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.
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.
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.
PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.