What follows are some simple answers to the questions Strategas research is receiving most frequently from their clients these days. We are happy to hop on a call to discuss them in greater detail should you have further questions about our answers.
What would make you change your mind?
There are two major themes underlying our bearishness on both the economy and the markets: 1) the bill is finally coming due for more than 12 years of financial repression and fiscal profligacy; and 2) given the magnitude of Fed tightening over the last 13 months, the odds favor a recession and its attendant effects on employment and corporate profits. Naturally, there are no gimmes in the investment business where a normal distribution of outcomes is rare. The tails are fat and the “unexpected” happens more frequently than one might think. In this regard, we would need to reconsider our bearish outlook if the rate of inflation dropped so rapidly in the absence of a financial crisis that the Fed could ease with a clear conscience. We would also need to reconsider our bearish outlook if the Fed decided that the economic costs associated with fighting inflation were too high and decided simply to let inflation run hot. This might be disastrous for the economy and the markets in the long run, but we wouldn’t want to be short risk assets in the short-term. Finally, we would reconsider our outlook if we came to the conclusion that the persistent shortage of labor was so acute that the Fed could successfully eliminate job openings (currently about 9.5 million) rather than jobs. This may be the most likely scenario of the three presented of avoiding a recession.
I agree with your bearish call, why hasn’t it worked out so far in your view?
I generally hate answering this question for fear that it can take on the character of excuse making or, even worse, whining. We must play the ball as it lies. To be clear we did not expect the S&P 500 to be up 7.5% at this point in 2023. The best answer for why we have missed the mark so far this year is that the economy and earnings, while showing meaningful signs of strain, have thus far been better-than-expected and it would be hard to describe our current economic situation as recessionary. Another more baroque answer is that the combination of reaching the debt ceiling and the burgeoning drama in the banking system has led to unexpected additions to liquidity in the economy this year. The Department of the Treasury has been steadily drawing down its General Account in the absence of new debt issuance while the Fed has, at least in part, slowed the pace at which it has sought to draw down the size of its enormous balance sheet. An irony in this scenario is that the market could face greater headwinds once the debt ceiling is actually raised and Treasury must replenish its General Account.
Growth has been ok so far in 2023, why the continued fear of recession?
The economy remains imbalanced. There have been numerous large shocks during the past 3 years, on both the supply side and the demand side of the global economy. Judging by the extreme volatility in U.S. growth (eg, some quarters >6%, some quarters <0%), macroeconomic policy has had (understandable) trouble getting supply & demand to match. We are likely now headed for a considerable period of below-trend growth, as “sticky” inflation takes a bite out of real activity and policy (both fiscal & monetary) re-orients. As we’ve noted previously, if supply cannot come up to meet demand, then demand has to fall to meet supply. Demand falling substantially is another name for recession. We’ve now started to see cracks appearing (eg, continued bank stress).
Is there anything that would get you to worry less about the economic setup?
Our key question is: what actually is the inflation target. Is 2% exactly 2.0%? The case for the softer landing probably involves declaring victory at 2-point-something vs. 2.0%. The mean U.S. CPI inflation rate in the last 40 years is 2.8%. If we can get the inflation run rate down < 3% - and declare victory after destroying job openings vs. jobs - that’s the path we see to a soft(er) landing. The < 3% rate would have to be considered stable (ie, inflation doesn’t pop back up as soon as monetary policy eases).
What’s the biggest obstacle in your mind to getting broadly more constructive on risk assets?
Financials… for as buoyant as the indices have been, the Bank stocks have barely rallied and the broader Financials sector remains in a weak absolute + relative position. Now 7 months off a market low (S&P bottomed on 10/12/22), Bank stocks shouldn’t be down – it’s an unprecedented occurrence looking back through 100 years of market history.
Is the Bond Market or AAPL right?
You could have owned two very different books and be having an equally good year… Portfolio 1: Long AAPL, Long NVDA, Long LVMH, Long Homebuilders vs. Portfolio 2: Short Banks, Short Small-Caps, Short Retail, Long Gold, Long Bonds. So who’s right? We’re not convinced the market has even made up its mind here yet, but are curious if credit will ultimately break the tie. There’s some modest widening in CDS recently, it’s subtle for now but bears watching. We suspect that 10-year yields decisively south of 3.30% would be a negative macro message as well, particularly with the Copper/Gold ratio already breaking down.
What’s the most bullish input you can come up with?
Probably sentiment. We’ve spent the last few months on the road, and regardless of geography, find it striking how content equity investors are to park client money in short-term Treasuries yielding 4-5%.
How does your forecast of the economy square with your recommended asset and sector allocations? What are the odds of a U.S. recession over the next 2 years?
We remain cautious on the outlook for the economy and markets despite the index being buoyed by the market heavyweights. We continue to recommend clients underweight both Equities and Fixed Income relative to their risk-adjusted benchmark. We have used a small allocation to Commodities and an above-benchmark allocation to Cash (with Gold as a subset) in an attempt to inoculate our tactical allocation portfolios from the headwinds of inflation and broader economic weakness. Despite some indexes trading near YTD highs, the leadership remains more defensive under the surface and we remain skeptical that the narrow leadership can endure. From a sector perspective, we remain Overweight Energy, Staples, Healthcare, and Materials while maintaining an Underweight exposure to Technology, Communications, Discretionary, and Financials.
What is the likelihood of default?
The threat of an actual default of the US debt is an extremely low probability. Policymakers often talk about default on the US debt during debt ceiling debates. We want to be clear that this is a political argument designed to pressure the other side into moving forward on the debt ceiling and/or their preferred attached policies. In reality, the US government has more than enough cash flow to pay interest even if the “default date” is reached. We believe that Treasury will have no other option but to make those payments based on current law, and their previous plans, which were outlined in a Fed conference call in 2013, when we were close to the X date. Treasury said that principal and interest payments on Treasuries would continue to be made on time, as maturing securities would be rolled over into new securities and interest would be paid out of the Treasury General Account, and then a daily decision would need to be made on what other spending to prioritize. Should Congress fail to raise the debt ceiling, the government would have enough money for Social Security, Medicare, Defense, and interest. Other government spending would come to a halt, which is akin to a government shutdown. In this current cycle, the prioritization of government spending would be short lived, as the Treasury expects new tax revenue on June 15th and new extraordinary item cash on June 30th, which can cover through the end of July. As such, we see little chance of default even if Congress does not act. But we do believe Congress will act before June 1st, making these mechanics less relevant.
What does a debt ceiling deal look like?
Congress is negotiating a debt ceiling deal. Progress has not been as positive as we thought it would be at this point, but we expect these negotiations to ramp up over the next week or so. We anticipate that there will be a two-step process. The first step would provide a short-term debt ceiling increase locked in with a top line agreement. The second step will fill in the details of the top line agreement and raise the debt ceiling past the 2024 presidential election. In our view, the most likely outcome would be a cap on discretionary spending, rescinding of unspent COVID funding, and energy permitting reform. We don’t believe work requirements for entitlement programs will pass. We would also expect several other items to be added to get a deal, but those items may emerge over the next couple of days. We also want to be clear that this is not a straight line. Policymakers may fail before they succeed. But the debate right now is “how” to raise the debt ceiling, not “whether” and that is an important distinction.
What are the investment implications of the debt ceiling?
We have argued that for investors the debt ceiling itself is less of an issue, but the key metric is the austerity that gets included. In 2011, nearly all the decline in the S&P 500 happened after a deal between President Obama and Speaker Boehner was reached. The reason for this is that the austerity levels were much greater than expected and growth expectations came down. Ahead of the debt ceiling being raised, Treasury is providing significant liquidity to financial markets by spending down the Treasury General Account. Over the past two weeks, Strategas’ net liquidity indicator has added $160bn of new liquidity. This is helping Nasdaq outperform the S&P 500. But under the surface, we are seeing nearly identical trends to 2011, with the defensive winners ahead of the 2011 debt ceiling fight outperforming the losers, gold rallying, and companies levered up to government spending underperforming. We believe this trend is important as there is likely more risk to financial markets after the debt ceiling is raised. The US economy is slowing, the liquidity currently being provided gets removed, and there will be new austerity.
Source: Strategas
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv.
Sincerely,
Fortem Financial
(760) 206-8500
team@fortemfin.com
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