The recent dismissal of Kevin McCarthy, the Republican Speaker of the House of Representatives, by members of his own party has a certain thespian quality to it. Sort of like watching a modern adaptation of Shakespeare’s Julius Caesar. It is not every day that a country as mature and advanced as the United States has its politicians comport themselves so theatrically.
In the eyes of the rest of the world this begs the question of how mature and advanced the United States actually is. Were the US self-sufficient in terms of meeting its financing needs such concerns would count for little. As it is, the country needs to import billions of dollars per year to meet the supply of its debt. The cost of the debt is decided by the balance between supply and demand. Every forecast shows the debt to be increasing materially as far as one can predict.
The demand for America’s debt depends on the perception of this country as a stable one, whose safe haven status makes it a place for funds to be sent from abroad. Watching a leader being deposed by his party does not engender a sense of stability on the world stage. It seems his crime was collaborating with the opposition to get legislation passed. This is what he was supposed to do.
Like Julius Caesar, McCarthy was done in by a small fraction of his own party. Only eight of the 221 Republican representatives voted against him. Democrats did not vote for him as he did not show any desire for them to do so. Whether this was political miscalculation or naivete will be something for historians to discover.
There is a sense that people are getting tired of theatrics on the national stage and yearn for more substantial debate and problem-solving which will involve compromise and collaboration by both parties.
Given the events of this past weekend (this was penned on October 9) with the attacks on Israel and the suspension of military aid to Ukraine as funds are depleted, voters are expecting the House of Representatives to conduct itself as a more deliberative body. Instead, people see the country run by some versions of the Crips and Bloods.
Several issues of political and financial importance await review. The government runs out of funds November 17 if nothing is done. The debt ceiling is set to decline, taking the borrowing ability of the government with it if not extended and increased. Matters of immigration overwhelm cities, begging the question of why this is not a national issue. The Supreme Court, the final arbitrator of rules of law, turns out to have no ethics guidelines of its own.
As these issues and others fester and are not resolved, the sense of the country’s ability to govern itself is called into question. This issue rubs off on the cost of debt. Who wants the promise to pay of a country that cannot seem to coherently describe its problems, much less address them?
Be watching for a reduction in the debt ratings of US Government obligations. Currently the debt is AAA and is referred to as the “risk-free rate” due to its supposed inability to default. If government debt does default, even temporarily, the reputational damage will be both severe and long-lasting. While this is not the first government default (should it come to that) it is the first in which no appropriation bills have been passed to date. Their absence means that government employees who were paid previously during shutdowns will not be paid this time around. The lack of a Post Office, TSA travel screeners, food and drug inspectors, social security and Medicare checks and the like will make this shutdown a far different experience than previously the case.
The issue of government deficits is a real one. Shutting down the government is not a way to address it. It requires the debating of what do we want the government to do, what will it cost, and how to pay for it. Holding citizens hostage for their basic services accomplishes nothing. Meanwhile, other counties look at the political turmoil of the United States and start looking for alternatives. An end of American exceptionalism will also mark the end of interest rates as we know it. Everyone will pay.
The Economy
The economy is fairly strong in terms of jobs and economic activity. It is less strong in terms of corporate profits. Look for a decline in corporate profit margins, by several companies as earnings are announced.
Worker compensation is taking a larger share of company revenues. Interest rates have risen substantially, especially for those firms who deploy floating rate debt. At the same time, higher interest rates are attracting savings from consumers, who in turn spend less. For the government, interest payments are 125 percent higher than pre-Covid.
Added to this environment is the fact that, at this stage of the economic cycle, the leverage from pent up demand is pretty much sated.
The cherished “soft economic landing” will not induce enough demand for a subsequent material upswing. At this point there are more jobs being lost among the higher paid than the blue-collar worker. This is a first on a national scale.
Inflation
Inflation is expected to come in around 3.6 percent this month, far above the two percent target rate set by the Federal Reserve.
There is some talk of another rate increase. More likely is a continuation of current rates in an effort to reduce demand and inflation. In truth, items like the price of oil and imported raw materials are outside of the ability of the Fed to influence.
Interest Rates
The impact of higher interest rates is becoming more apparent. There seems to be a transfer of wealth from spenders to savers, which is what the Fed wants.
The quoted price of s 30-year bond has declined over 40 percent since the tightening process began in early 2022. For those who speculate in interest rates by buying long-term bonds, this is a calamity.
The feeling now is that the Fed will not be satisfied until the 10-year bond has an interest rate of 5 percent. As this is the bond mortgage rates are priced off of, the implications are pretty sobering. This would imply an 8 percent mortgage. Already monthly mortgage payments are running 50 percent higher than two years ago for a mortgage of the same amount.
The Stock Market
Many stocks have not participated in this year’s rally. Fad names that are associated with artificial intelligence (AI) look like they are beginning to crack.
Stocks in general are more subdued. Retail names have been pressured as consumers pull back. Credit card use has started to decline.
Assuming a better political climate, firms that are involved in natural gas, infrastructure, and the more predictable aspects of consumer spending like health care should do well.
It would appear that this market will become one of industries and special situations. This is not the kind of market that responds to events across the board.
Warren M. Barnett, CFA
October 12, 2023
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