Actions Have Consequences
After a strong rally to close out July, equities took a bit of breather in the opening week of August with the S&P 500 and Nasdaq slipping 2% and 3% respectively last week. The Dow held up better, but still fell a little over 1%. Pressuring all asset prices was the rip higher in long-term interest rates following the announcement out of the Treasury Borrowing Advisory Committee (TBAC) that Treasury issuance for the back half of the year will be more than $1.8 billion in bills and bonds. This level of issuance ($1 trillion in Q3 alone) was more than the market was expecting and hence the rapid adjustment higher in interest rates, in particular at the long-end.
My guess is the announcement of increased issuance and Fitch downgrade was just the icing on the cake for the move up in yields that had been underway for several weeks. Other factors fueling the move include:
Chairman Powell proclaiming at his recent FOMC press conference that the Fed economics staff is no longer forecasting a recession this year. Couple this with the Q2 real GDP print of 2.4% and market participants have fully embraced the ‘soft landing’ path for the economy.
The BoJ tweaking its yield curve control policy by allowing the upper end of its yield range to move higher.
Saudi Arabia extending its oil production cuts, Putin attacking grain terminals in Ukraine, and rising expectations of stimulus hopes out of China have sent commodity prices sharply higher – since late-June WTI is up more than 20%, diesel is up almost 30%, wholesale gasoline prices are up more than 12% and the Goldman Sachs broad commodity basket is up more than 10%.
These factors haven’t been lost on the bond market where the 30-year T-bond closed on July 31st with a yield of 4.01% and rose more than 30 basis points to over 4.3% on Thursday August 3rd. Over the same period the yield on the 10-year Treasury rose 24 basis points from 3.95% to 4.19%. These are massive moves within a very short period of time.
Given interest rates are viewed as the price of money, a rise of this magnitude has implications for all asset prices. Admittedly, last week brought back nightmares of 2022, a year where a prolonged upward push in yields pressured asset values lower for everything except cash and the U.S. dollar. Outside of Oil, uranium, a few other select commodity prices – what were the only major asset classes on my monitor that were flat or positive last week? Cash and the U.S. dollar.
Keep in mind we rolled into last week with the equity markets having logged five consecutive months of gains and in my view are priced for perfection with the S&P 500 trading at a forward P/E multiple of just below 20. Moreover, positioning and sentiment now stand on the opposite side of the boat relative to where we started the year with everyone loaded for bear on the recession is imminent trade. Some of our work is showing a change of character and potential change in trend for the first time since the regional banking problems in early-March. Two weeks ago, almost 90% of the S&P 500 was trading above their respective 50-day moving averages and as of the close of last week this percentage has slid to around 60%. This is a constructive development thus far as it takes some of the froth out of the equity market. Outside of a larger market crash, a more dramatic decline in breadth from here would be surprising. However, there is a noticeable rotation at play within the stock market with the Energy and Materials sectors becoming leadership and Consumer Discretionary and Technology lagging.
As for positioning, according to Tier1Alpha’s model that tracks CTA flows, overall equity exposure is now in the 81st percentile using data over the last ten years, and in the 98th percentile over a three period. Since November 2022, CTA’s have increased their net equity exposure by around $150 billion and no longer stand as a marginal buyer to backstop a decline in the stock market. Frankly, they are in the polar opposite position from where they’ve been most of the year (buying on dips) where they will act as forced sellers on a deeper sell-off in equities (or rise in the vix), thereby magnifying downward price momentum. For example, a further 2% slide from the 4450 level on the S&P 500 would force these funds to sell north of $30 billion in net equities. Not for any fundamental reason, but rather because they must follow their quantitative rules-based trading models. The rise in popularity and size of these programs is yet another factor investors need to be aware of in their investment framework.
As for my thoughts on the credit rating downgrade of U.S. Treasury debt to AA+ by Fitch last week, its not at all surprising on a fundamental basis. Sure, you can take issue with the timing and/or the politics of the matter, but they are just catching up to what S&P did back in 2011 and the U.S. fiscal situation is demonstrably worse today than it was twelve years ago. Consider that back in 2011 gross U.S. federal debt was a little over 90% relative to GDP. Today that ratio is 120%. Federal spending in 2011 was $3.8 trillion compared to $6.5 trillion today – an increase of more than 70%. Well Corey, you can’t look at these things in isolation, what about the growth in GDP from then and now. Glad you asked. Nominal GDP was $15.46 trillion in 2011 and rose to $25 trillion in fiscal year 2022 or a nearly 62% rise (less than the 70% increase in federal debt). Classic illustration of negative fiscal multipliers at play which is typically what happens to countries once they see their debt ratios cross above the 100% debt/GDP threshold.
Back in August 2011, before S&P announced their downgrade this is what former Fed Chair Ben Bernanke had to say:
“Everybody who reads the newspaper knows that the United States has a very serious long-term fiscal problem.”
What else? Does the U.S. deserve a AAA credit rating? Sure, the strongest military in the world accounts for something. As does property rights, rule of law, and a functioning democracy (up for debate at times). But if one is being objective and focusing on the financial makeup the answer is crystal clear. There are now nine other sovereign central governments that enjoy the status of a coveted AAA rating, and the average debt/GDP ratio is 40% with a median of 23%. On an apples-to-apples basis the U.S. is at 120%. Keep this in mind when listening to the pundits proclaiming this is absurd.
As for the near-term market implications, I think it’s a nothing burger. However, bigger picture and longer-term it’s a very big deal with potentially significant implications for the U.S. dollar as the world’s reserve currency and Treasury securities as the world’s reserve asset. Keep in mind that we’re talking about implications with a time frame that will playout over the course of years and decades. Not exactly a time frame that is investable today. However, I do think there is a near term implication that investors should be considering and that is the impact this will have on fiscal flexibility over the next 12 – 18 months.
The angst and anxiety back in 2011 following the S&P debt downgrade provided ammunition for the fiscal hawks within the GOP (the Freedom Caucus) to extract budgetary restraint out of the Obama administration going forward. If you remember this is where the Tea Party gained prominence whereby from 2011 to 2015 the deficit/GDP ratio went from 8.1% to 2.3%. Now to be fair the setup today compared to then is not identical, so expecting a repeat is not appropriate. But, given the boost government spending has supplied to nominal GDP this year (Bidenomics as the Democrats like to label it), any reduction is going to be material for an economy whose potential rate of real GDP is just 1.8% and is already operating at full employment.
Last thing I’ll say on this file is that despite all the complaints out of the likes of Summers, El Erian, Dimon, and Yellen – Fitch did what needed to be done in shedding light on fiscal spending that has gotten way too far out of hand. This isn’t about Democrats or Republicans, its about the entire system and goes back to Trump passing tax cuts for big business and his cronies back in 2018 at the peak of an economic expansion. Now it’s the Democrats turn in passing the Chips Act and the Inflation Reduction Act (two bills targeted at resurrecting American industry but miss the mark in terms of precision) at a point in the economic cycle where stimulus isn’t needed. This level of deficit spending puts the U.S. in a position where when the next economic contraction occurs, we risk blowing out the deficit to unprecedented levels if countercyclical fiscal policy is enacted. It’s just backassward (excuse the language), but at some point, we’re all going to regret how well we had it, living beyond our means at the expense of future generations who will inevitably pay the toll. We’re not too far away from the point where debt/GDP ratio will be threatening 130% and interest expense to service the debt will exceed 5% of GDP – a dead weight drag on the economy and society.
As for markets, of late I find myself digging into the historical data trying the best I can to understand and appreciate the lagged impacts of prior tightening cycles on the economy and thereby markets. Right here, right now with the S&P 500 at 4,500, trading 19.5x forward twelve month earnings of $231 (a figure that includes 12% EPS growth), interest rates rerated higher with the 10-year Treasury at 4.10%, gold flat-lining around 1,970/oz, oil north of $80/bbl, and the U.S. dollar above 100 – is a market setup priced for a lot to go right. Which makes sense because much has gone right in 2023.
However, I must say I find myself more worried about the path forward than current market pricing. The 2004 – 2006 Fed tightening cycle and the 2007 – 2009 economic cycle are top of mind as I think about the future. In the ’04-’06 tightening cycle Greenspan and Bernanke raised the Fed Funds rate 425 basis points (1.0% to 5.25%) over the course of eight quarters and then paused in June 2006. Then the lagged impacts slowly began to work their way into the system with mortgage brokers representing the first cracks in the system as they began to go bankrupt culminating with the New Century Financial filing BK in April 2007. Then in June two Bear Sterns hedge funds blew up and the history books recognize these events as the opening salvo to what would become the GFC. These cracks started to surface roughly 12 months after the Fed paused its tightening cycle in June 2006. Which aligns with the normal ‘long and variable’ lag often referred to when assessing the impacts of monetary policy tightening. Then in the spring of 2008 Bear Sterns filed for bankruptcy which was followed by the worst of the crisis with Lehman Brothers and AIG failing in September 2008. These events were about 26 months after the Feds last rate hike that cycle. This showcases just how long it can take for these lags to work their way through the system.
Now think about the current tightening cycle where the Fed has hiked rates 525 basis points (0% to 5.25%) over the course of five quarters (not eight like the ’04 -’06 cycle). Twelve months after the initial hike we had the regional banking crisis in March 2023 with SVB, Signature Bank, and First Republic all failing in what appear to be the initial cracks in this tightening cycle. Today, just like back in 2007 after the mortgage brokers started going belly up and the economy was holding in, investors concluded that these were one offs with the S&P 500 going on to make cycle highs in October of 2007. Back then, the stock market (while volatile and trading sideways) buckled but didn’t break in the first half of 2008. The S&P traded above 1,400 in May 2008 (just 10% off its October 2007 cycle high of 1,576). The S&P 500 is just 6% off its January 2022 cycle highs, the economy is holding up, and I fear investors are being overly complacent in dismissing the monetary lags from this tightening cycle.
I’m by no means calling for another rendition of the GFC, but I’d be remiss if I didn’t acknowledge it took 24 months for the GFC to fully play out. Recall that the NBER ended up dating the start of that recession as December 2007 and they didn’t make this pronouncement until December 2008. So, the U.S. economy was in a recession for nearly six months before the S&P 500 really started to slide in the summer of 2008.
The moral of this story is not to assert with certainty that the big bad bear is about to show up to wreck the prevailing goldilocks setup, but rather to remind investors that such a risk still exists no matter how remote the risk may seem at the moment. The U.S. economy has never been more indebted and it just endured the most significant monetary policy tightening cycle in the last four decades – logic, economic theory, fundamental analysis, and history suggest there is more to this story in the months and quarters ahead.
Okay Corey, you got my attention even though market pricing isn’t indicating any concern whatsoever over your fear mongering – what do you do about it? First off, look back at the GFC – it is the poster child for ‘risk happens slowly and then all at once’. From May 2008 to late-November 2008 the S&P 500 went from 1,400 to 741, a 47% decline over the course of roughly six months. As if that wasn’t enough and you thought that was the end of it, it wasn’t, as it took the S&P 500 another four months to ultimately bottom in March 2009.
Without question this was one of the more severe and devastating recessions/economic crisis in U.S. history, so drawing parallels to it is without question using a worst case scenario as an example for reference. I do so because for the first time since 2006/2007 retirees or older investors have the luxury of making an asset allocation decision that they should be making regarding where they are in their lives. That is forgoing the unknown future return of stocks (along with the higher risk profile) and locking in the known decade-and-a-half high returns of high-quality fixed income. Secure, low risk, mid-single digit returns is an option retirees have been yearning for over the past fifteen years. It’s staring them in the face and likely comes close to meeting the returns needed to meet their long-term financial objectives – don’t be afraid to act upon it.
I’m not saying you abandon equities or a prudently diversified portfolio that includes commodities, stocks, bonds, and cash, but rather embrace it and appreciate the fact that you don’t have to go all in on the stock market to achieve your long-term return objectives. Nor do you have to subject your nest egg to a potential 30-50% drawdown that takes years to recover from. Also know that making such a choice with the earnings yield on the S&P 500 at 5.13% and the 1-year T-bill (5.34%) or 2-year T-bill (4.78%) is the superior risk/reward choice. The stock market and risk assets will be there for trading tomorrow, next week, next year, and five years from now. I don’t see anything in the market at this moment that is a screaming deal. Retaining some capital in equities is also prudent, but here isn’t the time or place to back up the truck.
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