The US stock market has been in one of those glass-half-empty moods for some weeks now, down nearly seven percent from the year-to-date high reached on July 31. There are several objects in the grab bag of negative news offered by the financial press to explain Mr. Market’s current malaise, one of them being the seemingly inevitable government shutdown about to happen. Given that the shutdown technically goes into effect on Sunday night (unless Congress has a magic trick to reveal that nobody has seen yet), this would seem to be a good time to take a closer look at the past history of shutdowns and the market.

Less Often Than You Think

This being the Washington, DC metro area, shutdowns are a pretty big deal (and an unpleasant one) for many of our fellow citizens who call the DMV home. In the course of casual conversations we often hear something to the effect of “yeah, these things happen all the time.” Do they, though? Well, the federal government has technically shut down 14 times since the beginning of the Reagan Administration. The vast majority of these shutdowns, though, lasted between just one and three days. There was a one-day shutdown in 1982 that happened for the sole reason that the leading figures in both the Republican and Democratic Parties had social functions that day that prevented them from the work needed to keep the government open (there is a memorable photograph of President Reagan being serenaded by Tammy Wynette during a barbecue on the South Lawn on the evening the shutdown was going into effect).

On only three occasions did the shutdown persist for more than three days. On none of these three occasions did the shutdown have any apparent effect on the stock market. Here’s a chart with the data.

Performance and Capitulation

The three shutdowns that persisted for more than a week were, for the most part, unwinnable ideological battles waged more for theatrical posturing than any real hope of achieving something. In November 1995 the Republican Congress under Speaker Newt Gingrich, flush with success after their sweeping victories in the 1994 midterms, pushed for the inclusion of their so-called Contract With America into budget discussions. These included repeal of the Clinton Administration’s 1993 tax increases and a balanced budget amendment. The parties briefly agreed after five days to fund the government while negotiations continued, but this agreement fell apart in December and the shutdown persisted for another 21 days. Public opinion swung against the Republican-led Congress, which finally backed down and ended the standoff. Meanwhile the stock market yawned, paid more attention to other things going on at the time and ended up 4.1 percent higher at the end of the standoff.

The 1995 template pretty much played out in similar fashion during the other two multi-week standoffs. In 2013 the Republican Congress pushed to dismantle key provisions of the Affordable Care Act, one of the signature policy accomplishments of the Obama Administration. Once again the drama was Kabuki-like in its flashiness without much substance. The standoff lasted for 16 days until Speaker John Boehner’s patience with his own team ran out and a spending bill was passed with no impact on Obamacare. Once again the stock market basically ignored the drama and continued what was already a very up year, gaining 3.1 percent during the shutdown for reasons utterly unrelated to it.

The longest shutdown to date happened at the end of 2018, the dispute this time centering on the Trump administration’s objections to a Senate appropriations bill that did not include $5.7 billion in funding for the border wall that was one of the administration’s constant talking points. Lots of political jiu-jitsu from all sides kept the shutdown dragging on until the administration agreed to a stopgap bill on January 25 that reopened the government. This time, the S&P 500’s gain of 10.3 percent really had nothing whatsoever to do with Congress or the White House, and everything to do with the Fed. The central bank had pivoted on its monetary tightening program, pausing rate hikes in December amid a near-bear market in stocks. The S&P 500 bottomed out just two days after the government shutdown began and soared through January as investors cheered the Fed’s pivot.

What About This Time?

So that’s the history. What about this time? Are there reasons to believe that this shutdown (assuming it happens) is going to be of a magnitude or more different from the previous occasions? Well, the Kabuki element is certainly there. Once again, it seems like ideologically-tinged performative politics is driving the bus. The public, we believe, has a certain reserve of resigned tolerance for these theatrics, but at some point not very long from now, the tolerance will wear off. At least for now, our take on things is that the shutdown will resolve itself through whatever arcane mechanics the key players come up with this time, allowing everyone to save a little face and sate their voting base back home with clickable outtakes. We will of course be monitoring events as they transpire. And we are dismayed that once again the dysfunctions of our political leaders are on public display for the world to see – but such are the times in which we live. Here’s hoping that public pressure will kick in and bring the antics to an end sooner rather than later.

Bonds for safety and equity for growth – this is the basic formula for long-term investment planning, the essence of portfolio construction around a client’s specific return objectives and risk tolerance. With that formula in mind, take a look at the chart below. Without looking at the labels, which one of the two price performance lines would you think represents a common stock index, and which depicts the yield for 10-year Treasury securities?

You would intuitively think that the line that moves with less up-and-down variance would be the one representing the safer asset – the one used as a proxy for the “risk-free asset” of financial valuation theory. Not here, though. The blue line shows us how the 10-year Treasury yield has moved from day to day over the last twelve months, which period includes a percentage change of 32.8 percent from its low point back in March to the high (thus far) reached yesterday. By contrast, the change for the S&P 500 stock index, in green, is just 28.3 percent from last October’s low to this year’s high point reached in July.  You can also see more pronounced short-term volatility swings in the Treasury yield than in the stock price index – in fact, the average daily percentage change in the Treasury yield is almost twice the average percentage gain or loss in stock prices (1.54 percent to 0.79 percent).

The Price of Money

Admittedly, we don’t intuitively think about bond yields in the same way we do about stock prices. If the yield on the 10-year Treasury note goes from, say, 4.245 percent to 4.33 percent – well, nobody’s going to breathlessly report that on the CNBC daily market wrap-up. In terms of a percentage movement, though, that change from 4.245 to 4.33 represents a magnitude of two percent (4.25 x 1.02 = 4.33). If, on the other hand, the Dow Jones Industrial Average goes up or down by two percent on a given day, that’s a newsmaker. It’s a gain or loss of around 690 points at current Dow levels – hundreds of points! Here is one of those behavioral traps of which the financial world has plenty. Since bond yields are already expressed as percentages, it’s hard for the brain to do the math to accurately express a change in yields in percentage terms, whereas it’s easy for the brain to register “690 points” as a big deal (which is a major reason why financial news reporters love to report on the doings of the Dow).

But a bond yield is also a price – it’s the price of money, a market price agreed to between buyers and sellers of credit. And US Treasury securities are arguably the world’s most important publicly traded asset. So it’s worth paying attention to those movements in Treasury yields and asking why they go up and down as much as they have been in the last year.

Getting It Wrong, All Year Long

One reason why yields on the so-called risk-free asset have been bouncing around so much this year is that the bond market spent much of the first half of the year adamantly refusing to believe that the Fed was going to keep interest rates higher for longer – even though Jay Powell and his colleagues literally said “higher for longer” every time the subject came up in their interactions with the public. Back in early March, when the collapse of Silicon Valley Bank and a couple other financial institutions raised fears of a general banking crisis, bond traders bid Treasury yields way down as expectations rose that the Fed would actually start immediately cutting – yes, cutting – interest rates. Those sub-3.4 percent yields you see on the 10-year note in the above chart reflected a consensus pricing in of at least two rate cuts in 2023.

Well, it’s almost October 2023, and the only thing that has happened since March has been more rate increases and – if the Federal Open Market Committee is to be believed from its Summary Economic Projections reached this week – one more to come at either the November or December FOMC meeting. The collective wisdom of the market simply got it wrong, and kept getting it wrong, for a good part of this year. Many of those sharp spikes in the 10-year yield you see in the above chart coincide with the dates of FOMC meetings. Reporters at the post-meeting press conference would try to goad Powell into saying something about rate cuts, Powell would push back hard and say “higher for longer,” yields would shoot up and then fall back down again as bond traders talked themselves back into believing that there really was a rate cut pony out back.

It’s taken awhile, but it seems that this past week’s FOMC meeting may have finally cemented the message into the bond market’s collective head. Perhaps there will be fewer of those wild stock market-like swings up and down going forward. The good news to be found here is that, with the economy’s performance so far this year exceeding the expectations of most economists, including those of Powell and his Fed colleagues, the danger of “higher for longer” triggering a recession is substantially lower than it was earlier in the year. If the Fed can actually pull off a soft landing while bringing inflation back to target levels, that should be a net positive for asset markets in general. Which would be nice, because there will be plenty of other challenges to deal with in 2024.

The Federal Open Market Committee will meet next week to determine whether to raise interest rates again. The broad consensus among those who pay attention to the FOMC’s doings is that they will not raise rates. The inflation measure the Fed pays attention to is more than two percent lower today than it was in September last year (4.39 percent compared to 6.64 percent, expressed on a year-on-year basis). That’s still more than two percent higher than where the Fed wants inflation to be, but it has been moving steadily in the right direction. Holding rates higher for longer will eventually get consumer prices back down to that two percent target level – that is what we expect to hear from Jay Powell next week.

Consumers Have Some Thoughts

So, about that inflation measure the Fed watches: it’s not the same one that we, the good American citizens and consumers that we are, have in mind as we go about our daily lives. It will likely come as no surprise to anyone reading this that gas prices are up, and up by a lot from where they were earlier this year. The price of gasoline is not included in so-called core inflation, which is what drives Fed deliberations on interest rates. Nor, for that matter, are food prices. So the two things that figure most directly into our weekly household spending are not part of the inflation equation that dominates the FOMC’s cogitating. And right now, these two different perceptions of inflation are moving in different directions.

Demand High, Supply Low

Typically, gas prices start to come down in late summer as vacationers return home and demand starts to fall. But prices at the pump started rising in a meaningful way in early July and have kept rising through and past the Labor Day weekend. While demand has remained somewhat higher than usual, the main reason for the spike in gas prices is that concerted supply cuts by Saudi Arabia and Russia have pushed crude oil prices to more than thirty percent higher today than they were in late June. The production cuts were initially announced to be a temporary measure, but this past week the Saudis and Russians confirmed that the production cuts would remain in place until at least the end of this year. That means about 1.3 million fewer barrels of oil per day than would be the case without the production cuts. This at a time when global demand for crude oil is set to reach a record 109 million bbl/day this year, thanks in large part to better economic growth than most economists expected at the beginning of the year.

The Expectations Game

Notwithstanding the Fed’s focus on core inflation, we expect there will be some discussion in the Eccles Building next week about gas prices – specifically, on the potential effect of continued higher prices on household inflation expectations. Inflation in large part is a game of expectations – households and businesses will shape their spending decisions around what they think prices will be next month and next year. This becomes a problem when expectations for higher inflation turn into a feedback loop. Businesses raise prices, workers demand higher wages and a wage-price spiral ensues.

So far this has not happened. According to this month’s University of Michigan Survey of Consumers, inflation expectations are in fact lower today than they were a month ago, with consumers expecting headline inflation (i.e., including those volatile food and energy categories) to be 3.1 percent a year from now. That’s down from the 3.5 percent one-year-forward expectation the consumers had in August.

Those expectations could change, though, if gas prices keep going up. If expectations for higher inflation become entrenched, it stops being a “headline inflation” problem and becomes a “core inflation” problem – and thus a problem for the FOMC and its interest rate decisions. For now, we are of the same mind as the broad consensus in expecting the Fed to wrap up on Wednesday without raising rates again. It wouldn’t hurt, though, to start seeing some lower numbers as we drive past those gas station signs on our way to and from work.

This should be the best of times for Apple, the world’s most valuable company with a $2.8 trillion market capitalization. The company is ever so close to knocking rival Samsung off its perch as the leading seller by volume of smartphones. Next week will see the launch of the iPhone 15, the company’s newest model, along with all the overcaffeinated hype that accompanies any Apple new product launch. And even in an environment where overall smartphone sales by unit are set to decline for a second consecutive year, Apple continues to set revenue records in its Services segment, which includes video, music, payment services, healthcare and cloud.

Leave Those Phones At Home

But this week saw Apple lose about $190 billion from that $2.8 trillion market cap. It should be noted here that $190 billion is more than the total current market cap of all but 36 companies on the S&P 500, and roughly the same size as streaming giant Netflix or Big Pharma leader Pfizer (for Apple it was a mere loss of six percent).

The proximate cause of this reversal of fortune, like so much other bad news of late, was China. Specifically, an apparent edict from somewhere high up in Beijing leadership circles banning the use of iPhones and other Apple products for public officials in their offices. China is one of Apple’s biggest markets, and relations between the country and the company have always been, or at least seemed to be, excellent. A crackdown on the use of iPhones, iPads and the like in state-owned facilities (which can include government agencies, state-owned enterprises, research centers, hospitals and a great deal more) could be very bad news indeed. It could also be a tempest in a teapot – as of yet there has been no official word either from anyone in China or from Apple about this apparent ban. But will be a matter of concern to a great many other US companies for whom China is a major contributor to their total sales.

Nothing To See Here, Go Away

The Apple story is just the latest in a series of developments that seems to reflect an unsettling petulance among China’s leaders. Last month the country quietly stopped reporting data on youth unemployment, which economists estimate to be well in excess of twenty percent. Even as the government tries to put window-dressing on the mounting problems in the property sector (for example, coming up with the means for Country Garden, a very large and very troubled developer, to make two bond payments and thus temporarily stave off technical default), nothing suggests a near-term solution for an industry sector that contributes more than a quarter of total gross domestic product. In a recent article in Foreign Affairs magazine Adam Posen, President of the Peterson Institute for International Economics, argued that China is suffering from “economic long Covid” – likening the country’s worsening economic condition to the chronic health problems suffered by patients whose Covid symptoms persist for months or years.

In the authoritarian playbook, the best way to solve problems is to cover them up – thus the cessation of reports about youth unemployment, thus the attempt to divert attention away from problems in the property sector, and thus – possibly – the attempt to reshape domestic consumer demand away from the popular products from the West that have become staples of daily life, be they iPhones or Starbucks lattes or Nike sneakers. It is perhaps not a coincidence that news about the purported Apple ban happened at the same time that Huawei, the Chinese phone maker burdened by a slew of Western sanctions, announced a new leading-edge phone that has outsiders wondering where the latest-generation semiconductor technology the phone appears to have came from.

Meanwhile, though, the numbers that do manage to get reported keep telling the same story. Exports declined in August for a fourth straight month, the Chinese yuan is trading at its lowest level versus the US dollar in sixteen years, wages are stagnant and property values – that linchpin of economic growth – seem to have nowhere to go but down. We will be listening very carefully to what the management teams of China-intensive US companies that we track have to say about their business prospects there when the next earnings season comes around next month.

April is the cruellest month, according to T.S. Eliot in the opening line of “The Waste Land.” Investors would beg to differ and point instead to September, which historically has been the worst-performing calendar month of the year for US equities. The S&P 500 posted losses in each of the past three Septembers: minus 9.3 percent in 2022, minus 4.8 percent in 2021 and minus 3.9 percent in 2020. Well, today being the first day of September, it seems like a good time to ponder what might happen in the month ahead. We think there are some good reasons to not fret too much about what the “average” September looks like and to focus more on the specific factors that may be at play this year.

Jobs and a Rate Reprieve

This past week saw US stocks recover a decent chunk of their August losses; the S&P 500 gained 2.3 percent from last Friday’s close through yesterday, leaving the index down by 1.8 percent for the full month. The big sentiment driver this week was moderation in the jobs market. A report on Tuesday showed job vacancies at their lowest level in two years. That was followed on Wednesday by the ADP Employment Survey posting payroll gains of 177,000, below the 200,000 expected. Finally, this morning’s employment report from the Bureau of Labor Statistics showed payroll gains of 187,000, a rise in the unemployment rate to 3.8 percent and an increase in the labor participation rate to 62.8 percent. That was the first meaningful rise in the participation rate since March, and probably explains much of the increase in the unemployment rate – more people as a percentage of the population at large are actively looking for jobs. That is a good thing.

What the market was looking for in the jobs data was some consistency in a pattern of slowing – but slowing at a pace that suggests “soft landing” rather than “recession.” All three of this week’s key reports showed precisely that, and the bond market responded with a significant drop in yields from recent highs. The 10-year Treasury yield just last week had reached its highest level since 2007. This week the 10-year basically gave up all its August gains and is currently at 4.08 percent, roughly where it started the month. Unsurprisingly, the reprieve in rates lit a fire under the growthier corners of the stock market, led once again by enthusiasm for anything AI.

No Two Septembers Are Alike

So is all this soft landing-supportive jobs data enough to not worry about another cruel September? Only time will tell – as we always say, the short term is essentially unknowable. But our base case outlook is pretty benign. We will get the August CPI report on September 13 and will be looking for month-on-month numbers for core CPI to be roughly commensurate with July’s 0.2 percent gain (which is also what the July PCE, a different inflation measure closely watched by the Fed, showed when that report came out earlier this week). That, plus the moderately slowing jobs data, should be enough to validate the current consensus expectation that the Fed will hold rates steady without a further increase when the FOMC meets on September 20. There are of course other factors out there to keep an eye on. The resilience of consumer spending has been called into question a bit this week with some equivocating forward guidance provided by retail companies in their quarterly earnings commentaries.

On balance, though, we do not see too much in the way of red flags that would argue for a more defensive position in equities heading into the remaining months of the year. Three or four months ago we would not have been described as believers in the soft landing scenario, but the data today seem to be telling us differently. Remember – it’s not what happens in the “average” September that matters, but what all the factors at play mean for what happens this particular September. So far, at least, so good.

The financial news media likes nothing more than an easy story. Stocks (or bonds) were up (or down) today because of X, X being the single event of the day to describe why the market did what it did. Every so often, that approach works. On September 15, 2008 the S&P 500 fell by 4.7 percent, a giant move for a single day. September 15 was also the day that investment bank Lehman Brothers declared bankruptcy. It was pretty much on target that day to report that “stocks fell by almost five percent because a giant securities firm failed and all sorts of collateral damage is probably going to come to the surface.”

Most days, though, come and go without the failure of systemically critical financial firms or other commensurately earth-shaking events. On most days, hundreds of potentially market-influencing events blow this way and that, like trade winds crisscrossing each other on the open sea. Like the waves created by the trade winds, these events more often cancel each other out than move collectively in a single direction. This is a particular problem for momentum trading strategies, which have had a rough time of things in 2023. An article in the Financial Times newspaper today noted that trend-following hedge funds this year have been sideswiped by a number of developments their high-powered algorithms didn’t see coming in the markets for equities, fixed income and commodities alike.

We thought this week would be a good time to revisit our “trade winds theory” of markets, because we have some fresh material to provide as an illustration. Recall that one of the big trend themes of 2023 thus far – arguably the biggest single theme in US equity markets – has been AI mania. All things artificial intelligence has been the big story ever since financial journalists started playing around with ChatGPT last November and sharing their amazement on Twitter, as journalists always do. A very small number of companies are central to the AI story, and they have done phenomenally well this year. One of those companies, Nvidia – a designer and manufacturer of graphics processors – saw its shares rise nearly 25 percent in a single day back on May 25 when it reported quarterly sales and earnings that blew away analyst expectations, thanks to overwhelming demand for its considerable AI capabilities.

Nvidia reported quarterly earnings again on Wednesday this week, and once again the report was stellar from just about every conceivable standpoint – well ahead of analyst expectations for the quarter past, a significant raise in guidance for the quarter ahead, and even a $25 billion share buyback as icing on the cake. This report came out after Wednesday’s market close, and shares in aftermarket trading popped immediately. In other words, the stage was set for a corker of a rally on Thursday favoring all the AI-adjacent asset classes and themes – semiconductors, growth stocks in general, the Nasdaq Composite.

For about fifteen minutes or so on Thursday, that expectation seemed to be playing out. On CNBC the talking heads were rehearsing what they fully expected would be their end-of-day wrap-up: “Stocks soared, with tech stocks leading the way on blowout earnings from Nvidia.” But then those darned trade winds came in from other directions. Earnings reports from consumer retail companies have also been coming in this week, with some concerns about pricing power, margins and demand weakness. Tensions grew about what Jay Powell might say about interest rates at the Fed’s Jackson Hole symposium on Friday. Durable orders were a bit worse than expected, Germany’s manufacturing sector is in the doldrums – winds blowing in all sorts of different directions.

At the end of the day, Nvidia shares were more or less flat, but the Nasdaq Composite was down nearly two percent and the S&P 500 lost more than a percent. There was momentum, in other words, but not the momentum that the algorithms or the financial reporters expected. As we write this on Friday mid-morning, shares generally seem to be under further pressure as the market digests a somewhat (though not unduly) hawkish speech from Powell in Wyoming, and a closely watched University of Michigan consumer sentiment report suggesting that one- and five-year inflationary expectations rose (despite a recent downtrend in both headline and core inflation).

Such is the unpredictable nature of the trade winds on any given day. Our message to our clients is always the same: you can’t know what is going to happen in the short term (and even if you did know what was going to happen, you would not be able to predict how the market is going to react). Markets usually do not close up or down on any given day “because of X” – excepting those rare days when things like systemically critical financial firms go bankrupt, and thankfully those really are few and far between. Focus on your long-term financial goals, and stay disciplined and patient while the trade winds blow this way and that.

Every year, for one week in August, our eyes turn to the great state of Wyoming and the delightful resort of Jackson Hole. There, the great and the good from the world’s major central banks gather to hash out the issues of the day and chart a course for monetary policy in the years ahead. The Jackson Hole meetings come at a particularly poignant time this year, because there is a great deal going on in securities markets and the economy at large. We don’t expect there will be much time for the bankers to enjoy the recreational offerings on hand, but at least they will have the spectacular views of the Grand Tetons for inspiration while they try and figure out how to stick the landing on beating back inflation while avoiding a protracted global recession.

Growth and the Great Repricing

It took more than a year, but it finally seems to have sunk into the collective brain of the investor class that “higher for longer” – the mantra the Fed has been repeating all this time – is actual policy. Fed chair Powell, whose keynote address next week will be the main draw for Jackson Hole proceedings, is unlikely to spell out what the FOMC is likely to do when it meets next in September. But he may give some hints as to how the Fed is digesting a string of economic reports suggesting that the economy is doing better than just about anyone had expected earlier this year. The rosier outlook is making itself felt in the bond market, where the nominal 10-year Treasury yield is now at levels last seen in 2007.

Here’s where this gets complicated. For more than a year now, the Treasury yield curve has been inverted, with short-term rates well above intermediate- and long-term rates. An inverted yield curve is normally a reflection of an expected recession – a theme we have discussed on many occasions this year. Now, however, it appears much less likely that a recession is in the cards for 2023, or possibly at all. That, of course, would be good news for American households and businesses. For the bond market though – not to mention the stock market, which is also directly impacted by interest rates – the news is a bit more mixed. A stronger economy implies fewer job losses, which gives the Fed more room to contemplate its interest rate moves without worrying about the potential effects on the labor market (remember that the Fed has a dual mandate to maintain stable prices and promote maximal employment). That lends more weight to the “higher for longer” policy, which is probably why the expectation of short-term rates not coming down below five percent any time soon seems to finally be conventional bond market wisdom.

But what does that imply for the near-term direction of intermediate and long-term rates? If (a) there is a low likelihood of recession and (b) short-term rates are going to stay anchored in the low-mid five percent range, are we potentially looking at the 10-year creeping back up over five percent or even higher? It’s not an impossible scenario. In the second half of the 1990s, a period of strong real GDP growth and low inflation, 10-year nominal yields fluctuated between six and seven percent for much of the time. The past fifteen years of abnormally low rates notwithstanding, there’s nothing to say it couldn’t happen again.

Curb Your Enthusiasm

That being said, we do not think a return to 1990s-era intermediate rates is a likely near-term scenario, nor do we think that the absence of a recession, if we are lucky enough to avoid one, means a return to ‘90s-era strong growth. In a report published this week, the San Francisco Fed projected that the excess household savings accumulated during the pandemic is likely to be fully played out by the end of the third quarter (which is just a month and a half away). This dynamic is something we focused on in our annual outlook way back in January as a key data point suggesting a slowdown. While we have been pleasantly surprised by the better-than-expected trends in consumer spending and business investment since then, we still expect that the drawdown in savings, along with persistently high levels of consumer debt, will act as constraints on growth levels.

The much-hoped for “soft landing” at the end of the Fed’s monetary tightening, as we interpret it, means sub-two percent real GDP growth, a modest level of payroll gains and a likewise-modest level of wage growth (it also should mean that inflation continues its slow retreat back towards pre-2021 levels). In the very near term we could see intermediate rates rising a bit further, particularly if we get a strong Q3 GDP report as some economists are now forecasting, along with a couple more months of strong jobs reports. But we also expect conditions to settle into the slower-growth phase as the end of the year approaches, which should take some pressure off rates. That’s our view, anyway – we’ll see what Jay Powell and his fellow central bankers have to say about it next week in Wyoming.

We have been in this business long enough to remember all the “Japan as Number One” mania of the 1980s. Those were the days when straight-faced financial reporters informed us that the three square miles of the Imperial Palace grounds in downtown Tokyo were worth more than the entire state of California (yes, really). All that nonsense ended on December 29, 1989, the last trading day of that decade, when the Nikkei 225 stock index hit an all-time high of 38,915. Thirty-three years and change later, that is still the all-time high for the Nikkei index, which closed out the current week at 32,475, still more than 16 percent down from the 1989 peak.

Exports, Property and Prices

We are not going to try and make the case that China’s situation in 2023 is a repeat of Japan’s in the early 1990son. But there are some similarities that are worth paying attention to. This week served up a handful of economic reports that called a few of these similarities to mind. On Tuesday we learned that China’s exports fell by 14.5% from a year earlier, a bigger than expected drop and a reminder that China is no longer the export powerhouse that it was in the early years of the twenty-first century.

That same report also showed a double-digit drop in imports, which highlights another current weakness in the Chinese economy: consumer demand. When Beijing lifted the austere zero-Covid restrictions in November last year there were widespread expectations of a consumer-led boom in demand for goods and services. That boom has largely failed to materialize. Retail sales in recent months have also been muted. China’s economic policymakers have for many years been trying to rebalance economic output to a more consumer-focused model; so far, those attempts have largely fallen flat.

What has until recently driven much of China’s growth has been its property and infrastructure sector, and another report this week reminded us why this is an ongoing problem. Country Garden, the country’s largest private property developer, missed interest payments of $22.5 million on two international bonds. Country Garden was supposed to be proof positive that the property sector had overcome its recent troubles; instead, the missed interest payments set up the potential for yet another prominent default, fully two years after the Evergrande collapse in 2021 set the unwinding of this sector – which contributes around 30 percent of China’s GDP growth – in motion.

Finally, prices at both the consumer and the wholesale level are deflating in China, even while most of the world’s other major economies continue to work at bringing down inflation. Deflation is a natural outcome of the problems reflected in those other reports – weak consumer demand, lackluster exports and a property market stuck in reverse. In many ways, deflation is a worse condition than too-high inflation, because it encourages hoarding at both the household and business levels and sets the stage for a years-long downward spiral. This, indeed, is what Japan experienced in the 1990s when its own property sector went bust, overextended banks stopped lending and households stopped spending.

Beijing’s Long Game

For all the similarities, though, China in 2023 is not Japan in 1990. For one thing, Beijing does have a specific strategy for long-term growth, something that cannot be said about Japan’s policy mandarins at the Ministry of Finance in the 1990s as they circled the wagons around their failing financial sector. China’s strategy has two key components: first, consolidate its position as the dominant supplier of the raw materials needed for transition to clean energy; and second, invest heavily in forward-leaning sectors including biotechnology, quantum computing, artificial intelligence and semiconductors.

This strategy may or may not work. In semiconductors, for example, China’s domestic capabilities are far behind those of leading centers of excellence elsewhere, including Taiwan, Japan and the US. The geopolitical climate is uncertain, to say the least. And it is entirely unknown whether there would ever be enough practical use cases in areas like AI and quantum computing to offset the ongoing decline in the erstwhile growth engines of property and infrastructure. That being said, there is a definite logic to the strategy, and it would be a mistake to ignore its potential for success one day. In our view, however, that day is not today.

A strange thing happened when we came into work on Wednesday morning this week and plugged into the daily news cycle: we learned, as the rest of the world was learning, that the credit rating agency Fitch Ratings, something of a third wheel to the more well-known Standard & Poor’s and Moody’s, had issued a downgrade on US government debt. Fitch was of course the second US rating agency to deprive Treasury securities of the coveted triple-A rating, fully twelve years after the S&P shock downgrade took place in August 2011. This was not telegraphed in any meaningful way, nor did there seem to be any news of the moment to warrant the timing. Fears of a major market swoon, though, were brief and mercifully shallow.

2011 This Is Not

For a quick refresher on that turbulent summer of 2011: Congress and the White House were locked in an implacable standoff over the debt ceiling for most of the summer, finally cobbling together an agreement to raise the debt ceiling (subject to all sorts of conditions that would come back to bite a couple months later) on August 2 of that year. On August 5, a Friday, S&P published the report downgrading Treasuries to AA+ status. The following Monday, August 8, the S&P 500 stock index plunged seven percent in a single day. The total damage to US stocks during this period would amount to about 19 percent from peak to trough, just shy of the threshold for a bear market.

Oh, and while all this was going on, the single-currency Eurozone was in the middle of its own crisis with the future of four of its members – Greece, Italy, Portugal and Spain – very much in doubt.

The market reaction to this week’s Fitch downgrade was a few magnitudes less dramatic than 2011. Stocks retreated on Wednesday, with the S&P 500 falling 1.4 percent and the Nasdaq Composite dropping 2.2 percent. But if the Fitch downgrade had anything to do with that, it would seem to be more along the lines of providing an excuse for investors who were looking for a reason to sell and book some profits from the market’s recent rally. Overall market sentiment continues to be more focused on the direction of the economy (better than expected) and corporate earnings (decent, but with a high expectations bar).

Supply Concerns Hit Yields

Over in the bond market, intermediate Treasury yields have been rising this week, but the key driving factor there seems to be the government’s lifting of its issuance target for the third quarter, beginning with a $103 billion issue to cover refinancing of $84 billion in notes coming due on August 15. A higher than anticipated supply of new government debt has some observers skeptical that it can be accomplished without rates going up some more (though similar issuance increases in recent months have not had the effect of moving rates as much as some had anticipated).

At the same time, a jobs report on Wednesday (the ADP National Employment Survey) revealed continued strength in the jobs market. That news, when translated into bond market-speak, offers no real reason to expect interest rates will be coming down any time soon, and thus nothing to counter the upward pressure on rates from the Treasury Department’s increased issuance report.

As we are fond of saying, though, it’s always best not to read too much into one report, or even one day’s worth of financial news. Today we got a different perspective on the jobs market from the Bureau of Labor Statistics, reporting job gains of 187,000 in July against economists’ forecasts of 200,000. The BLS number fits more squarely into the macroeconomic narrative that drove investor optimism in July – slower but still positive growth in the economy, with inflation continuing to trend down (we will learn more about that second aspect next week, when the July Consumer Price Index report comes out). On the heels of the BLS report, stocks are in modestly positive territory today and bond yields are down a bit. So it goes.

We expect there will be a few more twists and turns in the coming weeks. August is often a tricky time for markets, with lower volume and more potential for outsize price swings. Then comes September, which historically is the worst calendar month of the year for stocks (always remember that “historical average” is not the same thing as “what will happen this year”). We will see what risks and opportunities lie ahead.

It may be, or it may not be, the last time the Fed raises interest rates in the monetary tightening cycle that began in March 2022. After Wednesday’s FOMC meeting, when the Committee voted unanimously to raise rates by another 0.25 percent, we figured the likelihood of another hike at the next meeting, in September, was more or less a coin flip. Then came the second quarter GDP report on Thursday, showing that the US economy grew by 2.4 percent (annualized) from the first quarter, a much stronger showing than expected. Then came this morning’s Personal Consumption Expenditures report, the inflation reading that is less of a household name than the Consumer Price Index, but that is the Fed’s preferred measure for its policy deliberations. That report showed a month-on-month increase of just 0.17 percent for the core PCE (i.e., excluding energy and food prices).

Taking the GDP and PCE reports into account changes our calculus somewhat. We think there is a decent chance, not only that September will come and go without an additional rate hike, but that this past Wednesday may in fact turn out to be the final act of this tightening cycle. Take this with the grain of salt that any prediction deserves; there are plenty of data points due to come out between now and September 20, when the Fed next meets. But here’s what we have right now: inflation of both the headline and core varieties moving in a steady directional trend downwards, while the jobs market remains strong, consumer confidence is high, and the economy continues to grow. Modest growth alongside falling prices is the very definition of that overused air traffic control metaphor of the soft landing.

Supply and Demand

How is that even possible, though? The consensus opinion among economists, looking at comparable historical periods, is that a monetary tightening program as dramatic as this one has been (the sharpest and fastest increase in rates since the Volcker Fed in the late 1970s) was bound to create the conditions for, if nothing worse, a mild cyclical recession. That was our view earlier this year as well, and, to be sure, the probability of a recession is still greater than zero in our opinion. But there are factors at play this time around that don’t have good analogies to past tight money cycles. Some of those factors, indeed, have little or nothing to do with anything the Fed can control or influence.

Recall that, when consumer prices started to rise in a meaningful way in the middle of 2021, there were both supply and demand forces at work. Pressure on the demand side came from pent-up spending energy on the part of US consumers as pandemic shutdown conditions eased. That is what the Fed sought to influence, expecting that higher interest rates would act as a deterrent on consumer spending and help bring prices down.

But there was also supply side pressure as finely-tuned global supply chains went bonkers. Fewer goods came to market, and the obvious outcome of more money chasing fewer goods was the sharp increase in prices that reached a peak last summer. There was nothing the Fed could do about the supply side of the equation. Over time, though, those bottled-up supply chains have mostly worked themselves out. So even while consumer demand remains positive, the relative increase in goods supplied has had a cooling effect on prices.

That trend also helps explain why many of the stickiest categories in the consumer basket have been services. Prices for electric bikes, microwave ovens and the like may be lower than a year ago, but those for hotel rooms, airfare, concert tickets and restaurants remain elevated. This fact has some observers concerned that the “last mile” back down to the target level of two percent inflation will take longer than the time it has taken to get from last summer’s peak rates to today’s levels.

Those observers may well be right. On the other hand, a month-on-month gain of around 0.2 percent, such as reflected in both this week’s core PCE and the most recent core CPI report two weeks ago, implies an annual rate of inflation only slightly above that two percent target. We have two more CPI reports and one more PCE report to digest before the FOMC’s September meeting. In the absence of an unexpected spike upwards in any of those reports, why would the Fed arrive at the conclusion that it has to raise rates again – particularly while the economy otherwise continues to hum along at a modest but comfortable rate of growth? In our view, the odds that we have reached the end of the cycle are better today than they were at the beginning of July.