Holding Down the Fort or Burning Down the House?

‍

American Roulette

‍

Soundbite: In our view, there is one bullet in the chamber that could trigger a market meltdown—the administration's restriction of Fed independence. For now, a one-in-six probability of a left-tail outcome is not enough for investors to be worried. However, with every passing day, the chamber is not re-spun to reset the odds— Instead, the probability of an unfortunate event ratchets higher. Janet Yellen said it all: “History offers a blunt lesson: chaos follows when leaders capture their central banks.” She reminded us that we are in danger of repeating the mistakes of World War II, when that administration dictated that the Fed hold rates down to help finance the war. At this moment, the consensus is not concerned about a repeat of that inflationary mistake.

While investors currently seem unfazed by the administration’s threat to Fed independence, the most important question is whether events are approaching a crisis point or whether there truly is no reason to worry.

Markets are an objective discounting mechanism, which means that so far, investors are looking through any

· Possible increases in inflation expectations or falling consumer demand from tariffs,

· Weakening labor demand, or

· Mega cap tech valuations that may be too optimistic given potential problems with data center buildouts.

But we are increasingly worried the ground underfoot is receding.

It may be as simple as the market’s understanding that with each successive click of the revolver, it will become clear to the administration that their actions will yield results that run counter to their long-term goals. But what if the goal is simply to control an agency as powerful as the Federal Reserve? Can that be spun positively?

It is possible that their actions will result in an an improved operating environment for the Federal Reserve, assuming its independence is preserved. However, if the powerful undercurrent is to dominate rather than develop, then complacency turns to alarm.

With this version of Russian roulette, you never really know when the bad outcome will arrive, but you know it is coming. Hopefully, we will avert the negative outcome and justify investor optimism. However, if signs emerge that the tide is turning, be prepared to act quickly.

‍

Bay(rou) Watch

‍

Soundbite: Will the fifth time be a charm for France’s Fifth Republic? That would be the number of Prime Ministers chosen since President Emmanuel Macron’s second term started in 2022. Current PM Francois Bayrou is trying to do the right thing by proposing to cut the deficit by $50 billion, but is blowing himself up politically. The proposed cuts match the amount of this year’s interest expense, which, alarmingly, is forecast to grow another 30% next year. The confidence vote scheduled for today will likely end up against Bayrou, forcing Macron to pick a new prime minister. At best, Macron is hobbled for the last two years of his term; at worst, he is forced into a Centrist alliance with the Socialists. Political instability is here to stay, and debt downgrade concerns could spark similar concerns in the U.S.

The political story, which gained political heft yesterday on news of Japan’s LDP Prime Minister Ishiba’s resignation, is the inescapable political uncertainty amidst a shift toward right-wing populism. The likely path is that Bayrou will lose the vote, and Macron must stitch together another unstable coalition, this time with the Socialists. In discussing this possibility, the current coalition partners, the Republicans, have stated that they would be forced into opposition with the far-right National Rally Party. The RN is the largest single party in the National Assembly, and favors French nationalism and loosening, but not breaking, ties to the EU. The resulting political shifts will bring further calls for Macron to step down, which he refuses to do. The introduction of impeachment legislation to the National Assembly is not out of the question, nor are even more strident general strikes.

This tempest may not be contained within French borders when thinking about the investment story.

There is a market cost to further turmoil. Bayrou’s move toward fiscal conservatism is running counter to Germany’s newfound interest in expanding its fiscal budget to become less dependent on the U.S. That fiscal liberalism has attracted capital to Germany, and other European equity markets have benefited. That capital may grow uncomfortable with the severity of the problems in the Continent’s second largest economy.

The recent political turmoil has pushed French 10-year yields to 3.6%, the same rate as Italy, and the chances of a debt downgrade have risen enormously. France’s debt is $4 trillion, about one-tenth that of the U.S. Therefore, one could argue that our deficit should be met with ten Bayrou’s in Washington calling for debt reduction. If the conversation of a French downgrade grows, expect the discussion to start up about the U.S. deficit, which has gone dormant but has not gone away.

‍

What’s So Magical About 2026?

‍

Soundbite: UBS gave a stark warning last week…sort of. The bank looked at three months of economic data spanning May through July and found it is consistent with prior downturns. However, their conclusion is that a full-blown recession will be avoided. We believe that their assumption matches the outlook of general investors: markets will accept short-term economic turbulence, but 2026 growth prospects keep optimism alive. It is this hope for a solid 2026 that has prevented an equity buyers strike, which could explain why our first Point’s warning has been ignored so far.

UBS described recent hard data releases in the U.S. as reaching “historically worrying levels.” Their quantitative model looked at the four areas that the National Bureau of Economic Research evaluates to forecast recessions (personal income and consumption, industrial production, and employment), and it has raised a red flag since February. However, the model’s output has not accelerated downward since, and the bank places a 52% probability on an economic slowdown.

The chief economist at Moody’s has come to the same conclusion, placing even odds on a recession hitting into yearend based on individual state data. Moody’s recession outlook would only be confirmed if California and New York contract, because those two states comprise over 20% of U.S. GDP. For now, both are stagnating, but not shrinking.

Because the UBS 2026 growth pickup forecast is shared by investors, could Friday’s weak employment data be a tipping point? We believe that weak labor demand could accelerate later this year despite a Fed easing campaign, and erase 2026 optimism. The high 4.3% unemployment rate has our attention, but we cannot dismiss the strong Labor Force Participation Rate among workers aged 25-54, which ticked up in August. That percentage of individuals who have a job or are actively looking has been above its pre-Covid peak of 83% for two years. Any drop below its current level of 83.7% back below the prior peak would be a warning that 2026 may not be so rosy.

This “soft now strong later” view will lose its magic if there is any downward acceleration in the other subcomponents of the employment report we follow, such as the Employment-Population Ratio, Manufacturing Employment, or Residential Construction Employment. We are seeing slight deterioration in these three. Equity bullishness is dependent on their strength because consumers who lose confidence in keeping their jobs stop spending, and that will prompt downgrades in next year’s revenue and earnings forecasts.

‍

What to Look for This Week

(All times E.S.T.)

‍

1. Wednesday, September 10, at 8:30 a.m. August Producer Price Index. Watch Core PPI Final Demand ex-trade services because it rose from 2.55% in June to 2.78% in July. PPI is followed on Thursday, September 11, at 8:30 a.m. by August’s Consumer Price Index data. For CPI watch Core, which had registered a subdued 2.8% from March through May, but has increased to 3.1% in July. The Cleveland Fed forecasts Core to be unchanged in August at 3.05%. We will be looking at electricity prices as well, given that soaring electricity prices are becoming a political issue. The FOMC will focus on the shelter index, which has fallen from a peak of 8.2% in March 2023 to a more reasonable, but still high 3.7% in July.

2. Thursday, September 11 Initial claims for the final week of August. The 4-week average of Initial Claims has fallen steadily since June, but has reversed recently, rising in each of the last three weeks. Continuing Claims have been elevated, holding near their 4-year highs since June.

3. Friday, September 12 at 10:00 a.m. University of Michigan Consumer Sentiment for September (preliminary poll result). There was a drop from April’s 4.4% reading for 5-Year Inflation Expectations to 3.4% in July, but August ticked back up to 3.5%. If there is any appreciable increase for September, it could become a factor in the September 16-17 FOMC interest rate discussions.

FOMC Voters Speaking: Saturday, September 6 starts the FOMC’s External Communications Blackout period until the statement’s release on Wednesday afternoon, September 17. The ECB is expected to keep rates unchanged at 2.15% on Thursday, September 11 at 8:15 a.m.

Earnings: Dwindling down continues with only 72 companies scheduled to report for the entire week: Monday, September 8 Oracle ORCL after market close will give even more color on the AI theme. Tuesday, September 9 GameStop GME after market close for the meme stock crowd. Thursday, September 11 Adobe ADBE reports after market close with RH, and the latter’s earnings conference may add insight into higher-end durable spending.

‍