US Strategy Weekly: Spooked

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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