To hear our most recent Smart Macro discussion about this piece, see Three Trillion Dollars Fading from the Market, Says Chris Puplava
Author’s note: We prepared our client newsletter last week prior to the tragic events of this weekend, and we would like to address recent developments before proceeding with our regular content. Our thoughts and condolences are with those who have been affected by these attacks and the renewed outbreak of war in the Middle East. We sincerely hope that peace and stability will be restored soon, and we are closely monitoring the situation for updates.
In response to the attacks, we observed immediate market reactions. Oil prices surged by nearly 5%, and there were also significant rallies in gold, the US dollar (USD), and US Treasuries immediately following. If the conflict escalates further, with more countries becoming involved, there is a potential for oil prices to rise even higher. This could contribute to higher inflation and have widespread economic repercussions globally, necessitating a more defensive approach in our strategies.
We are monitoring the situation closely and will keep you updated with any major changes.
In a year filled with turbulence and economic challenges, one word that encapsulates the prevailing sentiment in the United States is undoubtedly "resilient." Despite facing the steepest surge in interest rates in decades, a nearly 20% surge in gasoline prices year-to-date, and the resumption of student loan payments, both the US consumer and the economy at large stand steadfast, forging ahead while the unemployment rate hovers near historic lows.
As the year unfolded, numerous voices chimed in late last year, warning of an impending recession, and, admittedly, we were among those who sounded the alarm. However, the US economy has not only defied these ominous predictions but has also left economic pundits and investors pondering the prospect of a "soft landing" – an economic slowdown without a surge in unemployment – or perhaps no landing at all. This latter scenario envisions the US economy not only avoiding a decline but actually accelerating, eluding the specter of recession altogether. The post-Covid recovery has proven itself to be an unprecedented phenomenon, distinct from any previous rebound following a recession, and this uniqueness continues to define the landscape in 2023.
While the calls for an impending recession are currently diminishing, we foresee their resurgence in the coming months. This anticipation stems from our belief that three of the major tailwinds that have propelled the economy and stock market toward this "Goldilocks" outlook are poised to morph into headwinds, potentially altering the course of the economic journey.
Tailwind #1: “A Trillion Here, a Trillion There, and Pretty Soon You’re Talking Real Money”
This famous quote (inflation-adjusted from billion to trillion) is attributed to Senator Everett McKinley Dirksen, who served as Senate Minority Leader from 1959 to 1969. He used this phrase to express concern about the escalating federal spending that was happening at the time, which ultimately contributed to the inflationary period of the 1970s. Traditionally, the government plays a role in stabilizing the economy during a recession and adjusts its spending as the economy recovers. However, recent times have seen a departure from this historical pattern.
The shift began with President Trump's tax cuts, which reduced tax revenue and expanded the budget deficit. This trend persisted even as the unemployment rate decreased during his tenure, until the COVID-19 pandemic struck in early 2020. As unemployment rates skyrocketed in 2020, so did government spending, as is customary during economic crises. However, even from mid-2020 to mid-2021, when the unemployment rate began to decline significantly, our budget deficit continued to soar, largely due to the issuance of multiple stimulus checks, reaching record levels under the Biden Administration.
During the Great Depression, the deficit as a percentage of the economy, measured as Gross Domestic Product (GDP), ranged from 3.5% in 1932 to 6.1% in 1936. This record was surpassed during World War II when the deficit relative to the size of the economy reached 6.3% in the 1943 fiscal year. However, these records were shattered during the Great Financial Crisis of 2008-2009, with the deficit growing to 9.8% in fiscal year 2009. Yet, none of these events came close to the staggering 17.9% deficit witnessed in fiscal year 2020.
Government spending began to recede by mid-2021, dropping from the peak reached in early 2021 to a low of 3.7%, even as the unemployment rate continued to decline by mid-2022. However, a contraction in the economy occurred due to reduced government spending in the first half of the previous year, compounded by a downturn in manufacturing, sparking concerns of a recession. Despite falling unemployment rates, the Biden Administration implemented several significant spending packages, including the $750 billion Inflation Reduction Act, the $280 billion CHIPS and Science Act, and the $300 billion PACT Act.
Between June 2022 and June 2023, the US economy, measured by nominal GDP, grew by $1.55 trillion. During the same period, federal government spending increased by $948 billion, accounting for 60% of economic growth. When nearly $1 trillion is injected into the economy in such a short time, it becomes challenging for it to enter a recession. Clearly, increased government spending has provided substantial support to the economy over the past year. However, this tailwind is diminishing because US fiscal spending has been constrained due to the 2023 debt ceiling battle. In June 2023, President Biden signed the Fiscal Responsibility Act of 2023 into law, suspending the debt ceiling until January 2025 but also imposing caps on discretionary spending for fiscal 2024 and 2025. Over the next year, Goldilocks will not be able to count on Uncle Sam increasing its budget by an additional trillion over what it has spent over the last year. This tailwind has disappeared.
Tailwind #2: The Fed’s Repo Facility
Since the Great Recession of 2007-2009, we have witnessed an unprecedented shift in monetary policy. The Federal Reserve resorted to a technique known as "Quantitative Easing" (QE) to stabilize financial markets and boost the economy. When the Fed engages in QE, it essentially creates money out of thin air, increasing the money supply in circulation. This injection of capital can stimulate both the economy and financial markets, benefiting various sectors.
However, a significant change occurred in 2021, the first since 2008. The Fed increased its balance sheet by $1.2 trillion, approximately $100 billion per month. This expansion coincided with the peak of small-cap stocks and speculative assets like Bitcoin in early 2021. The reason for this peak was that while the Fed was injecting liquidity into the financial system, money was simultaneously leaving through the reverse repo facility.
While the Fed's interest rate policy is typically viewed as its primary tool for influencing financial markets, it also has the reverse repo facility at its disposal. This facility can either inject or drain capital from the financial system. In 2021, as the Fed increased the money supply, the reverse repo facility drained liquidity rapidly. It went from $0.00 on January 8th, 2021, to $2.55 trillion a year later, surpassing the amount created by the Fed's money printing.
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Consequently, despite the Fed's money printing and expectations of strong market returns in 2021, the overall market performance was lackluster. This foreshadowed the changes that would come in 2022 when the Fed ended its money printing program. Money began leaving the US financial markets, flowing into the repo facility.
In 2022, this dynamic took a dramatic turn. The Fed's reduction of money in circulation actually supported the stock market, contrary to the previous correlation. In fact, in 2022 alone (through 10/5), the Fed's repo facility has declined by nearly $1.3 trillion, injecting liquidity back into the US financial system. Currently, the facility stands at just over $1.2 trillion. However, it is uncertain whether it will continue declining, potentially supporting financial markets, or begin to rise, pulling money out of the system and potentially hurting financial markets.
This repo facility has played a crucial role in supporting risk assets, but its future impact remains uncertain. In essence, we have seen a reversal of the traditional relationship between the Fed's money creation and the stock market's performance, making the repo facility a key variable whose role as either a tailwind or a headwind remains unpredictable.
Tailwind #3: “Be fearful when others are greedy and greedy when others are fearful.” – Warren Buffett
Warren Buffett, often referred to as the Sage of Omaha, has shared numerous valuable investment insights throughout his illustrious career. His wisdom has been particularly relevant in the past two years, accurately capturing the prevailing market sentiment and directional shifts.
Institutional investors of considerable size utilize the futures market to adjust their exposure across various markets, including bonds, stocks, commodities, and currencies. When these institutional investors alter their exposure to extreme levels, it builds up potential energy for large moves higher or lower.
For instance, towards the end of 2021, US equity futures reached a staggering value of just over $700 billion, coinciding with the market's peak. This level of exposure was one of the highest observed in the past decade, as reported by Goldman Sachs. Effectively, these investors were heavily invested, leaving them with limited capital available for further investments.
However, as the bear market of 2022 unfolded, these institutional investors underwent a remarkable transformation. They transitioned from their $700 billion exposure to US stocks to a neutral stance in the first half of the year. Subsequently, they took short positions (bets on market price declines in the future) amounting to nearly $500 billion, just as the market was hitting its bottom late in 2022. The swing from a $700 billion long position to a $500 billion short position constituted approximately $1.2 trillion in selling pressure, contributing significantly to the market's weakness during that period.
The short position in the US equity futures market during the fall of 2022 was the most substantial observed in over a decade. However, as the market stabilized, these large investors covered their short positions (bought back into the market to close out their positions). By July of the current year, they had amassed an exposure of over $400 billion to US stocks, marking an astonishing reversal of nearly $1 trillion in buying pressure within less than a year.
When these institutional investors purchase futures positions, they predominantly target US indexes like the S&P 500, NASDAQ, or the Dow Jones Industrial Average. Consequently, for every $100 spent on buying the S&P 500, a significant portion goes into large-cap tech stocks. For instance, out of every $100, $7 flows into Apple, $7 into Microsoft, $4 into Alphabet (Google), $3 into Amazon, $3 into NVIDIA, $2 into Tesla, and $2 into Meta (formerly Facebook). Although the S&P 500 comprises 500 companies, a substantial 28% of the investment in the index is concentrated in these seven stocks. Therefore, when a massive sum like $1 trillion is allocated to purchasing US indexes, a significant proportion is funneled into these select few stocks. These seven stocks have earned the moniker "Magnificent Seven" and account for a substantial portion of the S&P 500's returns this year.
To describe the current market conditions, we draw on insights from Jonathan Krinsky, a respected market technician who we’ve spoken with on our Financial Sense Newshour podcast many times in the past. In a recent note to clients, he expressed:
"As we have been emphasizing for some time now, the current market landscape can be viewed in two contrasting ways. It's either the slowest and weakest start to a new bull market we've ever witnessed, or it's one of the longest and strongest bear market rallies we've ever seen. We lean more toward the latter."
The strikingly narrow participation in this year's market rally highlights its lackluster performance. For instance, examining year-to-date returns through October 5th reveals a significant disparity between the S&P 500 and other major benchmarks, as illustrated in the table below:
- S&P 500 = +10.9%
- S&P 500 ex the Magnificent Seven = +1.4%
- Dow Jones Industrial Average = -0.1%
- S&P 500 Equal Weight = -1.7%
- S&P 500 Retail Index = -3.5%
- Russell Microcap Index = -9.1%
- S&P 500 Bank Index = -14.3%
Apart from the influence of a handful of stocks, most indices and stocks are in negative territory for the year. It becomes challenging to argue for a sustained bull market when consumer stocks are down for the year, especially given that the consumer sector represents more than two-thirds of the economy. Additionally, bank stocks are experiencing double-digit declines while increasing their tightening of lending standards, restricting capital to consumers and businesses, which casts further doubt on a bullish outlook.
The substantial injection of money into the markets, driven by the US equity futures market, helps explain the force behind this year's market movements and why they have been so selective. Looking ahead, the current positioning in the futures market is nearing levels not seen in the past decade. It's difficult to imagine futures players increasing leverage to inject another trillion dollars into the stock market from current levels.
This favorable tailwind that has supported the Goldilocks bull market is becoming stretched to the point where it might transform into a headwind in the near future.
From Tailwinds to Headwinds – The Outlook Going Forward
The United States economy and financial markets have demonstrated remarkable resilience in the face of numerous challenges over the years. However, as we look ahead to the next 12 months, there are several concerning headwinds that threaten to hamper economic growth and stability.
Ballooning Budget Deficit
One of the most prominent headwinds facing the US economy is the ballooning budget deficit. The pandemic response, including relief packages and stimulus measures, led to an unprecedented increase in government spending. While these measures were necessary to support businesses and individuals during the crisis, they have left the federal budget with a substantial deficit. The deficit is expected to remain elevated in the coming years, and this poses several risks. As the debt grows, so does the interest burden, diverting resources away from critical government investments in infrastructure, education, and healthcare. In the second quarter of this year, the annualized interest expense to service our debt was $909 billion dollars and nearly double the expense two years ago. Of the more than $30 trillion in government debt, a staggering $4.7 trillion matures over the next three months, and $5.4 trillion in 2024. Currently the average coupon the US pays on its debt is 2.15% while current interest rates range from 5-5.5%, more than double its average coupon. As the more than $10 trillion in debt matures between now and the end of 2024, it will be refinanced at significantly higher rates and raise major concerns next year as the budget deficit blows out. This is likely to lead to market instability and ultimately force the Fed’s hand to step in as buyer of last resort and help drive interest rates down.
Depleted Pandemic Consumer Savings
The pandemic-induced economic downturn prompted unprecedented levels of government stimulus and relief programs, which, in turn, boosted personal savings for many Americans. However, according to the Federal Reserve Bank of San Francisco, only the richest 20% of Americans had excess pandemic savings in the second quarter, with the bulk of Americans possessing less now than they did before the pandemic. The bank believes that the remaining excess savings were completely depleted by the end of the third quarter. This is concerning since the US consumer is the main driver of economic growth with consumer spending comprising around two-thirds of all economic activity. Should this major pillar of economic growth falter, the specter of a recession will only grow in 2024.
The Lagged Impact of Tight Monetary Policy
The Federal Reserve's response to the pandemic included lowering interest rates to near-zero and implementing various quantitative easing measures to support the financial markets and stimulate borrowing and spending. The inflationary impact of this unprecedented amount of stimulus in early 2020 did not lead to instantaneous inflation, but rather the full impact of the excess stimulus began to be felt late in 2021 and culminated in a 40-year high in inflation in 2022 at over 9%.
Just as the impact of loose monetary policy impacted the economy with a lag, so too will there be a lagged response to the Fed’s interest rate hiking campaign. The effects are already materializing as home purchase applications for the end of September fell to their lowest level since 1995, a 28-year low. Banks are tightening lending standards on every loan category, and consumers are beginning to stretch their buck by shifting spending towards lower-end retailers.
Just as the US government is going to feel the sting of higher interest rates with every maturing debt issue it has to refinance, this is also happening across the economy as well with US businesses, commercial real estate loans, or even on car leases where lease payments are now multiples above what they were just 2-3 years ago. Every facet of the economy is feeling the sting of higher rates and this will not end until the US economy breaks and allows the Fed to cut interest rates, which is Stein’s Law playing out. The famous quote, "If something can't continue it won't" is attributed to Herbert Stein, an American economist who served as the chairman of President Nixon's Council of Economic Advisers. Stein first made the observation in 1977, and it has since become known as "Stein's Law."
In summary, the US economy and financial markets are facing several challenges over the next 12 months that could impede growth and stability. These include the growing budget deficit, dwindling pandemic-era consumer savings, and the delayed effects of tight monetary policies.
We believe that the markets are reaching oversold levels, and this may lead to a bottom forming, potentially triggering the typical fourth-quarter rally often driven by corporations buying back their stock to fulfill annual buyback programs. In anticipation of this rally, we plan to capitalize on strength and gradually shift our client portfolios towards a more defensive stance.
This proactive approach aims to prepare our clients for what we anticipate will be a challenging first half of 2024, with the possibility of a recession on the horizon. If an official recession occurs, the stock market could experience further declines, with 2023 representing an extended period of market uncertainty.
By positioning our clients defensively, we aim to have the flexibility to re-enter the market and seek opportunities in both stocks and bonds. Our investment strategy will focus on assets with attributes of scarcity and necessity: strategic commodities, semiconductors, and companies poised to benefit from artificial intelligence (side note: We used an artificial intelligence program to generate the cartoons used in the first section). We are already building a portfolio of potential opportunities, which is expected to expand as the market experiences further turbulence.
If you have any questions regarding our outlook or your portfolio, please don't hesitate to contact your wealth advisor.
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Copyright © 2023 Chris Puplava