Financial update from Brewin Dolphin - 27 October 2023
The Weekly Round-up
Friday 27 October 2023.
In his latest weekly round-up, Guy Foster, our Chief Strategist, discusses the outlook for the US and eurozone economies, and the appointment of a new US House speaker.
Earnings season really hit its stride this week with some of the big tech names reporting. The market reaction was positive for Microsoft and Amazon whilst Alphabet’s cloud performance underwhelmed. In the US, nearly 80% of companies have beaten analysts’ estimates for earnings, a ratio so consistent that I would ascribe it little relevance. Guidance from companies in general is cautious. There does seem to be evidence of slowing demand, often associated with a cycle of destocking across many industries, which relates to the challenges of maintaining inventories with volatile demand and supply during the lockdown periods. There has been some pressure on margins from both weak revenues and high costs selectively.
Thursday saw a decline in equities coinciding with a rally in bonds, offering a hint at the return of the halcyon days of negatively correlated bonds and equities.
This week saw some suggestions that the bond rout could be close to an end. While US ten-year Treasury yields made a fresh assault on the 5% level, it was reassuring that they stopped short of last week’s high. However, their failure to drop below 4.8% means that the technical outlook is mixed.
Demand for Treasury bonds was also mixed, with very low demand for five-year bonds earlier in the week, but relatively high demand for seven-year bonds just a day later. Some high-profile bond bears announced that they have covered their short positions or turned incrementally positive on parts of the market (still predominantly the shorter-dated bonds).
The US economy remains uncomfortably hot from a bond holder’s perspective. The same cannot be said for all regions. In this week’s provisional purchasing managers’ indices (PMIs) covering the month of October, the US still seems fairly resilient. The services sector saw an accelerating expansion. If that was not what the Federal Reserve wanted to see (because it may imply ongoing inflationary pressure) it may take some comfort from the decline in the services output prices series, which suggests a lower share of companies are increasing their prices than was the case at any time since 2020.
Around the rest of the world, the outlook was less positive. The eurozone economy remains in contraction according to these indices. The European Central Bank will be hoping it has done enough to suppress inflation. Demand is certainly weakening as indicated in the PMIs. The money supply, which has historically been a very effective leading indicator of the eurozone economy, would suggest that growth will continue to ease from here.
However, pressures remain, and the worsening growth outlook throws the sustainability of debt in Italy into sharp relief. The budget deficit was already expected to be large this year and next. But earlier this month, Italy's Parliament approved prime minister Giorgia Meloni's budget plan, which is projected to result in a deficit this year and next of 5.3% and 4.5% of gross domestic product (GDP), respectively. This is more than the government was previously projecting. This means the deficit is now projected to be as big in 2023 and 2024 as it was at the height of the global financial crisis. A lack of urgency from the government with respect to deficit reduction, at a time of surging financing costs and slowing growth, is making investors nervous, and has contributed to Italy versus Germany bond yield spreads widening to near the highs of this year. The spread widening is being made worse by the risk-off phase markets are currently going through.
New US House speaker
The battle to control public spending is at the heart of political dysfunction in the US as well. The good news is that the US House of Representatives has a new speaker. But it is worth spending a bit of time to reflect upon whether this marks the start of new era of decisive policymaking, or just another step on the path towards a government shutdown or debt crisis.
This is an important development. Whereas in the UK the speaker of the House of Commons acts as a sort of referee, the speaker of the House of Representatives is much more of a team captain.
America’s presidential system powers are separated between the executive office of the president, which is responsible for enforcing laws, and the legislative body of Congress, which is responsible for making new laws and providing funds to the executive. Congress is formed of the Senate and the House of Representatives. The House of Representatives is generally considered to be the more powerful of the two houses because it has sole responsibility to originate finance bills (although both houses need to approve most laws and spending).
The speaker of the House is elected by its members and therefore is naturally drawn from the larger of the two parties. The speaker determines which laws are voted on by the House. The speaker appoints the chairs of the committees that draft legislation and oversee the actions of the executive. This means they should effectively control the process of creating laws. For that to happen, though, they need the support a majority of Congress, and we would assume that majority comes from their own party. This presents two problems for Republicans now.
The first is that they have a very slim majority, holding 222 seats while the Democrats hold 218 seats.
The second is that the party has huge divisions.
It is typical for a party to struggle to maintain unity on all issues as these will likely affect different districts in different ways. So, a majority of four is always likely to be difficult. But the Republicans are particularly split on social and economic issues. If the most extreme cuts to spending or the more extreme social policies advocated by some members are enacted, members in moderate seats will likely lose their seats at the next congressional elections in a year’s time. Securing all of their 222 votes on every issue is therefore very difficult. As few as four abstentions could allow the Democrats to block a piece of legislation.
This lack of alignment on issues has seen the Republican party vote down its own speaker and spend weeks failing to agree on a replacement. They have finally done so, appointing Mike Johnson and, in the sense that this is a more conservative candidate than the previous incumbent, Kevin McCarthy, that can be chalked up as a victory for the antagonists.
Being appointed speaker is difficult, but actually doing the job of speaker has been even harder for the last decade or so. The US Congress is required by law to pass a budget by 17 November. That seems unworkable, so the new speaker has suggested he will seek to pass a continuing resolution. Although this only needs a simple majority, many Republicans are opposed to a continuing resolution (which maintains spending at current rates and is typically used to spare time for continued budget negotiations). Many Republicans are opposed to the ongoing spending a continuing resolution would imply and so one would likely require Democratic support to pass.
At some stage, the House will have to pass some new finance bills requiring two thirds majority (and the consent of Democrats); or live from continuing resolution to continuing resolution (which many Republicans would consider intolerable); or pass around 12 single subject spending bills, each requiring two thirds majority. Otherwise, the government will shut down.
From the brief comments of the new speaker, and the responses received from his colleagues, it seems likely that the House will pass a bipartisan continuing resolution lasting until January 2024. After this, the challenges of achieving an agreed funding programme between the two parties will return and the threat of a government shutdown will loom once more.
Despite the amount of space devoted to this topic, a government shutdown should not be a particularly concerning outcome from an investor’s perspective. Whilst pretty uncomfortable for those directly affected, a temporary shutdown of the federal government has limited impact on the broad economy. Unlike issues with the debt ceiling, budget delays in the budget process would not result in a default on US government debt. Those risks are reserved for wrangles over raising the federal debt ceiling, which, mercifully, has been suspended until January 2025, after next year’s election.
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