The “Liquidity Ladders” on the U.S. capital market

S&P500 closed last week at the record figure of 4839.82 and also the all-time high!

Although stocks are thriving, behind that are inadequacies in the capital market that could ignite a recession occurring in 2024. These inadequacies are probably not too new to readers, as Viet Hustler's market articles have always emphasized the concentration risk in the stock market. And in fact, the Magnificent 7 group accounts for 35% of the weight in the value of the S&P500 basket. 

The stock market is closely linked to the corporate capital market, and more broadly to the entire economy - which greatly depends on capital allocation in the financial market. Therefore, Viet Hustler's weekend Macroeconomic article will provide readers with a macroeconomic view of the economy through the lens of the stock market.

The article includes 3 main parts:

• Market “concentration” risk and “liquidity ladder”

• Cost burden and credit crunch for businesses in 2024

• Economy revolves around government and technology.

1. Market “concentration” risk and “liquidity ladder” (Liquidity Ladder):

• The value of SPX has returned to the all-time high last week

  

• But the S&P500 index is weighted based on the market cap of the 500 largest companies in the market.

• If we equalize the weights of the 500 companies, the average stock value in the S&P500 basket is still far from the all-time high.

  

• In reality, the current market surge is largely driven by the wave of tech stocks, potential in the AI chip and semiconductor industry.

  • The market cap of MSFT and APPL has risen higher than Japan's Nikkei stock index…

    (…. while Japan's stock market is the 4th largest in the world!)

    

  • If excluding the Magnificent 7 group, then S&P 493 had no growth over the past year…

    (even though inflation is still >3% and the Fed's base rate is 5.25-5.5%)

    

• Taking a look at the situation of Russell2000 - 2,000 smallest companies in the market (orange line), their market cap is still far from returning to the peak at the end of 2021.

  

• And if we only consider the 500 smallest companies (microcaps), the bottom for these stocks is becoming more severe year by year:

  

By now, everyone must understand the meaning of “liquidity ladder”: when there is a large difference in liquidity between stock groups at different market cap levels.

This is evidence that the economic situation is deteriorating rather than improving (even though on the surface stock market values are still rising).

• Normally, if following the cycle where the economy is rising, small companies must have superior operating performance (even though they have higher beta coefficient, i.e., riskier). Due to improved business environment and increased borrowing capacity (their stock valuations also rise).

• However, currently, the stock performance of small-cap and micro-cap companies is declining, because this group will first face difficulties in production costs and cost of capital. They also will not have preferential borrowing conditions in the corporate bond market.

• Not to mention, there are many companies too small not yet eligible to list, this is the group of businesses most severely affected under the pressure of credit crunch!

2. Cost burden and credit crunch for businesses in 2024

Average borrowing rates for small businesses have risen to as high as 9.8%.

But cost of capital is not their only concern: 

• Only 5% of businesses say interest rates/finance is the most important issue (orange) ... 

• But up to 23% of businesses say inflation is the most important issue (white) - when prices are all high leading to higher costs for businesses.

  

=> Medium and small businesses will have to shoulder the two biggest difficulties: high borrowing costs and even higher production costs.

“Production cost inflation” is still not over

Although input cost inflation has decreased for businesses over the past year, there is still another cost weighing heavily on businesses: labor costs.

• If tcore PCE growth the consumer side is a relative measure for revenue growth; then average hourly wage is also a relative measure for business labor costs.

  • In December 2023, the expected Core PCE increase for December is only about ~+0.17% (predictions from major banks)…

  • … while average hourly wages increased to +0.42%.

=> Businesses are facing a faster increase in labor costs than revenue growth, and this gap is widening!

Demand for goods will soon decline

In addition to rising costs, businesses are facing declining demand for goods:

• With a 10% income increase, the proportion of consumers deciding to use income to pay debt instead of saving/investing/spending/donating also increases significantly.

  (New York Fed survey on consumer expectations)

  

Not to mention that reduced consumption will reduce GDP at the macro level, for businesses: reduced consumer demand means they will lose the driving force for consuming their products - especially for consumer goods and services sectors.

In fact, this is also directly reflected in the stock market when:

• Last Friday S&P500 hit all-time high with 4.3% growth from the technology sector, but the utilities sector fell -3.7%, the consumer staples sector fell -1.29%.

  

The early debt maturity wall arrives in 2024

Although recently, Fed members have continuously made hawkish statements more than the Fed's actual stance, Waller last week pointed out a completely correct point:

• Bank credit has declined for many consecutive weeks from early December 2023 to now, and is at -0.3% y/y.

  • in the past 2 decades, this only happened during recessions and in 2012 (the cause for the third wave of QE from the Fed since 2012). 

• Despite high borrowing rates, high credit-rated businesses (investment-grade) have increased bond issuance right from the first week of 2024:

  

  • Expected in 2024, this group of businesses will issue bonds on the largest scale in the past 7 years — as their old debts are also maturing one after another.

    

• With surging supply, corporate bond yields will soon rise (bond prices fall) – meaning borrowing costs for smaller businesses will continue to rise even higher. 

  • FYI: with high yields and relatively lower risk, cash flow is pouring into investment-grade bond funds.

    

The question is whether businesses with lower credit ratings (smaller businesses) can borrow capital in the market next year?

And whether the Fed can cut rates and end QT soon enough to reduce borrowing costs, before the debt maturity wall hits smaller businesses?

3. An economy revolving around government and technology

The final and most crucial question: What awaits the US economy if the manufacturing industry weakens?

A rather 'unrealistic' hypothesis put forward by Viet Hustler is: An economy revolving around government and technology.

First, let's talk about the economy revolving around the government. 

In 2023, alongside the Fed's major intervention in the US capital environment (interest rates), there was an even larger intervention in the economy, from the Treasury and the US government. 

• During the Covid period: massive government spending accompanied by a drop in tax revenues => leaving the US government with a budget deficit of up to 7% of GDP - far exceeding nominal GDP growth.

  

• Yellen saved the Treasury's “wallet” in 2023 by issuing the second-largest net amount of T-bills (short-term debt) in history…

  • T-bills issued last year accounted for 83% of new bond issuance:

  

• With high yields and even higher safety of T-bills, Money Market Funds are attracting a large amount of capital from the market.

  

• And net debt issuance (new debt issued - maturing debt to be repaid) will continue to increase in 2024.

  • This will further drive people's savings and investment money to flow into the government's pockets.

  • In other words, the government is absorbing a large portion of the economy's idle capital… while businesses are short of capital.

• The story doesn't stop there; once the Fed reduces Reverse Repos on its balance sheet (stops selling T-bonds with an agreement to buy back the next day)… demand for T-bills (short-term bonds) will also decrease…

  

• … at that point, the US Treasury will have to extend the average maturity of its current debt (meaning Yellen will have to increase long-term debt issuance).

• This will put even more pressure on long-term Treasury bond yields (long-term bond prices will fall due to increased supply relative to demand)

  => Therefore, long-term Treasury bond auctions next year will become more tense and may end with higher bond yields.

• => This is the real big risk: the Treasury will lock in loans at high yields for long maturities.

  There will be even less idle capital for businesses!

So what about the banking system: designed to circulate the economy's capital?

• Banks are taking advantage of cheap capital from the Fed's BTFP program to … deposit money back at the Fed…

  • and enjoy the preferential yield spread without risk.

Therefore, it's not wrong to say that a large part of the US capital market revolves around the Government and the Fed.

While businesses are not accessing a large amount of idle capital in the market!

The economy revolves around technology. 

First, Viet Hustler affirms that a high-tech economy is completely good. 

• This can maintain America's position on the technology and industrial development map. 

• The immense applicability of automation systems, AI chips, and semiconductor technology to industry, defense, and manufacturing is undeniable.

• Related article by Viet Hustler: NVIDIA - heart of the AI wave

However, if capital is scarce and costs are high, other industries (except chips and megacap companies) will also limit investment in R&D and new projects.

Not to mention that the US goods manufacturing industry will weaken => leading to recession and difficult recovery (similar to the 2008 financial crisis which made potential GDP growth hard to recover)…

=> high likelihood that the US will depend more on imported consumer goods.

(Nguồn: World Bank)

• Then, US prices and inflation will be more volatile due to external supply shocks.

Of course, Americans can proudly say they own tech giants like Microsoft and Apple - market cap larger than the entire Japanese stock market. 

But this does not confirm that the average American will be richer to afford more expensive goods, but only confirms that the wealth gap in the US will increase even more:

• Although according to statistics, 39% of the US stock market value (currently worth USD 73,000 billion) is owned by households….

  

• However, 33% of that is owned by the top 10% richest households in the US….

  (of which 17% of market value is held by the top 1% richest people).

  

CONCLUSION 

In contrast to the early days of 2024, last week, the US stock market value surged to an all-time high. But behind that is the market's concentration risk as most of the growth came from Mega-cap stocks.

From a macroeconomic perspective, the liquidity stratification between stock groups with different market caps has pointed to the biggest issue in the current economy: the difficulty in raising capital for small and medium-sized enterprises. 

This is also easy to explain as small businesses will be even more limited in accessing capital if the Fed maintains a high interest rate policy in 2024 – leading to larger businesses and even the US Treasury needing to borrow and pay investors a higher yield, with greater safety assured. 

• Capital in the stock market is flowing into Mega-cap stocks.

• Bank and financial institution capital is pouring into government bonds and bonds of large enterprises.

• Meanwhile, banks continue to tighten lending standards for small businesses.

These moves indicate a 'bubble' capital market that only revolves around the government and expectations in the technology sector, without focusing on circulating capital to businesses.

In addition to the capital wall and upcoming debt maturities, businesses are also facing a labor cost wall and declining consumer demand. It's only a matter of time before we witness the deterioration of the economy and labor market due to these negative impacts.