U.S. economic data releases over the past couple of weeks suggest that there’s a growing gap between the generally positive numbers for the economy and the underlying tail risks that keep building in the shadows. If you’re a close follower of the key macro-level data, everything looks pretty good in the U.S. economy. The Atlanta Fed’s GDPNow forecast currently expects 5% GDP growth in Q3, which would be the 5th consecutive quarter that the U.S. economy grew at at least a 2% annualized rate. The unemployment rate is at 3.5% and showing few signs that the labor market is cracking in any major way. Retail sales, which was looking like a potential pain point for the economy, grew an unexpectedly high 0.7% rate in July, the 4th straight month of at least 0.3% growth. This certainly doesn’t sound recessionary and is a big part of the reason why cyclicals have rotated into market leadership over the past month despite some signs of weakness in lumber and commodities, in general.
But China remains the tinder box. It’s got all sorts of problems at the moment (which you can read more about below) and it may be inevitable that those fears start spilling over into the global economy. The equal-weight S&P 500 and the Russell 2000 declined by more than 1% on Tuesday, which would be one of the few significant U.S. equity market reactions to global events in a while. Tech stocks are outperforming again and rate-sensitive utilities are looking ugly at the moment, so I don’t think it’s a universal risk-off moment just yet, but it’s not at all difficult to see how this ends badly. We’re seeing a pretty significant credit contraction in the U.S. real estate space as well, so we know that what’s going on in China is showing up in the U.S. to at least some minor degree right now. This is particularly troublesome because China isn’t something that the Fed can fix with liquidity, credit lines or lower interest rates. If China implodes, there’s not much the U.S. central bank can do about it and that makes it the most likely catalyst to bring about a credit event.
While the July retail sales number was a net positive for the U.S. economy, it also reinforces the notion that Treasury rates may not be heading lower anytime soon (outside of a China-type event taking place). Every positive economic report means that interest rates will remain higher for longer. While another Fed rate is still considered unlikely, the possibility can’t be written off altogether. There’s probably about a 1-in-3 chance right now that the Fed sneaks in another quarter-point hike and that’s a big reason why 10-year yields are retesting Q4 2022 highs. If it clears that mark, we have to go all the way back to 2008 to find a time when long-term Treasury rates were higher. We may be looking at well into the 2nd half of 2024 before a rate cut looks more likely than not.
Through all of this, utilities look disappointing. In recent months, there have been a few times where utilities perked up and pointed out to watch for a continuation of the trend for indications of a risk-off pivot. Each time, thus far, utilities have failed to follow through. If U.S. economic data continues to look healthy and that raises the likelihood that rates will at least stay where they’re at for the foreseeable future, that clears the path for risk-on conditions to continue and for utilities to remain an underperformer.
The Japan situation continues to get more interest while, at the same time, putting more and more pressure on the Bank of Japan.
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