The Weekend Edition # 112 - US Debt Affordability

Welcome to another issue of the Weekend Edition.

Thank you to all who’ve read and welcome to all the new subscribers this week!

Here’s what we cover:

• Market Recap - The Uneven Rally Continues

• Macro - US Debt Affordability

• Earnings Season Q3 - Retail earnings ahead

• The Week Ahead - Economic & Earnings Calendars

• Closing Thoughts - Shutdown looms again!

Let’s dive in ⬇️

Market Recap - Oct 30 - Nov 03, 2023

It was a choppy week in the market. Some of the momentum from the previous week carried through earlier in the week but, not without incident. We closed the week with a strong rally with the S&P500 crossing 4400, a key level that we talked about last week.

Thursday saw a strong down day after a weak 30Y Treasury Bond auction and comments from Chair Powell pushing back on some of the complacency in the markets. This sent the 2Y yield above 5%.

Fed Chair Powell made it a point to say that inflation is still a concern and while unemployment and growth were easing, it doesn't mean inflation is conquered. It makes sense to keep the pressure on, particularly given the strong "everything" rally the markets saw leading to easing of financial conditions.

The rally was led mostly by mega-cap tech yet again, other than the last day of the week. A look at the Vanguard Mega Cap Tech ETF (in grey, below) vs. the Russell Small-cap ETF (in green) shows the massive divergence until Friday. This is not particularly what we want to see, and until small caps stabilize it's challenging to say that the market is back to being bullish.

While the above is evidence enough that breadth has not particularly improved, we look at the the divergence between the S&P 500 and the S&P Equal Weighted Index. The S&P 500 is a market-cap weighted index which means if the companies with the largest market cap rally, the entire index will go up. But, that isn't necessarily representative of the market because the other companies, as we can see in the equal weighted index, was actually down for most of the week.

While this rally may continue, yields remain volatile as we've seen last week and this could likely remain the case until the end of the year. Next week will bring us the CPI, a number everyone will be watching because the Fed has made it clear that inflation is still an issue. And we'll be watching to see whether it is of any significance.

Bitcoin seems to be back. Nothing deterred its climb this week, closing in on the 38,000 level. There's been slight pull back since then, but sustaining above 40,000 could be key for Bitcoin to maintain some momentum to the upside.

Commodities

Oil and Gold are pricing in the risk-off trade.

 Oil extended it's pullback to a 3.5 month low with increased Russian export activity and a weekly API inventory build weighing on price. There was also some discussion that other OPEC+ members have actually had higher than expected output in the last 3 months due to seasonality. Actual targets have not changed. The next OPEC+ JMMC is set to be held on 26 Nov and there's speculation that production cuts will be carried into next year if oil prices continue to languish.

Natural gas extended losses to a ten-day low with milder temps for much of the US weighing on heating demand outlooks.

Sugar extended losses to a one-week low alongside the pullback in crude prices and a weaker Brazilian real. Corn and Wheat retreated later in the week after the USDA WASDE report came out. The Report discussed forecasts higher production and ending stocks for both commodities. The prospect of an increase in supply weighed on the price.

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Macro - US Debt Affordability

Moody's released a change to their outlook on US's ratings from "stable" to "negative". A change to the outlook come 3-6 months before an actual change in ratings if certain conditions are fulfilled. A change does not always follow and the outlook may be changed back to stable or even positive if the situation improves. As a reminder, Moody's is the only big ratings agency that still has the US rating at the highest level which is Aaa.

While this change in outlook may not share up equity and credit markets, the issues raised by Moody's are not altogether benign. The major issues cited are "weakening debt affordability and decline in fiscal strength", brought on by an increase in government spending and "continued political polarization within US Congress".

In terms of Debt Affordability, they are talking about the increasing level of interest expenditure on the ballooning levels of US Debt. It should come as no surprise that the current level of US Debt is the highest it has been in a long time.

But, what's more alarming is that the US is running one of the highest fiscal deficits, which means their expenses or outlays are much higher than their income or receipts.

This fiscal deficit is expected to increase over the years, primarily driven by interest rate expenses and aging-related entitlement spending. As the level of interest rates in the economy have increased drastically, there's been a huge increase in the interest burden on this debt. The chart below shows us that that interest payments will start to overtake the primary deficit in the next 5 years and continue on that path. Primary deficits will continue to remain in the range of 3.3% of GDP while, interest costs will triple by 2053.

With more and more of the fiscal deficit being driven by interest payments and mandatory entitlement programs, there will be very little wiggle room in the budgeting process and bipartisan political disagreements will lead to a further reduction in financial flexibility.

Moody's still retains the rating for the US given the country's exceptional economic strength, solid institutional & governance strength and the central role of the US Dollar and Treasury bond bank in the global financial system.

However, the rising debt levels and diminishing debt affordability remains a serious concern. Unless there is a meaningful increase in government revenues or a structural reduction in spending, the possibility of a downgrade remains.

Earnings Season - Retail Earnings Ahead

92% of the S&P 500 has reported thus far and with that the actual growth in earnings reported is 3.05% YoY. If this trend is maintained, the S&P 500 will be coming out of an earnings recession this quarter.

We still have a large number of retail earnings coming up. The earnings cycle for many of the retailers are a bit odd as they tend to end their third quarter at the end of October. Next week, we have a few significant companies reporting including Walmart, Home Depot, Target and TJX.

Retail as a sector has not done too poorly delivering earnings growth of +69.31% from 46% of companies reported thus far. However, much of that earnings growth is being driven by results from Amazon, that reported an actual earnings growth of +240% YoY. As a reminder, Amazon’s earnings were beaten down heavily last year on account of their investment in Rivian, which they had to mark to market, in line with accounting standards.

As a result of this, however, earnings estimates for the Q3 for the retail sub-sector has been increased. Given what we're seeing in the consumer slowdown, many of these discretionary retailers may still have some pain ahead, particularly home improvement (Home Depot and Lowe's) and electronics (Best Buy).

The Week Ahead - Calendars

US Earnings Calendar

US Economic Calendar in Eastern Time (Source: Trading Economics)

Closing Thoughts - Shutdown looms again

There will likely be a brief reaction to the Moody's news of the change in ratings outlook but, I doubt it will be major, given that it's not actual ratings change and that the other two ratings agencies already have the US ratings at one notch lower. This news will not cause a rebalancing in bond portfolios.

But the bigger issues of the US' debt and budgeting remains. There's still possibility of a US government shutdown on 17 November if a consensus is not reached. There have been stop-gap solutions proposed, yet again and this time on a piece-meal basis to avoid a government shutdown. Meanwhile, several government agencies are starting to prepare their staff for a partial government shutdown as per their policies.

This is where the issue continues to be a problem for the US Government and the reason Moody's and other ratings agencies are raising concerns. The political issues are giving rise to a situation where fiscal stability and strength of US Government has started to deteriorate. And while there may not be imminent ramifications, unless there is an actual shutdown, this lack of resolutions creates a bigger concern for the future and continue to hamper the US' status in the global financial system.

Here’s wishing you safe investing.

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.