Kicking the Can Down the Road

A stopgap spending bill that would extend government funding at current levels into mid-January was passed hours ago. This gives House lawmakers time to craft several detailed spending bills that will cover everything from the military and defense allotments to scientific research. Some Republicans on the party’s right fringe were frustrated that the bill did not include the steep spending cuts and border security measures they sought; nonetheless, the bill was passed with help from the Democratic side of the House, and it pushed the potential of a government shutdown into the New Year.

However, the partisan gridlock seen in Congress is not over and this is what led Moody’s to lower its credit rating on US debt from “stable” to “negative” last week. Moody’s pointed to economic risks including high interest rates, the government’s steadily-growing debt pile, and political polarization in Washington as reasons for the downgrade. Treasury Secretary Janet Yellen voiced disagreement with Moody’s shift, nevertheless, this implies she is blind to the ballooning deficits that now point to long-term fiscal risks. Burgeoning federal debt has recently provoked fresh warnings from economists, politicians, and credit-rating agencies.

Monthly fiscal deficits surged during the COVID shutdown and then fell on a year-over-year basis as stimulus payments began to fade and people went back to work and started paying taxes. However, a 12-month sum of monthly deficits began growing again this year and showed a 135% gain as of July 2023. This declined to a 29% YOY gain in October once Californian individual tax payments came due. Nevertheless, deficit spending is on an ominous trend, and particularly worrisome since the debt ceiling has been suspended until 2025. Not surprisingly, last week’s $24 billion sale of 30-year Treasury bonds (part of the government’s $112 billion debt sale) drew weaker-than-expected demand. This resulted in a yield of 4.769%, or 0.051% higher than the yield in the pre-auction trading in order to entice buyers. Primary dealers, who buy up the supply not taken by investors, had to accept 24.7% of the offering, more than double the 12% average for the past year. All in all, it was considered a bad performance, and it shows how rising debt levels will eventually push interest rates higher.

Moody’s had been the only one of the three main assessors with a top rating for the US. Fitch Ratings downgraded the US government credit rating in August following the latest debt-ceiling battle. S&P Global Ratings stripped the US of its top score in 2011 amid that year’s debt-limit crisis.

Here Comes Goldilocks

The equity market had a muted response to these debt risks, probably due to the fact that the economy has been surprisingly resilient. Yet it had a wildly bullish response to October’s CPI release. October’s headline CPI was unchanged for the month and up 3.2% YOY. This was down from 3.7% YOY in September and better than the consensus expected. However, if you look at the major components of CPI the only segments showing weaker than headline inflation were fuels & utilities, transportation, education & communications, and apparel. See page 3. There is still work to be done to get inflation down to the Fed’s target of 2%.

More importantly, core CPI rose 0.2% in October and was up 4% YOY, down slightly from September’s 4.1% YOY. Service sector inflation was still high at 5.1% YOY in October, down from 5.2% YOY in September. See page 4. What is clear from the history of inflation cycles is that it takes years for inflation to fall back to average or less after a sharp spike in rising prices. Inflation has been decelerating for 13 months and the consensus is declaring victory. This week equity traders began to discount an expectation that the Federal Reserve has not only ended its tightening cycle, but that rate cuts are on the horizon in the first half of 2024.

Some optimists suggest that inflation is already at 2% if housing, which lags home prices, is eliminated from the CPI equation. We doubt this is true and we doubt that consumers would agree or that renters are seeing only a mere 2% rise in rents. What is in fact helping to dampen service inflation is the recent decline in medical care services. But note that most medical services, including medical insurance, are repriced in the fourth quarter, so this favorable trend could shift in coming months and push core CPI higher at year end. See page 5. In short, this week’s rally is ushering in a Goldilocks scenario which we believe is unlikely.

Warning Signs

There are warning signs of economic weakening. The NFIB small business optimism index fell 0.1 point in October recording its 22^nd month below the long-term average. A long below-average reading is typically a sign of a recession. What we noticed in the last NFIB survey was that sales fell to their lowest level since July 2020, i.e., during the COVID recession, and earnings fell to their second lowest reading since June 2020. See page 6.

In recent weeks we reported that credit card balances increased to more than $1 trillion and newly delinquent rates on credit cards are at the highest level in over a dozen years. In addition, a Bank of America report indicates that a growing number of “cash-strapped Americans” are using their retirement nest eggs for emergency funds. The number of Bank of America 401(k) plan participants taking hardship distributions in the third quarter was 18,040, an increase of 13% between the second and third quarters and the highest level in the past five quarters since Bank of America began tracking this data. This ominous trend shows that while many financial commentators emphasize the “resiliency of the US economy” there is a growing segment of the population experiencing financial stress. The economy may be weaker than some suspect.

Big Technicals

The charts of the popular equity indices are surprisingly bullish after this week’s big price rise. The first upside resistance in most indices is found at the July highs, and the next resistance would be the all-time highs. This week the Russell 2000 index had it best performance since November 2020, rising 4.5% after October’s inflation report, but the index will encounter important resistance around the 1830 area where the 100-day and 200-day moving averages merge.

We remain cautious. Seasonal factors are usually bullish in November, December, and January, and this dramatic surge in prices could be hedge funds jumping ahead of what is seen as a seasonally strong equity market in order to lock in gains prior to yearend portfolio pricing. It does not appear to be a broad-based demand for equities. Either way, our view of the market is unchanged. The trend is neither bullish, nor bearish, but stuck in a broad trading range which is a substitute for a bear market decline. We have been expecting this trading range to persist until inflation is under control. In short, traders may be jumping the gun.

Gail Dudack

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As we near the end of the calendar year, we know that seasonal factors favor a stronger stock market. However, we also recognize that the outlook for 2024 is clouded by the Ukraine/Russia and Israel/Gaza wars, the uncertainties surrounding the presidential election in November 2024, questions about monetary policy, nagging inflation, rising credit card balances, rising credit card delinquencies, questions about the health of the US consumer, the ability of the US Treasury to fund ever-growing levels of debt, and most importantly, the prospect for corporate earnings.

Yet, what may soon jump to the top of the list of concerns will be the possibility of a government shutdown. This will not be a debt ceiling debate. On June 3, 2023 President Biden signed a bill that suspended the government’s $31.4 trillion debt ceiling until January 2025, in other words, until after the presidential election. Nevertheless, while there is currently no limit to how much the US government can borrow, Congress is required to approve government spending. Historically this has been in the form of a budget proposal originating from the President for the fiscal year (October 1 through September 30). Typically, this budget then goes to the House Ways and Means Committee which creates its own budget, details are debated and negotiated by both houses of Congress and passed. However, Congress has only completed this process in a timely manner three times in the last 47 years. The last time was the budget for the fiscal year ending in 1997.

Continuing Resolutions

The alternative to this process is a continuing resolution (CR). Continuing resolutions are temporary spending bills that allow federal government operations to continue when final appropriations have not been approved by Congress and signed by the President. Without final appropriations or a continuing resolution, there could be a lapse in funding that results in a government shutdown. This is the situation Congress will soon be facing, again. On September 30, House and Senate lawmakers passed a short-term budget extension to avoid a shutdown at the start of the new fiscal year which began on October 1 but that deal will expire on November 17. In short, lawmakers will be back in the same legislative predicaments they faced in mid-September in less than 10 days.

At present, House and Senate leaders have not made meaningful progress on a full-year budget deal or short-term compromise plan. The new Speaker of the House, Mike Johnson (Republican – Louisiana), has said that budget cuts or other policy riders will be included in upcoming proposals from his chamber but Senate Majority Leader Chuck Schumer (Democrat – New York), has called those ideas a dead end. Political analysts suggest there are three choices for Speaker Johnson. He could push for a simple funding bill that would move the November 17 deadline into next year without any strings attached. He could pair government funding with GOP priorities linked to immigration or other policies like cutting federal spending. Or Johnson could propose a “laddered CR” that would extend government funding for different agencies for different periods of time. This would allow lawmakers to favor certain parts of the government over others. For example, defense and homeland security spending would be placed ahead of other agencies. Still, without a continuing resolution, active-duty troops will not be paid any salary and hundreds of thousands of federal employees will be furloughed.

We suggested this once before, but we think Congressional salaries should be sacrificed for every day of a government shutdown. It might improve productivity in Washington DC.

Credit Card Woes

Recent data from the New York Federal Reserve revealed distinct pockets of weakness in the consumer sector and this could impact future economic activity. Total household debt balances grew $228 billion in the third quarter across all types of borrowing, particularly for credit cards and student loans. Credit card balances increased $48 billion in the quarter and $154 billion on a year-over-year basis. It was the eighth consecutive quarter of year-over-year increases and the largest increase since the NY Fed began collecting data in 1999.

This expansion in consumer debt helps to explain the surprisingly high GDP growth seen in the quarter, but it is coming at a cost. Credit card delinquencies increased from the historical lows experienced during the pandemic and topped pre-pandemic levels by the end of the quarter. Mortgages, which comprise the largest share of household debt, have delinquency transition rates that are below their pre-pandemic levels; nevertheless, auto loan and credit card delinquencies have surpassed their pre-pandemic levels. The rise in credit card delinquencies is being led by Millennials, whereas Baby Boomers, Generation X, and Generation Z have delinquency rates closer to 2019 levels. Delinquency rates have been increasing in each income quartile but are rising fastest for lower-income credit card holders. Those with combined balances over $20,000 have the highest delinquency transition rate, but fortunately these balances represent only 6% of credit card holders. Not surprisingly, delinquencies are rising most quickly for consumers with auto and student loans.

Haves and Have-Nots

In the second half of the year, the winding down of fiscal stimulus, the rise in interest rates, and the resumption of student loan payments, began to impact households, particularly the lower-income category. Still, the post-pandemic expansion has been an unusual one and continues to be a story of the haves and the have-nots. Seen from one point of view, higher income households have been going to Taylor Swift concerts, enjoying expensive cruises, and traveling the world for fun. Lower-income households have been battered by high inflation and are having trouble paying their mortgage, paying rent, putting gas in their car, and paying for their children’s education. The third quarter GDP of 4.9% did not feel all that special from their perspective.

This week we also review vehicle sales, Conference Board consumer sentiment (seven out of 10 consumers expect a recession in the next 12 months), ISM indices, the employment cost index, and S&P earnings. See pages 3-7.

Technical Update

The Russell 2000 index spent only two trading days below the key 1650 support level, which was too brief to confirm that the breakdown in the index was significant. This is good news since a breakdown would have meant much lower prices for the overall market. In upcoming weeks, the most important index could be the SPX as it trades between its 100- and 200-day moving averages, which represent resistance at 4400 and support at 4251. See page 8. The 25-day up/down volume oscillator is at a positive 0.90 reading this week and neutral, after recording an 89% up day on November 2, on volume that exceeded the 10-day average. See page 9. However, this indicator did not confirm the advance in August nor the weakness in October. This is in line with our long-held view that the equity market remains in a broad neutral trading range.

Gail Dudack

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Federal Debt Distress

There are many things to worry about this week. At the top of the list are the wars in the Middle East and in Europe, which are proxy wars for any and all democratic societies, and which could have an impact on the price of crude oil. Earnings season has been a mixed bag and results have not been confidence-building. The Federal Reserve meets this week, but we doubt there will be any change in the fed funds rate given the uncertainty of the world’s geopolitical situation. However, one of our main concerns is the rising level of government debt, the lack of political will to change current trends, and what this will mean for the future of interest rates. Total outstanding US debt has grown from $31.5 trillion in June to $33.17 trillion recently. And this level is up from $23.2 trillion in pre-pandemic 2020, which equates to a shocking 43% increase in 3 ½ years. Meanwhile, Congress seems willing to put this issue on the back burner.

This year the Treasury sold roughly $1.56 trillion of new Treasury bills through the end of September and the bulk of this materialized after Congress suspended the debt ceiling in June. This week the Department of the Treasury announced its estimates of privately held net marketable borrowing for this year’s fourth quarter and next year’s first quarter. The Treasury indicated it expects to borrow $776 billion in privately held net marketable debt in the current quarter, down $76 billion from its July estimate, due in large part to projections of higher receipts. Since this new estimate is lower than what was previously announced, the bond market responded favorably to the news.

But borrowing will increase. The Treasury also indicated it plans to borrow $816 billion in privately held net marketable debt in the first quarter of 2023, assuming their projections of cash on hand are correct for December 2023. Treasury yields, especially on longer-dated securities, have risen in step with growing bond supply and supply is expected to continue to grow. By the end of fiscal 2028, White House forecasts show gross debt rising to $42 trillion, a 28% increase from current levels, and debt held by the public rising to $34.5 trillion, a 33% increase. See page 3.

There are many problems related to growing deficits. The first risk is that supply drives interest rates higher, but eventually, high levels of debt become a Catch-22. Interest payments on the debt increase deficits and raise interest rates which increase the interest payments on the debt, and so on. As we noted last week, while defense spending grew 7%, to $774 billion in FY 2023, interest payments on the debt increased 33%, to $711 billion. At this pace, interest on the debt will overtake defense spending in fiscal 2024.

Another warning sign is the high level of short-term government debt. The TBAC, or Treasury Borrowing Advisory Committee recommends keeping Treasury bills at 20% or less of total outstanding marketable US government debt. However, the current level of short-term debt already exceeds 20% which increases the rollover risk as interest rates rise. See page 4. In sum, the market may be too complacent about interest rates, particularly as the Fed leaves rates unchanged after two consecutive meetings, but we see the potential for the bond market to upset the stock market in the months ahead.

Economics: A Strong September

The advance estimate for GDP in the third quarter was a surprisingly strong 4.9% and this follows a 2.1% gain in the second quarter. Consumer spending was an important source of growth as well as inventories. Residential investment made its first positive contribution to growth since early 2021. See page 5. In line with this was good news about September’s personal income. It rose 4.7% YOY, disposable income rose 7.1% YOY, and real disposable income rose 3.5% YOY. Real personal disposable income has now been positive for nine consecutive months. However, personal consumption expenditures rose 5.9% YOY, which explains why the savings rate fell from 4.0% in August to 3.7% in September. See page 6.

It is worth noting that September’s 3.7% saving rate is well below the 2000-2023 average of 5.7% and this suggests that the current rate of consumption is unsustainable. In addition, rising interest rates continue to pressure consumption. Personal interest payments were up 48% YOY in September and currently represent 2.8% of personal consumption. See page 7.

Therefore, we were not surprised that consumer sentiment indices were uniformly weak in October. The Conference Board confidence index fell from 104.3 to 102.6, with present conditions weakening from 146.2 to 143.1. The expectations index fell from 76.4 to 75.6. The University of Michigan sentiment index declined from 67.9 to 63.8, while present conditions fell from 71.1 to 70.6. The expectations component was much weaker, falling from 65.8 to 59.3. All in all, October has not been a good month for many households. See page 8.

Technical Breakdown

The deterioration in the technical charts of all the popular indices was obvious this week. However, the most significant development was the sell-off in the Russell 2000 index below the 1650 support level. This breakdown has not yet been confirmed since the index rebounded to 1662 on October 31, nonetheless, the pattern is worrisome. A confirmed breakdown will be a sign of lower prices for the overall market and the likelihood of another 5% to 10% downside risk. See page 10.

The 25-day up/down volume oscillator is at a negative 0.81 reading this week and neutral, after being in oversold territory for two consecutive trading days on October 20 and October 23 and for three out of four consecutive days on October 5 to October 9. It may surprise some readers that this oscillator did not reach an extreme oversold reading after last week’s decline; however, the lack of a consistent oversold reading continues to suggest that the equity market is in an extended trading range. Keep in mind that broad trading ranges are often substitutes for bear markets and are simply another way for prices to come in line with valuation. See page 11.  

The 10-day average of daily new highs is currently 34 and the 10-day average of new lows is at 454. This combination is negative with new highs well below 100 and new lows well above 100 since we assume 100 is the benchmark for defining the market’s trend. The NYSE advance/decline line fell below the June low on September 22 and is now 40,491 net advancing issues from its 11/8/21 high. July was the first time in two years that the disparity between the AD line’s peak and current levels was consistently less than 30,000 net advancing issues. However, in recent weeks this disparity has increased well above 30,000 issues once again. See page 12.

Last week’s AAII readings showed a 4.8% decline in bullishness to 29.3%, and an 8.6% increase in bearishness to 43.2%. Bullish sentiment is below its historical average of 37.5% for the 9th time in 11 weeks. Pessimism is above its historical average of 31.0% for the 8th time in 10 weeks. After hitting a negative one-week reading the week of August 2, the 8-week bull/bear spread is now neutral and closing in on a positive reading. We remain near-term cautious but sense a good intermediate-term buying opportunity is approaching.  

Gail Dudack

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Halloween is quickly approaching, but the financial markets are spooked for other reasons. It is already an unsettling time with Iran and Russia sparking wars in Israel and Ukraine and many of the world’s major cities experiencing disturbingly large demonstrations in support of the Hamas terrorist group. The breadth of antisemitism seen both domestically and abroad has been a frightening revelation for many. A small consolation is found in the growing number of industry leaders stating they want the names of pro-terrorist demonstrators seen on Ivy League campuses because they will not hire them. University donors are also pulling money from universities that are supporting Hamas, or do not differentiate between Hamas or other terrorist organizations and Palestine. These are small steps in the right direction in very troubling times.

However, here at home, there is another potential crisis. It began with the historic ousting of House Speaker Kevin McCarthy on October 3 which exposed the large schisms in the Republican party and how a small number of Republicans could wield control over the election of the Speaker of the House. Without a speaker, the House is unable to conduct government business, to continue its subcommittee investigations, or to push through bills, including vital spending bills that would prevent a government shutdown on November 18. As we go to print, a third candidate, Tom Emmer, Minnesota Congressman, who was nominated by fellow Republicans as Speaker candidate earlier this week, abandoned his bid due to party infighting. The House has now gone 22 days without a leader and a US government shutdown looms on the horizon. Government paralysis in the face of massive global disruptions and significant fiscal hurdles will not be good for the securities markets.

Crosscurrents

It is not surprising to us that the 10-year Treasury yield broke above the 5% resistance level in recent sessions. Treasury bonds are facing two strong and opposing crosscurrents. On the one hand, deficit spending has continued to increase. Year-end data from the September 2023 Monthly Treasury Statement of Receipts and Outlays of the United States Government show that the deficit for FY 2023 was $1.7 trillion, $320 billion higher than the prior year’s deficit. As a percentage of GDP, this was 6.3%, an increase from 5.4% in FY 2022. The Office of Management and Budget estimates that the FY 2024 deficit will be 6.9% of GDP. See page 3.

With both deficits and interest rates rising, interest payments on the debt have increased 33% from $534 billion in FY 2022 to $711 billion in FY 2023. In comparison, defense spending grew 7% from $727 billion to $774 billion in the same period. If this pace continues, interest on the debt will overtake defense spending next year. See page 4. In the near term, the anticipated record issuance of debt in the next few quarters has worried bond investors. But in the longer term, interest payments on this debt and its impact on deficits will soon become a Catch-22 problem for debt markets.

The other crosscurrent that is now helping the bond market is the war in the Middle East. Not only is the US bond market seen as a safe haven in a time of war, but this flight to safety is also having a positive impact on the price of gold and bitcoin. In sum, the cross currents in the bond market are as powerful as we have seen in a long time.

Higher interest rates seem likely over the intermediate term, although we doubt the Federal Reserve will raise rates in November, ahead of a possible escalation of the Israel-Gaza conflict. It will only raise rates once it has prepared the market for higher rates. Yet, the impact of rising interest rates is being felt throughout the economy. Mortgage rates have increased 425 basis points in the 24 months ended August 2023, and this is impacting the residential housing market. The August NAR housing affordability index dropped to its lowest level since June 1985, and mortgage rates have increased in the interim. The September report will be released November 9. The October NAHB confidence survey fell to 40, dropping 16 points since July and is now at its lowest level since January. See page 5. In short, the housing market is slowing, and we expect higher rates will impact auto affordability as well in the coming months.

Earnings

This is one of the busiest weeks in terms of third quarter earnings releases and as we noted last week, it includes a number of the large cap technology darlings. To date, the results are mixed. Microsoft Corp. (MSFT – $330.53) beat estimates for fiscal first quarter results in all segments, but Google-parent Alphabet Inc. (GOOG – $140.12) missed its cloud business revenue estimates and the stock was pummeled. The S&P Dow Jones consensus estimates for 2023 and 2024 are $218.71 and $244.97, respectively, down $0.84, and up $0.18, respectively as of October 20. LSEG IBES estimates for 2023 and 2024 are $219.74 and $246.91, down $0.72, and $0.05, respectively. This is the first time that the IBES estimate has dropped below $220. And based upon the IBES EPS estimate of $219.74 for this year, we believe equities remain overvalued. A PE multiple of 19.3 times is high given that inflation remains above average at 3.7%. The sum of inflation (3.7) and the market’s PE (19.3) equals 23.3 and this is barely under the 23.8 level that defines an overvalued equity market. See page 6.

Technical Indicators in Focus

The Nasdaq Composite index is the only index that has not broken below its 200-day moving average in the last week, although it did have an intra-day test of this long-term average recently. To date, it is unclear if this test will prove successful. The S&P 500 index rebounded after breaking below its 200-day moving average, but it is now trading only marginally above this long-term average. The Dow Jones Industrial Average and Russell 2000 are both trading below their 200-day moving averages as noted last week. Nonetheless, a break below the 200-day moving average is not unusual for a market that is in a long-term sideways trend. However, at 1679.50, the Russell 2000 is perilously close to key support at the 1650 level. This support has contained selling sprees in the past and it would be a major negative if this support level were broken. If it breaks, we believe it would be a precursor to further price weakness. See page 7

The 25-day up/down volume oscillator is at a negative 2.54 reading this week and neutral, but only after being in oversold territory for two consecutive trading days on October 20 and October 23. This follows oversold readings for three out of four trading sessions in early October. These oversold readings could be mirror images of the overbought readings seen in August, when no overbought readings lasted the minimum of five consecutive trading days. In short, August’s rally was unconfirmed. Now that this indicator has had oversold readings of minus 3.0 or less, the same is true – five consecutive trading days in oversold are needed to confirm that recent weakness is a confirmed downtrend. To date, there have not been five consecutive trading days in oversold, which means the decline is not confirmed and the longer-term trend remains vulnerable, but neutral. See page 8. We remain cautious but believe a buying opportunity could materialize before year end.

Gail Dudack

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There has been a lot of volatility in recent days, yet there was very little progress in the popular indices. This is not surprising to us. There are almost too many variables and risks to monitor at the moment and so the indices are whipsawed by the ever-changing news of the day. Aside from the economic backdrop, the Israeli-Gaza war creates a frightening and unpredictable global environment, and the sad state of affairs in the US House of Representatives — which seems incapable of electing a new Speaker — has put a dangerous halt to US fiscal and foreign policy. (Shouldn’t we stop paying their salaries until they do their jobs?) US border officials have released thousands of migrants onto the streets of the San Diego area and Russia states that it no longer needs to obey the UN Security Council restrictions on giving missile technology to Iran since the restrictions will soon expire. It does make your head spin.

The Magnificent 7

In times like these, it is always important to monitor earnings and valuation. In this regard, Refinitiv IBES, in conjunction with Lipper Alpha Insight, released an interesting study on third quarter earnings season. It included information reminding investors that the S&P Dow Jones earnings estimates are share weighted, not market capitalization weighted. It then looked at what they called the “Magnificent-7”. These are Apple Inc. (AAPL – $177.15), Amazon.com, Inc. (AMZN – $131.47), Alphabet Inc. (GOOG – $140.99), Meta Platforms, Inc. (META – $324.00), Microsoft Corp. (MSFT – $332.06), Nvidia Corp. (NVDA – $439.38), and Tesla, Inc. (TSLA – $254.85).

IBES noted that these seven stocks have a market cap weighting in the S&P 500 index of 29.9% — an all-time high — but have earnings and revenue weights of 15.6% and 9.7%, respectively. The Magnificent-7 also has an aggregate forward PE of 27.6 times, which represents a 55% premium to the overall index. A table from this report is presented on page 11 with the 11 sectors of the S&P 500, their market cap weighting, earnings share weighting, revenue share weighting, and forward PE multiples. It basically shows that the technology sector is by far the most expensive segment of the S&P 500, while financials and energy are the least expensive. It is an interesting macro view of valuation.

Given their excessive weighting in the S&P index, the earnings reports from these seven stocks will be important to monitor. Tesla, Inc. will be the first to report on October 18, followed by Microsoft Corp. and Alphabet Inc. on October 24, Meta Platforms, Inc. on October 25, Amazon.com, Inc. on October 26. Apple Inc. and Nvidia Inc. report on November 2 and November 21, respectively.

Economics in Focus

There were many economic releases in the last week which we would summarize as showing weakness in business and consumer sentiment, stickiness in inflation, resiliency in retail sales, and better-than-expected industrial production led by autos. All in all, these reports would probably lead to another fed funds rate hike in November, if all things were equal. But all things are not equal in the Middle East or in the US and as a result,  we do not expect the Federal Reserve to raise rates. Keep in mind that another debt ceiling crisis will materialize before the end of the year.

The NFIB small business optimism index fell slightly in September, from 91.3 to 90.8; however, the business outlook fell from -37 to -43 and “expected credit conditions” dropped from -6 to -10. See page 3. Preliminary data for October’s University of Michigan sentiment survey showed a decline in consumer sentiment even though gasoline prices had declined. The main index fell from 68.1 to 63.0; present conditions fell from 71.4 to 66.7; expectations fell from 66.0 to 60.7. Conference Board indices fell in September and October data will be released at the end of the month. See page 5.

Industrial production rose a better-than-expected 0.3% in September. Nonetheless, total IP was barely above the level seen a year ago, nondurable production was down 0.3%, but durables, led by auto production, rose 1.7% YOY. However, auto and truck production appears to be rolling over after its May-June peaks. See page 4.

Advance estimates for September’s retail and food services sales were $704.9 billion, up 0.7% for the month, and up 3.8% YOY. This was much better than the consensus expected; yet, after inflation, real retail sales in September were up only 0.1% YOY. At the end of August, real retail sales had been negative on a year-over-year basis for nine out of ten consecutive months. We believe this is an important point since year-over-year declines are typically seen only during recessions. See page 6.

The key reports last week were related to inflation. The PPI is usually a leading indicator of the CPI, and the good news was that core PPI, while still high at 3.4% YOY, appears to be decelerating. On the other hand, headline PPI, after being negative for months, has begun to uptick again and reached 2.5% in September. Similarly, core CPI, still high at 4.1%, appears to be decelerating, but headline CPI rose slightly in September to 3.7%. See page 7. Most of the major components of the CPI rose more than headline, both on a monthly and a yearly basis, and all items less food and energy rose 4.1% YOY. Stemming an even bigger jump in inflation in September were the declines seen in fuels & utilities and medical care. Still, since transportation costs typically lag the price of oil which has been rising, there is an upward risk to future inflation numbers. See page 8.

The Federal Reserve is most concerned about service sector inflation which eased only slightly from 5.39% to 5.16% in September. Owners’ equivalent rent inched down from 7.3% to 7.1% and rents of primary residences eased from 7.8% to 7.4%. Medical care pricing was negative for the third consecutive month falling 1.4% YOY. However, other services, with a 9.4% weighting in the CPI, are trending higher and were up 4.4% in September. See page 9.

The biggest risk to future inflation could be higher crude oil prices. This is likely given the chaos in the Middle East. After months of YOY declines, WTI rose 14.2% YOY in September and to date, is up 1% YOY in October. Equally important, the chart of WTI turned bullish once the price broke above the $80 resistance level. See page 10. Again, if it were not for all the domestic and global political risks, the Federal Reserve would likely be raising rates in November.

Technical Guides The Russell 2000 continues to trade below its 200-day moving average, the Dow Jones Industrial Average broke below its long-term average before recovering in recent sessions. The S&P 500 rebounded after an intra-day test of its 200-day average, which was technically impressive. The Nasdaq Composite, led by the Magnificent-7, continues to trade well above its long-term average. But overall, the patterns of the major indices remain characteristic of a long-term neutral trading range. This is best represented by the 1650-2000 range in the Russell 2000. If the Russell were to break below the 1650 support, it would be bad news for the broader market, in our view, but this is not our expectation. Our 25-day up/down volume oscillator was oversold for three of five trading sessions in early October but is now neutral. In short, it too suggests the market remains in a long-term trading range.  

Gail Dudack

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Our heartfelt prayers go out to all those impacted by the barbaric invasion of Israel, and we are shocked by the unspeakable atrocities enacted by Hamas. If it is proper to measure people by their actions and not their words, it is clear that terrorists like Hamas, have no desire for peace but seek only to terrorize and control others. This should remind all Americans of the beauty of our Constitution, the purpose of strong borders, and the need to fight terrorism wherever it exists. We will never forget, and we pray for Israel and all those who believe in and fight for democracy and peace.

It is difficult to write about equities when the newswires are dominated by the war taking place in Israel. Particularly since Syrian shells, purportedly shot by a Palestinian faction, landed in Israeli territory on Tuesday and Israel responded by firing back. This points to the risk of the Gaza-Israeli war spreading in the Middle East, and as a result, it is currently overshadowing the Russia-Ukraine war, where again, a sovereign nation was invaded by Russia. Ironically, wars are not usually bad for equity markets, however, note that neither war has been good for the equity markets of any country involved. However, it is a positive for defense stocks, particularly for makers of bullets and missiles, and since both the Middle East and Russia are oil exporters, it has been good for energy stocks.

Israel has also pushed important news about China into the background. Country Garden Holdings Co. LTD. (2007.HK – 0.75) announced it had defaulted on a principal payment which sets the stage for one of the country’s largest debt restructurings. Simultaneously, China Evergrande Group (3333.HK – 0.265) failed to get regulatory approval for its offshore debt restructuring proposal which will likely lead to its liquidation at a hearing set for October 30. The potential debt defaults of China’s two largest property developers will have devastating impacts on stakeholders, customers, supply-chain vendors, China’s economy, financial creditors, and to a lesser extent, holders of China’s US dollar-denominated bonds. Therefore, we are not surprised that Fed officials are sounding more dovish this week. An unstable world is not the right environment for another rate hike, particularly since previous rate hikes are already having an impact on consumers.

Decoding Employment Data

September’s employment report was a huge surprise, Not only was the addition of 336,000 jobs nearly double the consensus expectation, but revisions added 79,000 jobs in July and 40,000 jobs in August. This means that employment was 119,000 higher than previously reported, which makes one wonder how rigorous government data really is. Moreover, September’s year-over-year job growth was 2.1% in the establishment survey and 1.7% in the household survey. These percentages are both well above their long-term averages of 1.7% and 1.5%, respectively. See page 3. September’s 336,000 new jobs also lifted the 6-month average by nearly 20,000 to 233,670 which is well above the 50-year average of 128,000 new jobs per month. Charts of the labor force and employment show that there has been a steady increase in both since the end of the Covid lockdown. See page 4.

From a historical perspective, the US economy is at risk of a recession whenever job growth turns negative. But since job growth in September was definitely robust, it appears that the US economy is not at risk of slipping into a recession any time soon. This could support those who are expecting the US economy to remain in a lengthy period of stagflation.

However, some details in September’s job report tell a slightly different story. Multiple job holders increased by 368,000 in the month, suggesting that holding one job is not sufficient for some individuals and households. Meanwhile, those working part-time for economic reasons fell by 156,000. It is unclear if part-time workers found full-time jobs or are now holding two jobs. See page 5.

In September, average weekly earnings rose 3.6% YOY for all private industries and increased 3.7% YOY for production and non-supervisory employees. These statistics raised concern that wage growth is now fueling inflation. However, since inflation has accelerated in recent months it means that real hourly earnings have decelerated. For example, average hourly earnings grew 4.5% in August and 4.3% in September. This means that real hourly earnings rose 0.8% YOY in August and potentially rose 0.65% in September — if inflation does not increase from August’s 3.7%. See page 6.

The CPI for September will be reported later this week, and we fear it may be disappointing. After eight straight months of year-over-year declines in oil, the WTI rose more than 14% YOY in September. This jump in energy prices could easily create a higher-than-expected headline number in the CPI. In short, the 5-month stretch during which earnings grew faster than inflation may have come to an end in September. This will be a handicap for consumers.

September’s ISM data was interesting, and it showed a switch in the normal pattern. The ISM manufacturing index displayed more upward momentum than the service index. Yet even though the headline index for ISM manufacturing rose 1.4 points in September, its reading of 49 remained below 50 for the eleventh consecutive month. The headline ISM services index fell 0.9 to 53.6. Production, or business activity, rose 2.5 to 52.5 for manufacturing and rose 1.5 to 58.8 for services. New orders rose 2.4 to 49.2 in manufacturing but fell 5.7 to 51.8 in services. Manufacturing could get a boost from the defense industry in the months ahead and this could help both the economy and employment. See page 7.

Consumer credit growth slowed significantly in August. Overall credit balances grew 4.0% YOY versus 4.9% in July. Revolving credit grew 8.6%, down from 10.5% in July, and nonrevolving credit growth rose 1.8%, down from 3.1% in July. On a six-month rate of change basis, revolving credit contracted 0.2%, the first contraction since May 2016. It is not surprising to see credit card, or revolving credit, decline given that interest rates on credit card plans at commercial banks rose to 21.2% in August. However, it is important to note that sharp declines or contractions in consumer credit are signs of a recession. See page 8.

Technical Update

The Dow Jones Industrial Average and the Russell 2000 index are trading below their 200-day moving averages, the S&P 500 recently tested its 200-day average on an intra-day basis and Nasdaq Composite continues to trade well above its long-term average. Nevertheless, the major chart patterns remain characteristic of a long-term neutral trading range, best seen by the 1650-2000 range in the Russell 2000. If the Russell 2000 breaks well below the 1650 support, it would be bad news, but this is not our expectation. The 25-day up/down volume oscillator is at a neutral reading of negative 1.92 this week but has been oversold for three of the last five trading sessions with readings of negative 3.0 or less. This oscillator failed to confirm the July advance and we would not be surprised if it fails to confirm the recent decline with five consecutive oversold days. To date, the longer-term trend remains neutral.

Gail Dudack

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There were plenty of things for investors to worry about before the US House of Representatives voted to unseat House Speaker Kevin McCarthy on Tuesday. For example, Federal Reserve Chairman Jerome Powell has made it clear in recent weeks that there could be another rate hike in the near future and interest rates would not be coming down any time soon. This spooked the debt markets, and the 10-year Treasury bond yield broke above the 4.4% resistance level like a hot knife through butter.

The United Auto Workers strike does not look like it will be ending soon, and auto companies have begun to lay off workers. While the Writers Guild of America settled its strike recently, SAG-AFTRA, which represents 160,000 film and television actors, remains on strike. The 75,000 workers at Kaiser Permanente are set to go on strike this week and this would be the largest healthcare strike in US history. Meanwhile, big capitalization technology stocks are being sued by the Department of Justice and the Federal Trade Commission for monopolistic behavior and the goals appear to be to break companies like Amazon.com, Inc. (AMZN – $124.72) and Alphabet Inc.’s Google (GOOG – $133.30) into smaller pieces.

China’s property development sector continues to struggle and now Country Garden Holdings Company (2007.HK – 0.87), the largest company in the sector, is in default, following a similar pattern to that of China’s Evergrande Group (3333.HK – 0.41). Crude oil prices have surged to $89.44 a barrel and are now up 14% YOY. This will not be good for consumers, or for September’s CPI report. Perhaps more importantly, the rise in the dollar makes energy even more expensive for most non-US consumers. The triple-threat of higher interest rates, a strong dollar, and soaring energy prices will present problems for US consumers, but it could be even more damaging to emerging market economies. See page 8. Higher interest rates will also pressure regional banks since this could exacerbate deposit outflows and weaken balance sheets as Treasury bond prices fall. See page 4.

All the above makes previous concerns about the resumption of student loan payments and California personal income tax payments in October seem like child’s play. Nonetheless, these are all problems for equities. But the most immediate obstacle for equities is the 10-year Treasury yield which is closing in on 5%, and some people are beginning to think it could rise to 7% before the cycle is over.

Goldilocks or Recession

Nothing has really changed from our perspective. We were never advocates of the Goldilocks scenario which included a soft economic landing coupled with lower interest rates. We always expected interest rates to remain higher for longer and we also think that a recession is likely. Recessions are a normal part of an economic cycle and not all recessions are prolonged and systemic like in 2008. In fact, most recessions last for two to four quarters and are not even recognized as a recession until it is almost over. But historically, there has never been an inflationary cycle that has not been followed by a series of recessions. Hopefully, this cycle will see a slow steady slowdown that will bring inflation back in line with the Fed’s target of 2%. But it will take time. Meanwhile, we believe the equity market will continue to trade in a wide trading range.

The Silent Tightening Cycle

The equity market responded rather dramatically to the Fed’s statement that the fed funds rate would remain higher for longer; however, the real problem may be that monetary tightening is occurring on multiple levels, not just with the fed funds rate. The Fed continues to reduce the size of its balance sheet which means it is no longer a major buyer of US Treasury securities or mortgage-backed securities. This downshift in demand is part of the reason why Treasury bond yields and mortgage rates are rising. And it is also why the money supply, as measured by M1 and M2, has been contracting at a historical rate. See page 4. In addition, as the long end of the yield curve moves higher, this adds to the tightening process by making auto loans, mortgages, and consumer loans far more expensive. It is important to note that August’s personal income and expenditure data shows that interest income rose 8.5% YOY, but interest payments increased 47.5% YOY! See page 5. This is just one example of how higher interest rates will lower consumption in the coming months.

Much is being made of the fact that China’s ownership of US Treasury securities has been declining, and China is part of the reason that interest rates are on the rise. First, foreign official investors tend to buy and sell US bonds at a slow and deliberate pace and rarely make sudden shifts in supply or demand unless it is needed to support their own economy. In other words, it is unlikely that China is the cause of last week’s surge in rates (even though China is clearly lowering its exposure to the US). In fact, Federal Reserve data shows that foreign official and international holdings of US Treasuries have remained fairly constant since 2013. See page 3. We believe the real catalyst for last week’s surge in bond yields was that money managers and hedge funds came to a sudden decision that the consensus view of falling interest rates was an error.

Congress

This brings us back to the US Congress, the unseating of Kevin McCarthy as Speaker of the House, and the burgeoning US deficit. The chaos in the House of Representatives could not have come at a worse time. With interest rates rising, the risk of a third downgrade of US debt by Moody’s on the horizon, and analysts expecting the supply of federal government debt will be $2.5 trillion this year, the debt markets are under extreme pressure. Since the House of Representatives is crucial in terms of budgetary issues and the debt ceiling, this week’s historical ouster of the Speaker of the House adds to the uncertainty surrounding the debt markets. History shows that financial markets can deal with good news or bad news, but they do not deal well with uncertainty.

Technical Update

As we indicated last week, with the Dow Jones Industrial Average and the Russell 2000 trading below their 200-day moving averages, it is likely that the S&P 500 and Nasdaq Composite will have a similar test in the days ahead. Nevertheless, the major patterns remain characteristic of a long-term neutral trading range, best seen by 1650-2000 in the Russell 2000. If the Russell 2000 breaks well below the 1650 support, it would be a major negative for the chart, but this is not our expectation. See page 10. The 25-day up/down volume oscillator is at a negative 2.90 reading this week, down from last week and closing in on an oversold reading of negative 3.0 or less. The oscillator generated overbought readings in 10 of 22 trading sessions ending August 1, but it never confirmed July’s advance in the averages. Strong rallies should have at least one extremely overbought day and overbought readings that last at least five consecutive days. If, or when, this indicator becomes oversold, the same will be true – five consecutive trading days in oversold are needed to confirm that the decline is more than a normal pullback in prices. All in all, the market appears vulnerable, but the trend remains long-term neutral. See page 11.  

Gail Dudack

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The Federal Reserve did not raise interest rates last week, but Chairman Powell’s prepared statement and his question-and-answer period were sufficiently hawkish to convince investors that another interest rate hike may be needed this year. The dot plot revealed that most governors expect the fed funds rate will still be above 5% by the end of next year. And Chairman Powell’s comments underscored that interest rates are not likely to come down for a long time. None of this surprised us, but this had an impact on sentiment since there has been a staunchly held view that both inflation and interest rates would be coming down in the foreseeable future.

In the wake of the Federal Reserve’s hawkish stance, the benchmark 10-year Treasury yield rose to a 16-year high above 4.5%. More recently, Minneapolis Federal Reserve Bank President Neel Kashkari, one of the more dovish Fed governors, stated that there is a 40% chance the Fed will need to raise interest rates “meaningfully” to beat inflation. He indicated there was a 60% chance that one more rate hike would bring inflation in line and maneuver the economy to a soft landing. Kashkari gave no percentage for a recession. However, in our view, only if “it is different this time” will the US economy be able to escape a recession before inflation is once again under control.

Higher for Longer – Inflation and Interest rates

We continue to repeat several charts that show the history of inflation, interest rates, and the economy, since these charts are at the foundation of our stance. On page 3, the charts show that whenever inflation reaches a high level, such as the 9% seen in June 2022, inflation has declined, but only in concert with a recession. A tighter monetary policy has always been the key to reducing inflation, but the cycle of tightening typically ends only after the real fed funds rate reaches a minimum of 400 basis points. With inflation now at 3.7%, this suggests a 7.7% fed funds rate. We doubt that the fed funds rate will reach 7% or more, but we do believe the Fed is behind the curve and needs to keep rates higher for longer than most investors expect in order for monetary policy to be successful. This will also raise the risk of a recession.

Jamie Dimon, CEO of JPMorgan Chase & Co. (JPM – $144.93) told the Times of India in an interview this week that many businesses and investors were not prepared for a worst-case scenario in which interest rates hit 7% and stagflation grips America. Again, the risk of a recession is greater than Kashkari’s zero. We think there is a better-than-even chance that a recession is on the horizon, and it does not have to be a long debilitating recession, but it is part of a normal economic cycle. A recession would have come earlier and probably be over by now, if it were not for the multiple stages of fiscal stimulus put into place in the last three years.

One thing is clear – inflation is not apt to come down quickly. After 12 months of a disinflationary trend in the CPI, and after 8 months of negative year-over-year pricing in crude oil, both trends began to reverse in August. Sequentially, the CPI was up 3% YOY in June, 3.2% YOY in July, and 3.7% YOY in August. The PPI for finished goods was 2.2% YOY in August, the first positive year-over-year gain in four months. Oil was still negative in August on a year-over-year basis, and this helped to dampen headline CPI, but to date, it is up 14% YOY in September. This is likely to fuel price increases in September. Moreover, the technical chart of light crude oil shows that it has broken above a downtrend line and has no significant upside resistance prior to $100 a barrel. This is good news for energy sellers but bad news for inflation. See page 4.

The Impact on the Economy and Earnings

Interest rates are up over 500 basis points since the end of 2021 and the lag effect is beginning to be felt. The housing sector is showing weakness again with a 15% YOY decline in existing home sales in August and a 5-point decline in the National Association of Home Builders index. This puts the NAHB index below 50 for the first time since the banking crisis this Spring. New home sales in August were down 8.7% from July’s level, but still up 5.8% YOY. Housing affordability has been declining substantially this year as mortgage interest rates continue to rise. See page 5. These are signs that “higher for longer” could translate into a weaker economy ahead.

A weaker economy has implications for corporate earnings. There is a close relationship between GDP corporate profits and S&P reported earnings and both were negative on a year-over-year basis in the first two quarters of 2023. However, the consensus earnings growth forecasts for the S&P 500 for the next four quarters look rather arbitrary to us with analysts plugging in a 10-12% growth rate. A 10% earnings growth rate is a typical estimate whenever the outlook is unknown. See page 6.

However, there are many variables in earnings growth rates. GDP data shows that nominal final sales fell sharply in the second quarter as fiscal stimulus is fading. Plus, GDP after-tax margins have been slipping in recent quarters. Strangely, S&P operating margins increased as GDP profit margins decreased. This disparity between GDP and S&P profit margins has happened in the past and it is often a symptom of tax law changes or financial engineering, neither of which has longevity. See page 7. This data suggests that there could be both a decline in revenue and a margin squeeze ahead for corporate America.

Lastly, valuations appear stretched. When we index nominal GDP, GDP corporate profits, S&P earnings, and the S&P Composite index on one chart, it is easy to see when, or if, profits and/or the SPX become extended relative to GDP growth. There can be reasons for this disparity such as an increase in productivity from both workers and technology. However, the current disparity between the SPX and GDP is greater than that seen at the 2000 peak in equities. The March 2000 peak was also a time of great technological changes, but it ended in a dot-com bubble. Our valuation model tells a similar story since it suggests equities are nearly as overvalued as they were in 2000. See page 8.

Technically, Still in a Trading Range

What looked like a consolidation phase last week turned into a clear downtrend this week, with the Dow Jones Industrial Average and the Russell 2000 index now trading below their 200-day moving averages. The S&P Composite and the Nasdaq Composite are still trading above their 200-day moving averages but look like they might be about to test these levels in the near term. Nevertheless, the major patterns in the market remain characteristic of a long-term neutral trading range. This trading range is best seen by the Russell 2000 index which has support at 1650 and resistance at 2000. See page 10. There has been some clear deterioration in breadth data this week. The 10-day average of daily new highs fell to 65 and new lows rose to 199. This combination is solidly negative this week with new highs below 100 and new lows well above 100. In addition, the NYSE advance/decline line is 33,612 net advancing issues from its November 8, 2021 high. This disparity fell below 30,000 in July for the first time in two years; but in recent days it increased to more than 30,000 issues once again. See page 12.

Gail Dudack

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The CME FedWatch tool suggests there is a 99% chance that the Fed pauses this week and a mere 31% chance for a Fed rate hike in November. This makes sense since the UAW strike does not seem to be ending soon, the writers’ strike has been ongoing since May 1, and although over 800,000 student loan borrowers received forgiveness under the IDR Account Adjustment, for the first time since March 2020, millions of borrowers will soon get a notice to restart student loan payments in October. These three items will dampen economic activity, along with the fact that the impact of fiscal stimulus packages are waning, and a government shutdown looms in the background. A final reason to expect a pause this week is that Federal Reserve Chairman Jerome Powell has never surprised the financial community with a non-consensus rate hike.

Still, we believe the Fed could, or should, raise the fed funds 25 basis points this week since monetary policy has been persistently behind the curve in terms of fighting inflation. Not only did the Fed postpone raising rates in all of 2021, implying that inflation was “transitory”, but the real fed funds rate only became positive, net of inflation, in April 2023, or roughly five months ago. In other words, monetary policy has been easy and feeding an inflationary cycle for a very long time. This is likely to make inflation more difficult to curb.

Is It Different This Time?

Typically, a Fed tightening cycle ends only once the real fed funds rate reaches a positive 400 basis points. See page 3. With the fed funds rate currently only 200 basis points above the PCE index (July) and 170 basis points above the CPI rate (August), the end of this cycle appears to be several rate hikes away unless inflation suddenly falls. A real decline in inflation appears to be a long shot, in our view, particularly with crude oil on the rise. Keep in mind that on a year-over-year basis, WTI crude oil has been negative every month of this year, a factor that has helped headline CPI decline from 6.4% YOY to 3.3% YOY in the same timeframe. See page 4. For example, fuels and utilities were down 1.2% YOY in August. See page 5. But at the current level of $91.66, WTI is up 15% YOY and gasoline futures are up 8% YOY. In other words, the benefit from falling energy prices, which has helped cool inflation this year, is disappearing and this may become much clearer with September inflation data.

It should be obvious to economists and investors that inflation will be difficult to tame, even if energy prices were not rising. A warning was already visible in August data. After 12 months of decelerating inflation in the CPI, and after 8 months of negative YOY pricing in crude oil, both trends are beginning to reverse. The CPI rose 3% YOY in June, 3.2% YOY in July, and 3.7% YOY in August. The PPI for finished goods was 2.2% YOY in August, the first positive YOY gain in four months.

Some economists had been pointing to the fact that the biggest driver of the CPI was owners’ equivalent rent of residences, and that the OER was an outdated and overstated method to measure housing. But as seen on page 5, it is the service sector and not housing that is the current inflation problem. Other goods and services saw prices rise 0.4% MOM and 5.8% YOY. In addition, while fuels and utilities fell 1.2% YOY in August and helped lower headline CPI, it also rose 0.6% month-over-month, which was more than the CPI. This is a negative sign for future CPI reports. Therefore, if the Fed agrees that inflation will be sticky, it would be appropriate to raise the fed funds rate by 25 basis points this week.

Of course, it could be different this time, and the Fed might be able to maneuver a soft landing for the US economy without completing a full monetary tightening cycle and still manage to get inflation to cool back to the 2% level. But the odds seem slim, particularly since the crude oil futures chart shows little resistance between current prices and $100 a barrel. In short, higher energy prices are one item that could upset the consensus, the stock market, and monetary policy.

On the Horizon

It is more likely that other things could upset the market. The Department of Justice’s hearing into Google’s (Alphabet Inc. – $138.83) search engine is the first antitrust case in decades. The results of this could easily impact large capitalization technology companies. China’s property developer, Country Garden Holdings Co. Limited (2007.HK – 1.01 HK), is facing a deadline this week to pay $15 million in interest for an offshore bond. Plus, the long-standing inversion in the yield curve always poses problems to the finance sector, as the series of bankruptcies in March warned.

There are signs of weakening in the economy. August’s retail sales growth was above expectations, but beneath the surface the details were less strong since the excess growth came entirely from gasoline stations, and prior months were revised lower. Consumer spending is shifting back from goods to services, with restaurants being the fastest-growing segment over the last year. Inflation continues to be a problem eating into consumer incomes and higher interest rates make purchasing big-ticket items on credit more expensive than consumers had been accustomed to. When adjusted for inflation, retail sales have been negative on a year-over-year basis for the last seven consecutive months. This is a typical sign of a recession. See page 6.

The University of Michigan consumer sentiment survey fell in August for the second consecutive month. The weakness in the survey continues to be found in present conditions and is likely due to the rise in energy and gasoline prices. Conversely, a separate University of Michigan survey on consumer inflation expectations fell early in September. Neither the Conference Board nor NFIB business surveys have released September data, but both were lower in August. See page 7.

Technical Changes and Review

The market has been in a consolidation phase this week and in all three indices the near-term trend appears indecisive. Perhaps the most important event is that the Russell 2000 index is currently trading below its 200-day moving average. This could be a sign that the other indices will also test their 200-day moving averages in the weeks ahead. However, the longer-term pattern remains unchanged and is characteristic of a long-term neutral trading range. See page 9.

The 25-day up/down volume oscillator is at a negative 0.79 reading this week and relatively unchanged in recent weeks. It is at the lower end of the neutral range, and also indecisive. See page 10.

The 10-day average of daily new highs is 81 and new lows are 123 this week. This combination is now negative since new highs are below 100 and new lows are above 100. The NYSE advance/decline line fell below the June low on September 22 and is 26,543 net advancing issues from its 11/8/21 high. In sum, the trading range, best defined by the Russell 2000 index between support at 1650 and resistance at 2000, remains intact.

Gail Dudack

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It is a very busy news week. The Department of Justice is suing Alphabet, Inc. (GOOG – $136.07) in federal court for anti-trust violations. Republican US House Speaker Kevin McCarthy launched an impeachment inquiry into Joe Biden alleging that his son, Hunter Biden, and the Biden family profited in business dealings with foreign entities while Biden was Vice President.

Jay Clayton, the former chair of the Securities and Exchange Commission, appeared at a hearing hosted by the House of Representatives Select Committee on the Chinese Communist Party that is studying whether China poses a risk to US financial stability. Clayton proposed that companies with market capitalizations above $50 billion or with China-based revenues or costs above $10 billion unveil their exposure to the world’s second biggest economy and explain how their operations would be affected in the event of a disruption in US-China economic ties. This could impact a number of large US technology and finance companies and is another example of how China is becoming an uninvestible region.

Simon & Schuster released a new, and some say scathing, book by Walter Isaacson on Elon Musk. Automakers and the United Auto Workers union are quickly approaching a Thursday night deadline to reach a deal, or 146,000 autoworkers could go on strike. North Korean leader Kim Jong Un visits Russia to demonstrate the “strategic importance” of the two countries’ relations (and possibly to cut a deal to supply arms to President Putin). Morocco struggles to reach survivors from a recent earthquake that to date, has a death tool of nearly 3,000 people. At least 10,000 are missing in Libya after floods caused by a huge Mediterranean storm swept away a quarter of the eastern coastal city of Derna. Apple, Inc. (AAPL – $176.30) launched a new series of iPhones that include a new titanium shell, a faster chip, and improved video game playing abilities.

Inflation Matters

And despite all of this, the big story of the week will be inflation data. The CPI will be released Wednesday, the PPI on Thursday, and import/export prices on Friday. This week’s inflation data reports on the month of August, but we would point out that while headline inflation has been moving steadily lower for much of this year, energy prices have done likewise. However, after eight consecutive months of year-over-year declines in energy prices, WTI oil futures are up 10% YOY in September, to date. Fortunately, or unfortunately, the technical chart of WTI oil futures looks favorable and this suggests gains could continue in the weeks ahead. If they do, it would be a bad sign for September’s headline inflation number. A rebound in inflation could upset not only the consensus view of inflation, but Federal Reserve policy for the rest of the year. See page 3. In sum, we would not become complacent about inflation, and neither should the Fed. But according to a Reuters poll, the Federal Reserve will leave its benchmark overnight interest rate unchanged at the end of its September 19-20 policy meeting and probably wait until the April-June period of 2024 or later before cutting rates. In our view, next week’s FOMC meeting could bring some surprises.

The charts on page 4 are not new to readers, but they are important since they show that whenever inflation reaches a peak level like the 9% seen in June 2022, inflation has declined, but in concert with higher interest rates and a recession. Tighter monetary policy has been key to reducing inflation, and the tightening cycle typically ends with a real fed funds rate of at least 400 basis points. This suggests that even with a 3% inflation rate a typical fed funds rate would be 7%. And even if a 7% rate does not materialize, it does suggest that the fed funds rate is likely to move higher in September. We would not be surprised if it did. However, the CPI data for August is apt to set the tone for the next week and it will not include the recent rise in energy prices.

Household Haves and Have Nots

Quarterly data on household finances from the Federal Reserve shows that the net worth of households and nonprofits rose $5.5 trillion to a new record high of $154.3 trillion in the second quarter of the year. This increase came from a $2.6 trillion increase in the value of equities held directly and indirectly and a $2.5 trillion increase in the value of real estate. Keep in mind that not all households own equities or real estate, and therefore these increases accrue disproportionately to the wealthier households who benefited from rising stock and real estate prices.

The same release showed that household debt increased at a 2.7% annualized rate in the quarter to $19.6 trillion. Household equity ownership increased from 25% of total household assets to 25.6% of total assets at the end of the second quarter. This ratio peaked at 29.2% in June 2021, which was just ahead of the January 2022 market peak. See page 5.

The Federal Reserve released new monthly data on consumer credit. Consumer credit made headlines recently when credit card debt exceeded $1 trillion for the first time. July’s numbers show that consumer credit continues to grow but at a decelerating rate. Whereas revolving credit grew at a 16% YOY pace in January, this dropped to a 10% YOY pace in July. See page 6. Credit card debt rose as the savings rate declined this year which could be a sign that household finances were becoming stretched. Retail sales also slowed in 2023 despite the pent-up demand in the auto sector. In general, we expect credit balances to decelerate further given that the interest rate on credit cards rose from 16.65% in July 2022 to 22.16% by July 2023.

Income and poverty data released by the US Census Bureau this week showed the child poverty rate — based on a supplemental measure that adjusts for government benefits and household expenses — jumped from 5.2% in 2021 to 12.4% in 2022. The supplemental poverty rate rose from 7.8% in 2021 to 12.4% in 2022. The official poverty rate was largely unchanged from 2021 at 11.5%. Nevertheless, family incomes failed to keep up with a 7.8% jump in consumer prices that was the largest since 1981 and real median household income fell by 2.3% to $76,330 in 2022. According to Census officials, this was about 4.7% below 2019.

Technical Update There has not been much change in the last week after the three major indices rebounded from their 100-day moving averages and the Russell 2000 bounced up from its 200-day moving average. Overall, the near-term trend appears indecisive. Even if the rally moves higher, unless all the indices exceed their all-time highs (which we doubt), the longer-term pattern remains characteristic of a long-term neutral trading range. See page 9. The 25-day up/down volume oscillator is at a negative 1.03 reading this week, relatively unchanged from a week ago, and at the lower end of the neutral range. See page 10. The 10-day average of daily new highs is 103 and the new lows are 91. This combination tilts slightly positive this week with new highs above 100 and new lows below 100, but not convincingly so. In sum, the broad trading range market continues and is best represented by the Russell 2000 with support at 1650 and resistance at 2000.

Gail Dudack

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