Globally, stocks were little changed after a volatile week with the MSCI All Country World Index eking out a 0.1% gain. In the U.S., the S&P 500 rose 0.5% while the Dow Jones climbed 0.6%. Emerging markets underperformed as Chinese shares tumbled further. The 10-year U.S. Treasury yield jumped following the Fed’s September meeting - rising from 1.30% to 1.45%.
Concerns of possible financial contagion rose sharply early last week as China’s second-largest property developer appeared to be heading towards a default on its bonds. However, fears eased as the potential failure seemed somewhat contained and U.S. bank exposure seemed limited. Longer-term concerns about a potential slowing in China’s economy remain valid.
The Federal Reserve also moved markets by strongly signaling that a tapering of its monthly bond purchases could be announced as soon as their November 3 meeting. Although investors were concerned that the U.S. stock market might react negatively to such news, risk-sentiment seemed to improve as the uncertainty cleared. Interestingly, Fed Chair Powell stated that he does not need to see a blowout September employment report to feel like enough progress has been on the labor market front…simply a decent report. It seems like an official announcement by year-end is almost assured.
The Week in Review
Housing data improved in August.
Housing starts jumped 3.9% during the month to an annualized pace of 1.615 million units. However, it should be noted that the improvement came on the back of a 20.6% jump in the volatile multi-family starts category. Single-family starts fell 2.8%, which marks the second straight month of declines. Building permits were a bit more uplifting with single-family permits rising 0.6% and multi-family permits rising 15.8%. A rise in permits should translate into a rise in starts over the next couple of months. In general, the housing market remains in good shape with homebuilder sentiment rising for the first time in five months in September.
U.S. Treasury Secretary Janet Yellen called on Congress to raise the debt ceiling.
In a Wall Street Journal opinion piece, she said, ”We are finally emerging from the pandemic crisis. Let’s not plunge ourselves into a financial one.” She followed up by saying, “The U.S. has never defaulted. Not once. Doing so would likely precipitate a historic financial crisis that would compound the damage of the continuing public health emergency….Our current economic recovery would reverse into recession, with billions of dollars of growth and millions of jobs lost.”
That Was Short-Lived
Well, that was short-lived. The Dow Jones fell 614 points last Monday, fell another 51 points on Tuesday and then jumped almost 878 points over the next three days as the relief rally set in (see figure 1). Despite constant calls for a correction at the start of the week, the Dow Jones finished the week up 0.6%. So, what happened?
China’s Real Estate Sector Tests Investors’ Confidence
Let’s start with Evergrande. Investors were initially concerned that China’s second-largest property developer would default and lead to a widespread financial contagion akin to the Lehman moment experienced in the United States. However, the U.S. decided to let Lehman fail, which some would argue was a policy mistake. One can rightfully argue about moral hazard and that corporate bailouts should not occur, but letting the institution fail without backstops led to widespread financial contagion and a freezing up of the credit markets that materially worsened the Global Financial Crisis. The key worry with Evergrande, which has about $300 billion in debt, was that it would miss key interest payments on March 22 bond last Thursday. However, in the past week, Evergrande agreed to settle payments on a domestic bond and the Chinese central bank injected cash into the banking system, which helped to soothe fears. The downside of Evergrande is that they may not pay offshore debtholders, which could limit investors’ desire to invest in the country. At this stage it appears that offshore bondholders have yet to receive payment, but the developer technically has 30 days to make those payments before being declared to be in default.
While it’s not clear whether or not the indebted developer will eventually fail, fears of widespread financial contagion to U.S. markets were mitigated some when Fed Chair Powell said that “In terms of implications for us, there’s not a lot of direct U.S. exposure. The big Chinese banks are not tremendously exposed, but you would worry it would affect global financial conditions through global confidence channels and that kind of thing.” In our opinion, the key takeaway is that growth may be set to slow in China as it restructures its economy and copes with a highly leveraged real estate sector. Our advice to U.S. investors is to trim exposure if your portfolio has significant exposure. However, if you have little exposure, now may be an ideal time to add exposure, but investors should acknowledge the ongoing geopolitical risks associated with President Xi’s concentrated drive towards common prosperity.
The Man is for Tapering
The Federal Reserve finally gave the market what it was looking for – clear guidance on tapering the pace of its bond purchases. While investors were nervous that a tapering announcement would upend financial markets, removing the uncertainty seemed to help investor sentiment. Fed Chair Powell said four important things at the September Federal Open Market Committee (FOMC) meeting:
- A tapering announcement could occur as soon as next meeting
- Tapering would likely be finished by mid-2022
- He does not need to see a blowout September jobs report on October 3rd to move on tapering. In his view, he has seen enough progress on the jobs front and a reasonably good or decent report would be enough for a November announcement.
- The threshold for rate hikes is much higher than for tapering
If you back into the math required to wind down the current pace of $120 billion in bond purchases by mid-2022, it seems to point towards a November or December start of monthly reductions of $15 billion that would conclude in either June or July of 2022. Clearly, this is not set in stone with Chair Powell saying they could adjust the schedule if the economy started to show weakness, but all signs point to a largely orderly taper. While Powell has been very dovish when it comes to rate hikes, the market is pricing in one rate hike by the end of 2022. Though it could easily be early 2023 and we should also acknowledge that these forecasts rely upon assumptions that may or may not happen. Citi Research’s base case remains that the U.S. economy will expand by 3.8% in 2022 and that inflation will moderate to 2.7%. If that does not happen, then the current projections for the first interest rate hike could easily change…perhaps moving the first rate hike back into 2023.
What Does This Mean for Financial Markets?
The initial reaction has been a renewed rise in the 10-year U.S. Treasury yield, which started the week at 1.36% and closed the week at 1.45%. This jump in yields helped to boost both Energy and Financial stocks, which tend to rise along with interest rates. This is counter to Technology stocks, which tend to fall as interest rates rise as most of their earnings potential is likely to occur further down the road (see figure 2). Essentially, in a raising rate environment, a dollar today is worth more than a dollar tomorrow. Improving economic data may also be contributing to this rise in yields with Citi’s proprietary economic surprise index, which measures whether or not economic data are beating or missing consensus expectations, looking like it may have bottomed in late August. Likewise, early September data like the regional Federal Reserve surveys (such as the Philly Fed index and the Empire state index) are showing signs of a potential pickup in economic activity after an August swoon (see figure 3). This Friday, the national Institute for Supply Management’s manufacturing index should confirm that activity remains solid.
Longer-term, investors remain rightfully concerned that a normalization in monetary policy could remove a key support of the U.S. stock market. However, if the Fed’s normalization path in 2013 serves as a guide, then these concerns may be overblown. Between the end of 2015 and the middle of 2019, the Fed hiked interest rates nine times, but U.S. stocks went on to post positive annual returns in every single year except 2018 (see figure 4). That was the year when U.S. – China trade tensions led to a manufacturing recession as the Fed continued policy tightening. By mid-2019, the Fed was once again cutting interest rates (see figure 5).
All Eyes Turn to Washington
Looking ahead, all eyes are going to be on Washington with the House set to vote on the $550 infrastructure bill soon. While some expected the first vote to fail, House Speaker Nancy Pelosi said that she will not bring a bill to the floor unless she has enough votes secured for it to pass. Although the vote may be delayed, it is still expected to pass. Importantly, the proposed September 27 vote is non-binding. Our base case remains that the infrastructure bills will get passed with 21 out of 25 (or 85%) of past budget reconciliation bills having went on to be signed by the President. That said, the total price tag of the infrastructure bills will likely be trimmed down from the original $3.5 trillion price tag in order to accommodate moderate Democrats.
Fortunately for financial markets, a trimmed down price tag likely means trimmed down tax increases with the new corporate rate being floated at 26.5% (vs. the initial proposal of 28%), a top individual income tax rate of 39.6% for single filers making above $400,000 (up from the current rate of 37%) and a new capital gains tax rate of 25% (up from 20%, but well below the original proposal of 39.6%). While these examples are just a handful of the changes being considered, we think that a change to the corporate tax rate is likely the most important for financial markets due to its direct impact on corporate profits. While likely to serve as a drag on earnings growth in 2022, Citi Global Wealth still believes that operating earnings-per-share (EPS) growth across the world could rise by 7%-8% on average. This should support further modest gains in global equity markets over the next couple of years.
Should Investors Be Worried About the Debt Ceiling?
In terms of a government shutdown and the debt ceiling debate, it seems like we might see a brief shutdown. Since 1976, we have had 21 government shutdowns with the average shutdown lasting about 8 days…the longest was 34 days (see figure 6). During those shutdowns, the S&P 500 was essentially flat. Recently, Democrats have said that they will include the debt ceiling legislation in with the government-funding bill that is due September 30. While this sets up Congress for a showdown and a potential shutdown of non-essential government services, it should be noted that Democrats have an off-ramp and can always wrap the debt ceiling legislation into the party-line infrastructure bill and pass it with a simple majority.
|Year||President||Dates of Federal Government Shutdown||Number of Days||S&P 500 Performance During the Shutdown (%)|
|1976||Gerald Ford||September 30 to October 11||10||-3.4|
|1977||Jimmy Carter||September 30 to October 13||12||-3.2|
|1977||Jimmy Carter||October 31 to November 9||8||0.7|
|1977||Jimmy Carter||November 30 to December 9||8||-1.2|
|1978||Jimmy Carter||September 30 to October 18||18||-2.0|
|1979||Jimmy Carter||September 30 to October 12||11||-4.4|
|1981||Ronald Reagan||November 20 to November 23||2||-0.1|
|1982||Ronald Reagan||September 30 to October 2||1||1.3|
|1982||Ronald Reagan||December 17 to December 21||3||0.8|
|1983||Ronald Reagan||November 10 to November 14||3||1.3|
|1984||Ronald Reagan||September 30 to October 3||2||-2.2|
|1984||Ronald Reagan||October 3 to October 5||1||0.1|
|1986||Ronald Reagan||October 16 to October 18||1||-0.3|
|1987||Ronald Reagan||December 18 to December 20||1||0.2|
|1990||George H.W.Bush||October 5 to October 9||3||-2.1|
|1995||Bill Clinton||November 14 to November 19||5||1.3|
|1995-1996||Bill Clinton||December 16, 1995 to January 6, 1996||21||0.1|
|2013||Barack Obama||October 1 to October 17||16||2.3|
|2018||Donald Trump||January 20 to January 23||3||1.0|
|2018||Donald Trump||February 9||1||1.5|
|2018-2019||Donald Trump||December 22, 2018 to January 25, 2019||34||10.3|
|Average||average number of days shut down is 7.8 Days||average percent change for S&P 500 Performance During Past Federal shutdowns is +0.1%|
In terms of how long they have before the government approaches a default…it looks like they have until either late October or early November. Citi Research is calculating that the hard date is November 3, but there is a high level of uncertainty around the exact date at this point. Rest assured, there is going to be a lot of finger pointing in Washington, but we believe that Congress will once again act to raise the debt ceiling. In fact, Congress has acted 78 times since 1960 to adjust the debt ceiling because neither political party wants to be responsible for defaulting on the country’s legal obligations. Although 2011 stands out as unique period where the debt ceiling debate rattled markets as the country’s debt rating was lowered from AAA to AA+, we do not envision a repeat of that dynamic this time around. Importantly, in 2011, President Obama faced a Republican House, but that is not the case now with both the Presidency and U.S. Congress fully in the hands of Democrats. While thin margins in the Senate suggest heated debates, it seems likely that the debt ceiling debate will come and go without a material impact on financial markets (see figure 7).
|Historical Debt Ceiling Levels and S&P 500 Performance|
|Date||Debt Ceiling (Bils. of $)in the billions of dollars||Change in Debt Ceiling (Bils. of $)in the billions of dollars||S&P 500 Performance
|S&P 500 Performance
|S&P 500 Performance
|April 6, 1993||4,370||225||-1.1||-2.4||0.5|
|August 10, 1993||4,900||530||0.3||0.0||2.7|
|March 29, 1996||5,500||600||0.8||-0.8||1.3|
|August 5, 1997||5,950||450||3.9||1.1||-2.4|
|June 28, 2002||6,400||450||-7.9||0.1||-13.8|
|May 27, 2003||7,384||984||5.9||3.5||2.6|
|March 20, 2006||8,965||781||1.4||1.6||0.5|
|September 29, 2007||9,815||850||4.3||0.1||0.9|
|July 30, 2008||10,615||800||0.3||0.2||-0.1|
|October 3, 2008||11,315||700||-13.8||-9.4||-12.1|
|August 2, 2011||16,394||2100||-6.4||-5.8||-6.4|
|February 4, 2013||16,699||305||2.0||-0.3||2.0|
|October 17, 2013||N/A||Suspended||1.7||2.4||3.8|
|March 16, 2015||18,113||901||-0.8||0.1||1.1|
|March 16, 2017||19,809||1696||1.5||0.7||-2.2|
|February 9, 2018||21,988||1532||-4.8||-5.2||6.4|
|August 2, 2019||N/A||Suspended||-1.4||-3.1||-0.2|
|July 31, 2021||28,500||6470||2.3||-0.4||3.0|
|Maximum:||maximum percent change for S&P 500 performance one month prior across all given records in this table is 6.1%||maximum percent change for S&P 500 performance one week prior across all given records in this table is 3.5%||maximum percent change for S&P 500 performance one month prior across all given records in this table is 6.9%|
|Minimum:||minimum percent change for S&P 500 performance one month prior across all given records in this table is -13.8%||minimum percent change for S&P 500 performance one week prior across all given records in this table is -9.4%||minimum percent change for S&P 500 performance one month prior across all given records in this table is -13.8%|
|Median:||median percent change for S&P 500 performance one month prior across all given records in this table is 0.3%||median percent change for S&P 500 performance one week prior across all given records in this table is 0.1%||median percent change for S&P 500 performance one month prior across all given records in this table is 0.7%|
|Average:||average percent change for S&P 500 performance one month prior across all given records in this table is -0.7%||average percent change for S&P 500 performance one week prior across all given records in this table is -0.8%||average percent change for S&P 500 performance one month prior across all given records in this table is -0.2%|
|Index||Weekly Chg (%)change in percent||YTD (%)year to date change in percent||12 Months (%)12 month change in percent||Div. Yield (%)division yield in percent|
|Instrument||Weekly Chg (%)change in percent||YTD (%)year to date in percent||12 Months (%)12 month change in percent||Level|
|10-Year Treasury Yield (%)||8.9 bps||53.7 bps||78 bps||1.45%|
|Index||Weekly Chg (%)change in percent||YTD (%)year to date in percent||12 Months (%)||Div. Yield (%)division yield in percent|
The Week Ahead
|9/27||8:30||Durable Goods Orders||August P||0.7%||-0.1%|
|9/28||8:30||Advanced Goods Trade Balance||August||-$87.3b billion||-$86.4b billion|
|9/28||8:30||S&P CoreLogic CS 20-City YoY year on year NSA||July||20%||19.1%|
|9/28||10:00||Conf.erence Board Consumer Confidence||September||115.0||113.8|
|10/1||8:30||PCE personal consumption expenditures Deflator YoY year on year||August||4.2%||4.2%|
|10/1||8:30||PCE personal consumption expenditures Core Deflator YoY year on year||August||3.5%||3.6%|
|10/1||10:00||U of Mich.University of Michigan Sentiment||September F||71.0||71.0|
|10/1||10:00||Construction Spending MoMMonth over Month||August||0.3%||0.3%|
|10/1||10:00||ISMInstitute for Supply Management Manufacturing||September||59.5||59.9|
|10/1||10:00||Wards Total Vehicle Sales||September||13.20m million||13.06m million|