While markets have recovered from the selloff of early August, Kevin Hebner, Global Market Strategist with TD Epoch tells MoneyTalk’s Kim Parlee three issues may cause more volatility.

Transcript

Kim Parlee – My next guest says there are three fundamental reasons why markets are likely to remain volatile for some timed– artificial intelligence, what’s happening with labor, and a look at the yen carry trade. Here to break them down for us is Kevin Hebner, global investment strategist with TD Epoch. He joins us now in person, in studio, which I always love to see. Nice to have you here.

Kevin Hebner – Great to be here, Kim.

Kim Parlee – OK. So I’m just going to jump right in because I think these are pretty fascinating, and you’ve got some really great charts for us. The first reason why you think markets might be more volatile is with artificial intelligence and big tech. So tell us why.

Kevin Hebner – So big tech has accelerated their CapEx spending. So, for example, the big three hyperscalers– Microsoft (MSFT), Google (GOOGL), Facebook (META) — have doubled CapEx spending in the last three years. This is pretty enormous. And during Q2 results season, they were saying things like the risks to underinvesting are much greater than the risks to overinvesting. The CEO of OpenAI said it doesn’t matter if we burn $50 billion. We’re building AGI, and it’s going to be worth it.

So the market got the sense that they’re investing like crazy. They’re not concerned about when we’re going to get a return. The killer app is not in sight. And so the market became worried. And I think they should be worried. With the tech bubble in the late ’90s, there was a lot of CapEx spending. Eventually it made sense, but it took a decade longer than people expected. And I think we’re going to have something similar this time as well.

Kim Parlee – Let’s bring up the chart. I said you brought some great ones this time for people to look at. Because this– yeah, that’s quite the chart.

Kevin Hebner – Yeah, so over the last 25 years or so, we’ve had three distinct bubbles, you can call them– and using the term “bubble” pretty loosely– but tech, and then housing, and now with the Magnificent Seven. So the question is, is AI yet another bubble? And there are a couple of reasons to believe that’s true, but ultimately, it’s going to depend upon how quickly we get a return to all this CapEx. My guess is it’s going to take a lot longer than the market is currently anticipating.

Kim Parlee – Yeah, but it’s different this time, Kevin. That’s what people like to say. OK. Let’s talk a bit about labor. And you see that what’s happening in the labor market is also going to cause some volatility.

Kevin Hebner – Yeah, so there’s a concern that the US is moving into a recession. And globally, we have Canada slowing. Germany hasn’t had any growth this year or last year. China growth probably has a three handle. So it’s not just a US concern. It’s a global concern.

But in the US, we’ve had the labor market cooling. And so this chart shows core private employment, how it’s declined over the last year or so. The red line is the average last decade, and you can see that we’re already producing fewer jobs than we did last decade on average. So the market was very hot.

It’s cooling. Unemployment’s gone up from 3.5 to 4.1, and people are concerned of a type of reflexivity, that people lose jobs, they stop shopping, going to restaurants. Those establishments fire people, and suddenly, unemployment is at 5%, and we’re in a recession.

Our view is the labor market, it’s bending. It’s not breaking. It’s slowing. We’re not moving into recession, but we’re going to have bad unemployment reports, bad numbers coming out for the labor market. And I think that’s going to be a reason to cause more market choppiness.

Yeah, and, of course, that’s going to matter to the Fed in terms of what the Fed does as well. But we will wait and see that.

Kim Parlee – The third reason you think the markets will remain volatile is we had a taste of this already with the Japanese yen, the carry trade. Explain this to us like we’re laypeople, and explain us maybe the chart and why it matters.

Kevin Hebner – Yeah. So we’ve had an extended period of extremely low interest rates. And so what people do, naturally, then is they borrow a lot. Now, one place that’s been nice to borrow is in Japan because they’ve had low interest rates, really, for 20 years relative to the rest of the world. And speculators, they often borrow by shorting the yen in futures.

And so these are speculators who are taking these positions, and they’re not hedging on their underlying position. Apple gets a lot of yen revenues, and then they short the yen to hedge that so they don’t have an exposure. But these are just specs.

And you can see in this chart that in July, spec positioning shorts were the most extreme they’ve ever been. The only time they’ve been nearly the same degree of shortness was in 2007, just before the housing market burst. And so what we had then is very short positions, extreme market positioning. And then you had the BOJ talk a bit hawkish, Fed talk a bit dovish. The yen went from 160 to 144. These cheap positions suddenly became very expensive. They’re managed in a very tight fashion, so people have to close them very quickly, and we got this driving volatility.

There’s still lots of leverage out there, as you would expect. And a lot of it is in markets that are relatively opaque, less regulated, sometimes private markets. And I think we’ll continue to see this as a driver of market choppiness and volatility, certainly over the next– I would certainly think over the next 12 months.

Kim Parlee – So we talked about the volatility, so we can have some volatility going into the markets. But, of course, everybody is pointing and trying to understand what’s happening with the US election. And I have to say, I’ve talked to a number of people about this over the past few months. And at each time, the first time, it seemed that Trump was very clearly in the lead. And then it seemed that the announcement of Kamala Harris, that she was in the lead. Where are we now? Because I feel like it changes moment by moment.

Kevin Hebner – Yeah. And so prediction markets, which we follow closely, have moved a lot. In July, prediction markets had, say, a 27% chance of Democrats winning the White House, and now it’s doubled to about 54%. So just in a matter of five or six weeks, there has been a big move in prediction markets. And that’s clearly important.

Kim Parlee – So we’ve got a chart here showing the average betting sites here. So this is what you’re saying right here. It really doesn’t get much more neck and neck, then, does it?

Kevin Hebner – Yes, it’s extremely close right now, and similar if you look at the average polling results. Harris is about two percentage points ahead of Trump. And so that looks good, and it’s a big improvement from July with Biden. But in 2016, Hillary was 4 to 6 percentage points ahead of Trump, and obviously, she lost. And there’s concerns that there will be a fade from the bump that Harris has had with the DNC and with the momentum after Biden saying that he wasn’t going to seek a second term. So two percentage points sounds good, but we don’t think it’s going to be enough.

Kim Parlee – Yeah. And I guess the next big event, though, is the September 10 debate. And that will be– to say that will be widely watched would be an understatement.

Kevin Hebner – Yeah, there’s going to be an enormous amount of attention on that. And who can portray themselves as being the challenger rather than the incumbent, I think, is really important. And ultimately, with the United States– the US, the elections are always 50/50, and it’s a 50/50 country. The two candidates start with 40%, and then they’re fighting over the middle. And so who can be most effective in presenting themselves as a challenger and then getting a bigger part of that middle, I think, is super important. And that’s what September 10 is all about.

Kim Parlee – It’s not about just, I guess, the spectrum of views and getting the middle, but it’s about the geography. Because you’ve written the fact that there’s 50 states in the US, and 44 don’t matter, which, again, I’m not meaning to insult anybody. You mean from an electoral standpoint, it comes down to six.

Kevin Hebner – Yeah. And so in some sense, you think it’s a national election, but it isn’t. It’s a federal election, but it’s not national. In 2016, 11 states were important. 2020, eight were. This time, max, it’s going to be seven states that are important, so three Great Lakes states– Wisconsin, Michigan, and Pennsylvania– two Southeast states, so North Carolina and Georgia, and two in the Southwest, Nevada and Arizona. And so to some extent, California, New York, Democrats are going to win those by over 20 percentage points. There’s a host of states that Trump is going to win by over 20 or 30 percentage points.

So when you’re looking at campaign events, 95% of them are going to occur in these states. This is where all the time, all the money is going to be spent. And the election may well come down to what happens in particular in Pennsylvania.

Kim Parlee – Let’s bring up the chart. And again, what we’re looking at here as well, the maroon color, the burgundy, is what the polling was on July 7th.

Kevin Hebner – Yeah, and so that’s looking at support for Trump, less Biden or Harris. So Trump was ahead in all seven swing states in July. And if you look at it now, the most recent data, all of them are up for grabs. So we’ve had this dramatic change just in a matter of weeks.

Kim Parlee – Tell me– so this is support for, obviously, the presidential candidates. But, of course, we all know none of this matters about just the White House. It’s about Congress, about House and the Senate. So what are you thinking right now based on what you’re seeing in the markets? What will things look like on November 6? I hope it’s the 6th. Let me find out.

Kevin Hebner – So in July, we thought it was 75% likely Trump would win. We now think that’s 55%. In terms of the Senate, 75% likely the GOP takes the Senate. The House is a total coin toss, so 50/50 with the House. And then in terms of a sweep– and a sweep is important because if you’re president, ultimately, Congress controls the purse strings. Congress is what creates the legislation, so you need Congress. So 30% probability of a GOP sweep, 10% probability of the Democratic sweep.

And then the issue with that, then, is, OK, what does that mean for policy? Because to your point, when you get a sweep, everything you want gets to happen. So maybe tell me what we’re thinking– we’re still waiting, I think, a lot on what the actual policy directives will be. But thematically, we understand.

I think we know a lot. And for example, fiscal policy, neither candidate is interested at all in austerity. Trump is tending to favor more tax cuts. And he argues that those tax cuts will result in growth which will pay for themselves. Nobody believes that. Ultimately, we’re going get bigger deficits.

And Harris has lots of plans in terms of spending money for child tax credits, earned income tax credits, housing, child care, a host of different measures. And both of them are going to result in continued trillion-dollar deficits and continued pressure on inflation, interest rates, and so forth.

Kim Parlee – When you think about regulatory side of things, too, I know that generally, the corporate world would like to see less regulation when they’re doing these things. So what are you seeing there?

Kevin Hebner – So I think regulation is important, particularly for energy, for tech, for health care, and then increasingly, also for housing, because there’s a realization, I think, more and more a realization that a lot of the local and state regulations have prevented housing development. And that’s one reasons why we have so many issues there. And that really is a hot-button issue this election.

Kim Parlee – We’ll get to housing because that one has surfaced as well. But I want to ask you, though, too, from a market standpoint, from that pure standpoint, what should we be expecting?

Kevin Hebner – In terms of?

Kim Parlee – Either one. Sorry. In terms of the market reaction to Harris or Trump.

Kevin Hebner – Yeah, certainly, Trump would mean less regulation. And he’s been talking about that a lot. And to some extent, in his first term, he did have some success with peeling back regulations. So that is something the market would like a lot.

Kim Parlee – So that would mean, I guess, if you’re thinking these are long US markets, long US dollar, something like that would happen?

Kevin Hebner – Yeah, certainly– particular for tech and energy, it would be quite constructive. Health care is a bit more complex.

Kim Parlee – Yeah, yeah. Let’s talk a bit about the US housing and how that has become an election issue, and probably was not thought to be an election issue going into this, was it?

Kevin Hebner – It’s really interesting. So there was a lot of Democratic think tanks which were stressing housing, and then a lot of focus groups were stressing housing. But then last week, President Obama gave a speech at the DNC, and the first policy he talked about was housing. And that really got people’s attention.

And then more recently, candidate Vice President Harris has come out with some detail on policies for what she would like to do to increase the supply of housing. And this is important because since 2007 with the housing crash, the United States is supplying about 50% the number of houses that they did previously. And so the US is probably short by somewhere between 2 million and 8 million houses relative to what trend would apply. And the implication of that is this chart, housing affordability, which is the worst it’s ever been.

Part of that is because of relatively high mortgage rates, but pricing– but the big issue is supply. In all the Democratic focus groups, and I think also on the Republican side, this is coming up as a top issue. And so we’re going to be seeing, I think, both candidates talk more and more about this.

Kim Parlee – And it’s interesting, too, because it appeals to a younger demographic, obviously, who are trying to establish themselves and trying to get themselves in there.

Kevin Hebner – Yes.

Kim Parlee – Well, thank goodness you’re here to tell us what to watch for. It’s fascinating, and there’s a lot of moving parts. Thanks so much for coming in.

Kevin Hebner – Thank you very much, Kim.

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