US Strategy Weekly: A Constitutional Challenge

This could be an important week for the stock market since 30% of the S&P 500 components are expected to report first quarter earnings results. Earnings have become critically important now that expectations of Federal Reserve rate cuts are fading; but to date, earnings season has been mixed. The weekly S&P Dow Jones consensus estimate for calendar 2024 is $239.83, down $1.10, as of April 19, 2024. The estimate for 2025 is $273.65, down $0.33. The LSEG IBES estimate for 2024 is $242.06, down $0.98, and only the 2025 IBES estimate rose to $276.37, up $0.24. Using the IBES EPS estimate for calendar 2024, equities remain overvalued with a PE of 20.9 times and with the S&P estimate, the 2024 PE is 21.1 times. Both are extremely high, particularly with inflation currently at 3.5% YOY. See page 9.

However, the debt market is also having an important week given that the Treasury is scheduled to sell $183 billion of 2, 5, and 7-year notes. As we noted last week, fiscal 2024 year is a pivotal time for the US deficit since the CBO estimates that net interest outlays will soon exceed the primary deficit. This year the annual deficit is forecasted to be 2.5% of GDP, while interest payments will be 3.1% of GDP, a percentage last seen in 1995, 1992, and 1990. In fact, since 1940 net interest outlays exceeded 3.1% of GDP only once, in 1991 (3.2%), during the 1990-1991 recession. In our view, debt markets are a significant risk factor for the equity market since the supply/demand balance for debt and inflation each pose a threat.

And this week could also prove important for other reasons since we see a new trend developing in Washington DC – that of federal agencies “legislating” rules that are typically reserved for Congress. According to the Constitution, the power of the purse belongs only to Congress and all spending bills go through the Budget Committee in the House of Representatives, the legislative body that is closest to citizen voters. The Founders of our Constitution believed that the separation of powers would protect against “monarchy” and provide an important check on the executive branch. Keep in mind that our Founders fought against the British monarchy in the American Revolutionary War (1775 to 1783), and it was this experience that helped them to frame the Constitution in order to keep power with the people and not with politicians (or monarchy).

Nevertheless, after the Supreme Court ruled that President Biden did not have the authority to erase $400 billion in student debt without prior authorization from Congress, the Department of Education changed the rules on student loan repayment plans. Under Biden’s new effort, called the Saving on a Valuable Education plan (SAVE), “borrowers who originally took out $12,000 or less in loans and have been in repayment for 10 years are eligible to get their remaining debt canceled.” It also forgives debt for borrowers in public service for 10 years who have made 120 months of qualifying payments. In other cases, borrowers who have had loans for 20 years or more will see the remaining loan forgiven in total. Keep in mind that loan forgiveness impacts both the budget and deficits. It means less revenue to the Treasury and the likelihood of higher tax rates for others. There is no free money.

This week another agency, the US Federal Trade Commission, approved a rule to ban noncompete agreements commonly signed by workers in some industries. These agreements mean workers cannot just join their employers’ rivals or launch competing businesses without restrictions. According to the FTC, these agreements limit worker mobility and suppress wages and a ban should increase workers’ pay by $488 billion over the next decade and create 8,500 new businesses. (We would like to see that research!) Those who support the rule say it is necessary to rein in noncompete agreements, even in lower-paying service industries such as fast food and retail.

However, like many rules and bills coming out of Washington DC, we see both a risk and the possibility of unintended consequences. First, we doubt many minimum wage workers are asked to sign noncompete agreements. Lower-paying service industry workers tend to be supported by unions that fight for better conditions and better pay. But to the extent that nonunionized middle-level workers will have fewer barriers to switch jobs, this could force employers to increase salaries, which would be inflationary. Second, in many industries, worker knowledge, data, programs, systems, information, client lists, client relationships, etc. are proprietary and/or valuable assets of a company. The banning of noncompete agreements means this information can simply walk away and move to a competitor anytime a worker leaves the company. It could be very damaging to a business if there were no rules or agreements in place. And though there may be a need to set rules around noncompete agreements, the outright banning could be potentially harmful to many companies and to the economy.

Nonetheless, the more important issue may be that rules that impact federal and/or state finances, personal finances, or the ability of a corporation or entrepreneur to conduct business should be left to Congress, where it belongs. It should not be in the hands of anonymous unelected agency personnel in the executive branch. It simply challenges our Constitution.

New Housing Data

There were some signs of stress in recent housing statistics. Existing home sales for March fell to 4.19 million (SAAR) down 3.7% YOY, but the median price for existing home sales was $393,500, up 4.8% YOY. Newly constructed home sales were 693,000 units annualized, up 8% YOY, yet the median home price of $430,700, was down 2% YOY. From a broader perspective, the charts on page 3 show residential sales are well below both cyclical and historical peaks and home prices appear to have peaked in early 2023. Higher interest rates are apt to weigh heavily on the housing market in the coming months.

Existing home sales represent the bulk of housing transactions, but when combined with new home sales, it is clear that total sales, despite a recent increase, remain well below the average level seen over the last 30 years. Not surprisingly, total housing permits and starts for March were down on a year-over-year basis, although single-family housing activity was a bright spot for home builders. See page 4. In general, new home sales have done better in the last year than existing home sales, but builders have had to cut prices to generate demand. Existing home sales have been down on a year-over-year basis, but prices have remained relatively stable due to low inventory. In short, there are subtle signs of stress in both segments of the housing market. See page 5.

Technical Update

Last week we pointed out the technical breakout patterns in gold and silver. This week cocoa and coffee futures have had huge gains. These two commodities could increase food prices in the near future. See page 7. All four of the popular equity indices have recently tested their 100-day moving averages and to date, the rebounds from these levels have been successful. This is in line with a normal correction. However, note that the Russell 2000 appears to be slipping back into its long-term trading range of 1650 to 2000. See page 10. The 10-day average of daily new highs is now 57 and new lows are 94. This combination of new highs and new lows below 100 is neutral but note that new lows now outnumber new highs. This is not unusual in a correction, but both trends should reverse soon. In our view, the equity market remains vulnerable to inflation, rising interest rates, and disappointing earnings and we remain cautious.

Gail Dudack

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