S&P 500 Records Its Second Straight Year of 20%-Plus Gains

Raymond James

Markets & Investing

January 02, 2025

December's market activity highlights the need for caution in the near term.

December added a question mark to the end of an otherwise strong year of growth for the equity markets. As inflation numbers continued to stagnate above its 2% year-over-year target, the Federal Reserve (Fed) – despite cutting current interest rates by another 25 basis points – expressed diminished confidence in inflation reaching its 2% target. Back in September, investors expected four rate cuts to arrive in 2025. Now the expectation is two. This news caused a chilling effect in the markets, resulting in a flat month for the S&P 500 and a 5.3% loss for the Dow Jones. Only three of 11 equity sectors were positive for the month.

Continuing a now-familiar trend, mega-cap tech stocks stood strong while volatility ruled elsewhere in the market. Small-cap stocks were hit the hardest, with the Russell 2000 dropping 7.8%, reflecting their perceived vulnerability to higher interest rates relative to their larger peers.

“We’ve been highlighting the need for caution in the near term as investors are over-optimistic and the market is priced for perfection, leaving it vulnerable to any disappointment,” said Raymond James Chief Investment Officer Larry Adam. “Longer term, we remain constructive on equities as solid economic growth should keep earnings on an upward trajectory.”

Before we dive into the details, let’s see how we ended 2024, the second year in a row when the S&P 500 saw gains of more than 20%.

*Performance reflects index values as of market close on December 31, 2024. Bloomberg Aggregate Bond and MSCI EAFE reflect Dec. 30, 2024, closing values.

Mixed signals on jobs

The U.S. economy added 227,000 jobs in November, a strong recovery following a weak – but revised upward – October report. The household employment survey, however, provided a different picture, showing a large decline in employment by 335,000 workers. This pushed the unemployment rate from 4.1% in October to 4.2% in November. Headline retail sales numbers remained strong in November – aided by car sales and online sales – but those strong spots hid weakness across other retail sectors. December’s report will be important to shed more light on the relative strength of consumer spending.

Bond yields soar as rate cuts become less certain

The Fed’s surprising tone on inflation and messaging about future rate cuts caused the 10-year Treasury yield to sharply jump from 4.17% at the end of November to 4.57% at the end of December. Despite continued historically low relative spreads, corporate and municipal bond yields have pushed higher along with Treasury yields. Income-producing investment portfolios benefit from the increased yield environment providing a continued opportunity to lock into higher income streams for longer. The upward-sloping curve present in both the corporate and municipal curves means that investors are rewarded for taking on longer spans of interest rate risk.

Incoming administration faces debt ceiling

Congress passed critical legislation preventing a government shutdown while allocating $110 billion to disaster aid and funding the $895 billion National Defense Authorization Act, which seeks to bolster telecom and cybersecurity defenses as well as establish the Department of Defense’s approach to China. With a new administration incoming and the current debt ceiling expiring on January 1, there are a few potential pathways forward – a clean increase, an increase coupled with energy reform or an increase with concessions like budget cuts from the Department of Government Efficiency (DOGE), a proposed presidential advisory commission whose actions are likely to be supported by the narrowly GOP-controlled house.

Agriculture crisis causes cocoa price spike

Throughout 2024, natural gas prices rose by more than 40% in both the U.S. and Europe, driven by a mix of rising demand and tight supply. Meanwhile, gold and silver also saw prices climb around 30%. But all of these commodities pale in comparison to cocoa, which is starting 2025 with prices 150% higher than at New Year 2024. This comes as a result of worsening drought conditions across West Africa, combined with a virus affecting cocoa plants specifically. In addition to making sweets costs more, the cocoa crisis is putting the squeeze on chocolate manufacturers’ margins.

Threats of U.S. tariffs and domestic political turnover cool European markets

In Europe, political turnover continued to drive uncertainty, this time as France’s President Emmanual Macron installed his nation’s fourth prime minister in a year. Meanwhile in Germany, Finance Minister Christian Lindner has been fired and domestic manufacturing suffers. Volkswagen, for the first time in the company’s history, is threatening to close manufacturing facilities. The eurozone also waits with uncertainty the incoming U.S. administration and its threats of import tariffs and the risk of a protracted trade war.

The bottom line

For the second year in a row, equity markets demonstrated powerful though uneven growth and the U.S. economy remained resilient, despite some dents in the armor. The corporate earnings outlook remains healthy, and while still above target levels, inflation has declined – even if in fits and starts. There are clearly perceivable risks – inflation, consumer spending, investor confidence, international trade – but at the end of 2024, the outlook for 2025 is positive.


Investing involves risk, and investors may incur a profit or a loss. All expressions of opinion reflect the judgment of the Raymond James Chief Investment Officer and are subject to change. There is no assurance the trends mentioned will continue or that the forecasts discussed will be realized. Past performance may not be indicative of future results. Economic and market conditions are subject to change. Diversification does not guarantee a profit nor protect against loss. The Dow Jones Industrial Average is an unmanaged index of 30 widely held stocks. The NASDAQ Composite Index is an unmanaged index of all common stocks listed on the NASDAQ National Stock Market. The S&P 500 is an unmanaged index of 500 widely held stocks. The MSCI EAFE (Europe, Australasia and Far East) index is an unmanaged index that is generally considered representative of the international stock market. The Russell 2000 is an unmanaged index of small-cap securities. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. An investment cannot be made in these indexes. The performance mentioned does not include fees and charges, which would reduce an investor’s returns. Companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification. A credit rating of a security is not a recommendation to buy, sell or hold the security and may be subject to review, revision, suspension, reduction or withdrawal at any time by the assigning Rating Agency.  Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Income from municipal bonds is not subject to federal income taxation; however, it may be subject to state and local taxes and, for certain investors, to the alternative minimum tax. Income from taxable municipal bonds is subject to federal income taxation, and it may be subject to state and local taxes. Investing in commodities is generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. The Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. The Leading Economic Index (LEI) provides an early indication of significant turning points in the business cycle and where the economy is heading in the near term. This is not a recommendation to purchase or sell the stocks of the companies pictured/mentioned.  Investing in small-cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor. The prices of small company stocks may be subject to more volatility than those of large company stocks. The Nikkei 225 is a stock market index is for the Tokyo Stock Exchange (TSE). It is the most widely quoted average of Japanese equities. Sector investments are companies engaged in business related to a specific sector. They are subject to fierce competition and their products and services may be subject to rapid obsolescence. There are additional risks associated with investing in an individual sector, including limited diversification.

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Jimmy Carter, RIP

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 30, 2024

Jimmy Carter, the thirty-ninth president of the United States passed away this weekend, at age 100, the first former president to ever reach that milestone.

The Election of 1976, when Carter won, seems like it happened in a different country. The Democrats swept all the states of the Confederacy with the exception of Virginia. The Republican candidate, Gerald Ford, won a large group of states that included Illinois, Vermont, Connecticut, New Jersey, California, Oregon, and Washington. (Look it up if you don’t believe it!)

Although many political and economic conservatives still associate the Carter presidency with economic mismanagement, high inflation, and recession, his Administration’s policy choices and experience were not unique to his Administration.

Yes, inflation hit double-digits under Carter, but it did so in the Nixon Administration, as well. Yes, Carter tried to fight inflation by imposing credit controls on the banking system, but the Nixon Administration imposed economy-wide wage and price controls to try to address inflation.

Yes, Carter’s first choice to lead the Federal Reserve was G. William Miller, a lawyer with no particular insight into monetary policy or fighting inflation. But, when the going got rough, he replaced Miller with Paul Volker, who brought inflation back under control and was later re-appointed by President Reagan. Nixon’s Fed chief was Arthur Burns, who supported tight money when he was an academic but then bent over backwards to appease Nixon’s desire for loose money when running the Fed.

In the meantime, Carter was willing to take on many special-interest economic sacred cows and deregulate major parts of the US economy. Believe it or not, before Carter, bureaucrats in Washington, DC at the Civil Aeronautics Board (CAB) would set the ticket price for every seat on every airline that flew. They controlled which airlines flew which routes and only allowed airlines to use amenities, like food or seat-types, to compete. That’s why back then flying was expensive and unusual for the broad middle-class and below.

Carter appointed Alfred Kahn, who despised regulation, as his inflation czar. While most don’t remember, Kahn was a lightning rod, much like Elon Musk is today. He was outspoken and got in trouble for talking about “recession,” so he started to call it a “banana.” The banana industry got upset, so he then called it a “kumquat.” And all this happened before Twitter or X, or any modern social media existed.

Kahn tried to resign, but Carter wouldn’t let him, and appointed him to head the CAB. He is the only agency head in the history of Washington, DC to take over an agency and then dismantle it. The Civil Aeronautics Board is gone, and airline deregulation happened because of Kahn and President Carter.

The Carter Administration also led on deregulating trucking. We understand this is going to sound completely ridiculous, maybe even made-up, but before Carter a truck that left one state with a load and delivered it elsewhere was required to go back empty to the original state before it could make another round trip. (Seriously, we are not making this up!)

In addition, the Carter Administration led the fight to deregulate government rate-setting for trains and remove restrictions on long distance phone service. Older readers will remember their parents telling them to hurry up when talking to friends or relatives long-distance because it cost so much more!

The Carter-era, in general, happened before tribal politics made it impossible for the left to trust free markets. In addition to deregulating so many sectors, Carter supported a cut in the capital gains tax rate, in effect reducing the top tax rate on long-term gains to 28% from a prior 35%. Yes, Reagan then cut it to 20% for several years, but Carter cut it first.

Today the greatest economic challenges are different than in the late 1970s, but in remembrance of President Carter, we suggest politicians in DC think back to that era. Learning from history is important. Deregulating industries helped the American people with lower prices and more choices. Today, the US economy is like Gulliver tied up by a thousand strands of thread by the Lilliputians. Carter was the one who started to cut those threads.

Let’s do it again.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

We Need Peter Doocy at a Fed Presser

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 16, 2024

The most fun anyone has had at a Jerome Powell presser was when a reporter asked about President Trump removing Powell from his job. Otherwise, almost all the questions are about when and how much the federal funds rate will be cut.

The reason we bring this up is that there are only certain reporters allowed in the Fed’s press briefing, and, other than hearings on Capitol Hill, it’s the only chance the nation has to ask questions. If a member of the Press Corp asked about New Jersey drones, they might not get invited back. But it seems to us that there are very obvious and important questions that never get asked. Who will be the Peter Doocy of the Fed Press Corp?

So, just in case there is a member of the press who is willing to push the envelope here are a few questions we suggest.

First, about two years ago the Fed drew attention to something called “SuperCore” inflation, which excludes all goods, food, energy, and housing rents. At the time, SuperCore inflation was running less hot than overall inflation. Today, the CPI version of SuperCore is up 4.3% in the past year and is running hotter than it was a year ago. The PCE version is likely to be up at least 3.5% in the year ending in November, well above the Fed’s 2.0% inflation target. And yet the Fed now seems to ignore SuperCore. What changed? Did the Fed have second thoughts about the usefulness of SuperCore? If so, why did the Fed change its mind? Or did the Fed stop talking about it because the message from SuperCore is that inflation is nowhere near stabilized?

Second, the M2 measure of the money supply soared more than 40% in the first two years of COVID, and what followed was the highest inflation in four decades. The M2 money supply then dropped and, initially, inflation dropped fast. Do you think these were just coincidences, or do you think keeping track of the money supply might actually help the Fed predict future inflation trends? Do you know of any other measure that did a better job of predicting the COVID-era inflation trends than M2? If so, why weren’t you using it before the high inflation hit or back when you were claiming inflation was “transitory?”

Third, the Fed has been running operating losses of about $100 billion per year for each of the past two fiscal years. Those operating losses are covered by the Treasury Department out of general revenue. And yet Federal Reserve Banks around the country, and perhaps even at the Board of Governors itself, are still paying for and publishing non-monetary research.

For example, the Chicago Federal Reserve Bank is very concerned about childcare and lead water pipes. There are multiple other government agencies that focus on these issues. Doesn’t the Fed feel a responsibility, at a time when it’s running huge losses, to at least temporarily stop spending taxpayer money on these activities? How much of the research in the past two years is on topics outside the Fed’s jurisdiction, which, under law, is supposed to be monetary policy and bank regulation? What other initiatives outside these key topics are the Fed funding with taxpayer money? Do you think the Fed itself should be the sole arbiter of what kind of research it pays for? Is there any dollar limit the Fed should have on research and other spending?

Unfortunately, we doubt anyone in the press will ask Powell these questions. Maybe the new Department of Government Efficiency (DOGE) will ask. Somebody needs to. The Fed’s balance sheet has grown about 7X (700%) since the start of QE in 2008, and it seems that it has done so with very little oversight, from Congress, the White House, or the Press Corp.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Abundant Reserves, Abundant Losses: Fed's Q3 Financials

First Trust Three on Thursday

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 12, 2024

In this week’s edition of “Three on Thursday,” we look at the Federal Reserve’s financials through the third quarter of 2024. Back in 2008, the Federal Reserve (the “Fed”) embarked on a novel experiment in monetary policy by transitioning from a “scarce reserve” system to one characterized by “abundant reserves.” In addition to inflation, this experiment has resulted in some other developments that are worrisome. Higher interest rates have resulted in substantial unrealized losses on the Fed’s securities portfolio. Simultaneously, they have caused the Fed to pay out more in interest to banks than it is earning, resulting in sizable and ongoing operating losses. To offer deeper insights into where things stood through the third quarter of this year, we have included the two charts and table below.

Before 2022, the Fed earned more from its Treasury and mortgage-backed securities (MBS) than it paid banks. At the peak a few months ago, the Fed was paying an annualized 5.40% on reserves. Today, it pays banks 4.65% annually to hold reserves, exceeding its income from these assets, leading to significant quarterly operating losses for eight consecutive quarters. While losses will persist, they should lessen as the Fed continues to cut rates. The Fed plays fast and loose with accounting and labels these losses as a deferred asset on its balance sheet. It appears that the Treasury is lending the Fed money against this deferred asset, plus enough to cover its operating expenses. This is all based on the Fed’s promise to repay the Treasury when it returns to profitability. In Q3 2024, net earnings remittances to the Treasury were -$20.3 billion, with the deferred asset now sitting over $200 billion.

The Fed has over $800 billion in unrealized losses on its balance sheet, but it’s important to note the unique position it’s in. Unlike many financial institutions, the Fed doesn’t face solvency concerns because it’s not required to mark its portfolio to market values. The Fed has the option to hold its securities until they mature, and there’s no regulatory agency that can intervene and force it to shut down due to accounting losses. With total reported capital of just $43.4 billion in Q3 of 2024, the Fed’s unrealized loss of $818.4 billion represents more than 18 times its capital.

The real beneficiaries in recent years have been banks and financial institutions, which earned $57.2 billion in Q3 alone from just holding reserves and reverse repurchase agreements. As the Fed continues to cut rates and shrink its balance sheet, interest payments to these institutions will decline. However, costs are still projected to remain high, we estimate at over $200 billion for 2024. These expenses are ultimately borne by taxpayers.

There is no guarantee that past trends will continue, or projections will be realized. This report was prepared by First Trust Advisors L.P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Irresponsible and Addictive Deficits

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 9, 2024

Why hasn’t tighter monetary policy caused a recession? One reason: federal budget deficits have been huge. Don’t get us wrong, we don’t believe government spending is good for the economy in the long-run. But, in the short-run, it certainly can make things look and feel, better. Just ask Amazon, which basically doubled its workforce during COVID as people spent their pandemic payments buying stuff, instead of paying off student loans.

The budget deficit soared to 14.7% of GDP in Fiscal Year 2020 and was followed in 2021 by a deficit of 12.1% of GDP. They were the two largest deficits as a share of the economy since World War II, larger than in the 1981-82 recession and the Great Recession and Financial Panic of 2008-09.

Meanwhile, the M2 measure of the money supply soared. M2 rose a massive 41% in the twenty-five months during COVID. As a result, CPI inflation took off – peaking at 9 %.

However, after peaking in March 2022, M2 declined 5% by October 2023 and has since grown only 3% in the past year. Normally that kind of slowdown in M2 would be followed by a recession, but the economy grew a hardy 3.2% in 2023 (Q4/Q4) and appears headed for growth of about 2.6% in 2024, which is above the 2.1% trend of the past twenty years.

We think one of the reasons for continued growth in the face of tighter monetary policy is that the federal budget blowout never really stopped.

The federal budget deficit was 6.2% of GDP in FY 2023 and 6.4% in FY 2024, which ended on September 30. Let’s put these in historical perspective. During the 1980s, President Reagan was consistently criticized for running overly large budget deficits. He was criticized by the Democrats, the opposition party at the time; he was criticized by the media (Sam Donaldson comes to mind); he was even criticized by many of his fellow Republicans. And yet the largest deficit ever run under Reagan was 5.9% of GDP in FY 1983.

But Reagan had two pretty good excuses for that deficit. First, he was fully funding the Pentagon at the height of the Cold War. Second, and more important, the unemployment rate that year was 10%, meaning spending on unemployment and welfare were elevated.

There are no similar excuses for the past two years. In the past two fiscal years the unemployment rate averaged less than 4% and we aren’t at war. We get that Keynesians want stimulative budget deficits when the unemployment rate is high; but no serious Keynesian, much less a supply-sider, can intellectually support current deficits.

We think the enormity of these deficits, relative to economic conditions, have temporarily masked or hidden some of the pain we will eventually feel from the tightening of monetary policy in the past couple of years. In turn, this means the US is not yet out of the woods on recession risk in spite of the great optimism now embedded in US equity prices.

Also notice how little extra bang for the buck the US is getting out of these deficits. Keynesian theory suggests extra government spending should generate multipliers that can make growth soar. Yes, the economy is still OK so far, but soaring it is not.

The big question for the next few years is how quickly the federal government can wean itself from an addiction to big budget deficits and whether it can successfully implement progrowth policies at the same time. In other words, will the loss of deficit stimulus (if DOGE is successful at cutting spending) be offset by a productivity boost from less regulation and more certainty on tax rates in the future?

If government spending really is cut, and the government becomes a smaller burden on the private sector, that will boost growth – in the long-run. However, roughly 50% of new jobs in the past year were in government and healthcare (which is dominated by government). That boost to growth will recede when spending is cut in the short-term.

If the Fed tries to offset the short-term hit to growth with easier money, then inflation could easily flare up again. Quitting any addiction is painful in the short-term, but positive in the longterm. The next few years will be interesting for sure.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Inflation Distractions

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 2, 2024

It’s hard to keep track of all the theories about inflation. Remember policymakers and analysts blaming the surge in inflation in 2021-22 on supply-chain disruptions, too much government spending, and Putin invading Ukraine? Now some are saying that tariffs and deportations are going to cause a second surge in inflation.

The problem with all these theories is that they ignore the ultimate cause of inflation, which is too much money chasing too few goods. Why did inflation surge in 2020-21? Because in the 25 months ending in March 2022 the M2 measure of the money supply rose an unprecedented 40.6%. That’s why!

We’re not saying supply-chain disruptions were meaningless. If businesses couldn’t get a hold of the inputs they needed to make a product then of course the price for that particular item went up. But if consumers had to pay more for that item then that meant less money left over to buy other items – and roughly zero net change to inflation – unless the Federal Reserve changed the growth rate of the money supply, which is exactly what happened.

The same goes for the link between more government spending and inflation. Yes, without that spending some of the extra inflation might not have happened, but the spending itself wasn’t the key behind higher inflation: the key factor was that the Fed accommodated politicians’ desire for more spending by letting the money supply rip.

But now there are new theories to contend with, like the oncoming Trump tariffs or deportations of illegal immigrants causing a resurgence in inflation. There is plenty of room to argue about the merits of these policies on other grounds, but general price inflation is not one of them. President Trump raised tariffs and reduced immigration back in his first term, and CPI inflation averaged 1.9% annualized.

Yes, tariffs on certain goods will put upward pressure on prices for those particular goods. But unless the Fed starts increasing the money supply faster, that will mean countervailing downward pressure on prices for other goods and services.

The argument that low immigration (or even negative immigration) would boost inflation is even worse. Advocates of high immigration have always argued that newcomers don’t take jobs away from natives or reduce their wages because immigrants bring not only labor supply but also labor demand. Fair enough. But if that’s true, shouldn’t deportations reduce not only supply but demand, as well?

Immigration has surged since early 2021 and yet inflation has averaged 5.0% per year, the most in decades. If we can have high immigration and high inflation, we think the Fed can get to low inflation with low immigration, as well.

None of this is to argue that inflation hasn’t been a problem or won’t continue to be a problem in the years ahead. We think the bipartisan low inflation consensus that prevailed prior to the Great Recession and Financial Crisis of 2008-09 is dead and expect inflation will average 2.5% or more in the decade to come. But that’s because we think the Fed will conduct a looser monetary policy, not because of tariffs, government spending, deportations, supply-chains, or Putin.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Budget Rule Shenanigans

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 25, 2024

The Tax Cut and Jobs Act (TCJA) was passed in 2017, otherwise known as the Trump Tax Cuts. Because of arcane budget rules, the TCJA will “sunset” or expire at the end of 2025 in the absence of a brand-new tax law. The potentially expiring tax cuts include those on regular income as well as estates and qualified small businesses.

In turn, a key legislative problem throughout the process will be biased budget rules. You’d think that just keeping the tax code the same as it was this past year wouldn’t take any special political effort at all, but that’s not how it works.

Tax legislation must be “scored” by the Joint Committee on Taxation (JCT) and the Congressional Budget Office (CBO), in order to estimate the impact on revenues in future years. If the JCT and CBO compare current tax rates to the rates that existed before the TCJA, they call it a tax cut all over again. This scores as a cut in revenue (therefore a boost in the deficit from its current path), and 60 votes in the US Senate are necessary to make the new law permanent.

The other option is to find “pay fors” – offsetting tax hikes or spending cuts – that would “pay” for the tax cuts. If there aren’t 60 Senate votes or enough “offsets,” a tax cut can be made “temporary” as long as it fits inside other arcane rules. This is what happened in 2017. It’s why the TJCA expires in 2025.

So, the same issue will come up next year when the Trump Administration tries to extend the current tax rates. Senate rules say that if tax rates stay at the exact same level they are today, this will “cost” approximately $4 trillion in revenue over the next 10 years. Therefore, the Senate needs 60 votes to do this.

The problem is that the CBO and JCT were totally off on their forecasts of tax revenue back in 2018 when they scored the TCJA. In April 2018, the CBO said revenues would be $4.4 trillion in 2024. The were actually $4.9 trillion. Inflation, you say? OK…the CBO estimated that tax revenues would average 17% of GDP between 2021 and 2024, but they actually averaged 17.7% of GDP. To put this in further perspective, from 1974- 2023, the average federal tax share of GDP has been 17.3%.

In other words, the tax cuts did not lose anywhere near the revenue the CBO projected. Prior to the TCJA, the CBO said revenues would rise to 18.1% of GDP between 2021 and 2024. They estimated the TCJA would drop that to 17% of GDP, when in reality it averaged 17.7%. Why? Because government scores tax rate changes “statically.” But we all know the world is not static. Behavior changes when people face different incentives, and tax rates are a big one.

The biggest problem today is not tax revenues…it is spending. Back in 2018, the CBO forecasted that total public debt would be $22.9 trillion at the end of FY 2024. The actual figure was $28.3 trillion. Congress never has a problem spending more, and the rules are biased against tax cuts.

It is true that tax rates are “scheduled” to rise in 2026 and the CBO estimates this will raise revenue. But the CBO underestimated revenue after the TCJA. So, if Congress cannot find a way to say “extending current tax rates costs nothing,” the least it can do is admit that it underestimated the loss in revenue by 0.7% of GDP (17% vs 17.7%). That would mitigate more than 60% of the costs of extending the TCJA. Revenues did not fall from 18.1% of GDP to 17%...they were actually 17.7%.

Without moving to dynamic scoring, the government must pay for tax cuts with spending cuts or other tax hikes. In the past, Congress has scored potential savings from new rules in its budget, so why not score DOGE (the Musk-Ramaswamy enterprise) as cutting spending, even if it will come at some later date? Who actually thinks they won’t be somewhat successful?

The most frustrating part of all this is that if a new Administration and Congressional majorities wanted to raise taxes rather than reduce taxes the same burdensome legislative hurdles would not apply. A bill to raise taxes would be assessed using static scoring – no slower economic growth – and would show revenue going up, and then be allowed as a permanent change to the tax code, with no need for periodic temporary extension bills like tax cutters will have to pass next year. That is totally unfair!

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Don’t Forget the Lags

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 18, 2024

In our lifetimes, the best comparison for Trump’s election win is Ronald Reagan’s in 1980. That election, like this one, pitted big spenders and champions of government against tax cutters and critics of government.

It is pretty clear that markets approved of both winning campaigns as they were happening. Leading up to the election in 1980, like this year, the S&P 500 rallied as it became clearer that Reagan (like Trump) was likely to win. The market also rallied in the days following the election because markets like tax cuts, deregulation, and restrained government. And, at the same time, the policies the markets didn’t like – such as a tax on unrealized capital gains – were now dead.

But after being euphoric at the outcome of the election in 1980, reality set in. Paul Volcker was fighting inflation with tight money, a recession was inevitable and tax cuts took time to pass. The S&P 500 fell in 1981 and in the first eight months of 1982 before the Reagan bull market really started.

History doesn’t repeat itself, but at times it rhymes. And while there are similarities between today and 1981, there are also some key differences. For example, the Federal Reserve is now cutting interest rates, not raising them. However, there are some big differences that investors need to pay attention to. First, in October 1980, the Price-Earnings ratio of the S&P 500 was 8.6. In October 2024, the PE ratio was 27. In other words, while the market may appreciate better policies, it sure looks like they are already priced in.

Moreover, while Trump is selecting his cabinet rapidly and his team has likely already done the homework needed to move fast on executive orders that can boost growth, much of the real work will take time. It appears Congress wants to move fast, but it is still Congress and that means it’s messy.

Reagan cut tax rates across the board, Trump plans to maintain most current tax rates with some small changes, and promised to eliminate taxes on tips, social security, and overtime. These tax cuts are welcome, but they are not true supply-side tax cuts…the ones that boost entrepreneurship and innovation.

The really powerful potential of the Trump plans will come from DOGE, the Department of Government Efficiency, where Musk and Ramaswamy plan on proposing big cuts to the fourth branch of government – the Bureaucrats. Every regulation that they can cut, every bureaucrat that they can keep from gumming up the private sector, will boost productivity.

But in addition to cutting red tape, the US must cut the absolute size of government. John Maynard Keynes wanted deficit spending ended after a crisis was over. But, after both the Panic of 2008 and COVID, the US kept spending elevated. Government spending has risen from 19.1% of GDP in 2007 to 23.4% this year. Government is a ball and chain on the economy. We estimate that every one percentage point increase of spending as a share of GDP reduces underlying real GDP growth by 0.2%.

Every dollar the government spends is taken from the private sector, and the government taxes and borrows nearly 5% more of GDP today than it did seventeen years ago. From 1990 through 2007, real GDP grew 3% per year. From 2008 through the second quarter of 2024, real GDP has only grown 2% per year. No wonder “the economy” was the #1 factor for Americans in this election. Two percent annual growth is stagnation.

And this shouldn’t be happening according to fans of big government. Economists like Mark Zandi and Paul Krugman support government spending and argue that it has a positive multiplier ($1 of government spending creates more than $1 of GDP). Add this to the fact that the US has invented unbelievably productive new technologies in the last 17 years, and the economy should be booming. Especially with the Fed holding rates at zero for nine of those years.

But it hasn’t, and the reason is that government is just too darn big. Cutting government spending is a double-edged sword. Half of all job growth in the past year has been in government jobs directly, as well as healthcare which is dominated by government. Taking away that spending will initially slow job growth, but, with a lag, eventually boost economic activity.

In other words, the Trump Administration has a chance to boost underlying economic growth rates, and that would be extremely positive for living standards and equity values over the long-term. But initially, it may result in slower growth. The US had a car wreck with COVID. Easy money from the Fed and big deficits were like morphine. The US is addicted to short-term fixes that do nothing to boost long-term growth. Withdrawal from the pain killers hurts, but is necessary to get truly healthy.

While we are extremely positive about the long-term benefits of policy changes, like under Reagan, weaning the US from massively easy fiscal policies does not guarantee overnight success. It will take time, and the US will come through to the other side stronger. The entire world will benefit…with a lag.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The Fed's Challenge

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 11, 2024

The Federal Reserve cut short-term rates by a quarter percentage point last week, like pretty much everyone expected. In addition, the Fed didn’t push back hard against market expectations of another quarter-point cut in mid-December, so unless the economic or financial news changes dramatically by then, expect a repeat at the next meeting.

It's not hard to see why the Fed has been cutting rates. The consumer price index is up 2.4% in the past year versus a 3.7% gain in the year-ending in September 2023. Meanwhile, the PCE deflator, which the Fed uses for its official 2.0% inflation target, is only up 2.1% in the past year while it was up 3.4% in the year ending in September 2023.

However, in spite of getting into the Red Zone versus inflation, the Fed isn’t yet in the End Zone, and it looks like progress has recently stalled. According to the Atlanta Fed, the CPI is projected to be up 2.7% in the year ending this November while PCE prices should be up 2.5%.

It's also important to recognize that a few years ago the Fed itself devised a measure it called Supercore inflation, which excludes food, energy, all other goods, and housing. That measure of prices is still up 4.3% versus a year ago, which is probably why the Fed has stopped talking about it.

Moreover, it’s important to recognize that there’s a huge gulf between the policy implications of the Fed reaching its 2.0% inflation goal and the public’s perception of inflation no longer being a problem. Right or wrong, for now, the public seems to think that for inflation to no longer be a problem prices would have to go back down to where they were pre-COVID.

But that’s not going to happen. The federal government spent like drunken sailors during COVID and the Fed helped accommodate that spending by allowing the M2 measure of the money supply to soar. M2 is off the peak it hit in early 2022, but it would take a much greater reduction than so far experienced to restore prices as they were almost five years ago.

Instead, getting to 2.0% inflation means eventually accepting not only that prices aren’t going back to where they were but they’re going to keep rising, albeit at a slower pace.

And remember, even that goal has so far remained elusive. The embers of inflation continue burning. And since we have yet to see a significant or prolonged slowdown in growth, much less a recession, it remains to be seen whether inflation will reach 2.0% or less on a consistent basis. The bottom line is that the Fed’s inflation goal remains elusive. In turn, that means don’t be surprised if the Fed pauses rate cuts early next year.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Markets are Smarter than Government

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 28, 2024

To paraphrase Milton Friedman: There are four ways in which you can spend money. You can spend your own money on yourself. You can spend your own money on somebody else. You can spend somebody else’s money on yourself. Finally, you can spend somebody else’s money on somebody else.

Spending your own money (whether on yourself or on someone else) means you will care about it. But, when you spend somebody else’s money, especially on somebody else, you don’t care how much you spend or what you get for it.

We were reminded of this recently when reading the news. Google and Amazon inked what are likely multiple-billion-dollar deals with power companies to build small scale, modular nuclear reactors. At the same time, Microsoft has agreed to pay for the revival of the shuttered Three Mile Island nuclear power plant in Pennsylvania.

Why? Because they want to power their own insatiable needs for electricity that will come from data centers to support generative Artificial Intelligence (AI). Solar and Wind won’t get the job done because they are intermittent power sources. To efficiently run an AI data center they need non-stop, reliable, 24/7 electricity. For green energy, that’s nuclear!

What’s so amazing about this is that the Green New Deal movement shunned nuclear power. California, Michigan, and Germany have all closed nuclear plants in a single-minded mission to only use solar and wind. We assume they believe using natural things, like sunlight and wind is better than using man-made things, like nuclear energy. Otherwise, these decisions make no sense.

But isn’t that what spending other people’s money is all about? You don’t have to care about how it is spent. And boy did they spend.

In the past 20 years, governments around the world have spent or have incentivized companies to spend $18.8 trillion dollars on green energy and just 1.4% of that was on nuclear. Last year alone, the total was $3.5 trillion, with less than 1% going toward nuclear. As we said, many governments have shut down nuclear power plants.

Interestingly, over 40% of this spending was based on what the movement calls “sustainable debt issuance,” which includes government subsidized loans. We have always believed much of this investment would not have been made without government subsidies, including the Federal Reserve holding interest rates below the rate of inflation for 80% of the time during the past fifteen years, with nine of those years at near 0% interest rates.

Unfortunately, it isn’t sustainable…while few focus on this, this area of the debt markets is likely to have problems in the future. How do we know? Because when it comes to spending their own money, Google, Amazon, and Microsoft aren’t relying on the politically-favored flavors of energy.

They are buying electricity provided by nuclear power. When you have to spend your own money, you go with what works, not what is politically palatable with the greens. Let’s go back to markets…that’s actually the only sustainable course.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Inflation Simplified

First Trust Economics

Three on Thursday

Brian S. Wesbury - Chief Economics

October 24, 2024

Milton Friedman famously stated, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can only be caused by a more rapid increase in the quantity of money than in output.” Contrary to popular belief, inflation doesn’t stem from rising wages, greedy businesses, government deficits, or even rapid economic growth—it results from the excessive printing of money. In this week’s “Three on Thursday,” we break down inflation in the simplest terms. This is especially relevant today, as many people attribute the significant inflation of recent years solely to massive government spending or supply chain disruptions. However, these factors alone weren’t the root cause. For a deeper dive, explore the three graphics below.

Imagine a simple economy with only $10 and 10 apples. Since there are no other goods, each apple costs $1. Now, suppose the federal government wants to spend $2. The government typically spends money by either taxing or borrowing from the people who hold those dollars. So, let’s say they decide to tax $2 from the rich apple growers and give the $2 to others. After this, there are still $10 circulating in the economy—$2 that government redistributed and $8 with the other holders. Nothing fundamental changes: the total money in the economy remains $10, and there are still 10 apples, so each apple still costs $1. This illustrates why government spending, in itself, does not directly cause inflation. The money supply hasn’t increased; it’s just been redistributed.

Inflation occurs when the money supply grows faster than the amount of goods and services available. Let’s consider a scenario where the Federal Reserve increases the money supply by 30%, from $10 to $13. What happens next? If the production of apples doesn’t increase by the same 30%, and remains constant at 10 apples, each apple will now cost $1.30 instead of $1. This is because there’s more money in the system, but the number of goods (in this case, apples) hasn’t changed, leading to more money chasing the same amount of goods— inflation! Looking at what happened in 2020 and 2021, the money supply in the U.S. grew by 40% in less than two years! However, production didn’t increase nearly as much. As a result, there was significantly more money in circulation chasing only a slightly larger number of goods, causing the inflation we experienced.

Let’s enhance the scenario by considering the impact of government regulation. Initially, we planned to produce 10 apples, but the EPA says the herbicide we use is bad for the spotted-bluejay, so we can’t use it, and only 5 apples can be produced. This means that while the money supply has increased by 30%, production has dropped by 50%. As a result, the price of each apple rises to $2.60. We eventually invent a new herbicide after immense expense allowing production to return to 10 apples. However, even then, the price will remain elevated at $1.30 due to the earlier inflation. It’s only when production increases to 13 apples that prices can return to the original $1 per apple.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

GDP Growth Still Solid

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 21, 2024

With third quarter GDP being reported next Wednesday – less than a week before election day – the US is still not in recession.

Yes, monetary policy has been tight, but the lags between tighter money and the economy are long and variable. In addition, massive budget deficits continue to provide incomes for a wide range of occupations. The official figures for Fiscal Year 2024 arrived Friday afternoon (isn’t it just like the government to announce bad news right before the weekend!) and the deficit was $1.832 trillion, or what we estimate to be 6.4% of GDP. That’s the second straight year with a deficit in excess of 6.0% of GDP, in spite of an unemployment rate averaging less than 4.0%. These deficits, which are unprecedented in size given peacetime and low unemployment, may have temporarily masked the effects of tighter money.

Meanwhile, innovators and entrepreneurs in high-tech industries and elsewhere have been overcoming government obstacles to push the economy forward. It’s hard to tell how much each factor (government spending or innovation) deserves credit for recent GDP growth, but roughly half of job creation in the past year has been in government and healthcare.

In the meantime, we estimate that Real GDP expanded at a 3.0% annual rate in the third quarter, mostly accounted for by growth in consumer spending. (This estimate is not yet set in stone; reports on Friday about durable goods and next Tuesday about international trade and inventories might lead to an adjustment.)

Consumption: In spite of tepid auto sales, overall consumer spending continues to rise, possibly because of continued government deficits. We estimate that real consumer spending on goods and services, combined, increased at a 3.5% rate, adding 2.4 points to the real GDP growth rate (3.5 times the consumption share of GDP, which is 68%, equals 2.4).

Business Investment: We estimate a 1.7% growth rate for business investment, with gains in intellectual property leading the way, while commercial construction declined slightly. A 1.7% growth rate would add 0.2 points to real GDP growth. (1.7 times the 14% business investment share of GDP equals 0.2).

Home Building: Residential construction dropped in the third quarter, hampered by the lingering pain from higher mortgage rates as well as local obstacles to construction. Home building looks like it contracted at a 5.0% rate, which would subtract 0.2 points from real GDP growth. (-5.0 times the 4% residential construction share of GDP equals -0.2).

Government: Only direct government purchases of goods and services (not transfer payments) count when calculating GDP. We estimate these purchases were up at a 1.8% rate in Q3, which would add 0.3 points to the GDP growth rate (1.8 times the 17% government purchase share of GDP equals 0.3).

Trade: Looks like the trade deficit shrank slightly in Q3, as exports and imports both grew but exports grew faster. We’re projecting net exports will add 0.2 points to real GDP growth.

Inventories: Inventory accumulation looks like it was slightly faster in Q3 than Q2, translating into what we estimate will be a 0.1 point addition to the growth rate of real GDP.

Add it all up, and we get a 3.0% annual real GDP growth rate for the third quarter. Not a recession yet, but that doesn’t mean that the US economy is out of the woods.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Have We Reached Peak Keynesianism?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 14, 2024

There are two types of economists in the world…demand-siders and supply-siders. Without digging too deeply, one huge difference shows up in government policy. Supply-siders want low tax rates, high savings rates (and investment), and minimal regulation. Why? Because wealth and higher living standards come from entrepreneurship and invention – i.e. Supply.

Demand-siders think the way to boost growth is to boost “Demand.” John Maynard Keynes is the father of modern demand-side thought, arguing that if the pace of economic growth is too slow the government can step in to “stimulate demand” by running or expanding a government deficit.

A tenet of Keynesianism is that growth is best achieved by taxing money from those with higher incomes because they have a “higher propensity to save,” and giving it to those with lower incomes because they have a “higher propensity to consume.”

No wonder politicians love Keynes. It’s an economic theory that sanctions giving taxpayer resources directly to people under the theory that this will boost overall economic growth. At least in the short run according to the Keynesians – less economic growth and fewer jobs are worse than deficits. (And the long run doesn’t matter, they say, because we’ll all be dead, anyhow.)

The policy response to both the Financial Crisis and COVID was Keynesianism on steroids. Clearly, politicians of both parties have rallied behind the Keynesian flag in the past 16 years. As Richard Nixon once said,“We are all Keynesians now.”

Nixon may have been right if we apply that statement to politicians. But Friedman, Hazlitt, Mises, Hayek, and others continually pointed out the damage from this short-term, demand-side thinking would be immense and the stagflation of the 1970s proved them right and the politicians wrong. Like then, we think we have reached “peak Keynesianism” again!

The fiscal well is now running dry. The federal budget deficit was 6.2% of GDP in Fiscal Year 2023 and came in about 6.4% of GDP in FY 2024, which ended two weeks ago. To put this in perspective, the US did not run a budget deficit of more than 6.0% of GDP for any year from 1947 until the Great Recession and Financial Panic of 2008-09. Not during the Korean War, not during the Vietnam War, not during the Cold War. But now we did it two years in a row without a war and with the unemployment rate averaging 3.8%.

These deficits were made possible, in a large way, by having the Federal Reserve monetize the debt. At the same time the Fed held interest rates artificially low, meaning the actual cost of these deficits was masked. But, like the 1970s, inflation appeared due to easy money and now interest rates are up. The interest on the national debt has soared from a modest 1.5% of GDP in FY 2021 to what is likely 3.0% of GDP in FY 2024.

This means that if we hit a recession anytime soon, policymakers will find it very hard to rely on a Keynesian response. Deficits and interest payments are already too high!

At the same time, a Keynesian-motivated redistribution scheme to try to boost spending also faces a major hurdle. The personal saving rate – the share of after-tax personal income that is not consumed – was 4.8% in August. That’s well below the 7.3% average in 2019, prior to COVID, and less than half the savings rate of 12% that the US had in 1965. What this means is that trying to boost consumer spending by taking from Penelope to pay Paul will probably not work, either.

Put it all together and it looks like the traditional tools Keynesians like to use when economic troubles hit will not be available if the US runs into economic trouble. We see it everywhere. Evidently, the Secret Service, FEMA, and border security all need more money.

The system has reached Peak Keynesianism. Like the late 1970s and early 1980s, it is time to change course. The good news is that because of democracy, this can happen any time.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The Politics of Limits

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 7, 2024

The federal debt is already $35 trillion and currently rising by roughly $2 trillion every year – with no end in sight. As a result, some investors are worried that the US could become a 21st Century version of Argentina: completely bankrupt and unable to pay the bills.

We don’t think that’s going to happen. It’s not that the national debt doesn’t matter, it does matter. Instead, it’s because the recent surge in the interest on the national debt is going to have big effects on government policy.

The best way to measure the manageability of the national debt is not the top-line debt number, $35 trillion in the case of the US. Instead, it’s the net interest cost of that debt relative to GDP. Think about it like a national mortgage payment relative to national income.

Back in the 1980s and 1990s the US was regularly paying Treasury bondholders roughly 3.0% of GDP. From Fiscal Year 1982 through 1998, the interest cost on the debt relative to GDP hovered between 2.5% and 3.2%. At this level, even politicians felt the pain. Both parties enacted policies that led to budget surpluses and interest costs relative to GDP plummeted. Between FY 2002 and 2022 the interest burden averaged roughly 1.5% of GDP and stayed between 1.2% and 1.9% of GDP.

We call this period the “Age of Candy.” What happened during the Age of Candy? We cut taxes in 2001, 2003, and 2017. In 2004 the US added a prescription drug benefit to Medicare. In 2010, with Obamacare, we enacted the first major expansion of entitlements since the 1960s – not by coincidence, another period when the interest burden on the debt was low.

Why did all this happen? We are sure others can come up with plenty of ideas, too. But we think a large factor is that when the interest burden of the debt was low (which meant they didn’t have to pay bondholders as much) politicians realized they had a lot of extra money sitting around to buy our votes. And that’s exactly what they did.

But the Age of Candy is finally coming to an end. In FY 2023 the interest burden hit 2.4% of GDP, the highest since 1999. And in FY 2024, which ended exactly one week ago, the interest burden is on track to hit 3.0% of GDP, the highest since 1996.

In the twelve months ending in March 2021, net interest totaled $315 billion. In the past twelve months it’s totaled $872 billion. That’s an increase of 177% in less than four years.

A big part of the problem is that the Federal Reserve was holding interest rates artificially low. The Treasury Department could have issued long-dated debt to lock in lower interest rates for longer. But like homebuyers between 2004-2007, they borrowed at short-term rates, which were even lower and that meant more room in the budget to spend, spend, spend.

High inflation finally forced the Fed to raise interest rates back to normal levels. Unfortunately, this inflation only represents part of the problem. The bigger long-term problem is that by holding rates artificially low, the Fed fooled politicians into believing the cost of deficits was minimal. Hopefully, America will look back on this period and realize that Fed policy and all that spending was a mistake.

Ultimately, however, we think the spike in the amount that the government has to pay bondholders will lead to more focus on controlling the budget deficit in the years ahead. Unlike the homebuyers who defaulted on their mortgages in the Great Financial Crisis, government can buy itself time. During the period from 1982-1998, the Politics of Limits took place.

Think about what lawmakers did during that timeframe. In 1982, there was a bipartisan deal to raise the payroll tax. In the mid-1980s we had a bipartisan trio of Senators (GrammRudman-Hollings) push legislation to try to control the growth of spending. In 1990 George Bush the Elder cut a deal with the Democrats to violate his “no new taxes” campaign pledge, raise taxes, and set spending caps on military and social spending. Then Bill Clinton and Congress raised taxes even more, kept the Bush-era spending caps in place, and reformed Medicare and welfare to reduce spending.

That was the Politics of Limits. Don’t be surprised if by 2026 the bond market vigilantes have their machetes fully sharpened and once again bring politicians to heel. The Age of Candy is coming to an end. Will politicians react the same way in the years ahead? We hope so, because if they don’t inflation will not go away and investor fears may be warranted.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.