't made a decision to actually change my heavily overweight equity asset allocation at any point in the last few years. And so you should probably ignore my pessimistic side. And you should definitely spend the next 30 minutes or so listening to Dan.

DG: Hey, Tim.

TG: Feeling all right?

DG: Yeah, I'm feeling all right. The voice is slowly coming back.

TG: Well, you sound good. You sound tired, but you sound good.

DG: Well, I'll try to change that. I'll put some force into the voice.

TG: You live in New Hampshire. Surely there's all sorts of, you know, antiquated remedies that are available up there.

DG: Absolutely.

TG: Let's get going, shall we?

DG: We shall.

TG: Well, Dan, appreciate you doing this on the day where you're not feeling your best, but we will manage. But this is a podcast I wanted to do with you about asset allocation, but actually, I think in the last couple of days, I've taken more questions about equity valuations than I have in some time. And just as a sort of initial statistic, let me throw this at you. Well, we know our own institutional equity holdings are at the highest levels or near the highest levels since 2008 in terms of portfolio weight.

But really, the thing I wanted to focus on, I don't love bringing up the Bank of America Fund Manager Survey, but 58 percent of investors in that think the market is overvalued, which is the highest proportion going back to 1998. By any objective measure, this is an expensive market.

And I guess the question to you to start is, if you are a benchmarked investor, do you continue to build this off benchmark overweight that we see in US stocks and tech stocks in particular?

DG: Yeah, it's a great question. And this comes up a lot in my own meetings with clients. I think it's probably the most discussed topic. You know, what I think is interesting about the survey data is, as we know, that survey data can often be what people wish they had done, what they want to do in the future, rather than what they're doing. So I think our behavioral data is really key in honing in on what's actually happening. So to answer your question directly, yes. I think for now, the equity allocation is justified.

For a couple of reasons, we can get into for a minute. But what we continue to see is, even though the concerns are there on valuations, is that the behavior is not on in trimming equities, in moving out into duration. And that's been going on for some time. These allocation shifts and the risks we see that come from these big allocation shifts tend to be pretty short-lived these days.

That March, or let's call it first quarter drawdown, I think that was the first major drawdown of its size that was not credit related in two decades at least. It was allocation related. It was those worries popped up on equity valuations. And what do you do in that case? You trim what you have. But it bounced back pretty quickly because of the drivers to valuations, those liquidity drivers plus the pretty decent earnings growth that we're seeing even if that earnings growth is concentrated.

TG: And that's actually the part two of the question, I suppose, is the expectations for earnings. And this is another statistic. It's from actually a client this time. It's from Joe Davis from Vanguard. I was listening to a podcast with him. And he talked about not now, but actually three or four months ago when he did this, the expectations that were built in to AI and AI adoption and all of its adjacencies were comparable to the historic experience of the adoption of electricity in terms of just how optimistic the growth rates investors saw and analysts saw were.

Does that strike you as achievable optimism? And I have a follow-up to that as to, if it’s not what we should be thinking about, but let’s just start with the original premise of, are we investing on a premise that is comparable to the adoption of electricity?

DG: I'm not sure it's the right analogy, but let's just say it is. I think it's more like the adoption of internet search. In that sense, we have to decide, or investors are going to find out soon, is this a period like the tech bubble where our valuations just got way ahead of any potential earnings? Or is it a period like 2007 when we looked at Google? Google was expensive and it was trading at extremely high levels, much higher than now. A lot of investors said, you know what, actually, this is cheap.

And those investors turned out to be incredibly correct because of what we didn't know was going to happen, was that the entire world was going to change because of this new technology. And look, we were almost 10 years into the Internet already, and we didn't know what was coming. That's what I think we're in, in this AI sense.

We have absolutely no idea yet how this is going to impact the world in which we work in, live in, play in, all of that. It's still very hard to see how people make money in AI. But that doesn't mean it's not coming, it's coming. There are a few restrictions that we're going to have to get over. One of those major ones is power. We just don't have enough power for that change yet in terms of powering these chips. You know, if you think about some of these high powered NVIDIA chips, they take the same amount of power as a family of four. If one company like Microsoft buys half a million chips, that's like a new city of two million people that we need to power.

Though that's the restriction now. I don't think it's the innovation that's coming. So yes, I think that we are still probably underestimating the earnings and the breadth of change that is coming from this new world we live in. Is that the same as electricity? I don't know. We only have a few people on our team that were around to see that then. But we'll save that question for them.

TG: If we're making that joke, I have to assume I'm probably one of those people.

DG: No, you and me both.

TG: Yeah, it's similar. That's true. That's true. We're not so far off. I guess the main question then is separating the wheat from the chaff within this sector especially and how we do that. Because I'll throw another non-State Street chart, which I actually think is a great chart from Alpine Macro. And I'll put it in the notes when we publish those on our research platform.

But it shows the sort of greed element in markets, and it shows Bitcoin, it shows the performance of ARK, the ETF that leverages a lot of this technology. But also, I think, most importantly, it shows the notion of non-profitable tech, this index that Goldman Sachs, I think, publishes and produces. And that also making all-time highs, and maybe not quite as extreme as Bitcoin or as extreme as ARK or gold. But its sentiment is very, very stretched for names that don't make money. And there are names in this space that do make money, make, you know, the Magnificent Seven make a cash hand over fist.

And so I guess the question is how, as an investor, do you think about reducing risk maybe of those unprofitable companies and focusing, if you're an indexed investor, how you avoid those unprofitable elements while getting the maximum exposure to those high quality names.

DG: I think what you're really getting at here is, if I boil that question down, is it time to be a stock picker yet? Because really that's what that's about. If I'm buying broad index participation in the tech space, then I'm getting the winners and the losers become a smaller weight. And it's still too early to figure out what those winners and losers would be.

I mean, we think about non-profitable, some of it could be because of massive CAPEX and their CAPEX needs. You know, just thinking about, did Amazon fit in that bucket a few years ago, right? I mean, we never argued that that wasn't a good investment. If we look at the earnings world, and let's just try to put some structure around that question. For the earnings space, what do we see that happened? We saw that the earnings game from the sell side is changing a little bit. And when the tariffs popped up, the sell side analysts took down their forward, next few quarters forward numbers pretty rapidly. And then when the tariffs were kicked out, for some reason, they kept taking down Q2 earnings and left the other out quarters alone. That didn't make sense to me at all. We had a huge beat in Q2. Analysts never started really raising Q3. They still haven't started raising Q3, which means even though historically Q3 earnings are a seasonally better earner than Q2, we have about flat expectation of earnings growth. That's a way underestimate. Analysts have started taking up Q4 and Q1 for next year. And that seems to be the game they're playing.

It's instead of this old game of, I'm going to take up just enough, and then we'll see the beats come through, and then I'll work on the next quarter. It's taking out the out quarters so that the sequential earnings growth matches, and you still have an underappreciated growth out in the future. And that's why I think that, to boil all this down, our earnings expectations are still not excessive. We still have, even if it's concentrated in that tech space, and that's what it is. We know it. There's almost no earnings growth anywhere else. But that's okay because of this kind of cap-weighted, earnings-weighted basis that's focused in tech.

I would hate to be a stock-picker in this environment still. I think most of the returns continue to come from your asset class allocation and your sector allocation. And it's in an unknown world where the winners and losers are still very hard to decipher because of the adoption of this tech and how it's going to unfold. That's really where you want to be. And the earnings weighting will take care of it.

TG: And so is it fair to characterize your remarks as saying, for the rest of this year, perhaps, into Q1, the market doesn't really have that high of a hurdle to beat or actual results, I should say, don't have that high of a hurdle to beat to keep market price pressures on the upside.

DG: That's right. And it's not going to be an earnings adjustment that either takes this market higher or lower. This is still really about the liquidity in the system and the rate side of the coin, the creation and the flow of capital into financial markets. That's what's driving this here. I don't think it's going to be an earnings story until we get through this liquidity portion of what's keeping multiples so extreme compared to any point in history.

TG: On that note, I want to take it in a slightly off-tangent direction because, and this, we could do an entire podcast about this, and I think actually you'd be the perfect person to talk to about it when we do. But, we've gotten to the point now where passive investing represents about something like 50 percent of the capital invested. And it's to your point, I suspect, that this is still not a stock picker's market.

Does that, though, offer you any red flags in terms of that percentage being as high as it now is?

DG: It doesn't at this point. I mean, I think the research has been telling us for a long time how hard it is for a stock picker to focus even when you have a strong background and knowledge. Just how difficult it is to pick companies. So I think that that move into passive investing, a lot of it is just generational. People have more access and availability to invest and don't have any expertise. And the expertise they have, they don't know if they can trust or not. So that's just part of that side of that coin. But that is not changing. It’d probably move more in that direction than away from it.

And I think, if I want to put my opinion in there, I think it should, not to downplay stock picking and its importance for some investors. It's just that for the masses, that ability to take equity exposure for their future is something that just needs to happen more and more. It's a trend that will continue.

TG: It felt like when I was doing these podcasts on equity markets last year, it was similar to what we're talking about today. Like what pops this market? I don't want to call it a bubble. We've used that word. It's overused. It's potentially not given some of the descriptions you've given of the earnings outlook.

But we are in an environment and in a week, especially where rates are very much in focus. We are recording this the day before the Fed is highly likely to cut rates by 25 basis points. It will be coming out the day after. So there's not too much we necessarily want to commit ourselves to here, although we will in a moment.

But I want to think about the rate channel as a potential threat here, because we are in an environment, we talked about this last week with respect to the UK, where long end yields especially are becoming a bit de-anchored, especially in markets, non-US markets where fiscal balances are a little bit more challenged.

I'm wondering if rate markets have any influence for good or ill on the equity market at this point, and where are you seeing there being a potential risk? And what basically needs to happen in rate markets to really rattle equities?

DG: Yeah, this is the deep question to go into, because it is a deep question. It is not necessarily about the rates. It can be, but the rates is a reflection of what else is happening in the monetary environment. And I think this is a very important topic because of its potential to feed into itself. If we just think about where we are now compared to 15 years ago or before the credit crisis, the monetary world is in a very different place.

We used to be in a world where the Fed controlled a credit cycle. It was about money supply and rates, and those two things would interact and create either demand for financial securities or demand for loans. And that cycled back and forth in a pretty good mean reverting way. But once we entered that QE era, and the Fed was actually not just influencing its agent, the commercial banks, but influencing its balance sheet and overall liquidity, everything changed. And the question really is, are we going back to that now? Are we going back to a period where the Fed's balance sheet is more neutral? It seems we are, and if so, the activity of commercial banks is actually very, very important. So that's a big prelude to your question here.

But the reason it's important is because even though institutional investors have been shying away from buying duration, buying treasury yields, commercial banks see peak rates. They are actually going back in, buying bonds again in a pretty big way, which is funneling money back into the financial system, keeping rates in check, and providing overall liquidity to keep valuations high. The danger of higher rates is that they've taken the wrong bet. And if because of inflation expectations, if because of massive supply and not just behavior, we start to see the long end of the curve rise, and I think that level is probably around 5 percent, that it really starts to matter. It's not that that level of rate is going to hit equities in some bad way because of the longer duration of equities. I think it's because the credit funnel stops. It is about de-leveraging at that point, and it's about protecting earnings from the bank side in a world where the Fed is actually contracting their balance sheet or at least keeping it neutral at the worst. The end of this era of equities that we see, it's not an earning story, it's a de-leveraging story that makes people sell what they have.

TG: But isn't that ultimately a risk appetite decision? And you and I have talked about this for a long time, I think, back and forth. We have views on what the central bank does and how their channel operates. And the points of disagreement, I actually think, are not that great. It's just that they are the channel through which things get influenced, where what you've said is, to me, a risk appetite motivation for de-leveraging. But we know risk appetite right now is relatively robust.

And so I guess it's the underlying catalyst for that changing, that I'm curious as to what you foresee as being a potential problem.

DG: I think part of it is risk appetite, but there's part mechanical. Money supply hasn't mattered in 15 years in a way, because we've gotten away from this monetary rate environment, where the Fed is managing their abundant reserves. If we have a mechanical decline in the ability for monetary growth to continue, then there's a deleveraging in the financial space, or not even just deleveraging, but no leveraging means that multiples can't continue to grow.

And if there's no loan growth, then earnings growth stalls. And because we know earnings growth is so concentrated already, that's the double risk there. So the behavioral part, the risk appetite part, I think, is secondary to that. If we look at traditionally what happens when the Fed starts cutting rate, the Fed cutting rates does not actually increase loan growth and economic growth. What you tend to see is this buying treasuries and buying securities, because that's the easy money to make at that point. That's kind of where we are. I think there's an 18-month lag or so between the start, I'm looking back, 75 years of data at this point, but there's about an 18-month lag where rates start being cut and the trigger is for the investment to go into financial market and not support growth and jobs and all of that. And I think that that's what we need to be wary of here because of the high inflation regime that we're still in. We're still above target inflation. The economy is still very strong.

That's what I think is going to be the risk here is that maybe the expectations that people have that this rate cut is going to do something else besides boost markets is misplaced. And maybe that's down the line, not quarter, not two quarters from now, maybe not three quarters from now. That's going to be where we really need to start looking at this risk appetite and wondering, can we continue on this path?

TG: So that's interesting because in that history, the scenarios that mostly determined when people went into treasuries in your scenario, the feds cutting rates, people go into treasuries, that is because of a slowdown in economics and response to pending or at that point, probably current and maybe even past recessionary pressure and risk appetite also tends to fade and credit contracts in that environment. So they all kind of happen at the same time.

And so that's an interesting discussion for now because, as you've said, that's not really what's happening. Risk appetite is very strong. The Fed is cutting rates. We saw economic data today on the retail sales side that can confirm the consumer is maybe spending money because of higher costs, but also you yourself put a chart and I will steal that for the show notes of real retail sales volumes starting to pick up again. So I guess that's where I wanted to make the delineation and to ask you about whether there is potential de-anchoring of long rates that ultimately does disrupt the economy as well as markets, even if the fed is cutting, even if there are these bank flows into treasuries that you’ve talked about.

DG: Yeah, and maybe the way to phrase that question is, are we at neutral? Are we restrictive?

TG: Yeah, precisely.

DG: That's really what we want to know. And it's a tough question. I continue to argue that this is much, much less restrictive than people are saying, other market participants and pundits are saying in this world. Just because of where the rate is doesn't make this restrictive.

We've had rates where we are and been actually expansionary at these levels. Yeah. There's been an argument for so long that the neutral rate has changed. I don't know if that's true or not. The way I like to define neutrality, and we can define it a lot of different ways, is what is the impact of rates on the financial market participants' decision? So, and I mean, really the commercial bank decision. That's a good way to measure it. A commercial bank would always rather make a loan than buy a bond. So if we look at their behavior, neutral to me means they're indifferent about making a loan and buying a bond.

And we've been indifferent actually for some time. So I think we already were kind of saying that this is a neutral level. The Fed, I think, is risking, or maybe not risking, but happy with keeping this economy hot. They have really said, if, you know, forget 2 percent, I'm almost happy with a little bit higher inflation even if I don't state it, because I'm going to protect the market environment because so much of the economy is tied into the market environment. That's a new era. We haven't been in that one before.

I think the real risk here is the term premium and inflation expectations and supply on the long end of the curve here. Because if inflation expectations start to pick up because participants believe the Fed is running this economy hot, that's going to be, will end up being the downfall of it. And it'll be quite ironic that the Trump administration, who has been pushing so hard for lower rates, like any administration would, might end up hurting their interest cost by pushing for lower rates if the long end rises and we get steepening.

TG: This is a bit different than 2022, 2023, where the Fed was hiking rates and almost didn't care about the market response. We had a big market correction in that environment, and it was sort of, you know, damn the torpedoes full speed ahead, and we are getting rates back to restrictive territory.

What do you think has changed in their mind to go down this path?

DG: Well, 2022, 2023 was a very different environment. It was one of the few periods where we had actual deleveraging. We had the rate environment plus we had a drawdown of the balance sheet. What changed after that was even though the Fed continued with their QT headline view, the excess cash that had been stored in the Reverse Repo Facility, for example, it actually balanced out the QT and you didn't really have QT. So the deleveraging stopped.

What's just happened now is something that we haven't seen yet in this era, which is the Reverse Repo Facility is now 99.9 percent drawn down. We just saw US$200 billion more of money come out of that facility into the financial markets over the past month and a half. That's it. It's done. The Fed is still technically doing QT. We'll see how long that lasts. But the balances to liquidity have actually gone away. And we are left now with the system we had, pre-financial crisis, which is much more dependent on commercial bank action as the agent to create or destroy money. And I think that this is what the Fed is looking at. They know now that they are not the same kind of balances. They know that if they don't stop QT, then they must completely rely on banks to believe in peak rates.

Maybe one more way to put this is, if the system was working perfectly, if we had a perfectly functioning banking system and banking transmission, and we still had four or five trillion dollars of excess money that was created, then monetary theory would tell us that banks would, you know, multiply the fractional banking multiplier effect tenfold or so. That's not going to happen. They can't allow that to happen.

So I think in the back of their minds, they've got to draw down their balance sheet, and that is number one focus. And to do that, they need to keep rates slowly ticking lower to create participation to make up for their withdrawal. That I think is really the key to all of this.

TG: That's an interesting place to end the conversation, but not before I ask one final question, which, as I mentioned, this podcast will come out the day after the Fed has presumably cut rates by 25 basis points and most likely will project one, possibly two, I think the consensus now actually is two, more cuts this year, and maybe a few more down the road.

Where do you think they’ll stop?

DG: They're going to stop at another 75 basis points after realizing that again, it was a mistake. And I say that because last year, I think we clearly can see now, it was a mistake to cut that much. It just created interest rate volatility, uncertainty, economy has done just fine. And probably if they had left it alone, we would have had inflation back down to almost target level at this point, if they had just been patient.

So I think that they are going to be forced to stop after maximum three cuts and really start having to think about reversing course.

TG: I lied. One last question.

Would the labor market be in any worse shape had that been the path they followed? I appreciate I'm trying to argue a counterfactual here, but the labor market is slowing.

DG: I think the labor market is not slowing. It's not the term I would use. I would say it's normalizing. We have one of the strongest labor markets we have ever seen outside of wartime. And I know it's kind of a crass way to say it, but I think too many people are working. And there needs to be more friction in the turnover for that, to be at something closer to NAIRU. How do we know this? Well, we still have pretty good services inflation.

The labor market has to be allowed to loosen a bit. The question is, would it have been? Yeah, I think it would have been a bit looser at this point, had they not cut. But it's just a new era of central bank management discussion and communication than we have seen previously from people like Greenspan and Bernanke and even Yellen, who specifically didn't focus on economic growth because that was not their mandate. They focused on more of a monetary supply issue, and they focused on what full employment should be in a very spongy kind of way, rather than keep as many jobs as possible.

TG: Too many people are working. That's my headline. That's going to be the first line. Dan Gerard, as always, a pleasure. Some really high-level thoughts that will take some time for me to get through, but I always appreciate you coming on and offering what you have to say.

DG: Thank you very much, Tim. Always a pleasure to be with you. See you next time.

TG: Thanks for listening to Street Signals. Clients can find this podcast and all of our research at our web portal, Insights. There you'll be able to find all of our latest thinking on markets, where we leverage our deep experience in research on investor behavior, inflation, media sentiment and risk. All of which goes into building an award-winning strategy product. And again, if you like what you've heard, please subscribe wherever you get your podcasts and leave us a review. We'll see you next time.