Slowing But Growing And Deflating
Equity markets ended the month of August with some panache, having erased a nasty 10% correction from July 16th to August 5th. The S&P 500 closed out August just 20 points from its all-time high. Still, I find myself a bit uneasy with the setup as we head into an unforgiving seasonal backdrop and a U.S. election that will have significant implications depending on who wins.
As I'm in the midst of moving – an experience I wouldn't wish on anyone – I'm going to keep it big picture and hit the highlights (still looking for the box with my socks and underwear in it). Maybe a bit of TMI, but you can't lose your sense of humor in these moments. Back to markets, the 'Goldilocks' environment everyone wants to play out is fully priced. The economy is growing but slowing, and inflation is on a downward trend. Expectations for a 50-basis point cut by the Fed in September are slowly evaporating (down to 25% odds), and the forward-looking inflation backdrop looks less sticky by the day. Yes, prices remain elevated, and this is a critical political issue on the campaign trail, but inflation in market parlance is the rate of change. That is what drives monetary policy, which drives bond yields, which filter into asset prices and the economy. On this front, 100 basis points of cuts are priced in before year-end, and nearly 200 basis points of cuts over the next twelve months - looks a bit aggressive from my perspective – even if I think that's what should happen, it's not what I think will happen.
Couple this with sentiment, having quickly moved back into the bullish camp without having exercised a thorough cleansing in early August, and I fear we set ourselves up for a tough September and October. September commands the most pronounced negative seasonal influences of all the months of the year. And while momentum has been strong even with the bloom coming off Nvidia's epic run, valuations are stretched, and expectations have outrun reality on the Goldilocks front. Analysts have had a double-digit growth rate for earnings over the next twelve months for a while now, but that number has not been moving up, and yet the equity market continues to rally. This has the S&P 500 trading near a 22x forward P/E multiple. Not only that, but now that we are past Labor Day, investors will pay more attention to the November 5th election.
Deutsche Banks Chief Strategist Jim Reid put out some good information about September over the weekend (via The Market Ear).
As for politics, most polls show that the race between Trump and Harris is very close. I'm sure you can find a poll that validates what you want to see, but a runaway, this is not. Nate Silver,r who got his fame when at FiveThirtyEight,t recently published some thoughts breaking down the electoral college vote (which is what really matters, and shows Trump having a 52% chance of winning the election versus 47% for Harris. Please don't construe me pointing this out as an endorsement for Trump because it isn't, and my sentiment is the same when it comes to Harris (I'm an atheist when it comes to political parties). Polls are polls; we've learned that over the past decade, so take them with a grain of salt, and we'll all have to wait and see how things shake out come November.
As for policy, Trump's agenda is viewed more favorably by markets as it pertains to his stance on corporate and individual tax rates. The 2017 tax cuts expiring next year are the equivalent of a roughly $350 billion fiscal drag annually for the next decade (measured against the baseline from what already exists). I am not sure who has dusted off the cliff notes of what was passed back in 2017, but below are some highlights of what will lapse come the end of 2025 if Trump doesn't win in November (even if he wins, there's no guarantee they still don't lapse):
Lowered many individual income tax rates, notably the top rate from 39.6% to 37% for the highest earners.
Nearly doubled the standard deduction, so only about 10% of filers now itemize their deductions.
Eliminated the personal and dependent exemptions.
Capped the state and local tax deduction at $10,000 per filer, which generally hits blue states harder.
Doubled the annual child tax credit to $2,000 and allowed more higher-income parents to claim it.
Significantly reduced the number of filers subject to the alternative minimum tax (AMT).
Essentially doubled the estate and gift tax exemption, so even fewer wealthy people are subject to it.
The sun-setting of these provisions could drag GDP growth down by as much as -1 percent (annualized). That may not tip the economy into recession, but it's a hit to growth when U.S. growth is already slowing, and the world's second-largest economy (China) can't seem to lift itself off the matt. However, this could set off the dominos that get the Fed to take more aggressive actions to recalibrate interest rates from restrictive to less restrictive or even outright accommodative.
While all the focus is on who wins the White House, the makeup of Congress will matter the most for financial markets. Four of the past five Presidents in their first two years in office enjoyed one-party rule — and all five at least at one point in their tenure. Betting markets indicate that the House will flip Democrat, so the Senate is the key — where the current makeup is 50 Democrats (including four Independents) and 49 Republicans (1 seat is currently vacant). The good news for the GOP is that of the 34 seats up for grabs, Democrats or Independents hold 23. No matter which way the majority falls, it is going to be close, but right now, all indications suggest the GOP would win by a small margin. Remember this — if Harris wins and the Senate shifts to the Republicans, she has little chance of getting her populist-type policies into action. The same can be said for Trump and some of his extreme populist ideas.
A split government would be good news for the bond market as it forces some fiscal restraint (recall what happened with President Obama after the Democrats lost control of Congress in the 2010 midterms and any ambitious spending agenda was thrown away, and the deficit-to-GDP ratio came in considerably until 2016 when Trump and the GOP took over both the executive and legislative branches). But in the populist era we are in, it is hard to imagine that one-party rule is good for bonds or inflation. This makes the stakes high from a markets standpoint because if either candidate wins an outright electoral majority, one can reasonably expect the downtrend we have seen in market-based inflation expectations to reverse course. This is singularly the greatest risk to reinvigorating the inflation dragon.
The 1970s were considered a populist era as well, with LBJ’s ‘guns and butter’ program kicking it off in the late ’60s. I point this out because the following chart overlays the CPI inflation rate from 1970-1979 to 2017-2024 and the scary resemblance so far (compliments of The Market Ear). Analogs versus prior eras are not very reliable as actionable analysis, but this is worth keeping in the back of your mind when thinking about all the grand policy ideas being thrown about in the interest of buying votes.
Current market conditions feel heavy, with markets pricing in a deflationary regime: volatility is up, equities are directionally lower with defensives leading cyclicals, bonds are rallying with yields falling, and commodities are getting slammed like a recession is imminent. I'm still not in the recession camp for the rest of this year, and this bout of market angst is one to be weathered with new all-time highs in equities by year-end. Don't get me wrong, I think there are things to worry about on the horizon, and as a result, I'm not suggesting investors load up on risk, but I don't think we're at the baton down the hatches part of the business cycle.
Moreover, the labor market remains the key to the perpetual passive bid underpinning the equity market. The jobs report at the end of the week will give us the latest update on the health of the labor market. If and when cracks turn into crevasses, it will be time to reign in the risk parade and prepare for crevasses to turn into canyons.
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