Above the Noise: So long, September. Strikes, shutdowns, and Social Security

We made it through August and September! Readers of Above the Noise know that I say that with sarcasm. The media is happy to remind us each year that stock markets have had historically weak performance at the end of summers. But I’ve never been a big fan of investing based on seasonal patterns. It’s a bit silly. The Great Depression, 9/11, and the collapse of Lehman Brothers skew the data.

Now, stocks were in fact challenged over the past two months,¹ but I’d attribute this year’s August and September downturn to too-strong US growth and higher rates rather than anything specific about the calendar. Nonetheless, if you care about this sort of thing, we are now entering what has historically been the best two months for stocks.² Either way, investors who didn’t “sell in May and go away” were right this year, as is often the case.³

Personally, I’ll continue to focus on the big questions rather than the date on the Gregorian calendar. Speaking of which…

A ’keep it simple’ strategy

We start with three simple questions.

1. Where are we in the cycle?

Historically, it has taken roughly 12 to 18 months for the impact of interest rate hikes to be felt on the US economy. A year ago, the Fed Funds rate was 2.50%. Eighteen months ago, it was 0.25%.⁴ Give it time. The slowdown in the economy is still ahead of us.

2. What’s the market telling us about the direction of the US economy?

Financial markets (over the past three months)⁵ and global central banks have revised their respective assessments of near-term recession probabilities, as reflected in favorable asset returns and recent upgrades to economic outlooks. Our research indicates that the odds of a recession in 2023 are minimal, and that economic resiliency should persist through the end of the year.

3. What will be the policy response?

Is a Federal Reserve rate hike in play for November? Regardless, the Fed Funds futures market suggests that the end of tightening is near.

A backdrop of economic resilience and improving risk sentiment (over the past three months) has us favoring risk assets over the remainder of the year, if not into 2024. We favor credit over Treasuries as well as cash-like instruments. Within equities, we overweight cyclical factors with high operating leverage and a higher sensitivity to a rebound in growth expectations, such as value and smaller capitalization stocks. From a regional perspective, we remain overweight emerging markets, supported by improving risk appetite and expectations for US dollar depreciation.

It may be confirmation bias, but…

… today, as in the past, I expect another late cycle rise in oil and gasoline prices to have a deflationary impact on the US economy, rather than result in higher inflation and further policy tightening. Energy prices surged going into the recessions of 1991 and 2008 also.⁶ Back then, the increase in gasoline prices lifted headline US Consumer Price Index (as it did again this August),⁷ but it cut into real consumer income just as the consumer spending was already slowing.⁸ It feels like déjà vu all over again. I’d expect the rise in energy prices to again serve as a “tax” on the consumer rather than the impetus for additional policy tightening.

It was said

”When we come back, we're not going to leave. We're going to get this done. Nobody wins in a government shutdown.” – Kevin McCarthy, Speaker of the US House of Representatives

Get out the popcorn! The House speaker appears willing to move ahead with a short-term spending bill, despite threats from members of his party that such a move would result in a floor vote to remove him. Personally, I’ll be watching with faint interest as these things rarely matter much to the economy or to the financial markets. Here’s some things to know to prepare you for the showdown.

• There have been 21 government shutdowns in US history. They have been resolved, on average, within 8 days.⁹
• Essential government functions would continue to operate during a shutdown, including but not limited to air-traffic control, border patrol, federal prisons, the power grid, mail delivery, disaster relief, food-safety inspections, military, and tax collection. Seniors will continue to receive their Social Security and Medicare benefits. Veteran benefits, unemployment benefits, and food stamps will be unaffected.
• The likely direct economic impact of a government shutdown is difficult to quantify, but it’s relatively small. Government spending is roughly 17% of the $26.5 trillion US economy, but only roughly 3% is “non-essential” spending.¹⁰
• Non-essential federal workers would be furloughed, and essential workers would receive IOUs instead of payments. This would impact roughly 3 million Americans. Importantly, the number of people working in federal jobs as a percentage of total workers is the lowest on record, suggesting the impact to the economy would be minimal.¹¹
• The US equity market, as represented by the S&P 500 Index, posted positive returns over 12 of the 21 government shutdowns. The average return over the shutdowns is +0.1%.¹²

Phone a friend

The European Central Bank (ECB) continues to raise interest rates even as the economy is slowing. Is this the next “Trichet” moment, when the European Central Bank under President Jean-Claude Trichet raised interest rates on the eve of a financial crisis? I posed the question to Arnab Das, Global Market Strategist-EMEA at Invesco. 

His response:

“It’s a valid concern. Trichet made the same proverbial policy mistake twice in two financial crises, 2008 and 2011. In both instances, energy prices had spiked, the result of geopolitical events. The ECB targets headline inflation, which was being driven higher by the rising oil prices even as core (ex-food and energy) was falling. Trichet and the ECB understood the dilemma but per their mandate were forced to raise rates despite the deep economic downturn and severe financial crises in the US in 2008 and in the eurozone in 2011.

The similarities are self-evident. Energy prices are being driven back up as OPEC+ cuts output.¹³ Headline inflation remains above target.¹⁴ At the same time, the economy is slowing as goods demand worsens, particularly from China. The ECB has already tightened a lot and there’s a risk of another rate hike if inflation doesn’t cooperate.

Fortunately, there are no signs of financial crisis, as there was in 2008 and 2011. The impact of additional rate hikes would likely be on economic growth and not on the integrity of the financial system. 

Personally, I think the ECB will end their tightening cycle, but the risk of tightening overkill is high. Paradoxically, I therefore wouldn’t be surprised if the ECB begins cutting interest rates before the US Federal Reserve returns to accommodative policy.” 

Since you asked (part 1)

Q: Doesn’t Social Security run out of money by the middle of the next decade?

A: No. The Social Security trust fund will have been depleted by the middle of the next decade. From there, the US will pay out what it collects in payroll tax revenue. It is expected that retirees would then receive roughly 80% of benefits, although I would expect politicians to act to ensure Social Security’s long-term viability.¹⁵ This would include similar action taken by the Greenspan Commission in the early 1980s, such as increasing the taxable maximum, altering the cost-of-living adjustments, or raising the retirement age, to name a few.

Since you asked (part 2)

Q: How will the auto strike affect the US economy?

A: There are a few potential concerns:

• There would be a hit to economic growth at a time when the economy is already posed to slow.
• It’s estimated that the drop in motor vehicle production would be a 0.1% to 0.2% drag on gross domestic product (GDP) per week.¹⁶ Over an entire quarter, that would be a drag of 1.5% to 2.0%, which could result in a flat quarter.
• New and used vehicles have been a source of deflation in recent months. A long-term hit to production would once again put upward pressure on vehicles. This would not be ideal as the market anticipates a coming end to Federal Reserve policy tightening.

However, strikes have not historically lasted for very long. The United Auto Workers union has a finite strike fund in which to provide strike pay. Additionally, most domestic car manufacturers have ample supply, and the used car companies have rebuilt their fleets. Supply has increased at a time when consumer demand is slowing. As a result, any upside move on inflation would likely be very limited.

Everyone has a podcast

David Nadel joined the Greater Possibilities Podcast to discuss the misperceptions investors have about small- and mid-cap international (SMID) stocks and where his team sees opportunities in this often-overlooked space.

Among his insights:

• US investors don’t tend to see international SMID as a distinct asset class. US investors have less than 1% allocated to international SMID caps, versus around 14% for US SMID.¹⁷ For many, that’s because they see international SMID as high risk. But compared to international large caps, international SMID has produced attractive risk-adjusted returns.¹⁸
• In the US, it’s rare for a SMID cap company to be a global market-share leader in its industry. But David says that’s a more common occurrence internationally: “You can be a $4 billion company in the US and sell to a single state in the country, like California, or Massachusetts. On the international stage, it's a much tougher and more demanding standard. So, if you're coming from a small country, you don't have a large home market. You must figure out how the whole world works. You must adopt basically global standards. And so, these are battle-tested businesses.”
• David’s bottom-up process looks for attractive stocks, not popular themes. But when themes do emerge, he looks for companies that are close to the action. For example, he cited IT consulting companies as “an agnostic play” on the artificial intelligence theme.

On the road again

My travels this month took me to Detroit, a homecoming of sorts for this University of Michigan graduate. Let’s just say I’m not surprised to hear businessman Dan Gilbert proclaiming “Detroit is back” and rock star Alice Cooper declaring Detroit to be “the coolest place around.” A mere 10 years after becoming the largest municipality to declare for bankruptcy, the city has a great combination of new hotels, restaurants, stadiums and arenas, and apartments. Challenges remain but the progress is great. Anytime the company needs me in “the 313” for an investment conference, I’ll be happy to get a great meal in Detroit’s Corktown Historic District and to take in a Tigers or Red Wings game. 

See you next month. I promise to not waste October sunshine.