June 5-9, 2023

Tactical Signal 9

With Sowell’s technical signals transitioning to positive, aka full position (100%), the week of May 22, the recent market momentum and better-than-expected economic reports continue to stabilize its positioning across the TAP and TAP Overlay models.

Major averages gained momentum on last Friday’s passage of the debt ceiling Fiscal Responsibility Act of 2023, allowing the U.S. to continue to issue debt. Equity markets, including the S&P 500 and Nasdaq, gained +1.88% and +2.0% during the week, respectively, resulting in 12.37% and 27.01% YTD gains. The last couple of weeks also included favorable trends in key economic reports, including better-than-consensus reports on Consumer Confidence @102.3, Construction Spending @1.2%, Non-Farm Payroll increased @ 339,000, and GDP growth rate @ 1.3%. So much for a decline in economic activity and fears of a recession, although pundits now have shifted their narrative to “full-employment recession.”

The Fiscal Responsibility Act does have some noteworthy outcomes:

  • No limit on the debt ceiling, and suspended beyond the next presidential election until 2025.
  • Limits on non-defense spending: flat in 2024 and up to a 1% rise in 2025.
  • Unspent Covid funds to be returned.
  • $80 billion in IRS funding to enforce the tax code; and
  • Streamlining the environment review process for energy project permits.

The week ahead will continue to focus on inflation and the Fed, albeit eased with the reported rise in the unemployment rate to 3.7% from 3.4% - The Fed views a rise in labor supply indicative of businesses not having to pay higher wages as a means to ease inflation. Following, key reports on Factory Orders, Consumer Credit, and Wholesale Inventories will continue to guide the state of the soft landing. 

US-China public aggression and geopolitics will likely heat up again from last Thursday’s announcement Washington signed a new US-Taiwan trade agreement.

We’ve always had polarization in America. If you go back to the Jefferson, Adams presidential race in 1800, the things that were said in that election would fit right into a current political environment. But what’s been different, more recently, is not just a measure of paralysis, as indicated by the debt ceiling, but a level of meanness and a lack of civility among our politicians, or the sense that somebody who disagrees with you is not just somebody you disagree with, but is an enemy, is a bad person. This lack of civility is something new and pretty pervasive in the Congress..” – Former Defense Secretary Robert Gates, Interview on Face the Nation, May 21, 2023.

A Rock and a Hard Place

“High tax rates,” wrote Arthur Okun,“ are followed by attempts of ingenious men to beat them as surely as snow is followed by little boys on sleds.” For these insights, Okun can be considered one of the original supply-siders.

Arthur Okun, a Yale economist, was a member of the CEA during the Kennedy Administration and Chairman of the CEA during the Johnson Administration and provided the intellectual underpinnings for Kennedy’s proposal to cut tax rates. He was later known for Okun’s Law, measuring the statistical relationship between employment and GDP – a 1% increase in unemployment has an associated 2% drop in GDP relationship.

After leaving Washington, he became a consultant to DLJ and a resource for DLJ’s clients. A member of our investment team was invited to meet with him at lunches and breakfasts about once a quarter, and it was there we also became aware of Okun’s Law for Forecasting:

1.) Don’t.

2.) If forced to forecast, forecast often.

3.) When forecasting, don’t give a date.

We will attempt to make a forecast without giving a date.

A bipartisan agreement to continue government spending was finally reached last Friday. The Federal budget deficit will likely reach $1.5 trillion or more for the fiscal year 2023, up from the original estimate of $1.0 trillion presented last August. The latest CBO estimate for the aggregate deficits from 2024 to 2033 is $20.0 trillion. The outstanding debt as a percentage of GDP will reach 119% in 2033, according to the CBO, and interest payments as a percentage of Federal Government spending will rise from 11.5% to 14.6% over the period. All of these estimates are subject to revision.

As the Fed attempts to reduce inflation by reducing liquidity, how will the Treasury finance these enormous deficits? They can borrow money from offshore holders of dollars. This borrowing would increase the U.S. money supply as the funds reached the U.S. banking system. If the Fed pursues reducing liquidity, it will need to sterilize these inflows. Alternatively, the Treasury can appeal to the Fed to abandon its efforts to reduce liquidity and finance the deficit. Post the Treasury Accords, the Fed is under no obligation to heed this appeal. The Fed will likely be subject to substantial pressure from the political establishment to relent. If the overseas money is not forthcoming and the Fed continues to reduce liquidity, the Treasury might try and squeeze the funds from the private sector. The third option would likely drive-up interest rates and limit funds for private investment; net private domestic investment would decline. 

A fourth path for raising funds would be raising tax rates. We saved this option for the end. As Okun argued almost sixty years ago, raising tax rates increases incentives to avoid taxes. Additionally, raising tax rates in a slow-growth economic environment risk pushing the economy into a recession. A combination of increased tax avoidance and a recession will raise the deficit.

The economy will collapse under the weight of increased tax rates and increased regulations. The argument that the economy is resilient does not square with the evidence. Over the period from 2/2020 to 4/2023, the net number of new jobs is 3,303,00 on a base of 153,000,000—or a 2.2% total increase over more than three years. The initial estimate for real growth in the first quarter is about 1.0%, well below the long-term trend. Commentators point to a low unemployment rate as an indication of strength in the economy. However, the labor force participation rate, which has been falling for over 20 years, has continued its decline. The rate fell from 63.3% in 2/2020 to 62.6% in 4/2023. 

Our forecast is that we could experience both a recession and rising inflation at some point.

Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.


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