Investment Insights

 — Steve Orr 

Drifting  

The November rally back to 2023 highs appeared to have stalled until last Thursday. Google announced an upgrade to its Bard AI chatbot that day. The Gemini large language model comes in three “sizes,” so it can be sold from data centers down to smartphones. Whether you are interested in talking to an LLM on your phone is another matter, but one could see an advantage when trying to appear to be in deep conversation on your phone. AMD announced a new AI-focused chip and that Microsoft, Meta and Oracle will be buyers. The two announcements were enough to get the AI excitement going again and push stock indices barely into the green for the sixth week.

Interest rates are also consolidating around levels last seen in late summer. Treasurys maturing two years from today are yielding 4.72%, about one-half of a percent below their October high. The two-year Note is usually a good gauge of where traders think short-term rates will be a year from now. In short, markets still think rates are coming down later in 2024. The 10-year Treasury was changing hands late Friday at 4.23%, up from 4.11% the day before. This is still three-quarters of a point below their 4.99% peak in mid-October. Wall Street priced a “soft landing” into rates before Silicon Valley in March and during the summer. 

The story

The recent narrative on Wall Street has been that the economy is slowing so fast that the Fed will need to cut rates by at least a full percentage point in the coming year. We agree that the economy is slowing — likely to a 1% to 1.5% growth rate in the coming months. We do not buy the logic that a coming recession is so bad that the Fed will have to cut rates. Remember the Fed is always late, whether raising or lowering rates. The Committee rarely lowers rates when there is just a slowdown underway. Cuts are usually reserved for a more shocked reaction to a deepening recession or external event like 2020’s shutdowns.

So, are the economy and markets just drifting, waiting for something to happen? Mid-December is usually a “pause” period for stocks and bonds. Think of these shopping days as time for markets to rebuild energy after November’s rally. Over the last 10 years, Barron’s reports that there have been 30 such occurrences. Stocks are higher three months later about 70% of the time.

If the big indices stall around these levels, then the case for a multi-year Bear consolidation can be made. If the NASDAQ and S&P 500 break out above these current levels toward their lifetime highs of late 2021, then a new Bull cycle can be called. Both indices have come a long way fast, so we would not be surprised if we backtracked and drifted lower a few percentage points before Santa arrives. 

Lying around

Markets like certainty and liquidity. Certainty comes from confidence that central banks and outside events have a low probability of upsetting the apple cart. This is “CB Week” for the quarter. The Fed, European Central Bank, Norges, Swiss, Bank of England all meet. The Bank of Japan already issued their stance (no change) early Monday. We expect most, if not all, of these banks to leave rates unchanged for the moment. The ECB may signal a slight tilt toward easing monetary conditions, as parts of Europe are in recession.

We count five major conflicts going on around the globe. The International Institute for Strategic Studies (iiss.org) released their Armed Conflict Survey last week and they count 183 regional and local conflicts. Now that an Exxon consortium has discovered another play in the Guyana Stabroek field, Venezuela is suddenly making noises again about border claims. Venezuela over the last century has asserted it owns the western two-thirds of Guyana. We are not sure what to make of Venezuela’s saber rattling. It already has the world’s largest proven oil reserves but is unable to produce much. Clearly it wants more, and that would add another conflict to the list.

Liquidity, or money in the banking system, has popped back toward shutdown-era highs. The more money sloshing around, the easier it is for fast money to borrow and buy stocks, so the theory goes. Historically, the U.S. Treasury kept in the single digit billions in its deposit (“checking”) account at the Fed. Today that balance is near $680 billion. 

Source: Bloomberg, L.P.

Some of that cash may be needed for year-end payments. Some may be dribbled out next (election) year as part of the Inflation Reduction Act. Still a very nice piggy bank to have lying around. The source of that cash is the $1.01 trillion borrowed by the Treasury in the third quarter. So roughly 35% of the $2 trillion deficit is sitting at the Fed doing nothing. Well, not entirely nothing because the offset is higher excess reserves at banks. Think of excess reserves as more of a sentiment boost to stocks than actual money buying stocks. 

Modest

Meanwhile we, the taxpayers, are paying interest on the debt that funded the Treasury account. If Congress could pass a budget, we would submit a rider to 12 USC § 355. This section controls what the Fed can buy and sell. Congress could amend the statute to allow the Fed to assign securities it owns to the Treasury. If the Fed gave $4 trillion of its $7.8 trillion Treasury and mortgage bonds it holds to the Treasury, the national debt and excess reserves would come down. That modest reduction in the national debt might dampen animal spirits on Wall Street, but paying less interest and a lower national debt would improve the mood of taxpayers. 

Part 2

Job growth is also drifting lower, consistent with the economy downshifting from second to first gear. Friday’s November payroll came in above expectations at 199,000 net new jobs. Peeling back the layers shows small growth in the important private sector. Returning strikers accounted for 47K, healthcare 77K, Federal government 49K and, finally, local government accounted for 32K. Note those add up to more than the headline, suggesting models and plug figures subtracted from the total. The prior two months’ numbers were revised lower by 35,000.