Forecast for the US Economy Beyond the Elections

Forecast for the US Economy Beyond the Elections

IN SUMMARY

• The Federal Reserve is again in a dilemma; it just slashed its inflation-fighting interest rate policy by a factor of 9%, but the economy is giving little indication that it needs more help from further interest rate cuts. The US stock market has been strong all year and it apparently needs no further help, although its current robustness no doubt stems from pricing in its expectation of even lower borrowing rates. Despite its strong year-to-date returns, the market’s overall fundamentals project a continuation throughout the next 12 months. In fact, the broad forward price/earnings ratio is now more bullish than at the beginning of 2024.
• Despite a smoothly running economy, the US Government’s financial situation is poor and getting more so. We reviewed the key elements of its operations and laid out the grim facts about how, in the relatively calm 2024 fiscal year which ended last month, the spending structure left a $1.8 trillion (12 zeros) cash flow deficit in its wake. And unless artificial intelligence, or some other boom factor shifts the US economy and its tax collections into a higher gear, the accumulating federal debt is increasing parabolically and, hence, out of control. 
• The national elections of the President, the entire House of Representatives and a third of the Senate will occur in a few weeks. Razor thin margins of victory in many of the races may set off an even more discordant government than we have yet seen.   
• By far, the presidential race this time is sucking the air out of the slate of Congressional election campaigns. But presidents have no direct power to deliver on any promises that involve taxes and expenditures. Only the Congress can do that. We have boiled down to three critical issues that the new president surely must address, in a leadership way…. although neither candidate has chosen to speak about them; they are: 
  • The US’s financial standing in global trade is declining because of the Dollar’s gradually increasing replacement as the world’s reserve currency.
  • Continued unsustainable federal tax and spending deficits and accumulating debt burden logically lead to yet another credit downgrade for Treasury debt.
  • The fast-approaching demise of the 90-year-old Social Security System’s financial underpinnings must be fixed… again… and very soon. That said, the System’s investment of tax revenues is fundamentally flawed because it cannot keep up with the inflation-adjusted retirement benefit payout formula.
• A sustained runup in stock prices dependably brings out a chorus of bubble-mongers. We always caution that bull-phase stock markets do not end because they get old. Instead, the underlying fundamentals must weaken, while exogenous world events can cause or contribute to the severity of risk exposure. Today, there are continued, or even improving, stock market fundamentals. Although the tech companies (and their suppliers) do have singularly high valuations, their expected growth in the new world of artificial intelligence is egging them on. 

Before the elections, the Federal Reserve is in control; after the elections, the Fed will still be in control, while Congress likely continues to be out of control.

Institutional investors, their Wall Street banks, and especially the financial press, hang on any public words spoken by Federal Reserve Chair Jay Powell and by members of the Federal Reserve’s Open Markets Committee. In any one of its nearly monthly meetings, it can and does change the near-term course of the US economy, via significant moves in Fed-driven interest rates. High and low interest rates drive all things financial, including stocks, because the Committee has permanent, Congressionally granted authority to declare and modify the two fundamental steering wheels beneath the US economy:  

1. the quantity of dollars in existence, and  

2. the economy’s core money-borrowing interest rate. 

With tools like that, what financial act of consequence can the Fed not do?  The clear answer is the Fed has no control, not even influence over the US Congress’s Constitutional power to manage the national purse.  

In the Fed Committee’s meeting last month, it announced a much-anticipated reduction in the core borrowing rate: it was an aggressive 0.5% cut, from 5.3% to 4.8% (which is a 9% move) and, as usual, further gradual cuts are expected in the future, until the Committee’s data show that enough progress has happened in fulfilling the Fed’s two chartered mandates: to maintain (1) stable prices and (2) full employment.  

Where to from here?

Falling interest rates will not help to reduce or stabilize inflation. Instead, unless there is recession, interest rate reductions will likely feed inflationary forces. So, if the stock market’s continuous 2024 boom and forecast is telling us that all’s well and expected to be well in the foreseeable stages of the economy, then the Fed must halt its rate reductions.  

The past two years of high interest rates were a big deal because, for the 15 years before that (2007 to 2022, with one mild exception in 2017-19), the Fed’s policy interest rate was near zero. Such a sustained low interest rate was possible because there are two inflations:  

1. Price inflation (in the real economy) and                

2. Money supply inflation (the Fed’s creation of new dollars).  

Fundamentally, a significant bump in the money supply soon drives up price increases at the grocery store.  

Congress’ 2020-21 legislative triple-whammy during Covid sent $815 billion of cash directly into our homes ($3,200 per taxpayer, plus $1,900 per child). Those three legislative Acts, especially the final one (which began as a giant $5 trillion proposal by the new president that was whittled by Congress to a bit under $2 trillion), explains most of the reason that inflation shot skyward from a puny 0.6% in mid-2020 to a 9.1%, 40-year high, only twenty-four months later.  

[The Fed’s outside layer is very public. Here is a description of some internal workings we think are important. As of October 9, 2024, the Fed owns $4.4 trillion of US Treasury debt. Traditionally, the Fed’s interest income from its Treasury debt portfolio holdings delivers a handsome net “profit” which the Fed simply pays back to the Treasury. The result: Treasury enjoys a zero net interest cost on those trillions of debt dollars. So, in 2022, the Fed’s net income was $59 billion which went back to the Treasury, but in 2023 that figure turned into a $114 billion loss, which it presumably had to cover during the year with newly created dollars. Clearly, this highly unusual and unstable state of the Fed’s internal affairs is not healthy. If its net losses reoccur, they could cause further discombobulation at the Treasury and adversely affect the already delicate international state of the Dollar.] 

Government finances in a bind 

Federal Expenditures: In 2023, “Entitlement” programs made up 55%. Entitlements are social welfare programs which are, by law, funded automatically, according to fixed formulas. Entitlements include: 22% for Social Security retirement, 24% for Medicare and Medicaid/Obamacare and 9% for Welfare and Unemployment benefits. 

The rest of annual budgets are “Discretionary” expenditures for Defense: 19%; Interest on debt: 11% (and climbing); all others: 16% (which includes providing “income security” payments to low-income individuals, general government operations, education and “supplemental appropriations”, such as the funding of support for wars in Ukraine and Israel. 

Federal Revenues in 2023 were: Individual income taxes: 50%; Corporate income tax: 10%; Social Security and Medicare tax: 36%; estate and gift tax: less than 1%; customs duties and other, 4%. 

The bottom line, for the fiscal year just ended in September 2024: outlays exceeded revenues by $1,800,000,000,000, even though the income tax base is healthy and growing and there are no US troops in combat anywhere, as of today. 

So much for presidential campaign promises 

A few days ago, a new federal budget year began…. as usual, without the benefit of Congressional budget legislation, or even a draft budget. In this election year, we have now heard more than the usual amount of both presidential candidates’ promises for tax-cuts and increased spending. The press corps, as always, takes them seriously. 

The two remaining presidential candidates cannot credibly promise to deliver changes in revenue intakes and/or spending outlays; only Congress can trigger any of that. And if, say next year, a majority in both Congressional houses decides to adopt one or more of the winning candidate’s promises, the result will add new layers of record-setting peacetime budget deficits on top of a post-World War II record level of accumulated debt (measured as a percentage of the US economy) and a rapidly growing interest burden. 

Realistically, here are three critical issues that the newly elected United States President must face up to: sadly, neither presidential campaign is mentioning them: 

1. The US Government’s financial standing in the world is declining.  Entitlement outlays must be examined and re-configured. Robust presidential leadership is needed to push Congress away from its ingrained, can-kicking habit. Absent that leadership, a razor-thin political party balance will continue to thwart orderly resolution of fiscal train-wrecks and government shutdowns. When the next Congress is sworn in January, it must immediately dive into yet another painful battle over elevating the authorized “debt ceiling”.  This process will create another desolate ending: more federal debt and (probably) no new tax revenue to pay for it, because the new president will be anxious to deliver on one or more tax-relief promises. 
    

2. Federal Government debt and soaring peacetime budget deficits are recklessly out of control. Until recently, US Treasury bills, notes and bonds were deemed “risk free” investments by investors in all parts of the globe. Last year, we wrote about the US’s unprecedented credit rating downgrade by both the Fitch and S&P Global credit agencies. The reasons they gave significantly included political operations failures that are serious, and now persistent. 

Especially in this century, the US Treasury has always been able, without fanfare, to issue more debt to cover the continuous annual budget shortfalls that were caused in significant part by involvements in ill-defined wars and limitless military occupations, such as Iraq and Afghanistan. Worldwide investors have always readily bought all newly issued US Treasury notes and bonds. The predominant reason for that global appetite is just one thing: the US Dollar’s reserve-currency standing.   

As we detailed in an earlier column, the past few years have seen the formation of a trading coalition comprised of US adversaries, and now some neutral countries. This group… the “BRICS” countries that include Russia, China and India… together make up almost half of world population and over a third of global GDP… has formed a non-dollar trading compact among themselves, using each of their own currencies instead of dollars [i.e., “de-dollarization”], to settle nearly 20% of all recent international trades. We note that even Treasury Secretary Yellen has publicly referenced this dollar decline on several occasions. Another dark cloud was formed over the dollar’s global status, when, as Russia invaded Ukraine in 2022, the US and NATO allies confiscated more than $300 billion of Russian government-owned US Dollars that were on deposit in the US and Europe. 

The threat: There is general agreement among most financial professionals that, if the US Dollar recedes from its nearly 100-year-old reserve status, the financial consequences for the US will be deep and lasting. 

3. The Social Security System’s permanent financial deficits must be among the new President’s top leadership priorities; Congress’s chronic procrastination on this subject must halt. In the presidential campaign of 2000, both George W. Bush and Al Gore tackled the emerging Social Security funding crisis, head-on. Gore proposed a “lockbox” concept to insulate the System from erosion, while Bush argued for a new carve-out, equities investment approach, to be made optionally available to the under-age-50 generations. 

Ninety years ago, the System was created to deliver known and dependable monthly income to retirees, for life, beginning at age 65. (At that time, a significant portion of the population had a life expectancy below age 65.) The System’s annual outlays have always been readily forecastable, because sudden demographic surprises are not possible. Funding: After its many decades of serving as a continuous government “net cash cow”, the System recently crossed into net annual cash deficits. And everyone knew that was coming, and when. So, the System’s depleting trust fund “assets” (consisting entirely¹ of non-marketable US Treasury “IOU’s”) will simply be gone in a very few years from now.  
 

Possible Social Security System funding solutions for the new president and Congress to consider will be: 

1. Working age and mortality update: Immediate postponement of full retirement benefit eligibility from age 67 now, to a new set of ages that are determined from recent actuarial studies². 

2. Jack up the FICA tax rate (again): Increase the payroll tax rate from an already significant 6.2% each, on employers and employees (plus another 1.45% each for Medicare); this solution would become increasingly less effective, in direct proportion to the amount of time delay before its adoption.  

3. Tax the currently untaxed earnings: Remove the maximum FICA-taxable pay limit (now $168,600), in order to tax 100% of highly paid earners’ total income. Clearly, this idea will apply to a small portion of income earners, so that it will have very limited System-wide impact. 

4. Removing those who “don’t need it” from receiving benefits: “Means testing” of individual high income social security recipients, in order to remove some, or all of their participation in the System’s benefits and simply converting it into a 2^nd form of income tax. (Such a move might be styled as requiring those affected to pay their “fair share”.) 

5. Introduce a measured-risk-level equity investment program for some portion of the FICA tax collections. In order to avoid politicians’ allegations that this would be a Wall Street fat-cats enrichment scheme, set up the entire investment program under a specialized government sub-agency. 

The most successful presidential campaign promise in American history  

Perhaps the most consequential and long-lasting economic impact that any US President has caused was Dwight Eisenhower who, in the middle of his 1956 bid for re-election, collaborated with a bi-partisan Congress that enacted his first-term dream [House vote: 388 to19]: the remarkable Interstate Highway construction program which has remained the all-time champion among governmental attempts at infrastructure. It was a mammoth investment program that will apparently last forever; by contrast, the 21^st Century has seen nothing even similar to its impact. The Interstate Highway program is still perpetually funded via a trust fund that, for 68 years and counting, collects a user-tax on sales of every gallon of gasoline, diesel fuel, etc. We suppose the tax must soon be broadened to add a “battery tax”. The legislation ingeniously put individual states in charge of devising all projects within their borders and it requires them to pay $10 of every $100 spent on Interstate road construction. 

Is the US stock market in a bubble? 

Probably not… Yet. As in the past, we look to the bond market to uncover emerging debt situations that would disrupt the banking system (and carry stocks sharply down with them). 
The broad US equity markets are not bubbling over as of now. Only some parts of it are. To draw that conclusion, we look at the returns from first 9 months of 2024 for the popular version of the S&P500 Index, which is internally weighted by each stock’s market value; we compare that to the same index, equally weighted. Among other things, this makes small cap stocks have the same impact as large cap. As of September 30, the market weighted index returned 22.1%, while the equal weighted version returned a solid, but much less extraordinary 15.2%. Thus, so far this year, the capitalization-weighted version has returned 145% of the equal-weighted one. 

Fundamentals: Today, the S&P 500’s aggregate, 12-month forward-looking price/earnings ratio is a little under 23x, which is full-bodied, but hardly bubble-istic. In fact, that figure is below what it was a year ago. By comparison, the tech sector’s forward p/e ratio is a frothy 33x. 

US credit card debt has recently risen very strongly from its Covid-period low and commercial real estate faces a serious struggle to fill possibly long-term-vacant office buildings and meet their debt repayment schedules (as noted in our most recent Commentary). Primary lenders must be watched for signs of relaxed credit standards that led to the 2007-08 Great Recession, when equities were sailing smoothly to new highs, while money lenders created credit extensions to un-credit-worthy borrowers on zero-down-payment loans.  

NOTE: Without public comment, Warren Buffett/Berkshire Hathaway has, since July, sold about $10 billion of its shares in Bank of America, a 23% reduction; earlier this year, he sold nearly 60% of his massive holding in Apple. This leaves Berkshire holding an extraordinary mountain of cash awaiting re-deployment. The Apple reduction is easily understood; the BofA one is perhaps more intriguing, because its industry functions on debt and interest rates. 

As of now, there do not appear to be emerging crisis conditions among worldwide debt and debtors, but we keep an eye on the European lynchpin governments of Germany and France. Both have run into serious economic woes, amid governmental mismanagement that has led to upheaval and a politically sharp right turn.

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Commentary

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