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.

Profits and Stocks

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 30, 2024

Like it does once every year, last week the Commerce Department went back and revised its GDP figures for the past several years. And while the top line revisions to Real GDP were pretty small, there was a larger revision to corporate profits.

Real GDP was revised up 1.3% for the second quarter of 2024, which means the annualized growth rate since the start of 2020 was about 0.3 percentage points faster than previously estimated: 2.3% per year rather than 2.0%.

And the statisticians also said profits were underestimated. The government now thinks its comprehensive national measure of pre-tax corporate profits is 11.5% higher than previously thought, mostly due to profits at domestic non-financial companies (such as manufacturers, retailers, transportation & warehousing, etc.). Meanwhile, after-tax profits were revised up 13.3%.

As our readers know, we judge the value of the overall stock market by using a Capitalized Profits Model. Using these revised economy-wide profits from the GDP accounts and a 10-year yield of 3.75% (Friday’s close) suggests the S&P 500 would be fairly valued at about 4,725, 18% below Friday’s S&P 500 close.

Our readers know that this measure is a view from 30,000 feet. The Capitalized Profits Model is not a trading model and there are many other tools to judge the value of stocks. In addition, in an election year, another factor is in play as well and that is the tax rate on corporate profits.

In 2018 the top tax rate on corporate profits was cut from 35% to 21%. This 21% tax rate is the lowest tax rate on corporate profits since the Great Depression.

We have always used pre-tax profits to judge stock values because the corporate tax rate moves up and down with the political cycle and pre-tax profits are a true reflection of economic activity, not just tax rate changes.

Clearly, the stock market has continued to rise in spite of the fact that our 30,000-foot view suggests it is overvalued. This could be a repeat of what happened in the late 1990s, when stocks rose in spite of the fact that they were overvalued, or it could be explained by an expectation that tax rates will stay low, and possibly be cut again.

Using newly revised after-tax profits in our model, instead of pre-tax profits, suggests that stocks are fairly valued today. And if President Trump were to win the election, and cut the corporate tax rate further as he has suggested (to 15%, from 21%) then there’s a case for stocks being mildly undervalued. (In theory, cutting the tax rate to 15%, which means companies would get to keep 85 cents on the dollar rather than 79 cents, translates into an 8% increase in after-tax profits).

However, there is also a risk of corporate tax increases, both in the near future as well as beyond. Vice President Harris’s campaign has mentioned lifting the rate to 28%, which would translate into a 9% reduction in after-tax profits.

It is hard to look at the federal budget situation and think the US government won’t be raising tax rates in the future. We’d prefer spending cuts, but we don’t live in a world where policymakers do what we want. In a worst-case scenario, tax rates could go up on both corporate profits as well as investors’ capital gains.

Net, net, what does this all mean? At the very best, upward revisions to profits mean stocks aren’t as overvalued as our models showed before. Nonetheless, with the M2 measure of the money supply down from its 2022 peak, and the risk of recession higher than it has been in a long time, we still believe stocks are overvalued.

The Federal Reserve is reducing interest rates, but even with a 10-year yield of 3% the stock market is not cheap. From 2008 to 2022, the market was significantly undervalued, and we were bullish for almost that entire time. Today, this is just not the case. There are sectors of the market that remain less expensive than the market as a whole, but caution is still 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.

The Budget Blowout

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 23, 2024

With only one week left in the fiscal year, it looks like the budget deficit for the federal government for Fiscal Year 2024 is going to come in at about $1.9 trillion, which is 6.7% of GDP.

To put this in historical perspective, we know of no other year in US history where in the absence of a major full-mobilization war (like World War I or II) or a major recession and its immediate aftermath when the budget deficit was so large. Some may point out that the budget gap was this large in FY 2012, a few years after the Financial Panic and Great Recession of 2008-09. However, the unemployment rate averaged 8.3% that year, more than double the average jobless rate of 4.0% this year. In other words, the economy in 2012 was still far from a full GDP and job-market recovery.

You may not remember, but Democrats hammered Ronald Reagan for deficits in the 1980s. Well, looking back the largest deficit we ever had under Reagan was in 1982, when the unemployment rate was 10% and we were fully funding the Pentagon at the height of the Cold War. In other words, there is simply no excuse for running a deficit this large given the lack of a major war and the absence of a recession.

And yet here we are. What’s amazing is how much the budget situation has changed in only the past five years. When looking at the budget it’s important to compare apples-to-apples, so we like to use the budget at the same point in the business cycle. In 2019 the economy was at a pre-COVID peak and 2024 is, so far, a peak business-cycle year as well. (It remains to be seen if 2025 is an even higher peak, in which case we will be happy to make a 2019 versus 2025 comparison a year from now).

Five years ago, in FY 2019, the deficit was 4.6% of GDP, so with this year at 6.7% it is 2.1 percentage points higher. Is it higher because of less revenue? Not at all. In the past five years revenue as a share of GDP has risen to 17.2% from 16.3%. They were $3.5 trillion in 2019, this year they are $4.9 trillion, $1.4 trillion higher.

Instead, the problem with the growing deficit is on the spending side. And while many just chalk it up to Social Security and Medicare because of our aging population, this just isn’t true. There are three major factors: (1) net interest on the federal debt, (2) “other” mandatory spending, and (3) major health care programs, such as Medicare (for senior citizens) and Medicaid (for those with lower incomes).

The growth in the net interest on the federal debt has been astounding and we plan to write more about the major political and policy implications of that change in the months ahead. Back in 2019, net interest was 1.8% of GDP; this year it will clock in at 3.1% of GDP, the highest share since 1995.

Meanwhile, “other” spending is up because the Biden Administration has been busy finding ways to forgive as many student loans as it can legally get away with (as well as ways that may end up being illegal, like with policy changes announced in 2022 and later overturned by the Supreme Court). When loans are forgiven, the Department of Education calculates present value of less future repayments, and factors that into the current budget year. As a result, “other” spending, which was 2.7% of GDP in 2019 is 3.8% this year.

Then there are the health care programs, which cost 5.3% of GDP five years ago, but 5.8% this year, with Medicaid growing much faster than Medicare. With population aging and barring major reforms to these programs, this share should only grow in the decade ahead.

The bottom line is that the US faces big structural budget challenges in the years ahead, particularly on the spending side. With low interest rates in the past fifteen years, we had the chance to avert our eyes from the problem, but we are soon to run out of time. No matter who we elect in November, we expect getting our fiscal house in order to eventually become a major policy theme of the next Administration as well as those beyond.

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.

It’s Money, Not Spending, that Causes Inflation

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 16, 2024

You don’t have to read or listen for long these days before you hear a politician, pundit, or politically-inclined person say: “Government spending causes inflation.”

Don’t get us wrong…anyone who wants to cut the size and scope of government is a friend of ours. Government is WAY too big. It slowed the growth rate of the economy, hurt living standards, and made people fight over fixed slices of the pie rather than working to grow the pie. But, government spending, itself, doesn’t cause inflation.

Just think about it. If government taxes (or borrows) $1,000 from Peter and gives that $1,000 to Pauline…Peter doesn’t have it, but Pauline does. Is there any more money in the economy? Absolutely not.

The only thing that can increase inflation – in fact, the definition of inflation – is excess money creation. Inflation is a decline in the purchasing power of a currency caused by central banks that inject more money into an economy than an economy really needs. Inflation isn’t an increase in the prices of goods and services, it’s a decline in the value of money. And government spending, all by itself, does not increase the money supply.

And if you don’t believe us, how about Milton Friedman? He wrote “Fiscal policy is extremely important in determining what fraction of total national income is spent by government and who bears the burden of that expenditure. By itself, it is not important for inflation.”

Some people wrongly assume that government borrowing creates money. But think about it. Who does the government borrow from? China, Japan, retirees, and banks all buy Treasury bonds. They buy them with dollars that they earned exporting to the US, working for incomes, or taking in deposits.

If any entity buys the debt of the US they no longer have the cash, the government does. Like Peter and Pauline, it is just a transfer of cash from one account to another. It doesn’t increase spending. If China buys debt, then they can’t buy imports with those same dollars. If banks buy debt, then they can’t make loans with that same money.

What is true is that if the Fed (or any central bank) creates new money (say with QE) and buys government debt, this injects new money into the economy. That IS inflationary. But it’s the money creation that caused the inflation, not the spending itself.

We think government spending needs to be cut. In fact, it may be the most important policy proposal on the table today. But we should cut spending for the right reasons. Making mush of economics doesn’t help anyone in the long run.

In that vein, many people correctly point out that the more the government borrows and taxes, the less the private sector has. This slows the growth of the economic pie and holds back the production of goods and services. Fewer goods and services, with the same monetary policy, means higher prices than we would have if government were smaller.

But this is not inflation, it is a (negative) supply-side boost in prices. The Fed could pull money growth back in such a situation and keep prices from rising as much, but the Fed actually does the opposite. The slower the economy grows, the more likely the Fed is to print excess money to boost it.

Again, this excess money is what causes the inflation, not the government spending. Even though a bigger government holds back output, it is not the ultimate cause of inflation.

The US was able to fix the inflation of the 1970s by slowing down the growth rate of the money supply. And, contrary to popular belief, the US does not need easy money and low interest rates to grow. In fact, the high-tech sector has thrived with declining prices.

Let’s cut spending for the right reasons. We get it: if saying spending creates inflation and that bumper sticker argument gets voters on board it would be easy. But the real reason to cut the size of government is to create more of a free market, reduce corruption, and allow workers to keep more of what they earn.

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.

Slower Faster

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

September 9, 2024

Friday’s employment report suggests the US economy may be slowing down faster than most investors think.

Nonfarm payrolls increased 142,000 in August, but revisions to June and July brought the net gain down to a modest 56,000. And the details were worse. We like to follow payrolls excluding three sectors: government, education & health services, and leisure & hospitality, all of which are heavily influenced by government spending and regulation (that includes COVID lockdowns and re-openings for leisure & hospitality). That “core” measure of payrolls rose only 25,000 in August and is up only 31,000 total in the past three months.

In particular, government plus education & health care jobs have made up 37% of all the net payroll increases since the pre-COVID peak in February 2020, an unusually large share.

For August itself, things looked better if you focus on civilian employment, an alternative measure of jobs that includes small-business start-ups, which rose 168,000 for the month. However, it’s hard to make a strong case for the US economy if you stick with that civilian employment measure. The August gain was the largest in five months but civilian employment is down compared to a year ago, with a loss of 66,000 jobs. Even worse, full-time employment is down one million from a year ago while part-time employment is up 1.1 million over the same timeframe.

Another recent report from the Labor Department revised down the payroll increase in the year ending in March 2024 by 818,000. That makes sense given that payrolls had been previously estimated to have grown 2.9 million during this period while civilian employment was estimated to have grown 642,000. But even after reducing payroll growth by 818,000 that still leaves a large gap. One way to close that remaining gap is an upward revision to population numbers due to high immigration, which would lift civilian employment, as well. But another way would be an even larger downward revision to payrolls.

This week the Labor Department will report on inflation and we – and the consensus – expect a moderate 0.2% increase in consumer prices for the month of August. In turn, that would mean that CPI prices were up around 2.5% from a year ago, which should translate into PCE inflation (the Federal Reserve’s preferred measure) of 2.3%. That’s a big drop from the 3.3% gain in PCE prices in the year ending in August 2023 and suggests that by the early part of next year inflation may temporarily hit or go under the Fed’s 2.0% target.

Why is this happening? Why is the economy slowing and inflation decelerating? Because monetary policy has been tight. After surging in 2020-21, the M2 measure of the money supply peaked in early 2022. Although it’s been rising gradually since October, it’s still down 3.1% from the peak in April 2022.

The Fed obviously realizes this, hence all the talk about cutting short-term interest rates. For now, our base case is that the Fed will cut rates by a quarter percentage point at each of the three remaining meetings this year (starting next week) and continue that pattern well into 2025.

The problem is that the Fed still thinks its focus should be on rates, not the money supply. If growth in M2 picks back up quickly, we risk a return to higher inflation, like we did multiple times in the 1970s. If growth in M2 remains lackluster in spite of rate cuts, the landing could get harder than anyone thinks.

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.