by Franklin J. Parker, CFA
The Summary
- What a difference a week makes! US stocks sold off 3% last week on the Fed’s commentary. While the Federal Reserve kept rates unchanged, Fed officials communicated that rates will likely need to stay higher for longer than markets otherwise expected — Powell even pointing to another rate hike before year end. Rather than declare “mission complete” the Fed’s tone was more of a “the war is still raging.” With borrowing costs reaching generational highs, investors are beginning to worry about the viability of many companies.
- The US government is scheduled to shut down starting Sunday if a spending bill is not passed by congress. Keeping the government running has now become a common bargaining chip in an otherwise deadlocked congress, so investors are not particularly rattled by it like they used to be (it does not carry the same consequences as the debt ceiling). If the shutdown stretches on for months then concern will grow, but for now this is more symptomatic of the challenge to get things done politically (more on that in this week’s Details).
- I am reiterating my view that the current market environment is not favorable. While I have not gotten the “recession is imminent” signals, I do see more downside risk than upside in this environment. I would be more cautious if the data deteriorated further, and I would be more optimistic if corporate earnings, spending, and unemployment improved. At the moment, however, I think we are stuck in a wait-and-see mode.
The Details
The looming government shutdown is a symptom of the growth in political polarization over the last 50 years.
Since 1994, according to Pew research, Democrats and Republicans have pulled further apart, with much of that move happening between 2004 and 2014.
Of all the figures, however, it is the number of bills passed by Congress that stands out the most to me. Since 1973, the number of bills passed by Congress has been cut almost in half. While not a perfect proxy, this is a signal (to me at least) that negotiation across the aisle is getting harder and harder.
Why does this matter to investors? Well, investors and businesses are required to make long-term plans. When policy, especially tax and economic policy, are uncertain, making those long-term plans carries more risks. After a general downward trend in the 1990s, we have seen economic policy uncertainty climb fairly steadily, and, while not as high as it was during Covid, economic policy uncertainty has reached much higher levels than what we saw in the mid-1980s.
Beyond the social effects, political polarization has a secondary economic effect that investors are forced to care about. One study found that increases in political polarization resulted in lower long-term business investments and a subsequent economic drag in local economies. While investors have many variables to worry about, increasing political polarization is one that tends to pop up more and more. And, let us not forget, next year is a presidential election year, a difficult time for markets anyway.
While not a primary concern, it does behoove investors to keep one eye on politics (but maybe only one).
Chart of the Week
We haven’t talked about zombie companies in a while. As a refresher: in a nutshell, a zombie company is a business that does not earn enough revenue to cover the cost of its debt. Therefore, zombie companies require constant infusions of cash from investors to stay alive. In 2021, a report by Deutsche Bank estimated that around 1 in 4 US companies were zombie companies! There is lots to say about the disadvantages of so big a number in an economy, but suffice it to say it is generally bad. With rates moving higher and the Fed reversing its decade-long policy of easy money, we have begun to see many companies fail.
Bankruptcy filings have increased by about 20% over this time last year. And, while this may be a healthy signal that many zombie companies are finally on their way out, it is also a strong recessionary signal. Such a move tends to happen just before the economy begins to contract.
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