The "Financialization" of the U.S. Economy: Yellen and Powell as the Gatekeepers of the U.S. Stock Market?

Recently, the U.S. Treasury Department released the federal finances for March and updated the latest budget, while the Federal Reserve also announced its decisions at the May interest rate meeting. Based on this latest information, let's delve into an updated understanding of the U.S. economy:

1. Reality Check: Paying Attention to the Risks of Financialization in the U.S. Economy

Why is the real economy becoming financialized? It mainly manifests in the following aspects:

Firstly, a high proportion of financial wealth in U.S. residents' wealth, with financial assets that ultimately translate into equities and bonds accounting for 43%, surpassing real estate. Therefore, fluctuations in stocks and bonds have a significant impact on residents' wealth.

Secondly, significant tax implications linked to financial assets in federal taxation

In federal revenue, individual income tax accounts for 42% of total revenue. However, about 40% of corporate taxes are withheld, while the remaining 60% is self-declared by residents, including interest, dividends, and capital gains.

Within this 60%, there is a significant correlation with income from financial assets such as stocks and bonds. For example, under the Reconstruction Act in 2024, if fiscal expenditure contraction is not feasible, and resident employment remains stable, the key tax increment then becomes the fluctuating financial assets.

Thirdly, the Decline in Savings Rate and the Dreamlike Linkage to Financial Asset Appreciation

One key factor enabling high GDP growth in the U.S. is the ability for resident consumption to outpace income growth under high employment and high income, thereby driving robust domestic demand in GDP (both in goods and services consumption) with a decreasing marginal increment in savings rate.

Therefore, the ability for the savings rate to continue declining, or even to remain at its current low level rather than reverting to the pre-pandemic 6-8%, is crucial for assessing the future economic growth momentum.

When a low proportion of current income is allocated to savings, the reasons generally include a) high cash reserves at home and strong debt repayment capacity (cash repayment capacity); b) asset appreciation. If both of these conditions are met simultaneously, with assets and cash on the balance sheet, coupled with strong current income generation (strong income statement), then there is hope for a marginal decline in the savings rate.

Looking at the current situation of U.S. residents' balance sheets, total assets have indeed continued to appreciate due to the inflation of financial assets, while the liquidity assets on the asset side, such as deposits, have a very strong savings capacity relative to debt repayment due to excess savings during the pandemic and good employment post-pandemic, eliminating the need to hold additional cash for repayment.

In other words, the three main factors supporting the decline in the current savings rate are good employment (linked to strong resident demand, to some extent mutually reinforcing), ample cash reserves, and the appreciation effect of assets (mainly the appreciation effect of risky assets) The combination of these three points means that the financialization risk of the U.S. economy is further increased, and financial fluctuations may have a significant secondary impact on economic growth, strengthening the pro-cyclical nature of the economy.

II. Dual Protection of the Federal Reserve and Treasury

Breaking down the above content, we can understand some actions of the current Federal Reserve and Treasury:

First, the Federal Reserve re-embraces the "Fed Put" function

The key information from the May interest rate meeting mainly includes two points:

a. The possibility of raising interest rates has been basically eliminated, with a clear statement that the current policy rate is "restrictive enough" to achieve the 2% inflation target. The issue now is when to start cutting rates and the pace of rate cuts. In a situation where monthly employment for residents is 200,000 and the savings rate for residents is decreasing, this decision-making approach itself is dovish.

b. The plan to slow down the pace of quantitative tightening has been officially announced: the passive selling of treasuries has been reduced from $60 billion per month to $25 billion, starting in June. The pace of MBS sales remains unchanged at $35 billion.

The background of this decision is that the liquidity withdrawn from last year's quantitative tightening was originally excess liquidity from previous excessive easing. Since the liquidity was withdrawn starting from May 2022, the withdrawn funds have been mainly from reverse repos, which are idle funds. The reserve requirements of banks have not been reduced at all. With a certain amount of space for reverse repos (currently $850 billion, corresponding to an average of $200-300 billion before the pandemic), the slowdown will begin in June, and a reduction of $35 billion has been directly cut, a move that exceeds Dolphin's prediction.

Regardless of the decision-making approach on benchmark interest rates in monetary price policy or the slowdown in quantitative tightening in monetary quantity policy, Dolphin believes that the current Federal Reserve is increasingly showing a loose monetary policy mindset behind the scenes, resembling the "Fed Put."

Second, high government spending still provides strong support for the economy

Looking at the fiscal budget, although the $1.5 trillion fiscal deficit is not as high as last year's massive $1.7 trillion stimulus, and this year's fiscal tailwind is not as strong as last year, comparing the absolute value and deficit rate before the pandemic, it is still relatively high In the past year, with overall high returns in the financial markets, the overall revenue situation of the United States in the first three months of this year has also performed well, driven by excess personal income.

In April, due to it being the tax season, the latest fiscal data for April showed even better performance: with higher individual income tax revenue collected from the household sector, the US federal government had a fiscal surplus of $210 billion in April, reaching nearly $300 billion excluding interest expenses.

However, even so, when the US Department of the Treasury announced its financing plan for the 7th to 9th months, it exceeded the market's original expectations. In the next quarter, assuming the Federal Reserve continues to sell $60 billion in treasury bonds each month, the Treasury Department plans to borrow nearly $850 billion from the market, while raising the target balance of the TGA account from the previous $750 billion to $850 billion.

Let's analyze this target:

The current balance of the TGA account is close to $820 billion, almost not needing to be filled relative to the increased target of $850 billion, so there is no need to tighten market funds.

Since the actual amount of treasury bond sales by the Federal Reserve has been $25 billion per month starting from June, instead of $60 billion, with other conditions unchanged, the Treasury Department's borrowing scale should be $750 billion.

Although it is not as high as previously announced, it is still not low (in September 2023, the fiscal debt ceiling was just lifted, issuing $850 billion), meaning that the fiscal "restraint" on spending can be almost ignored.

Mainly from the perspective of the announced debt maturity arrangement, the upcoming financing will still be dominated by short-term debt, rather than burdening the market with long-term debt. Therefore, with the Federal Reserve's reduced QT, the actual amount of fiscal financing is not that large.

After operating in this manner, the bank reserve balances closely related to the stock market trend will not be too depleted. With a combination of monetary and fiscal policies, the trading funds in the market will still be relatively abundant, making it difficult for the market to kill liquidity. The main focus will still be on corporate growth and profit expectations.

III. Rapid Return of Liquidity

Previously, it was mentioned in the portfolio strategy that the reason for the previous pullback in the US stock market, besides the rise in risk-free interest rates, was the rapid expansion of the TGA account balance during the mid-April tax peak, which absorbed market funds. However, after this situation lasted for two weeks, market liquidity has begun to marginally increase, no longer dragging down Financial Update

In terms of finance, after the tax season in April replenished the treasury, the Democratic government, known for its high spending, wasted no time in starting a spree of spending:

In the past two weeks, the reduction of assets on the Fed's balance sheet was achieved through a decrease in the balance of the Treasury General Account (TGA). The conversion of TGA into market funds increases the turnover of funds in real industries, promoting economic growth.

IV. Portfolio Rebalancing and Returns

With the U.S. earnings season over, based on the information from the released financial reports, Dolphin Jun has made some adjustments to the portfolio. Next, after clarifying valuations, more companies will be added to the portfolio, so stay tuned.

Last week, Uber and Luckin Coffee were mainly removed from the portfolio, for specific reasons as follows:

At the end of last week, the portfolio's returns increased by 0.4%, underperforming the CSI 300 (+1.7%), MSCI China (+1.9%), and S&P 500 (+1.9%), but slightly outperforming the Hang Seng Tech Index (-0.2%).

This is mainly because the Chinese concept assets in Dolphin Jun's portfolio had significant gains in the previous two weeks. As for the undervalued rebound stocks with weak logic, Dolphin Jun does not engage in short-term trading or allocate to them, resulting in smaller gains in the latter part. Last week, the rise was mainly driven by the increase in state-owned dividend stocks, which Dolphin Jun did not cover or allocate to.

Since the start of the portfolio testing until the end of last week, the absolute return of the portfolio is 36%, with an excess return compared to MSCI China of 52%. From the perspective of asset net value, Dolphin Jun's initial virtual assets of USD 100 million have now risen to USD 139 million.

V. Individual Stock Profit and Loss Contribution

Last week's fluctuations were mainly driven by the fundamentals of individual stock earnings season.

For the companies with significant increases and decreases in Dolphin Jun's holding and watchlist pools last week, as well as the possible reasons, Dolphin Jun's analysis is as follows:

VI. Allocation of Portfolio Assets

After Alpha Dolphin cleared its positions in Uber and Luckin, it currently holds 19 individual stocks and equity-type ETFs in its virtual portfolio, with 5 core holdings and the rest of the equity assets being underweighted, while the remaining allocation is in gold, US bonds, and US dollar cash. Currently, there is a relatively high amount of cash and cash-like assets, and in the coming weeks, there will be further increases in equity assets.

As of the end of last week, the asset allocation and equity holdings distribution of Alpha Dolphin are as follows:

VII. Key Events This Week

As the US earnings season draws to a close, the Chinese concept stock earnings season is intensifying. This week, Dolphin will cover the following companies, with a summary of the key points of interest for each company: