US Strategy Weekly: Politics in the Wind

President Joseph Biden announced his reelection campaign for president this week, even though 44% of registered Democrats say the 80-year-old president is too old to run. Biden’s current leading Republican rival, Donald Trump, who is 74 years old, is not supported by 34% of registered Republicans. Although Biden’s announcement could be the first step toward a rerun of the 2020 presidential election race, the political polls indicate it is a scenario most Americans do not want to see. Still, a lot can happen in the next 18 months and the early leaders do not always make it to the finish line, particularly since both of these candidates are hampered by legal issues and Congressional investigations. All in all, we do not expect the presidential election to impact the equity market this year, or any time prior to when the parties confirm the selection of their candidates and their platforms at their respective national conventions.

Watch Over the Dollar

However, domestic politics is not tabled. The pressing political issue on the horizon is the all-important debt ceiling and this could prove to be more serious than any election outcome. Treasury data for the days following the April 18^th deadline when most Americans file federal income taxes, suggests that the tax windfall for the Treasury is falling short of expectations. This shortfall could have several sources. There is a postponement of the tax filing deadline for disaster-area taxpayers in California, Alabama, and Georgia from April 18 to October 16.

In addition, the Congressional Budget Office forecasts that capital gains tax receipts could be as much as 17% lower on a year-over-year basis. This is directly due to the performance of the stock market in 2022 versus 2021. Nevertheless, the tax shortfall has major implications for the debt ceiling debate on Capitol Hill. Most economists were expecting the debt ceiling standoff to take place in August; however, it may become an emergency as soon as June. Failure for both parties to come together to address the debt ceiling and spending would be a disaster. The dollar and US Treasury securities have always been the world’s global currency and the world’s safe-haven investment. To change that would weaken not only the US economy, but the global financial balance that has existed for decades. And this comes at a time when the dollar is already under pressure related to challenges from China, Russia, India and Brazil, countries that have been pushing for settling more trade in non-dollar units. Even French President Emmanuel Macron has recently warned against Europe’s dependence on the greenback. A French multi-energy conglomerate, TotalEnergies SE (TEF – 58.31 €) and China’s national oil company, CNOOC Ltd. (12.42 HK$), recently settled a major liquified natural gas transaction in the yuan. According to Bloomberg, Malaysia has initiated talks with China on forming an Asian Monetary Fund in a bid to decouple from the dollar. A weaker dollar could have many ramifications, but the most immediate one would be higher inflation.   

Earnings Season

Meanwhile, the first quarter earnings season is filled with surprises. First Republic Bank (FRC – $8.10) plunged nearly 50% after reporting that more than $100 billion in deposits left the bank during the quarter. Deposit flight has been at the center of investor concerns as clients continue to move capital out of regional banks and into money market funds where higher returns are available or to larger ‘too-big-to-fail’ institutions. However, First Republic is not the only bank suffering from deposit flight. The decline in commercial bank deposits reached $979 billion in mid-April, and only 25% or $251.8 billion exited the banking system since, or due to, the March banking crisis. See page 8. In short, the banking system has been suffering from disintermediation since the Federal Reserve began to raise interest rates a year ago. This trend is apt to continue throughout the year. And in our view, there is no guarantee that a 25-basis point hike in May will be the last rate hike. In other words, the banking system will continue to suffer from a decline in deposits and a painful inverted yield curve. The banking crisis of March will only add to the pressures and credit crunch that began months ago. 

Still, the banking system appears to be stabilizing from the March panic and loans from the Fed’s new Bank Term Funding Program fell modestly from the April 5, 2023 high of $79 billion to $73.8 billion on April 19, 2023. This is a ray of sunshine. But it is worth pointing out that now that the banks are no longer in crisis, the Fed’s policy of quantitative tightening has been reinstated. As seen on page 8, the Fed’s balance sheet contracted by $140 billion in the 4 weeks ended April 19, 2023. In short, the stimulus put into the banking system in March was temporary and is slowly reversing. This means that equities no longer have the wind at their back from this temporary liquidity boost. And this fading liquidity is beginning to show up in some technical indicators.   

Employment and Recession

A simple way to predict a recession is to monitor the year-over-year growth, or contraction, in jobs. See page 3. This indicator is simple, but useful, because the main characteristic of a recession is a decline in jobs. In the post-Covid recovery period job growth has been positive as people went back to work after the shutdown. And the year-over-year growth in both the employment and household surveys has been positive. The household survey has been the weaker of the two surveys recently and it decelerated to an “average” growth rate of 1.5% YOY in March. The interesting thing about job growth in the second half of this year is that comparisons will become more difficult when compared to 2022, and it is quite possible that job growth will stagnate of decline. We will be monitoring this in the coming months.  Meanwhile, consumer sentiment, which is normally a good indicator of a recession, has been extremely weak.

The Misery Index, which is the sum of inflation and unemployment, hit 12.7% in June 2022, a sign of household stress, but it dropped to 8.5% as inflation eased to 5% in March. However, March employment data included a small warning. The number of permanent job losers has been rising and was 26.6% of those unemployed in March. This is the highest percentage since December 2021. In sum, employment data could get weaker in the months ahead and job data will be the key to whether a recession appears in 2023 or 2024.

Technical Update

It has been a difficult equity market in which to maneuver and this can be seen by the year-to-date performances of the indices which are currently: S&P 500 up 6.1%, DJIA up 1.2%, the Nasdaq Composite up 12.7% and the Russell 2000 index down 0.9%. In other words, gains are concentrated in large-cap growth stocks this year, and we fear many of these large-cap favorites, with high PE multiples, may hit a major hurdle as interest rates continue to rise. See page 11.   The 25-day up/down volume oscillator is at positive 1.94 this week and neutral after recording one-day overbought readings of 3.0 or higher on April 18 and April 24. The inability of this oscillator to sustain either overbought reading reveals a weakness in underlying demand. We remain cautious.

Gail Dudack

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