US Economy: Investor Exits, Stronger Recession Indicators

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US Economy: Investors Exit, Indicators Worsen

MARKET INSIGHTS
07 Nov 2022

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The US goes into midterm elections tomorrow and the current administration is expected to lose ground to a “Red Wave”, i.e. the conservative Republican Party (or the “Red” party) is being widely touted to gain control of both houses of parliament. This creates a “gridlock” situation wherein the ruling administration controls the President’s chair while both houses of parliament will be aligned against them, thus leaving any new policy-building potentially in tatters.

As the electioneering for the midterms commenced earlier this year, the ruling administration leaned heavily into social issues such as abortion (which the U.S. Supreme Court effectively abrogated from being a national mandate to a matter that should be determined at the state level) and debate on transgender rights. In surveys conducted by the venerable non-partisan Pew Research Center in May, it was determined that neither of these issues were in Top 10 issues considered to be of concern by the average American voter. The top three issues were, of course, inflation, the high cost of healthcare and violence that had been rippling through many major American cities for almost two years.

By August, perhaps on account of the strident coverage churned since the Supreme Court decision, abortion emerged as No. 8 in another survey carried out by the same institution. The top 4 issues continued to same 3 issues as in May, with gun policy added as increasing number of Americans armed themselves in light of rising crime and lenient laws towards criminals being afforded by prosecutors generally aligned with the current administration.

The opposition had remained consistent in their core issues throughout this time: echoes of “It’s the economy, stupid” – a phrase coined by James Carville, a strategist for the current administration’s party during their successful bid to unseat George Bush from the presidency in 1992 – seemingly buoyed the opposition’s candidates in the lead-up to the midterm elections.

The Republicans’ focus on the economy isn’t exactly misplaced. Earlier this month, more than a third of small businesses surveyed randomly stated that they’re unable to pay October’s rent. This number has been steadily ramping throughout the year with “Blue” states (i.e. states controlled by the current administration’s party) holding all of the Top 5 positions where business owners reported this at levels well above the national average.

As per the the U.S. Small Business Administration Office of Advocacy, small businesses are a key part of the U.S. economy and account for a little under half of all private workers in the U.S.. The National Federation of Independent Business (NFIB), another long-standing advocacy group for small businesses reported that its Small Business Optimism Index – which has been calculated since 1986 – inched up 0.3 points in September to 92.1, making it the ninth straight month below the 48-year average of 98. While small business respondents were generally stating optimism in continuing their business, nearly 30% of owners indicated inflation was a critical problem for their business.

On an “average citizen” basis, personal savings in the U.S. is estimated to be at historical bottoms, with credit card debt soaring to highs:

Cross-sectional analysis made on different data sources by Harvard Professor Jason Furman indicate that nearly half of net savings accrued via pandemic-era financial relief measures have been spent in the past 12 months at a steadily increasing rate. As inflation continues to weigh large, the balance can be estimated to burn off even sooner:

On the topic of credit cards, many major credit card issuers who issue monthly report broadly report that delinquency rates continued to slowly climb toward pre-pandemic levels in September. Although some issuers also report that charge-off rates are falling, October levels can be expected to not be any better when the data is made available.

Mr. Michael Cembalest, Chairman of Market and Investment Strategy at JP Morgan, made a rather interesting observation from data of recessions in the past: equities tend to bottom several months (at least) before the rest of the victims of a recession.

Furthermore, economic indicators in the present day that have a strong relation to market momentum, show a near-unshakeable “downbeat” trend:

Let’s juxtapose this with data from Bank of America near the end of last month. As governments around the world leaned into debt issuances since the end of the Cold War, negatively-yielding debt has seen a precipitous fall in issuances and nearing 10-year lows. This is largely due to waning demand for bonds among investors (which was reported in an earlier article):

This did not translate to, for instance, increasing flows into equity markets. As of last month, the US 2-Year Treasury Bonds yielded more than $S&P 500 dividends:

Now, despite bonds being so unattractive to investors in general, BofA’s private clients have shown a 10-year high in inflows to bonds. The bank’s private investors have historically shown a heavy tendency to own stocks.

This outflow from stocks is not just limited to high net-worth investors. Given the historical falls, it is logical that individual investors would do so as well. According to an October survey by the American Association of Individual Investors which was released at the start of this month, individual investors increased the share of cash in their portfolios to around 25%, the highest level since March 2020, which is when the stock market crashed.

Robinhood, the leading commission-free brokerage app used by small-value individual investors, reported in the latest quarterly update that Monthly Active Users (MAU) are at lows not seen since Q4 2020:

By no means is inflation worries limited to the U.S. Fidelity estimated that, as per end of September data, inflation in the Eurozone will overtake that of the U.S. in 2023, with the United Kingdom already doing so.

Overall, as it turns out, holding cash was comparatively a better choice than holding any instrument: be it leading global stocks, corporate bonds, gold, the S&P 500 or even U.S. Treasury Bonds of any tenor:

However, it is incomplete to say that most investors are cashing out altogether. As an earlier article on Amazon indicated, there have been strong inflows into holding ETFs by investors who have to maintain coverage over equities. It can be estimated that this had some effect on the slight spike seen earlier this month in the S&P 500’s forward equity valuations:

This inflow, rather than strengthening conviction in any single stock or sector or an expectation in economic downturns ending, is likely to be a prime factor in the slight rises seen in markets in recent times. As Mr. Cembalest stated, the current economic scenario may not be the worst yet.

This is also where the Republican contentions that the economic downturn is solely the current administration’s fault. Markets were deemed overvalued by leading fund managers in survey after survey since 2019 and inflation had been creeping throughout previous administration’s tenure as well. While a number of policies by the current administration can arguably have exacerbated the situation to present-day lows and woes, the simple fact is that the US economy has been a ticking time bomb for quite some time now. Only recently has the ticking gotten louder and faster.

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Sandeep Rao

07 Nov 2022

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