Pressure Builds

Small business optimism rose slightly in in August.

The National Federation of Independent Business (NFIB) reported that optimism rose from 99.7 in July to 100.1 in August. Interestingly, this is counter to consumer sentiment which dropped sharply in August as Delta cases rose and reminded individuals that the pandemic is not over. The report also countered the weaker-than-expected August employment report with a record 50% of small business owners saying that they had unfilled positions. This continues to support the theory that the economy is facing more supply-side issues than demand-side issues.

Inflation moderated a bit in August.

The consumer price index (CPI) rose by 0.3% month-on-month (versus consensus expectations of 0.4%). Core inflation, which excludes the volatile food and energy categories, rose just 0.1%. Year-on-year, core inflation slid to 4.0% - down from 4.3% the month prior. The headline index remains 5.3% higher year-on-year. With used auto prices starting to moderate, we think that inflation may continue to moderate, but is likely to remain above the Fed’s 2% inflation target for some time.

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Investors have been increasingly nervous about a market correction (defined as a sell-off over 10%), but the exact catalyst has yet to be clearly defined as it is a series of coalescing events that could lead to further market weakness (please see our Should Investors Be Nervous? piece for additional insights). However, we would be quick to point out that as of right now, the S&P 500 is just 4.4% off its September 9th high at the time of this writing. The most recent event to occur is the prospect of a potential default of China’s second-largest property developer, which is burdened with $200 - $300 billion in debt, and is set to make an interest payment on these bonds this Thursday. Importantly, this story is not new with the developer saying just last Tuesday that its cash flow situation could worsen, but with investors proceeding cautiously in September the news has led to further de-risking. We think it is too early to say whether or not this is a significant market event with a distinct possibility that China’s central government, or even the central bank, could react with supportive measures or a restructuring that could quickly change the dynamic, but the situation needs to be monitored closely.

Incoming Economic Data Improved Last Week; Fed on Deck

Apart from the news emanating from China, this week was likely to be a cautious one for financial markets anyway as investors await the results of the Federal Open Market Committee’s two-day meeting this Wednesday. Investors were widely expecting the September meeting to include an announcement that the Fed will begin to taper its bond purchases (currently $120 billion per month) in the near future. However, following the weak August employment report, many investors shifted their expectations to a November announcement. We continue to believe that while a strong signal may be sent at the September meeting, a later date (like November or December) seems like a more probably timing for a formal announcement. With little chatter on the Street about the potential for a September announcement, one would likely serve as a hawkish surprise for investors.  

Incoming economic data will continue to be of utmost importance. With the Fed focusing heavily on their full employment mandate, we suspect that the Fed will at least want to see one more strong employment report with the pandemic jobs deficit narrowing, but a ways from closing (see figure 1). On the inflation front, the Fed’s transitory narrative (meaning that they view the recent rise in inflation as largely temporary) gained some support from the August Consumer Price Index (CPI). The report came in tamer-than-expected with core inflation rising just 0.1% month-on-month and falling to 4.0% higher year-on-year – down from 4.3% the month prior. This is in line with what we expected with used car prices starting to fall rapidly after spiking this spring (see figure 2). Apart from inflation, U.S. retail sales came in better-than-expected in August – rising 0.7% in month. Some of this is because the prior month was revised downward from -1.1% to -1.8%. However, control group retail sales, which exclude the volatile autos, gas stations, and building supplies categories and factors into GDP calculations, jumped by 2.5% in the month. This suggests that consumer demand remains strong despite weaker consumer sentiment following the recent rise in Delta COVID cases.

This line chart shows the U.S. Jobs Deficit Since February 2020. After a steep drop in March and April 2020, there has been a steady return to job positions filled. As of August 2021, there is still a deficit of 5.3 million jobs from February 2020.

This line chart shows the Manheim Wholesale Used Vehicle Index versus CPI Used Car and Truck Prices from 1997 to 2021.

A couple of other releases that got little attention were the Philly Fed manufacturing index and the Empire state manufacturing index. While not widely followed, both jumped in September. The reason this is important is because these regional surveys feed into the national ISM manufacturing index and are pointing towards a tentative rebound in economic activity in early September (see figure 3).

This line chart shows the ISM Manufacturing Index vs. Regional Fed Business Surveys from 2016 to 2021.

It will be interesting to see if the Fed mentions these early signs of a rebound in activity or if they remain focused on the August slowdown and the elevated level of Delta cases as a reason to remain cautious. Citi Research believes that the Fed’s so-called “dot plot,” which shows the individual members’ projections for when the federal funds rate, will likely shift upward (reflecting a positive view of the economy). However, Fed Chair Powell may seek to distance himself from the “dot plot” and emphasize that the tapering of asset purchases is a completely separate move from tightening policy rates.

The Pressure on Congress Builds

  Beyond China and the Fed, pressure is also building on the U.S. Congress to tackle a broad swath of legislation – including the Biden Administration’s infrastructure bills, funding the federal government, and raising the debt ceiling. In terms of the infrastructure bills, the House Ways and Means Committee released its proposal for potential spending and changes to tax rates last week. One key proposal is a rise in the U.S. corporate tax rate from 21% to 26.5%, which is below the Biden Administration's proposal for a 28% corporate rate, but above the 25% tax rate that Senator Joe Manchin (D-W. VA) said he would support. Another component would be raising the capital gains tax rate from 20% to a 25% flat rate, which would be applied to gains recognized on or after September 15, 2021.

As it stands right now, the self-imposed date to vote on the infrastructure bills is September 27. However, it is important to note that this date is non-binding and can be missed without serious ramifications. With much left to be done and several Senators arguing over what size of a bill they can ultimately support, it would not be surprising to see the first vote fail and for eventual passage to slip into October or beyond. Though a difficult lift, we think it’s worth noting that since 1980, 21 out of 25 (or 85%) of budget reconciliation bills have went on the be signed by the President. It seems likely that the total size of the infrastructure bill will have to be trimmed down to get passed, but our base case remains that Congress gets it done.

One binding date that it is approaching is September 30, which is when the federal government needs to be funded for fiscal year 2022 or face a potential shutdown of non-essential government services. Financial markets should be able to look past this. Since 1976, the federal government has shutdown 21 times for an average of 8 days. During those shutdowns, the S&P 500 averaged a return of about +0.1% with the worst drop being -4.4% in 1979. And who can forget the constant, reoccurring debate over raising the debt ceiling? Democrats are currently attempting to get bi-partisan approval to raise the debt ceiling, which would require 60 votes in the Senate, but they do not have to. While finger-pointing seems assured, Democrats can technically include the debt ceiling legislation in the budget reconciliation process and pass it with a simple majority. Though likely to garner major headlines, Congressional leaders in both parties have always recognized that it is necessary to raise the debt ceiling to service the nation’s legal obligations.

In fact, the debt limit has been either permanently raised, temporarily extended, or revised 78 times since 1960. It is worth noting that the “hard” debt ceiling is unlikely to be reached until around possibly late October or early November, but some Democrats may wish to tie suspending the debt ceiling to a vote on keeping the government open beyond September 30. Though others have argued that the votes should not be tied together. While 2011 stands out as an example of why the debt ceiling matters with the S&P 500 falling between 5.8% in the week leading up the eventual lifting of the debt ceiling as the U.S. credit rating was lowered from AAA to AA+, we do not expect that dynamic to repeat as Democrats control both the Presidency and Congress. In 2011, President Obama faced a Republican House, which complicated matters.

Conclusion: Volatility is Normal and Should Not Derail Long-Term Goals

Importantly, Citi Global Wealth’s Investment Committee moved in advance of these events by raising its portfolio quality by adding exposure to more defensive equities like global healthcare and dividend growers. As we suggested last week, we believe the right move is to remain focused on long-term investing goals and to remain invested. While caution may be currently warranted as investors wait to see the final size of the infrastructure bill, the breadth of changes in the U.S. tax code, and the passage of critical government legislation, we believe that once the uncertainty clears investors will once again take on a more risk-positive stance. Particularly towards year-end as we enter a seasonally strong period for stocks with the S&P 500 averaging a return of 5.1% in the fourth quarter since 1990 (see figure 4).

This bar chart shows the average monthly S&P 500 Returns since 1990 in percent.

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