A Vibe Shift with No Backing (Yet)

Weekly Monologue

It feels like something shifted this week, mood-wise.

Perhaps it was the start of earnings season forcing the bank CEOs out in front of the media. Or maybe it was the steep rise in market volatility against a backdrop of tit-for-tat U.S.-China trade snipes, as each side looked to build a negotiating position ahead of the APEC Summit at the end of the month (more on that in this week's Market Monitor). Or it could simply be something to fill the media void, as the headline "government still shut down" attracts dwindling engagement.

Whatever the reason, there has been a noticeable downshift from the buoyant mood that kicked off the quarter, hot off the Fed's rate cut and upgraded GDP growth numbers.

Consider:

• The CEOs of Goldman Sachs, JPMorgan, and Citi all said the word "bubble" in reference to equity markets.
• They were backed up by the official sector, with the IMF warning of the potential for a 'disorderly' correction, statements echoed by the Bank of England and their own former Chief Economist Gita Gopinath.
• None other than Sam Altman admitted the AI market is a bubble—the VC industry is, of course, now claiming that's a good thing.
• Ray Dalio has been more vocal than usual, focusing his bearishness on global government debt and morphing into the most unlikely of goldbugs.
• Speaking of gold, it hit fresh highs as flight-to-safety dynamics intensified—and maybe it too is a bubble.
• A spate of articles pointed out that credit is overvalued and the leveraged loan market is showing some signs of strain after the recent auto sector defaults (the subject of this week's Memo).

Why now?

Stretched valuations are hardly a new phenomenon. To take just one benchmark, the cyclically-adjusted price-to-earnings ratio (CAPE – see chart below) has been telling us for two years – aside from the rapidly reversed April correction – that the market is overvalued to a degree not seen since the peak of the dotcom bubble. And it's not like we weren't aware of the vast sums of capital flowing into AI and related infrastructure.

Plus, those bank CEOs were speaking in the context of earnings beats, emphasizing rising investment activity and reassuring us about stable credit quality. Indeed, the pickup in M&A activity on the back of accommodative financial conditions (we're close to a record high in mega-deals this year) is a major favorable tailwind for the broader economy.

If you don't believe that last bit, I refer you to the winners of this year's Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, "for having explained innovation-driven economic growth;" "for having identified the prerequisites for sustained growth through technological progress;" and "for the theory of sustained growth through creative destruction."

You can't destroy or create without some M&A, baby.

For now, this mood shift is all vibes, no new information.

And if you take a moment to reflect, this is how it's been all year. We went from winter thaw (Trump administration optimism) to spring chill ("Liberation Day") to hot summer (rebound) and now a fall frost. At least we're syncing up with the seasons...

To be clear, I do see the chance for a winter blizzard; it's just not my base case. Here is how it would go: China/U.S. tensions continue to ratchet up, dealing a further blow to world trade and triggering a substantial and sustained equity correction/bear market. Recall that consumer spending and a good share of AI investment are tied to rising valuations. A crisis and recession would ensue, exacerbated by stubbornly high inflation.

All it would take, however, to kick that scenario into the long grass is some sweet talk between Trump and Xi in South Korea, and/or a strong earnings season from AI darlings and consumer-focused U.S. firms.

So, my central scenario remains that we stay a while longer in the "Sluggish" stasis we've been living in for two years—not quite healthy, but not in crisis either.

Market Monitor

The overall character of price moves across asset classes had a "risk off" flavor this week. Equities moved sideways overall after Monday's partial recovery from the China/U.S. trade spat rout last Friday, the Swiss franc appreciated, and gold continued its historic rise. The VIX popped to it's highest level since April.

But "risk off" moves aren't what they used to be—the dollar fell (the DXY index down -1.1% since October 9th), and yields on U.S. Treasuries appreciated only marginally (although yields on the 10-year did briefly dip below 4.0%). This tells us the U.S. is very much the driver of negative sentiment, and no longer offers the stability and asset scarcity (relative to demand) that characterize a true safe-haven asset. This is one of the structural underpinnings behind the gold rally, which will persist.

On the subject of gold, I recommend an excellent long read from the FT, which assesses the different theories on how long the mania can last.

I'll just say this: bubbles occur when investors pile in based on recent price action alone, not the underlying investment case.

One should always pair that insight with an equally important opposing mantra: a bubble can be clearly identifiable as a bubble, yet last for a very long time. For exactly as long as there is a "greater fool" who is buying.

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Macro Monitor

The shutdown-induced data drought continues. The unfurloughed staff who were brought back to get the CPI data out ahead of the end-of-month meeting couldn't meet this week's schedule.

The main move in macro this week came from the FOMC members. Led by a speech by Chairman Powell on Monday, and later backed up by comments from various committee members, the Fed all but confirmed that its best move in the absence of official data and no meaningful shifts in alternative data sources is to stick to the dots. That locks in a 25bp October cut, though we still view December as a toss-up depending on what the inflation and labor market data reveal in the lead-up.

My read of the week came from the Atlanta Fed, whose research team took a look at the microdata within the main business surveys. They found convincing evidence that business leaders expect prices to accelerate next year—a delayed but meaningful effect of higher tariffs.

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What we'll be watching next week

• Earnings season is in full swing. We'll be keeping a close eye on industrials (General Motors, Ford Motor, GE Aerospace, Lockheed Martin) and those that give us some insight on consumer trends (Coca-Cola, Hilton, PG&E). Tesla's earnings on Tuesday may move the broader market. Blackstone is the first of the listed private markets firms to report on Thursday.
• CPI (Friday): All going well, the delayed inflation data will be out on Friday. Consensus is for a +3.1% YoY rate for both core and headline.

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Memo: There will probably be more First Brands—don't panic

The collapse of U.S. auto sector companies First Brands Group (parts) and Tricolor (subprime auto lending) has released a wave of anxiety in credit markets. That was evident in the prominence given to Jamie Dimon's warnings of a potential deterioration in credit quality, as well as the -6.3% plunge in U.S. regional bank stocks this Thursday after two regional banks said they had uncovered fraud in loans to distressed investing funds.

Dimon was speaking in the context of JPMorgan upping its reserves for credit card defaults, but investors' concerns mostly center on whether a receding economic tide might reveal more surprises in the leveraged loan market, especially those involving opaque securitization arrangements or private lending.

We see a possibility – even a likelihood – that there will be similar blowups to First Brands and Tricolor. But we don't see any reason to think that this constitutes a systemic risk. In the ranking of recent busts, this will likely be a smaller episode than the 2023 bank failures.

There are three main reasons behind this view.

Reason 1: These were idiosyncratic results with underlying fraudulent or misleading practices: First Brands parked $2 billion in liabilities off balance sheet through a complex related party securitization and aggressive factoring of accounts receivable. Tricolor was an outright fraud involving double-pledging identical loan portfolios for credit lines.

Reason 2: There are no macro/structural drivers: This makes these two bankruptcies very different from the last asset-backed market rupture in 2008, or even the mini-crisis in regional banks in 2023. In the former case, an over-leveraged housing market turned over. In the latter, the Fed's rapid interest rate rises eroded the value of banks' assets and created technical insolvencies, which in turn caused terminal deposit flight. First Brands and Tricolor failed because unsustainable, hidden, and/or fraudulent capital structures were unearthed, not a structural turn in the economy.

Reason 3: Contagion mechanisms are less severe in private credit: This is a view that needs more modeling (see upcoming research), but an advantage of private lending is that losses from bad bets can be absorbed within the funds and limited to the investors in those funds. This is not great for LPs, but the contingent liabilities should essentially end there. As the industry becomes more complex (e.g., secondaries, GP stakes) and more leveraged (e.g., NAV loans), and as a larger pool of investors gets involved (retail), this will become less true. But for now, it's a benefit of the private markets.¹

All that said, we're seeing a weakening in the lower end of the consumer income distribution that will expose flawed business models. Had Tricolor's core subprime lending market – undocumented migrants – not deteriorated substantially over the past year, the fraud would likely still be hidden.

We're also seeing a slowdown in the intermediate economy, the B2B transactions which encompass ~60% of total gross economic output. Take the auto sector, to which both Tricolor and First Brands were exposed: demand is volatile and slipping, and intermediate activity between industry participants is flagging as tariffs halt investment spending and force producers to reduce costs.

This will pressure some business models, no question. Combine this slowdown with a surge in securitization, and there will be some failures in the industry. But we think they'll remain idiosyncratic and orderly.