3 Intractable Problems For The Economy And Markets

seekingalpha07-25

The market has seen some significant sector rotation recently and increased volatility from the NASDAQ.Still, the major indexes remain near all-time highs despite myriad concerns around equities and ...

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sector rotation recently and increased volatility from the NASDAQ.Still, the major indexes remain near all-time highs despite myriad concerns around equities and the economy.Three of these problems seem intractable, and investors are significantly underestimating their negative impact on the economy and the markets in the quarter ahead.These huge economic/market challenges are highlighted in the paragraphs below.   sefa ozel Back on July 3rd, I posted an article entitled “Market Breadth Has Become Beyond Problematic.” In it, I chronicled just how overvalued the Magnificent Seven and Big Tech had become, and a sector rotation was long overdue. The piece proved prescient, as the market has provided investors a massive sector rotation over the past ten days. On Thursday, July 11th, the NASDAQ (COMP:IND) lost two percent on the day, while the Russell 2000 (RTY) surged over three percent. This was the largest daily divergence between the two indexes since 2001 to put in perspective. On Wednesday, July 17th, the tech-heavy index had its biggest one-day sell-off since 2022. Whether the recent rotation into the small-cap Russell 2000, Dow (DJI) and other laggards of the market continues remains to be seen. One thing is for sure, though, and that is the overall market has three huge challenges to overcome that are likely to remain considerable headwinds in the quarters ahead. This is especially true with the S&P 500 (SP500) trading at just north of 22 times forward earnings. Now, notice these are not the only concerns that investors should have with the overall market trading at these valuations. Other worries should include:  The uncertainty of the upcoming election Further escalation in the Ukraine conflict Continue shipping issues in the Red Sea and potential rising Middle East tensions Sticky Inflation Tepid Global Growth Overall valuation of market by variety of metrics (P/E, P/S, Market Cap to GDP ratio).    Goldman Sachs Global Investment Research However, there are three key issues I don't seeing getting resolved in the foreseeable future. They are the following: Massive Governmental Debt:   CBO/Capital Economics If the U.S. has one existential problem presently, it is the huge and rising federal debt load. The federal government has added $2.3 trillion to this burden just over the past 12 months. The debt to GDP ratio is now the highest level it has in been in the country's history, and this includes WWII. As you can see below, the national debt has increased at an accelerated rate since the Great Financial Crisis and blew out again due to the COVID-19 pandemic and its aftermath. Federal Debt Levels (Federal Reserve Bank of St. Louis) The U.S. is now to the point it is paying north of $1 trillion annually just to service its debt obligations. This is more than any other program, including Defense or Social Security. Obviously, this is not sustainable. At some point in the near future, Congress is either going to have to cut spending (unlikely) or increase taxes. Unless the November election brings a Republican sweep, most of the 2017 tax cuts are likely to expire in 2025. While this might help bonds incrementally and the deficits marginally, it will also increase corporate tax rates substantially. This will be a significant crimp to earnings and a headwind to equities. In addition, the government is going to have to continue to pay much higher rates to float this debt than they have for most of the past decade and a half. The days of ZIRP are gone. This means continued higher mortgage rates for consumers, interest rates on corporate debt, as well as higher yields on Treasuries. We will likely never see three percent mortgage rates again in my lifetime. Outside a major recession, I doubt we will see even five percent mortgage rates again on the foreseeable horizon. Investors are currently woefully underestimating the consequences of this huge debt load and the resulting higher interest rates will have on the economy and markets in the years ahead. Continued Deterioration In Commercial Real Estate: Based on current futures, there is a near certainty the central bank will cut the Fed Funds rate at the September FOMC meeting. However, a 25bps rate cut or even a series of cuts that bring down interest rates by 100bps in the coming quarters is likely to help the dire situation in much of the commercial real estate sector, except on the margins.   Wolf Street Office values continue to collapse in most major cities. Overall vacancy rates are at record highs nationally. More than a third of the office space is in San Francisco is currently available despite some one million square feet being taken up by AI related concerns in the city which is the epicenter of the AI revolution. Vacancy rates pre-pandemic in the City on the Bay were around five percent in ways of comparison.   June CMBS Delinquency by CRE Sector (Trepp) As you can see above, delinquency rates on Commercial Mortgage Backed Securities {CMBS} have moved up across all sub-sectors of CRE. The office CMBS delinquency rate is now north of 7.5%, compared to under two percent at the beginning of 2023. Delinquency rates would also be much worse without the significant amount of “Extend & Pretend” banks and other lenders are currently engaging in this space to delay the inevitable. Trepp/WolfStreet Fitch recently projected that the delinquency rates for office CMBS will surge past that of the financial crisis in 2025. This will have a major impact on regional banks that originate some 70% of CRE loans and hold approximately 30% of overall CRE debt. Seeking Alpha The market is far too complacent about this risk, given the SPDR® S&P Regional Banking ETF (KRE) just hit a 52-week-high due to increasing hopes for a cut to the Fed Funds rate. Increasing delinquency and default rates and higher CRE losses are going to increasingly impact at least the regional banking system in the quarters ahead. This could trigger a “credit crunch” especially for small business which is primarily served by regional banks. As it is, corporate bankruptcies are already at their highest levels since 2010. A Tapped-Out Consumer: During first quarter earnings season and just after investors heard negative commentary from numerous well-known consumer names about the tepid demand, they were seeing from weakening consumer base in North America. These companies included icons like Home Depot (HD) whose management noted many customers were pushing back purchases of big-ticket items. Starbucks (SBUX) and Nike (NKE) also have negative outlooks on consumer demand. In addition, McDonald's (MCD) just extended its $5 value meal promotion, as it is the only thing that seems to be boosting traffic in its stores. It is difficult to see how consumer demand will pick up in the coming quarters. GDP growth in the first half of this year should come in between 1.5% to 2.0% when all readings are final. That is a far cry from just over four percent GDP growth in the second half of 2023. The jobs market is also deteriorating as job openings have fallen, and the unemployment rate has ticked up to 4.1% from its nadir of 3.5% in July last summer.   U.S. excess personal savings (Bureaus of Economic Analysis) All the massive excess savings from the COVID-19 stimulus programs have now been spent. The personal savings rate has also fallen to historical lows and half the pre-pandemic rate. In addition, the average American household has lost ground to inflation since 2021. Although they have gained a bit of ground back recently as inflation levels have subsided. However, that is only if you go with “official” statistics on inflation, which I highlighted in a recent article, significantly understates the true inflation experienced by the average American household for numerous reasons. U.S. Personal Savings Rate As Of June 28th, 2024 (Federal Reserve Bank of St. Louis) In summary, the market is trading at 22 times forward earnings despite myriad concerns outlined in the opening narrative. More importantly, both the economy and markets face three huge challenges that don't like they will be overcome, at least on the near-term horizon. They are a weak overall consumer class in an economy that demands on consumer spending for nearly 70% of economic activity. The commercial real estate market also continues to deteriorate and looks heading for a reckoning in 2025. Finally, the U.S. has a massive and fast-growing debt load, with absolutely no easy or otherwise solutions that appear to be forthcoming.  Given “risk-free” short-term treasuries yield over 5.3%, approximately half of my portfolio is allocated to this asset class, awaiting lower entry points in the market to deploy some “dry powder.” Almost all the rest of my portfolio is held within covered call positions around the few stocks I am finding in this overbought market that have reasonable valuations. A quite cautious, but prudent approach given the valuation of the overall market and the myriad challenges the economy and equities will face in the months and quarters ahead.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"-1","news_tag":"economic","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2454853307"}