Last week’s passage of a bi-partisan debt ceiling bill extended the worrisome debt ceiling debate to January 2025. This bill resolved a major crisis that could have triggered a default on US obligations and crushed the US dollar and economy. However, the aftermath of this bill could result in different unintended circumstances. And while some investors may be celebrating these consequences, we believe the short-term positives may not outweigh the longer-term problems.
The balance in the Treasury General Account dropped from $140 billion in mid-May to under $23.4 billion last week and the lifting of the debt ceiling means the Treasury can and must refill its coffers in the coming months. Analysts at Deutsche Bank have estimated that a whopping $1.3 trillion in Treasury bills will be issued over the remainder of 2023, bringing total issuance for the full year to about $1.6 trillion. This massive issuance of Treasury bills will almost certainly drain liquidity from the financial system and could also steepen the yield curve.
The problem with this is that a further rise in short-term interest rates and a further steepening in the yield curve will make the environment even more difficult for the banking system and for the regional banks in particular. Banks borrow on the short end of the yield curve and lend on the long end and a steep yield curve is not a profitable situation. Regional banks are already suffering from a serious exodus of deposits as account holders seek higher-yielding investments found in the Treasury market and/or money market funds. And as deposits continue to leave the financial sector, credit conditions will continue to tighten, and this will slow economic activity.
Adding to the pressure on the banking sector is the fact that regulators are currently planning to increase capital requirements for all banks with $100 billion in assets or more (down from $250 billion in assets) and this could mandate increases in capital cushions for some banks by as much as 20%. Again, this would add another burden on regional banks.
Last, but far from least is the potential for a crisis in commercial real estate and the ramifications on the commercial real estate debt market. According to the Wall Street Journal, in the next three years an estimated $1.5 trillion in commercial mortgage loans will come due. Data provider Trepp indicates that interest-only loans as a percentage of newly issued commercial mortgage-backed securities have represented 65% or more over the last ten years but this increased to 88% in 2021. And while borrowers typically pay off these mortgages by selling real estate or getting a new loan, falling real estate prices, and rising interest rates make neither of these options attractive in the current environment.
Given all these pressures on the real estate and financial markets, we find it curious that regional bank stocks have rallied in recent trading sessions. However, it may be that investors have viewed this from a short-term perspective and have concluded that the Federal Reserve is unlikely to raise interest rates next week. Given the fact that the Treasury market will already be dealing with a significant increase in supply in the month of June and is faced with an unknown amount of demand, this may prove to be true. In fact, it is questionable whether the Fed can continue with its quantitative tightening policy in the face of record debt issuance. Therefore, we are less convinced that the Fed will raise rates in June. But while the Fed may choose to pause next week, this is not great news, and it does not make us bullish.
The BLS establishment survey indicated an increase of 339,000 jobs in the month of May, which was stronger than expected. However, the accompanying household survey suggested that employment fell by 310,000 jobs and that unemployment grew by 440,000. This discrepancy explains the increase in the unemployment rate from 3.4% to 3.7% for the month, but it also raises questions about the real strength of the job market. Job trends are important since one of the best leading indicators of a pending recession is a year-over-year decline in jobs. From this perspective, neither BLS survey suggests the economy is on the verge of a recession. See page 5. And the household survey showed other cracks in the data. Permanent job losers as a percentage of all unemployed was 26% in May, up from 21% in October. Of job losers and those completing temporary work, 36% were permanently laid off in May. The number of workers no longer counted in the labor force, but who indicated they want a job, increased from 5% to 6%; while discouraged workers increased 93,000 in the last 2 months to 396,000 in May. See page 6. Overall, the headline 339,000 job increase with upward adjustments to previous months was just not what it seemed. There were signs of weakness beneath the surface.
The Stock Market
Tesla Inc. (TSLA – $221.31), Alphabet Inc. C (GOOG – $127.91), Amazon.com (AMZN – $126.61), Apple Inc. (AAPL – $179.21), Meta Platforms, Inc. (META -$271.12), Microsoft Corp. (MSFT – $333.68), Netflix Inc. (NFLX – 399.29) and Nvidia Corp. (NVDA – $386.54) , represented about 22% of the S&P 500’s market capitalization at the start of the year, and now account for more than 30%. These stocks have been investor favorites this year which helps to explain why the equally weighted version of the S&P 500 (.WEGSPC – $5842.49) is up just 1.1% this year, the DJIA is up 1.3%, and the Russell 2000 index is up 5%, while the SPX is up 11.6% and the Nasdaq Composite has gained nearly 27% YTD. The recent rally clearly generated breakouts in the SPX and the Nasdaq Composite but is not visible in either the DJIA or the Russell 2000. See page 11. And despite the drama of a 701-point gain in the DJIA on June 2, 2023, there was no meaningful change in our 25-day volume oscillator or the NYSE cumulative advance/decline line in recent days. Moreover, the 701-point move materialized with NYSE volume that was below the 10-day average and volume continues to trend below its 10-day average. See pages 12-13. These are not impressive breadth statistics. We remember the Nifty Fifty and Dot-com eras, so we know narrow markets can be sustained longer than many expect. But we are not chasing this rally and believe the broad market will remain in a wide trading best seen in the Russell 2000 between 1650 and 2000.
S&P Earnings As the first quarter earnings season ends, the S&P Dow Jones consensus estimates for 2023 and 2024 were $218.69 and $244.70, up $0.77, and $1.03 for the week, respectively. Refinitiv IBES earnings estimates for 2023 and 2024 were $220.89 and $246.70, up $1.54, and $1.63, respectively. But note that last week’s big increases effectively erased the declines seen in estimates over the prior three weeks. We did not see any major earnings release to account for this big change and therefore believe it is due primarily to positive forward guidance. However, it is also important to note that S&P data shows that 18.4% of companies reporting first quarter earnings had a decrease of 4% or more in their shares outstanding. This decline in shares outstanding boosts earnings per share but does not represent a significant change in overall earnings growth. In sum, earnings are not all that it seems. See page 9.
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