Stocks fell yesterday, led by the tech sector reacting to a disappointing outlook from Oracle# and a ho-hum reaction to the new iPhone offerings from Apple#. The weakness also reflected concerns that today’s CPI report might spook investors as the cost of living in August likely rose, thanks to higher energy costs.
Today I am going to skip around a bit. I will start by closing the circle from Monday when I discussed the fight between Disney# and Spectrum. On Monday, the fight ended predictably, with Disney agreeing to offer some of its streaming offerings through Spectrum at a discount to consumers. While neither side got all they wanted, a complete divorce whereby all Disney products were pulled from the Spectrum lineup was never more than a remote possibility. With that said, the end game remains inevitable. Linear TV as we have known it for many decades is going to disappear. Over time, access to streaming will become easier and life will go on. That doesn’t mean cable TV is dead; it just means that programming will be delivered in a technologically more efficient manner, one that will allow viewers to view all but live programming wherever, whenever and on whatever device they want. As with any disruptive new industry, what begins with hundreds of entrants fairly quickly narrows down to less than a handful. The rest die or fade away in some other manner.
Now to today’s CPI report. If you haven’t noticed, the price you pay for gasoline has been rising. Crude oil now trades near $90 per barrel. It was near zero in the depths of the pandemic. August was a particularly tough month with prices rising about 10%. That won’t be fully reflected in today’s report, but it will likely make the headline increase in today’s CPI report close to 0.5%, hardly a number one wants to see in a battle to reduce inflation. Investors and the Fed will be more focused on the core rate, ex-food and energy. That should remain subdued, close to 0.2%. But the public doesn’t allocate what it can spend based on core inflation. Higher oil prices pinch. If you pay an extra $10 at the pump, you spend $10 less on everything else. Bottom line: the Fed will focus on the benign core inflation numbers. If oil prices jump too far, too fast, they will pinch overall growth rates, actually helping the Fed in the future. However, bond yields have been creeping up again. The 2-year is back above 2% again and the 10-year is back over 4.3%. Mortgage demand continues to dip. Higher rates and slower economic activity aren’t good for stocks.
So, what is Washington going to do about all this? Let’s start with the Strategic Petroleum Reserve. Its primary purpose was to have a reserve for national emergencies such as war or a boycott by petroleum producing nations. President Biden decided post-pandemic, as inflation began to rise, that selling some of the Reserve in open markets could cap oil and gasoline prices. It worked, at least while he was pulling oil out at a rapid pace. But now the reserve has been cut in half. The rate he can pull oil out has been reduced. Less oil in the reserve reduces potential withdrawal rates. Biden has proposed to buy oil to replenish the Reserve, but only below $70 per barrel. Thus, we now face a situation where major producers (Saudi Arabia and Russia) are holding back oil to boost prices while the U.S. is slowing releases from the Reserve. Until Saudi and Russia decide to increase production, or a recession leads to reduced demand, oil prices are likely to remain elevated.
OK, what else can Washington do? It could try to limit spending and reduce the size of the deficit. I know there are many who believe the amount of debt outstanding doesn’t really matter. After all, the U.S. can print money and pay its debt. The dollar remains the world’s reserve currency. What’s the problem? The problem isn’t the debt; it’s debt service. There are 3 untouchables, at least for now in Washington. One is debt service. No one, even the crazies on the far left or far right, think it is a good idea to default on debt payments. The other two are Social Security and Medicare. Collectively, the three are rising at a pace close to $400 billion per year. That means, all else being equal, debt requirements will rise at that pace. At some point it crowds out other borrowers and it certainly will lead to higher borrowing costs. What’s Washington’s answer? PUNT! Right wing Republicans are trying to force a partial government shutdown at the end of this month. They appear willing to take the blame on principal that they are spending hawks. What is more likely to happen is that a partial shutdown will happen for a few days or weeks until pressure leads to some continuing resolution or similar compromise. And because next year is a big election year, nothing serious will be done to rein in the deficit.
Instead of dealing with serious issues like spending, Republicans are moving toward impeachment. The bar to impeach has gotten lower and lower since the Clinton-Lewinsky affair. No one knows how low the bar may move over the next several months. Thankfully, the Senate standards for impeachment haven’t budged as much. Obviously, wherever this goes, there will be little direct economic impact. But it does divert a lot of time and energy away from more important issues. Republicans only gained control of the House after the 2022 election. So far, very little has gotten done. It’s certainly not all their fault. But if incumbents need to campaign next year on accomplishments, the list is likely to be almost non-existent.
With that said, the Democratic answer remains the same. Spend more and increase the regulatory burden. They also say tax more, but they know that won’t happen anytime soon. Thus, their game plan will only increase the deficit and debt service costs. One caveat to note. Many of the Trump tax cuts of 2017 expire at the end of 2025. Most will be extended. Without extension, the result would be a de facto tax increase. The one exception could be estate taxes. Today, only a small sliver of Americans pay estate taxes. All are very wealthy by almost any standard. If the estate tax exemption rates today likely die at the end of 2025 and fall back toward $3 million, lawyers will work with wealthy clients to shift wealth to children and grandchildren. Such wealth transfers will have significant economic implications in 2026 and beyond. It’s an issue to be addressed by us at some future date.
Back to the inflation battle, one item that gets little attention is the Fed’s actions to reduce its balance sheet by about $1 trillion per year. Money supply is falling by a similar amount. That drains liquidity from the system. When the economy is stressed, that leads to crisis. We saw that this past March when a handful of banks failed in very short order. In today’s world money can move instantaneously. That means when storm clouds increase, money can flow quickly, leading to serious consequences. Hedge funds, for instance, have been investing using extreme leverage in hedges between government bonds and government bond futures. In normally functioning markets, the trading is orderly. But when events push everyone to quickly move money in the same direction, disorder and leverage are a toxic combination. In the late 90s, such disorder created the bankruptcy of Long Term Capital Management. Is that about to happen again? The seeds are there, but just as seeds need water and nourishment to grow, there has to be a catalyst that ignites disorder.
We didn’t see the Silicon Valley Bank failure until a few days before it happened. That is what will happen the next time as well. My only point is that declining money supply, banks forced by regulators to be more protective of capital, and more leverage employed by hedge funds sets the stage for another possible toxic event. The problem is that no one will be able to identify the next catastrophe until it happens. Then it is too late.
If the economy continues to slow and core inflation continues to come down, it is time for the Fed to consider whether liquidation of its balance sheet is providing more risk than reward. Money is already expensive. The San Francisco Fed notes that a combination of the Fed Funds rate and balance sheet reductions is equivalent to a 7% rate. Small businesses pay much more, close to 10% or greater. The screws do not need to be tightened any more. I wrote a few weeks ago about oversteering. The last thing the Fed wants is a spike in short-term rates that quickly forces a fast decline. The only question today should be what conditions will lead to future reductions and at what pace.
Simply looking at GDP data can be misleading. The sale of a new home is reflected in GDP. The sale of an existing home is the transfer of an asset from one party to another. It isn’t in GDP. Today sellers are scarce. No one wants to give up a 3% mortgage, so buyers must turn to new homes, which now make up about 35% of home sales. Their business has been booming. But is the housing market booming? Hardly, total sales volume is down significantly. Covid savings are still impacting demand in a positive way. But the impact is slowing. Domestic air travel demand is weakening noticeably. Retailers are experiencing stress. Whatever today’s CPI report says, the Fed has done its job. Now it simply has to monitor the lagged impact and adjust as necessary. That is good news for investors. The bad news is that a weaker economy will weigh on earnings, and tighter credit conditions increase the possibility of financial accidents.
Former baseball great Bernie Williams is 55 today.
James M. Meyer, CFA 610-260-2220