A Wall of Worry
It is often said the stock market likes to climb a wall of worry, meaning once the bearish investors have been shaken out of the market, the remaining ones are bullish and will keep buying stocks, pushing prices higher. Of course, climbing the proverbial wall of worry has its limits. If the worries continue or they intensify, more investors turn bearish, and the climbing comes to an end. Investors certainly seem particularly worried lately, as the enthusiasm from the election and inauguration of the new administration have given their place to anxiety over the big economic challenges the new administration in Washington DC faces. The Chicago Board of Exchange (CBOE) volatility index (VIX) hit a level of 21 this week, suggesting investors had elevated demand for portfolio hedging mechanisms. Also, the CNN fear and greed index this week dipped to a score of 22 (extreme fear), while only a week ago it was comfortably resting at 47 (neutral). While the stock market in the long run is a valuation weighing mechanism, in the short run it is simply a sentiment gauge. Sentiment can change quickly. There is no doubt the investors’ euphoric sentiment of early January has turned to fear and anxiety in late February. There are valid reasons for the souring sentiment, but none are new or surprising. We have covered all of them, at various lengths, in previous newsletters. What is always surprising is when investors decide to focus on them:
Federal Government Deficits
The last fiscal year of the Biden administration ended with approximately $1.85 Trillion deficit (6.4% of GDP) and $36.4 Trillion in federal debt. This is an unsustainable budgetary situation as annual deficits are added to the federal debt, requiring even more borrowing to pay interest and service the debt, which further increases the debt. It’s a vicious cycle that leads to the default of federal government to its obligations (debt or entitlement programs or some combination of the two). The goal should be to reduce the government deficit to a more sustainable 3% of GDP ($0.85 Trillion at current GDP level). The question is where will the spending cuts of approximately $1 Trillion come from to change our irresponsible fiscal course?
In fiscal 2024 for instance, the federal government spent $6.8 Trillion. About $5.69 Trillion were consumed by mandatory or highly inflexible outlays (Social Security $1.46T, Interest $0.882T, Defense $0.874T, Medicare $0.874T, Medicaid 0.6T, Income Security-support subsidies $0.67T, and Veterans Affairs $0.325T). That left about $1.11 Trillion outlays for all other government departments (State, Homeland Security, Education, Transportation, etc.) The point being, there are no easy choices here.
Meanwhile, this week, the House passed the 2025 budget framework (blueprint) to kick-start the budgetary negotiations with the Senate. This House proposal trims both revenues (due to tax cuts) and outlays (due to spending cuts), but projects $2.08 Trillion budget deficit. This is not good enough, and Wall Street knows it. First, the plan assumes no economic slowdown in the revenue collection projection. Second, it assumes the government will be able to achieve major spending cuts through the efforts of the Department of Government Efficiency (DOGE).
It is certainly very intriguing that DOGE has discovered $4.7 Trillion in untraceable Treasury payments. The records for these payments lack the identification code linking them to a specific budget line item. If we don’t know which government department or agency spent the funds, how can we ever trace them? Brilliant bookkeeping! This is exactly what the founding fathers of the nation were afraid would happen to the U.S. The federal government would grow too big and powerful, and could end up accountable to no one. Nevertheless, because these payments are untraceable, they may not be unnecessary, thus we may not be able to eliminate them going forward. So, while we can all hope that DOGE will identify a lot of wasteful spending and target it for elimination, it is highly doubtful the federal government will reduce its spending by $1 Trillion or more in fiscal 2025.
Slowing Economy
A side effect of high government deficits is the need of the government to keep borrowing more and more. To entice lenders, the government has to offer higher yields on Treasury securities. These higher yields bleed to the rest of the economy and slow down economic activity. For instance, mortgage rates are tied to the 10-year Treasury Note. Currently, the interest rate on a 30-year conventional mortgage loan hovers around 6.9%. The combination of high housing prices with high mortgage rates has led to a frozen housing market. Sales of existing homes declined by 4.9% in January (month over month). A housing slump affects adversely multiple industries feeding directly from it. Think of construction, materials, lending, furnishings, appliances, etc. The housing sector accounts for 20% of the US economic activity and has been in recession for more than a year! How long before the rest of the economy falls into a recession too?
Meanwhile, as companies are reporting their fourth quarter earnings, we are getting firsthand forward guidance about consumer spending. Companies such as Home Depot, Lowe’s, Walmart, Domino’s Pizza are all warning us about weaker consumer spending. The 0.9% drop in retail sales in January (month over month) confirms consumers are more cautious about their purchases. Perhaps this could be attributed to the softening of the labor market. This week the Initial Jobless Claims (filing for unemployment benefits) rose to 245,000. That’s very close to the 250,000 critical level, which if continues for several weeks usually tips the economy to a recession. Certainly, the plan to reduce the federal workforce by hundreds of thousands of workers cannot instill any spending confidence in the affected households. It is entirely plausible to have a DOGE-induced recession. Trying to right the federal government fiscal ship we may inadvertently derail household finances and precipitate a recession.
Higher prices can also be a factor for consumers pulling back their spending. Necessities like housing, transportation, food, and energy consume most of the household income, leaving very little for discretionary spending. January inflation (CPI) came to 3%, rising for 4 straight months from the 2.4% CPI in September. Consumer prices are certainly moving in the wrong direction!
Uncertainty Over Tariffs and Prices
Taxes on imported goods (tariffs) have an adverse effect on the effort to limit increases in consumer prices. However, President Trump’s favorite negotiating tool with foreign countries seems to be the threat of restricting their access to the US market, through the imposition of tariffs, which make imported goods more expensive and thus less desirable to American consumers. President Trump employed the same strategy during his first term and managed to secure favorable trade terms for the US. The problem this time around is first, the unfortunate timing of imposing tariffs when inflation is elevated, and second, the uncertainty about what the future tariffs will be, on which goods, and from which countries.
For instance, there is a difference between Universal tariffs, which candidate Trump was campaigning on, and Reciprocal tariffs, which President Trump seems to be leaning to. Universal tariffs imply a similar tax on all foreign made goods. While they lead to more goods getting price hikes, the flip side is that they are very predictable and could boost manufacturing on-shoring and employment in the U.S. Reciprocal tariffs on the other hand, imply each country gets an individually negotiated tax rate. While they may lead to fewer goods getting price hikes, they are very difficult to predict and plan business activities accordingly.
For example, President Trump announced his intention to negotiate separately with each European Union (EU) country, instead of the EU as a group of 27 countries. Therefore, similar goods from some countries may be subject to higher tariffs than those from other countries in the region, who may enjoy lower or no tariffs at all. Imagine the uncertainty trying to make business decisions like which country to order materials or components from. These require long-term planning, because it takes many months to build the necessary supply chain infrastructure to support fulfilling these orders. Furthermore, without knowledge of the ultimate cost of materials and components, businesses cannot price their goods or projects for their clients. This uncertainty leads to decision paralysis, project postponement or cancellation, and a decline in economic activity. So, higher inflation combined with economic stagnation, and we have a recipe for the first period of stagflation since the 1970s!
Despite these very valid worries, investors must weigh the risks versus opportunities, the negatives versus the positives, and make informed decisions. Certainly, there are positive developments for investors to hang their hats on. The problem is they are more of long-term green shoots of the above-mentioned government policies.
On-shoring: Apple announced its plans to build a manufacturing facility in Texas and build some of its products in the US. Continuing to produce everything in Asia and import them to the US for the American consumers, Apple would subject these products to the new US tariffs. We assume the Texas facility will be manufacturing the electronics that will be sold domestically, while the Asian facilities will be manufacturing the devices that will be sold in these markets. This is certainly a big win for American workers. Furthermore, given the size of Apple, perhaps more companies may follow its example and re-shore their manufacturing. It’s not difficult to imagine that companies like Skyworks and others, who make components for Apple laptops and cell phones, may benefit from establishing manufacturing facilities near the Apple Texas facility. This may lead to more orders for them and more jobs for American workers. With a time lag, that could certainly boost workers’ confidence in their employment security and boost consumer spending.
Tax Cuts: The House 2025 budget framework includes extending the 2017 tax cuts into the future. While this means lower tax revenues upfront, consumers will get to keep and spend more of their income, and businesses will have more revenue, pay less in taxes, and book more profits. Both are good for economic activity and the stock market. Hopefully, and again with a time lag, higher level of economic activity and capital gains from the stock market should generate higher tax revenue for the government to reduce the budget deficit.
End of War in Ukraine: President Trump’s intention to reach a quick resolution to the war in Ukraine is very positive for both the humanitarian and the economic aspects. We cannot underestimate the “peace dividend” for the stock market. Once hostilities are finally over, the reconstruction of the destroyed areas will begin. This will be an economic boom for the construction, equipment, and materials industries. Even the defense industry should do well, as European countries will be spending to rebuild the war supplies they sent to Ukraine. We expect lots of US companies to benefit from the reconstruction of Ukraine and the resupply of weapon systems to our European NATO allies. Meanwhile, President Trump is negotiating U.S. access to Ukrainian rare earth minerals, which are necessary for modern technological and defense systems. Such plentiful access to lower the cost of rare earth minerals will sustain the U.S. high tech and defense industries at their world leadership position for decades to come.
As you can see, a lot is still up in the air. This is more than the usual cyclical case of the first year of a presidential term, where lots of policy uncertainty makes the first part very volatile, but the second part smoother as policies take shape, and their effects become more predictable. Instead, investors are now trying to balance their immediate worries about a potential recession, inflation, and even stagflation against the long-term economic green shoots of the new government initiatives. Ultimately, what matters more to investors will determine the path of the stock market.
We also need to consider the usual pattern of seasonality during the year. Typically, the 4 to 5-week period between mid-February to mid-March is a very low return period. Volatility usually picks up, investors become nervous, and selling ensues. This could be the time when we experience a decent size (5%-10%) correction in the currently expensive U.S. stock market. On average, the stock market experiences a few corrections per year, and one could be useful in the near-term to bring some high prices down to earth and create a potential “buying zone”. We are certainly on the lookout for some good opportunities during this period. After all, buying good companies at discounted prices is one of the hallmarks of successful investing!
As always, we are here to answer your questions and assist you in your financial journey.
Stay Fierce!
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