US Strategy Weekly: Goldilocks Rally

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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