Transcript:
Caroline Woods:
Kicking off a new week with the big question how much runway does this bull market have left? Darius Dale is founder and CEO of 42 macro and joins us now. Darius, great to have you on.
Darius Dale:
It’s a pleasure to be here. Thanks for having me, Caroline, and happy to give it to you and your family.
Caroline Woods:
Thank you so much. And to you. So, Darius, we have the Dow sitting near an all time high. The S&P 500. Not too far from it. And a lot of investors wondering whether they’re too late to this game based on your macro work. Are we still early in this bull market or are we getting closer to the later innings?
Darius Dale:
Well, that’s an excellent question. I love that you posed the sort of ending question, because I think we’re a lot closer to the seventh inning stretch than I think the median investor realizes. For a couple of reasons. One, we think the markets will eventually have to transition to pricing peak or transition from pricing in, peaking inflation to ultimately sticky inflation.
Darius Dale:
And we think that transition is ahead of us over the next 1 to 2 quarters. And then secondarily, you’re getting a lot of signals from the market itself to the max seven companies to a lot of the AI CapEx spenders to perhaps throttle down on the rate of change on the acceleration of all that CapEx. And if they do that, then it’s likely to have a negative impact.
Darius Dale:
It’s going to ripple through financial markets negatively in terms of revising down sales and earnings growth expectations. So though that’s kind of A12 punch that we see, as developing market risk, over the next couple of 1 or 2 quarters. But ultimately we don’t think this is the ninth inning. We don’t think the game is over.
Darius Dale:
We think the 42 macro paradigm, see bull market is lags into and perhaps even through 2027.
Caroline Woods:
Okay. But let’s talk about what pricing in sticky inflation could mean for where this market goes in the next 1 to 2 quarters.
Darius Dale:
Yeah. Look, I mean we’ve been coaching our global investor community to anticipate something like a summer of 1998 style market dynamic. You know, we don’t want to be too specific on, you know, the magnitude and the timing because in our opinion, we think market timing is for newsletter writers. You know, we are serious institutional investors here at 42 macro in terms of trying to keep our clients on the right side of market risk, but just kind of looking at that, you know, 1998 example, we saw that the S&P 500 rallied about 20% in the first half of 1998.
Darius Dale:
We’re obviously in the, you know, for full throttle full throttle tech bubble, back then, but then ultimately, as we saw some of the issues developed with Russia, the board and long term capital management, we ultimately saw the market pull back about 20%. We eviscerated the entire, up 20 plus percent year to date return. But then ultimately, the fed started cutting interest rates and easing monetary policy, to offset some of those, macro dynamics.
Darius Dale:
And then ultimately, we had a very, very vicious rally off those lows in August into into year end. And so we ultimately finished up plus 29%, in 1998. But this is inclusive of a 20% rally, a 20% crash and a viciously bottom after that. So we’re expecting some. Okay.
Caroline Woods:
Okay. So help us wrap our heads around that. We’re up about 10% year to date in the S&P 500, only about 1% off all time highs. So you’re expecting a correction before year end. But then ultimately you think we’ll end this year higher.
Darius Dale:
Yeah ultimately. So what we’ve been we’ve been exactly. And that’s a great way to characterize it. You know we’ve been essentially saying the fed needs to play action pass to set up the run. And if you think about what the what the passing does, is it a lot, you know, regaining a little bit of credibility on inflation fighting would go a long way for the Kevin Warsh Fed to allow for this.
Darius Dale:
You know, this AI CapEx build out to continue in a way that doesn’t drain resources and tax the productive other sectors of the economy in a way that pushes up overall the general price level in the economy. And so they ultimately need to regain a little bit of credibility on inflation fighting. What we’ve been saying is back the safeties in, the linebackers up, that’s the bond market, essentially get the bond market on board with, you know, this is a Federal Reserve that is serious about its 2% inflation target.
Darius Dale:
That’s serious about its price stability mandate. But ultimately what we think this is all headed. And this is why we don’t believe the bull market is over, is when you look at the five task forces that Kevin Warsh laid out, the June FOMC, the communications task force, the balance sheet task force, the data and the data task force, the Productivity and Jobs Task Force, and the Inflation task Force, the net result of those five task forces, in our opinion, based on our deep understanding of the data and all the critical variables and how they connect together.
Darius Dale:
In our opinion, we think the net result of those task forces will be varied on a net basis. Not every single one of them. We don’t think the balance sheet is going to be positive. We don’t think the communications task force will be positive, but the net result is likely to lead to a much more dovish monetary policy and a dovish reaction function starting in like late 2026 or maybe even early 2027.
Darius Dale:
And if that is true, you can’t go from peak inflation to sticky inflation to dovish monetary policy. They’re going to have to have some sort of intermission there. That’s that’s in this message to the bond market that they’re serious about inflation okay.
Caroline Woods:
So the market needs to price in this sticky inflation. Do you think the market also needs to price in rate hikes then or no.
Darius Dale:
Well we’ve been of the view that rate hikes are the wrong tool to address the current drivers of inflation coming out of the economy. We know that the bottom of the cake, whether it be the consumer sector, whether it be the, the business sector, and ultimately whether be just generally interest rate sensitive sectors, the bottom of the key in the economy, if we’re being honest, we’re still in recession.
Darius Dale:
And you look at, you know, real consumer durable goods growth, when you look at residential fixed investment growth, you look at nonresidential fixed investment growth and structures in particular, you look at, you know, delinquency rates for credit cards, auto loans, student loans, those are essentially at or near levels that are consistent with the height of the global financial crisis right now, on an aggregated basis, delinquency rates are consistent with, you know, where we were at the trough of the Great Recession.
Darius Dale:
And so that tells you that there’s very clearly a downturn going on for the households and the businesses on the lower end of the economy. So using the policy rate tool, in our opinion, would be a mistake, because all you’re going to do is exacerbate the downturn that we’re seeing in that segment of the economy without actually addressing where the inflation is coming from.
Darius Dale:
Because obviously, if they’re in recession, they’re not the contributors to the inflation where inflation is coming from right now, it’s three main vectors. One, we obviously have a massive aggregate demand shock from AI CapEx. When you look at the roughly $800 billion of hyperscale CapEx that’s expected for 2026, that’s about 2.5% of U.S. nominal GDP. The $1.2 trillion that’s currently projected for 2027 is about 3.6% of nominal GDP.
Darius Dale:
I mean, this is a this is not something that I don’t have another word to say. This is it’s insane how big the massive aggregate demand shock. This is not a percent of of the economy. So that’s one. The other two vectors are policy driven and monitor driven. On the policy side of things, we have, you know, growth and in deficit spending tracking about, you know, eight 9% year over year.
Darius Dale:
We have the Fed’s rate of change, the annualized rate of change, the Fed’s monetary, the monetization of U.S. public debt, because, again, they’re still doing reserve match purchases. That’s somewhere around, you know, 6 or 7% year over year. And then you have bank credit growth growing at about 7 to 8% year over year. These numbers are incredibly inconsistent with 2% inflation.
Darius Dale:
And so ultimately, we know that all that’s kind of really going to and being driven by the top part of the economy. And so the fed in our opinion, would be, do a much better job of targeting this current level of inflation, this current inflation pressures, by using its balance sheet first by ending reserve manager purchases, but ultimately reinstating quantitative tightening, and threatening to do even more of that, heading into the fall into next year, which ultimately, in our opinion, give the bond market some comfort that this is a Federal Reserve that is serious about inflation.
Caroline Woods:
Yet you’re bullish. So you aren’t necessarily painting the picture of, you know, a bullish landscape, especially since in addition to that, you said companies might start throttling down. I think you said on CapEx. So give us the reasons that you think that this is a market that can continue to run higher.
Darius Dale:
Yeah. Well, we don’t think ultimately the Federal Reserve’s going to end the CapEx bubble. So that’s unlikely. If we did that at the mark, in our opinion, we think the market would ultimately reward some discipline by the capital spending, the CapEx spenders. Because ultimately, what we’re seeing from the end user data is that they’re, you know, they’re no longer earning tokens.
Darius Dale:
You know, I, I would like it’s going out of style. You know, they’re the companies that they’re selling to the compute to, in the real economy are actually throttling back their usage because they’re not seeing the, the advent of productivity growth as quickly as, you know, the CapEx spenders would probably like. And so ultimately, we think the market will reward that discipline because it’ll ultimately elongate the process.
Darius Dale:
As long as you elongate the process and don’t end the process. And you still have an upward sloping earnings curve, which albeit maybe having to get revised down a little bit from a rate of change perspective, but ultimately it’ll settle out in a still, you know, up trending, you know, expectation from the perspective of earnings and sales growth.
Darius Dale:
So, you know, the the micro side of the story isn’t over. We know we’re going to be, you know, spending 8 to 8 perhaps, you know, even higher than $1 trillion in CapEx between now and 2030. We know there’s a lot of money that needs to go into the ground. And and from picks and shovels perspective. So this, this tree, this this I build out is not over.
Darius Dale:
And more importantly, as we said earlier, the net result of the five task forces, you know, if we think we’re right, I absolutely think we’re right on this. If we’re right on that view that it’s going to be dovish, then you the markets are going to have to price in a significant amount of right tail risk starting. You know, in our opinion, our current expectation of when they, outline the the the findings of the task forces is in the December FOMC.
Darius Dale:
And so if they outline a very dovish monetary policy outlook for 2027 at the December FOMC, then the market’s going to have to price in a significant amount of right tail risk. And that’s how you have a significant up upcycle in 2027. And I think the markets will bottom well ahead of that because the market for looking okay.
Caroline Woods:
So we saw chip makers struggle last week. Do you look at that then is a healthy reset or a crack in the eye trade. And if leadership broadens from here where should investors be looking next.
Darius Dale:
Yeah that’s a great question. So it’s it’s a healthy reset. It’s an appropriate crack. It should be cracking I mean again we were with the the the expectation heading into last quarter was that I CapEx was an asymptote that was just going to keep going higher. And in our opinion we think that that that is no longer true, that at least according to the median investor, that is no longer true.
Darius Dale:
So ultimately the investors have to migrate to a two or 2 or 2 understanding that, you know, trees don’t go to the moon. We’re not going to be able to just ratchet up AI CapEx indefinitely because ultimately we’re not, you know, the cost of all this compute from the perspective of the businesses that are using the service, using the I, the cost is not yet justified by the, the expansion in productivity growth.
Darius Dale:
And we think it ultimately will be, justified. But, you know, there’s a mismatch, there’s a timing mismatch that needed to be reset. And so we’re in our opinion, we’re in that reset process. But ultimately in our opinion where we think this is headed longer term, this in our opinion we think this trade has a lot of legs from a from a time from next axis standpoint is our source of funds.
Darius Dale:
We’ve been of the view since last fall that investors should use the Mac seven companies to capitalize as a source of funds to capitalize other businesses, particularly other businesses, down in cap and out across geographic borders. You know, you think about the, you know, mid caps, for instance, here in the US or or international stocks, by and large, they’ve been left for dead from a valuation perspective.
Darius Dale:
But what ultimately is going to happen is I this technology is going to diffuse across Cap. It’s going to diffuse across borders. And it’s also going to cause a compression in the relative spread between Mac seven companies, productivity margins and earnings with everyone else. And that compression, in our opinion, is likely to lead to a compression in valuation between the Mac seven and all the other businesses and companies.
Darius Dale:
And so we’ve been disrupting our global, global investor community quite successfully since last fall to use the Mac seven as a source of funds to capitalize everything else. And as we can see, everything else is demonstrably outperforming.
Caroline Woods:
And just to clarify, using the Meg seven as a source of funds means trimming profits from the Meg seven and buying basically the the S&P Equal Weight Index.
Darius Dale:
S&P equal weight mid caps. As a great segment of the market to be focused on, international equities is a great segment of the market to be focused on. I mean, there’s been a significant compression in the relative productivity, the margins, as well as the earnings expectations between US markets and international markets. You know, cap weighted, US markets relative to, uncapped weighted markets.
Darius Dale:
We’ve seen the compression in the operating metrics already. And in our opinion, we believe this technology will, you know, perpetuate that compression and perpetuate the, you know, the expand, you know, the improvement in operating metrics for some of these companies that have been left for dead from a valuation perspective. But what what has not happened yet to it, in our opinion, to it, to its significant enough degree is the compression valuation.
Darius Dale:
In our opinion, we think that compression evaluation has has legs from from the set of other next, you know, at least 1 or 2 years, perhaps even much longer than that.
Caroline Woods:
But do you still want exposure to the Meg seven at all? And what about those investors who maybe aren’t Meg seven heavy, but their S&P 500 heavy? What do they do.
Darius Dale:
Yeah, well in our opinion you so we would not we want Max to have an exposure at all right now because again you’re eviscerating their own free cash flow. Now if they finally get some dissipate the market gives them if they get disciplined from the market to start to slow down that rate, that maybe they become a, an attractive buy from a valuation perspective.
Darius Dale:
But again, just as an investor, you want to skate to where the puck is going, not to where the skate that the puck has been. And so what we’re essentially telling you and have been telling our global investor community since last fall, is the puck is going elsewhere, the puck you want to go chase the new earnings growth, go find the new free cash flow.
Darius Dale:
Go, go find the expansion and gross margins. And it’s not it’s not Mac seven. It’s other companies. It’s the companies that are going to adopt AI to increase their productivity. It’s the companies that are going to adopt AI to increase their profitability. Companies are going to adopt are to increase their their earnings expectations. And we’ve seen this movie before, you know, we saw it in in the equities market going back to early 2000 when China joined the WTO in 2001.
Darius Dale:
You know, they gave it China access to a unified global market, much like, you know, I unified technology that that creates productivity for most businesses, at least, you know, service industry businesses. And so we saw China outperform US markets by about 500 percentage points from the time they joined the WTO to the middle of the 2000. And that’s exactly what it’s the kind of, you know, that’s the kind of technology transfer, open market access that we are essentially calling for, for, you know, going down and cap here in the US and across our geographic borders to, to international stocks.
Darius Dale:
We saw this movie before in Europe as well. You go back to, the Maastricht treaty, which was signed in 1992, which was the creation of the euro, you know, from the time the treaty was signed in 1992 to the time the euro was officially adopted and introduced in 1999, we saw a massive compression in credit spreads across all the peripheral countries.
Darius Dale:
In Europe, for example, Italian BTP, they were trading about 6 or 700 basis points above treasuries, whereas German booms are about, you know, on par with treasuries. We saw that entire 600 basis points spread compress to where the German boom was because of the adoption of the single monetary policy, the common monetary policy, the common currency. And so we’re essentially saying I equals euro, I equals, you know, open access to the to the international markets, much like in China’s case.
Darius Dale:
And so if that is true in terms of the source of funds seeing this convergence expectation that’s going to last for years.
Caroline Woods:
Okay. So for those investors who are heavily exposed to the S&P 500, they need to be making some changes as well.
Darius Dale:
Yeah. In our opinion yes. Absolutely. Yeah. We don’t. Again this trade has relaxed the the the the valuation alone will tell you where every investors are crowded in terms of their position. Investors are crowded. And all these names that have worked for many years and appropriately so this is where the cash flow growth was. This is where the gross margins were.
Darius Dale:
And we’re essentially saying that on a relative basis, the cash flow growth and the gross margin expansion will not come from these companies. They will come from other companies going down and cap mid caps in the US and go international equities abroad. And you don’t have to be specific a sector. You don’t have to pick stocks in this in this trade.
Darius Dale:
This is a long term structural macro tailwind. If you’re in the right you know exposures you know going down and cap equal weight S&P international. This is a long term macro headwind. If you’re stuck being, you know allocated to things that you know everyone that if you talked to yesterday’s trade, if you’re if you’re stuck allocate it to yesterday’s winners.
Darius Dale:
Then your portfolio is going to perform like your stock allocated to yesterday’s winners. And that’s what we’re trying to go to our best opportunity to to to to to to to to offset. Yeah.
Caroline Woods:
And then just quickly if you still want exposure to the eye trade then how do you get that if you aren’t getting it through the max seven.
Darius Dale:
If you want exposure to the eye trade. So obviously the picks and shovels have been working. The semiconductor sheet was working. We’re in a risk on reflation market regime. And that’s exactly what you would expect. High beta growth technology. These are the types of things that work in risk on market regimes which are market regime. Now casting process is signaled.
Darius Dale:
We we’ve been in since April 11th. And so you know since April 11th, our our global investor community has been going further out on the risk spectrum, chasing higher beta equities, more cyclical exposures in the equity market, you know, going down and going further out in the risk spectrum in the in the credit markets. And that’s exactly the kind of behavior you want to take as an investor to maximize upside, capture any risk on, reflation market regime.
Darius Dale:
We were essentially arguing going back to the beginning of our conversation, Caroline, is that we’re essentially saying we might be nearing the end of this reflation market regime. I’m not you know, we’re not going to be specific on timing because that that’s you know again we don’t we don’t market time. We don’t predict. We’re just you know, we’re fast reactors.
Darius Dale:
We’re going we’re essentially saying the distribution of probable economic policy, market outcomes is likely to evolve. It has been evolving and it’s likely to continue evolving in a negative manner. And if it evolves in a negative enough manner that we’re going to have a massive disconnect between being any risk on market regime and having a lot of left tail risk to pricing.
Darius Dale:
And so right now that spread that, that, that, that awkward, you know, kind of, you know, disconnect has gotten increasingly awkward in recent weeks. And so at some point in the next 1 or 2 quarters, we’re expecting it to be so awkward that the markets actually have to price in a risk off market regime that looks something like summer of 1998.
Darius Dale:
And so that that, in our opinion, is a reasonable probability outcome. And if that’s true and you have to be, you know, dispassionately execute any risk management process that tells you to, you know, take down risk, to come in on the credit spectrum, to go up in cap to, you know, to, to, to, to to take a little bit of risk off the table, to give yourself a better opportunity to buy what we ultimately think will be a very viable dip, at some point this summer, this will.
Caroline Woods:
Okay. And just digging into that a bit more, it has to be quick because we’re just about out of time. But should it if we do see that play out, if we do see kind of this pullback that you’re expecting within still a bull market that can charge higher, how should investors actually respond. Should they buy any dips?
Caroline Woods:
Should they take some profits or should they just stay the course?
Darius Dale:
In our opinion, we think when our system says, you know, it’s time to head for the exits, the risk off market is you need to be reining in risk. You need to be coming in on the credit spectrum. You need to be going up in cap. You need to be taking down the beta of your overall portfolio, maybe even raising a bit of cash to the extent that, you know, that’s what our case and doctor signals are signaling.
Darius Dale:
But ultimately, what we’re essentially coaching our best community saying is that is likely to be a transitory outcome. If that outcome occurs, it is likely to be a transitory outcome. In our opinion, we think would have caused the outcome, to occur. Is the Federal Reserve trying to, you know, create a little bit of more, more credibility, a little bit of scope to to ease monetary policy more significantly later in the year by tightening more than what’s currently priced in, at the current juncture.
Darius Dale:
And if that doesn’t happen, then it’s unlikely we have a material enough correction to warrant taking down risk. And if that does occur, we’re going to continue to rally and we’re going to have an inflation problem in 2027.
Caroline Woods:
Okay. So if the fed decides to hike is when you might change your bullish tone. I get no.
Darius Dale:
No no we right now. Yeah. No. We run very sophisticated quantitative algorithms to tell us you know, what to do in financial markets. You know, none of the none of our fundamental views have any impact on the my or our investor, our investors portfolio. So you know what I’m essentially saying? I’m predicting the predictors, if you will. I’m saying I think the algorithms are going to tell us to take down risk in the future because of these fundamental dynamics.
Darius Dale:
If we’re wrong on those fundamental dynamics, and the algorithms don’t tell us to take down risk, and we’re going to continue to bubble and ultimately have an inflation problem. 2027.
Caroline Woods:
Okay. All right. I think this is a great time to transition to our rapid fire game of this or that. Quick questions. Quick answers. Are you ready to.
Darius Dale:
I love it. This is awesome I love this segment.
Caroline Woods:
All right here we go. Second half risk on or risk off.
Darius Dale:
Both here. Now hedging both.
Darius Dale:
Risk on first half a second half. Risk us our risk off first half of the second half. Risk on second half of the second half.
Caroline Woods:
Stocks or bonds.
Darius Dale:
Stocks.
Caroline Woods:
Individual stocks or ETFs.
Darius Dale:
ETFs.
Caroline Woods:
U.S. or international.
Darius Dale:
International.
Caroline Woods:
Large caps or small caps.
Darius Dale:
In all caps made caps.
Caroline Woods:
Equal weight or market cap weight.
Darius Dale:
Equal weight.
Caroline Woods:
Meg seven or the rest of the market.
Darius Dale:
Definitely not maxed out in rest of the market.
Caroline Woods:
No surprise there. Healthy chip reset or AI cracking.
Darius Dale:
Healthy chip reset. I is not cracking.
Caroline Woods:
AI spending boom. Are we in the middle of it or near the end?
Darius Dale:
You know.
Caroline Woods:
Broadening market or I still leads.
Darius Dale:
Broadening market, but I probably see anything tethered today. I will continue to lead a mapping. And that’s where the earnings growth is.
Caroline Woods:
One sector that’s just getting started.
Darius Dale:
Oh I love this one sector that’s just getting everyone keeps trying to buy health care. I don’t have a real strong view on that in our opinion. But if we go into a risk off market regime, investors are going to want, you know, more defensive, lower beta plays. And so health care is a sector that could potentially, pick up some relative flows in that in that scenario.
Caroline Woods:
One sector that’s fairly valued here.
Darius Dale:
A sector that’s fairly valued here.
Caroline Woods:
Technology next 12 months by the dip mentality or play it safe.
Darius Dale:
By the.
Caroline Woods:
Economy, resilient or overheating.
Darius Dale:
We invented the Resilience Academy theme in the summer of 2022, and we see no change to that view.
Caroline Woods:
Inflation, cooling or sticking around sticking around.
Darius Dale:
That’s the biggest that’s the biggest misnomer in markets right now. Markets are focused on peak inflation appropriately. So we think 1 or 2 quarters from now they’ll be very much focused on sticky inflation and and the lack of progress towards 2% sticky inflation.
Caroline Woods:
At what level.
Darius Dale:
Close to three or.
Caroline Woods:
Higher for longer rates or rate cuts.
Darius Dale:
They all be cutting rates a lot in 2027. If we’re right on the task forces.
Caroline Woods:
Recession in 2027. Yes or no?
Darius Dale:
Oh, no. God, no. You. Then we’re kind of going to go 3% just for me. I can’t max alone. Absolutely not. No.
Caroline Woods:
One word to describe how your feeling about the market for the rest of this year.
Caroline Woods:
My one Darius Dale, founder and CEO of 42 macro. Thanks so much for playing along. We really appreciate your insights as well.
Darius Dale:
We appreciate you, Caroline. Thank you for having me. I look forward to next time. This is great.
Caroline Woods:
If you enjoyed this street talk, check out our full conversation with Frances Newton Stacey. She breaks down how I bottlenecks are reshaping the market and what to do about it now.