It’s the Same Bear Market

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 30, 2023

The S&P 500 closed at 4,117 on Friday, more than 10% below its recent peak in late July. Some are saying it’s a brand-new bear market for stocks. In this view there was a bear market in 2022, a bull market from October 2022 through July this year, and a new bear market that started in August.

We don’t think this is the appropriate way to look at things. This is not a new bear market. Instead, it’s the same bear market. We had a bear market in 2022, a temporary rally, and then the bear market reasserted itself.

The driving forces behind the ongoing bear market have not changed. Federal policy of easy money and extremely loose fiscal policy during COVID kept a serious recession at bay. That is basically over now. The M2 measure of money is down 3.6% in the past twelve months. Second, the massive episodes of COVID-era government spending/stimulus had to eventually wear off, which is revealing lots of malinvestment and now generating economic headwinds.

We think much of the headwinds from these shifts are still in front of us. Yes, the economy grew at a rapid pace in the third quarter but that includes contributions from consumer spending and inventory accumulation that were unsustainably hot. Meanwhile, business investment should slow as companies can earn robust returns by hoarding cash with little to no credit risk. Speaking of interest rates, they are now above inflation across the yield curve. The artificial boost from artificially low rates is gone.

This is why we remain bearish. At the end of last year we forecast that the S&P 500 would finish 2023 at 3,900 and we haven’t budged since, remaining bearish throughout the rally that took the S&P 500 all the way up to 4,600 this summer.

It hasn’t been easy taking this position. Equities tend to trend upward over long periods of time, as the real economy and profits tend to grow, and the price level rises, as well. We still believe the US future is relatively bright: entrepreneurs are still creating and innovating, and artificial intelligence shows great promise. We are also hopeful that sometime in the next few decades there will be major technology breakthrough in the energy sector. Our natural tendency is toward bullishness.

Clearly, we are not “permabulls” and never have been. From 2009, all the way through 2021 we remained bullish. We didn’t run with the herd of other forecasters worried that the world had come to an end in 2008. And, while we are bearish today, we don’t think it’s the end of the world now.

Eventually, stock prices will reflect fair value. More importantly, we expect the political pendulum to swing back toward the center. Big government directed economies eventually suffer…then recover when policy shifts back.

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.

Growth Surge in Q3 Masks Weak Trend

First Trust Monday Morning Outlook

Brian S. Websury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 23, 2023

We still think a recession is coming, but it definitely didn’t start in the third quarter. Instead, as we set out below, it looks like real GDP expanded at a 4.7% annual rate. If we are right about that number, that would be the fastest pace of growth for any quarter since 2014, with the exception of the re-openings from COVID in 2020-21.

Keep in mind, though that even with growth that fast, the growth rate since the end of 2019 – the pre-COVID peak – would be only 1.9% per year, reflecting an underlying trend that is still slow.

Why do we still think a recession is coming? Because after the surge in money creation in 2020-21, monetary policy started getting tight in 2022. In the past year the M2 measure of the money supply is down 3.7%. Meanwhile the yield curve (we like to compare the 10-year Treasury yield to the target federal funds rate) has been inverted since late 2022 and is likely to stay that way for at least the next several months.

Higher short-term interest rates mean businesses have the ability to lock in healthy nominal returns on cash with minimal risk. In turn, this should lead to a reduction in risk-taking and business investment.

Meanwhile, jobs are still expanding rapidly. Payrolls are up 2.1% in the past year. During the economic expansion that happened before COVID (mid-2009 through early 2020), a pace that fast (2.1% or more) only happened when the unemployment rate was about 5.5%, which meant plenty of workers still available for hire. Now it’s happening when the unemployment rate is less than 4.0%. This suggests employers are out over their skis and vulnerable to any softness in demand.

The bottom line is that the economy grew rapidly in Q3 but Q4 and beyond are likely to be much slower.

Consumption: “Real” (inflation-adjusted) retail sales outside the auto sector rose at a 3.7% annual rate in Q3 while it looks like real services, which makes up most of consumer spending, should be up at about a 4.0% pace. The one weak spot was autos and light trucks, which declined at a 2.5% rate. Putting it all together, we estimate that real consumer spending on goods and services, combined, increased at a strong 4.1% rate, adding 2.8 points to the real GDP growth rate (4.1 times the consumption share of GDP, which is 68%, equals 2.8).

Business Investment: We estimate a 4.5% growth rate for business investment, with gains in intellectual property and equipment leading the way while commercial construction was roughly unchanged. A 4.5% growth rate would add 0.6 points to real GDP growth. (4.5 times the 14% business investment share of GDP equals 0.6).

Home Building: Residential construction is showing some resilience in spite of some lingering pain from higher mortgage rates. Home building looks like it grew at a 7.5% rate, which would add 0.3 points from real GDP growth. (7.5 times the 4% residential construction share of GDP equals 0.3).

Government: Only direct government purchases of goods and services (not transfer payments) count when calculating GDP. We estimate these purchases – which represent a 17% share of GDP – 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 in Q3, as exports expended rapidly in spite of foreign economic weakness. We’re projecting net exports will add 0.5 points to real GDP growth.

Inventories: Inventories look like they grew a little bit faster in Q3 than in Q2, suggesting they’ll add about 0.2 points to the growth rate of real GDP. When a recession hits, we expect inventory declines to play a significant role in the drop in GDP.

Add it all up, and we get a 4.7% annual real GDP growth rate for the third quarter. Look for much slower growth in the fourth quarter.

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.

Big Government Weighing on Growth

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 16, 2023

At the end of October we will get our first look at real GDP growth for the third quarter and it looks like it was very strong. We’ll have a more exact estimate a week from now – after this week’s reports on retail sales, industrial production, and home building – but it looks like the economy grew at about a 4.5% annual rate.

Even if that turns out right, however, the underlying pace of growth is much slower than what happened in Q3. From the end of 2019 through the third quarter, the average rate of growth would be 1.9%. From the end of 2007 – right before the Great Recession and Financial Panic – through the third quarter, the average growth rate would be 1.8%. Both these figures pale in comparison to the growth of the 1980s and 1990s.

Raising the long-term growth rate of the US economy ought to be a key focus of policymakers. Unfortunately, we seem to be moving in the opposite direction, with the government expanding, which means more redistribution.

According to the Congressional Budget Office, federal spending should total $6.131 trillion in the fiscal year that ended on September 30. But that includes the effects of the Supreme Court striking down much of President Biden’s plan to forgive student loans. That decision created a $333 billion “negative outlay” for Fiscal Year 2023. Without that decision, which didn’t affect the government’s cash flow, total federal spending would have been $6.464 trillion. We estimate that would translate to 24.0% of GDP, in a year when the jobless rate averaged 3.6%.

Let’s put that in historical perspective. In FY 2019, the last year prior to COVID, the jobless rate averaged 3.7% and federal spending was 21.0% of GDP. Back in 2000, at the peak of the first internet boom, federal spending was 17.7% of GDP. Some of this increase is due to higher interest costs, but most of it is not and the trend is not good.

In turn, this reminds us of one of our fundamental ways of thinking about the economy. Imagine ten people stranded on an island, living at subsistence, each person using a spear or even her hands to catch two fish each per day, barely surviving. Then two of them decide to risk it all and build a boat. They go out one day and bring home twenty fish. Hallelujah! Enough to feed everyone.

With this bounty, the others use their talents to find easier ways to get their two fish. Some of them climb the trees, bring down coconuts, and trade for fish. Others build fires to cook the fish just right. Others build better huts. And so on and so forth. In other words, the innovation of making that boat and net didn’t just help those original two; it helped everyone. Life is better.

But one of those islanders isn’t happy. He watches all that trading and realizes that the two owners of the boat and net who took the big risk are better off than the rest. It wasn’t like it was before, where all everyone had was two fish per day, barely eking out survival, but at least they were equal.

The unhappy islander – let’s call him Sernie Banders – comes up with a plan to bring “equity” to the island. He gets them to impose an 80% tax on the “rich” boat/netmakers! That way when the boaters bring in their haul of twenty fish, the rest of them get their “fair share” of sixteen (two fish per person, eight other people), with no extra work.

Common sense tells us what happens next. The inventors have little incentive to maintain or repair the boat or fix the net. Why waste your time or take a risk when the rest of the islanders are just going to seize the extra value you’ve created? In the end, the islanders are eventually back where they started. Or maybe worse, because they forgot how to fish.

The US isn't at 80%, yet. But Federal, State and Local spending are already roughly 42% of GDP. If we don’t get spending under control, tax rates will eventually go much higher. Bigger government means less innovation, less investment in and maintenance of capital, and less economic growth.

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.

Crisis Management Government Leads to No Good

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 9, 2023

Back in 2008, Ben Bernanke and Hank Paulson, using fear of financial collapse, convinced President Bush and Congress to 1) pass a $700 billion bailout of banks (called TARP) and 2) allow the Federal Reserve to pay banks interest on reserves at the same time the Fed moved from a scarce reserve model of monetary policy to an abundant reserve policy. These policies, to spend and print massive amounts of money, were super-sized during COVID.

Both policies proved incredibly damaging. The 2008 financial panic could have been addressed by changing mark-to-market accounting. In the six months following the passage of TARP and the institution of Quantitative Easing, the S&P 500 fell another 40%. Only when mark-to-market accounting was changed in early March 2009 did the panic end.

But, because so few people understood this, the idea that any kind of crisis requires trillions of dollars of spending and money printing became the roadmap for government in a crisis. We fully understand that early on during COVID, fear that we were facing another 1918 flu pandemic was real. But by the end of 2020, there was enough data to show that government shutdowns were harming education, small business, and supply chains, while it was also creating inflation.

But government kept spending and printing money in 2021 and 2022. And then, rather than returning spending back to pre-crisis levels, government spending has ratcheted higher. Between 2000 and 2007, non-defense federal spending averaged 15.3% of GDP, between 2008 and 2019 it averaged 17.6% of GDP, and now from 2020-2023 it is 24.5% of GDP.

For perspective, non-defense government spending was just 10.1% of GDP in the five years between 1965 and 1969. Total government debt is now $33.5 trillion, and with interest rates rising, the total cost of this borrowing is lifting government spending even more.

According to an August 3, 2023 CNN article, “The public remains broadly negative about the state of the country, with just 29% saying things are going well in the US and 71% that they’re going poorly….” We think we know why. Keynesians think government spending can boost growth, but, if so, that extra growth is just temporary. Every dime the government spends is created in the private sector, and the more the government redistributes, the less growth the economy will experience. Potential real GDP growth was roughly 3.5% per year in the 1980s and 1990s…today, we estimate it is just 1.5%.

Meanwhile, monetary policy is a mess. Quantitative Easing signaled a shift to an abundant reserve monetary policy. In 2007, the Fed’s balance sheet was roughly $800 billion. Today it is near $8 trillion. This money creation ended up as deposits on bank balance sheets.

In turn, banks have been forced to hold more deposits than would have existed without QE. And when banks hold more deposits, they also hold more assets. To complicate matters, in an abundant reserve monetary policy, the Fed basically sets rates wherever they want. And in the past fifteen years, the Fed has held short-term interest rates below inflation 84% of the time. In other words, banks (and the Fed itself) are holding assets that they bought at much lower interest rates than exist today.

If the banking system was forced to mark all their assets to market today, many banks would be underwater. In other words, the policies put in place to supposedly save banks have actually created a less safe banking system.

But there are other strange developments as well. One, is that the Treasury Department has a bank account at the Fed, called the Treasury General Account. On October 4 the TGA held $679 billion. The TGA is not new, but for decades through 2007, it held an average of only $5 billion. It was designed as a cash management tool.

Why the Treasury needs hundreds of billions in this account makes no sense. Using an interest rate of 5%, Americans are paying $34 billion a year so that the Fed can hold this cash. The cost of big government just keeps going up and up. It needs to be reversed.

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 stock indexes mentioned are unmanaged and cannot be invested into directly.  Past performance is no guarantee of future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.

Tax Policy Outlook

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 2, 2023

The fiscal year ended last week, alarms went off both literally and figuratively, and a last-minute deal was reached to keep the government open for another forty-five days. Later in October the Treasury Department will figure out the final budget numbers for last year and we estimate the deficit will come in a little north of $1.7 trillion, or 6.5% of GDP.

In a fiscal year when unemployment averaged only 3.6%, that’s a horribly high budget deficit to run, and a sign that something is deeply wrong with US fiscal policy. Worse, this past year’s deficit was artificially and temporarily held down by the Supreme Court striking down much of President Biden’s plan to forgive student debt. Without that decision, the deficit would have been close to 8% of GDP.

The bottom line is that the US is approaching a fiscal reckoning sometime in the next few years where it will need to either reduce future spending or find more future revenue. Even tougher, this will have to happen in a geo-political backdrop where the US may have to ramp up military spending to project more power in the Pacific.

We root for spending cuts, particularly to entitlements. But, given that politicians who advocate for spending cuts using any tool they can find (debt ceiling or shutdowns) are verbally flayed by the establishment, we are not holding our breath. The establishment wants tax hikes, and that’s likely what we will get.

The good news is that we don’t think tax hikes will hit until at least 2026. Why that year? Because significant parts of the tax cuts enacted in 2017 under President Trump are set to expire at the very end of 2025. That expiration will focus the minds of politicians running for federal office in 2024, House, Senate, and President. In turn, in 2025, depending on the outcome of the election, some sort of deal will be reached about extending those tax cuts.

We think there’s about a 35% chance of a Republican sweep in 2024 (the presidency and majorities in both House and Senate). If that happens, we will likely get an extension of all the Trump tax cuts. However, unless that extension is coupled with aggressive spending cuts or entitlement reforms, it will be tough to sustain those tax cuts well beyond 2026.

We also think there is about a 20% chance of a Democratic sweep. If that happens, we’re likely to get significant across-the board tax hikes. Policymakers will claim they are only raising income tax rates on “the rich,” but we think other kinds of tax hikes would be on the table, like higher gas taxes or maybe a carbon tax like the Clinton Administration proposed in 1993. In addition, taxes would likely go up on corporations, even though much of the burden from such a tax hike would be felt by their workers and their customers.

That leaves a 45% chance of having mixed government in 2025-26, with each party having control of at least one of the White House, the House or the Senate. In that case, expect most of the Trump tax cuts to be extended, except at upper income levels, where tax rates would likely revert to where they were under President Obama. This would be similar to the compromise that was reached for 2013, when the Bush tax cuts enacted in 2001 and 2003 were set to expire.

The one thing we know for sure is the US is on an unsustainable path. If we don’t cut spending, tax hikes are eventually on the way.

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 Fall for the Q3 Head-Fake

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 25, 2023

We have plenty of data reports to go, but, so far, the third quarter is shaping up to be a strong one for the US economy. The Atlanta Fed’s GDP Now model is tracking a Real GDP growth rate of 4.9% for Q3, which would be the fastest quarterly growth rate since the earlier part of the COVID recovery.

Our models aren’t tracking quite so high but are projecting growth at about a 4.0% rate, still strong by the standards of the past couple of decades.

However, we would not get too excited about what’s happening in the third quarter and don’t think one quarter of strong economic growth means a recession is off the table.

With all the oddities of the COVID era – first overly strict lockdowns and then overly gradual re-openings – it’s entirely possible the GDP reports are exhibiting some “seasonality,” where certain quarters look better than the underlying economy really is. The third quarter is when children typically go back to school, for example, but, unfortunately, they did that less so during COVID. As a result, normal back-to-school behaviors might make the economy look extra strong for now.

To put some numbers on this, statistical adjustments to retail sales (called seasonal adjustments) subtracted 1.8% from reported sales in July 2019, prior to pandemic shutdowns. Back to school spending in July (much like Christmas) makes for some big spending months, and the statisticians adjust the numbers down. But in 2020, 2021 and 2022 July sales fell because so many schools were closed. This reversed the seasonals and this July (2023) seasonal adjustments added 1.4% to reported sales. We think this is distorting our view of the economy.

Meanwhile, the economy is likely feeling the last positive remnants of the surge in the money supply in 2020-21. The lags between monetary policy and the economy have always been long and variable, as Milton Friedman taught us. Beyond the third quarter, the economy is likely to show more of the effects of the drop in the M2 measure of the money supply from mid2022 through early 2023.

Another reason we think the third quarter is a head-fake is that deficit spending by the federal government is very unlikely to expand in 2024 like it has in 2023. Were it not for President Biden announcing his student loan debt forgiveness plan last year the budget deficit would have been 4.0% of GDP in Fiscal Year 2022, high but not extraordinary.

And if it hadn’t been for the Supreme Court striking down that plan this year, the deficit would have been about 7.8% of GDP for Fiscal Year 2023, well beyond even the highest deficit under President Reagan in the 1980s and all while the unemployment rate is averaging about 3.6%.

The rise in the deficit of almost four percentage points of GDP with the unemployment rate so low is unprecedented. Other prior leaps in the deficit of this magnitude have been during major wars or recessions, not when the US is at peace and the unemployment rate is unusually low.

In particular, the way some of the extra deficit spending is structured looks designed to temporarily and artificially boost economic growth. The CHIPS Act, for example, is encouraging private investment in chip manufacturing facilities in the US. So far this year (through July), private spending to construct manufacturing facilities in the computer, electronic, and electrical sector are up 228% versus the same period in 2022.

But these buildings don’t have to be rebuilt every year. Sometime soon the gains in this sector will dwindle and reverse, with collateral damage to other sectors, like trucking.

To be clear, we do not believe government spending is a positive for long-term growth. In fact, it often distorts and diminishes overall activity. However, in the short-term, as we saw during COVID (and apparently this year as well) it can make the economy look stronger than it really is. A price will be paid, and as all this extra stimulus wears off a recession is highly likely. We don’t see how it is avoided.

The next recession is unlikely to be as devasting as the ones in 2008-09 or 2020. But our view remains that a recession is on the way.

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.

Higher Rates & A Shutdown On The Menu

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 18, 2023

The University of Colorado Buffaloes are undefeated and suck up a lot of oxygen in the college football world. After just three games as the new head coach, Deion Sanders was interviewed by 60 Minutes. For now, the Buffs have gone from irrelevant to essential in the college football world. In the competitive arena of sports or business you need to stand out to be noticed. But, when you’re the government, standing out isn’t hard to do.

This week, the Federal Reserve is set to release a new statement on monetary policy. And, by the end of this month, Congress is supposed to either pass a new budget or possibly shutdown non-essential government services. Investors will be watching intently.

We don’t think the Fed will provide many surprises. As of the Friday close, the futures market was putting the odds of a rate hike at this week’s meeting at less than 1%. That may be too low, but the Fed won’t surprise on this front. It will release a new batch of economic forecasts as well as “dot plots” that show where policymakers see short-term interest rates heading.

This could be the surprise: The futures market’s odds of a rate hike by the December meeting are roughly 45% and we think that’s too low. Oil prices are lifting inflation once again, and rising health insurance rates will keep inflation elevated later this year. Meanwhile, real GDP growth looks solid in Q3. Mixing stubbornly high inflation with solid economic growth is not a recipe for a prolonged pause by the Fed, at least not yet.

We think the Powell presser and the dot plots will make it clear the Fed is leaning toward one more rate hike before the year is through. Our greatest hope is that someone asks Powell about the money supply and he acknowledges its importance for conducting monetary policy, but if that happens we’d be (happily) surprised.

Instead, we expect to hear at least one question for Powell about the looming possibility of a government shutdown at the end of September. The media and investors are starting to focus on this issue. We don’t think this is time well spent. History shows no relationship between federal shutdowns and the performance of the economy.

We had two shutdowns in late 1995 and early 1996, and saw no recession either time. There was a shutdown in 2013, no recession. There was a brief shutdown early in 2018, no recession. The most recent shutdown was the longest, thirty-five days from December 2018 through January 2019. You guessed it, no recession. The last time a shutdown coincided with a recession was in October 1990. That was only a four-day shutdown, but money was already tight and a recession was inevitable either way.

Here's another way to think about it: In the last forty years, the government has been shut for 91 days. Among those days, the US was in recession for four days and not in recession for eighty-seven. By contrast in the past forty years the US has been in recession about 8% of the time. That means the economy was more likely to be growing when the federal government was shut than when it was open!

This doesn’t mean a recession can’t start in the fourth quarter. But if we do get a recession it’ll be a coincidence, due to the lagged effects of the tighter monetary policy of the last year, not a shutdown itself.

Note that unlike some other budget confrontations in the past, this one does not involve paying the federal debt. For better or worse the debt limit has been suspended until January 2025. This means that even if the government is shut all the debt will get paid on time; there will be no default.

Social Security checks and other benefit payments will still go out. The mail still gets delivered. Essential government workers keep working, including those needed for national defense. The government is not the economy, even though many in DC (and many voters) think it is. But, those that produce wealth are the ones who have to pay for it. And that cost keeps going up. In 1930, the federal government (without defense) was about 2% of GDP. Today that percentage is 22%. The government has grown about 10 times more than the economy as a whole. Debt is at a record high and, with higher interest rates and rapidly rising entitlement costs, we are on an unsustainable path.

As we said two weeks ago, the federal government is running the most reckless and irresponsible budget in US history. Even John Maynard Keynes’ would not support such massive deficits with the unemployment rate so low. This can’t go on now that interest rates have returned to more normal levels. If a shutdown is the price we pay to start moving in the direction of less government spending, investors should be eager to see that happen. The shutdowns in the mid-1990s caused the government to become more fiscally responsible and led to Clinton era surpluses. And that was good for everyone.

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.

Our Stagflationary Future

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 11, 2023

A month ago, many people were pretty sure serious inflation concerns had passed. After the equivalent of 22 quarter-point rate hikes and the biggest drop in the M2 money supply since the Great Depression, consumer prices rose only 0.2% in July, with the year-over-year rate of increase down to 3.2%, well below its 8.3% increase in the twelve months ending in August 2022, after Russia invaded Ukraine.

But oil prices have reversed course, and in a few days, the monthly increase in the August CPI will likely show inflation came in hot. If we are right that consumer prices rose 0.6% for the month, then consumer prices are also up about 3.7% versus a year ago, an acceleration.

This is a far cry from the Federal Reserve’s stated inflation goal and more than enough to show that inflation wasn’t just the “transitory” result of COVID-related supply-chain issues or Vladimir Putin.

Other measures also show the job isn’t done. Last November, the Fed invented something called “Super Core” inflation, dropping energy, food, and housing prices, but even this measure is up 4.7% in July versus a year ago, higher than the 4.4% when it was introduced.

Some now dismiss this measure of inflation, but these are often the same people who focused on it (touting it as a better gauge than overall inflation). It’s hard for us to shake the sneaking suspicion that they went from enthusiastic to skeptical about this measure because it wasn’t showing the progress on inflation that they’d like to believe. Meanwhile, the Cleveland Fed’s median PCE inflation rate is up 4.8% in the past year.

We are not back to the 1970s yet, but there are some similarities. Great Society spending pushed government spending on a steep upward trajectory in the 1970s, in spite of the eventual wind-down of the Vietnam War. In turn, policymakers monetized much of this extra spending. The result: a wet blanket of big government which slowed growth, but a boost to inflation from easy money. Reagan and Volcker reversed these two policies and growth accelerated, while inflation fell, after going through a severe recession early in the 1980s.

Does this ring a bell? The government’s response to the Great Recession and Financial Panic of 2008-09 was a big shift upward in spending and the economic recovery that followed was unusually weak. Then policymakers responded to COVID with more of the same, now adding higher inflation to the mix.

It is entirely possible that the drop in the M2 measure of money ends up bringing inflation down to the Fed’s 2.0% target sometime over the next couple of years. But, if so, we don’t expect low inflation to last. There is a growing series of voices calling for the Fed to raise its long-term inflation target from 2.0% to something closer to 3.0%.

In the short run, we expect the Fed to stick to a 2.0% inflation goal. Changing the target at this juncture risks severely undermining the Fed’s credibility. This happened in the 1970s…even if not explicitly stated, the Fed shifted their thinking on inflation and said it was too hard to stop.

Inflation averaged 1.8% in the ten years pre-COVID. Don’t expect inflation to average that low in the decade ahead. Not until the US finds a way to repeat the 1980s policy mix.

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.

Fiscal Madness

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 5, 2023

Back in the 1980s, President Reagan took enormous political heat (Sam Donaldson comes to mind) for being fiscally irresponsible. His offense? Presiding over a budget deficit that peaked at 5.9% of GDP in Fiscal Year 1983.

But at least Reagan had an excuse. Actually, multiple excuses. The unemployment rate averaged 10.1% in FY 1983, which pushed up spending, while reducing revenue. The Reagan tax cuts were phased-in, so many people pushed off income (and taxes) into future years. Finally, the US decided to bury the USSR under massive defense spending.

The reason we bring this up is that we estimate the budget deficit for this year (FY 2023, ending September 30) will be $1.74 trillion, or 6.5% of GDP. That’s larger relative to GDP than the largest budget deficit ever under Reagan. Worse, this is happening when the unemployment rate will average about 3.6%, the lowest average for any fiscal year in more than fifty years.

But the current budget situation is even worse than these numbers suggest. Last year (FY 2022), the budget deficit came in at $1.375 trillion. But this deficit was artificially boosted by government accounting. President Biden’s plan to forgive student loans lifted the deficit by $379 billion, the present value of the extra future losses estimated on the forgiven debt. The government’s budget accounting rules included it as extra spending last year, even though it didn’t affect the government’s cash flow.

In other words, without the Biden loan forgiveness plan, the budget deficit would have been about $996 billion last year, or 4.0% of GDP. Not good, but not horrible, either.

But this year the Supreme Court struck down most of the loan forgiveness plan. As a result, extra future loan repayments are now being added back into the budget. The government counts this as a “negative outlay,” and this change results in a one-time artificial reduction in the deficit of $330 billion. Without the Supreme Court ruling we estimate the budget gap this year would be about $2.07 trillion, or about 7.8% of GDP.

These government accounting rules might make sense in normal times, but right now they are leading to a bizarre result that hides a massive increase in the “cash flow” deficit of the US government. The result is a much bigger change than the “official” numbers, which will show the budget deficit going from $1.375 trillion (5.5% of GDP) to $1.740 trillion (6.5% of GDP).

There is no economic justification for expanding the “cash flow” deficit by 3.8 percentage points of GDP (from 4.0% to 7.8%) unless there is a recession or World War III. We never had a budget deficit greater than 6.5% of GDP in any year from 1950 through 2008. Not one. Reasonable people can disagree about the size and scope of the budget deficits we should have run in the aftermath of the Great Recession as well as during COVID Lockdowns. But running a budget deficit this high right now is madness!

We are supply-siders. We think the key to long-term economic growth is removing barriers and disincentives to work, save, and invest. We do that with lower tax rates, smaller government, and less regulation. We think institutions matter, like democracy, property rights and freedom of contract. We are not Keynesians. But even John Maynard Keynes must be rolling over in his grave. No serious or intellectually honest Keynesian can support a deficit at 6.5% of GDP (much less 7.8%) in a year when the US is at peace and unemployment is averaging 3.6%.

And just so everyone knows, we are not attacking one party over the other. TARP, multiple rounds of quantitative easing, COVID lockdowns, unprecedented fiscal stimulus during COVID, and repeated failures by both parties to address entitlements have all paved the way to the current deficit bubble.

We realize the US had bigger deficits right after the Financial Crisis and during COVID, but given low unemployment and peacetime, we don’t think we’re overdoing it when we say that this year’s budget is the most reckless and irresponsible in the history of the Republic.

We think that the unprecedented surge in the deficit this year is a key reason why a recession has yet to materialize. A surge in the deficit this large can sometimes artificially maintain growth in the very short-term. But, given higher interest rates on government debt, this kind of support can’t last. The party continues for now, but a hangover looms in our future.

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.