Tuesday, July 9, 2024

With a little luck we'll survive Biden's departure

This is one of those times when it's easy to find things to worry about, and right now they add up to a big deal. Figuring out what that means for the world of investments is the tough part.

To begin with, for years the federal government has been spending way too much money on non-productive things, thus sapping the economy's inherent strength. The federal debt is now almost 100% of GDP, and debt service costs are rising rapidly. The Fed is most likely too tight, holding short-term interest rates uncomfortably high relative to current and expected inflation. Meanwhile, the economy is growing at a modest pace that is unlikely to pick up anytime soon. Interest-sensitive sectors (particularly housing) are really being squeezed.

But the elephant in the living room is HUGE. The press and the DNC can no longer hide the fact that the president of the United States is mentally and physically unable to perform the duties of his office, and he's getting worse by the day. There is no question that he will not be the Democratic candidate for president on the November ballot (for proof of this, see this editorial in the NY Times). By all rights, and since he is unqualified to run, he is also unqualified to serve. It is thus quite likely that he will depart the Oval Office well before November, since he is now the DNC's worst nightmare. Worst of all, he poses a threat to global peace; nature abhors a vacuum, and the vacuum that pervades the White House is intolerable.

When you consider all this in the context of an equity market that has reached new highs in both nominal and real terms, it is troubling to say the least.

One way to make sense of all this is to conclude that the market is looking across the valley of despair to better times ahead. Biden's vow to allow the Trump tax cuts to expire at the end of next year and to instead raise taxes on the economy's engines of growth is now off the table. Happily, Biden will no longer be able to make foreign policy mistakes (he's been on the wrong side of every foreign policy issue for the past four decades, as Robert Gates once said). The Supreme Court recently issued decisions which will drastically curtail the power of the administrative estate, long Biden's ally, and Trump is likely to do even more in that regard. Green Energy subsidies are now an endangered species, as demand for electrical vehicles crumbles and the nation's power grid struggles to compensate for unreliable wind and solar power generation.

The charts that follow highlight some of the problems the economy is facing, as well as some of the indicators that suggest all is not yet lost.

Charts 1 & 2

Chart 1 shows government transfer payments (e.g., social security, medicare, medicaid, welfare) as a percent of disposable personal income). Since 1970, transfer payments have swelled from 10% of disposable income to now over 20%. Chart 2 shows the percentage of people of working age who are currently working, which began to collapse right around 2008-2009, when transfer payments surged in response to the Great Recession. Transfer payments essentially give money to people who aren't working. To paraphrase Art Laffer, when you pay people who aren't working, don't be surprised to find that fewer people are willing to work. 

Chart #3

It's not surprising, then, that the economy can only muster sub-par growth, as Chart #3 demonstrates. The 3.1% trend growth line (green) began in 1965, only to finally break down in the wake of the Great Recession and its avalanche of transfer payments. 2.2% per year seems now to be the new norm, as the red line illustrates. Had 3.1% prevailed, the economy today would be about 25% bigger. What a difference a 1% annual shortfall in growth can make after 17 years!

Chart #4

Chart #4 is one of my long-time favorites, since it shows two variables that have, until recently, foreshadowed the onset of every recession in my lifetime (with the solitary exception being the Covid black hole). When the Fed raises short-term rates to levels significantly higher than inflation—otherwise known as monetary tightening—and the Treasury yield curve inverts (red line), recessions typically follow. We are now very close to seeing both of these variables manifesting: real rates (blue line) are 3% and rising (still a bit shy of past peaks however), and the yield curve has been inverted for several years. If the economy avoids a recession it will likely be due to the Fed's policy of abundant reserves, an argument I've been making for the past 15 years. Abundant reserves all but guarantee that liquidity remains abundant, and that has the effect of inoculating the economy against credit busts and related recession. I've been making this argument frequently in the past 18 months.

Chart #5

Chart #5 reminds us that interest rates tend to follow inflation, albeit with a lag. (I've chosen ex-energy inflation to illustrate this since energy prices are by far the most volatile of all prices.) Note the asterisk on the lower right-hand side of the chart: inflation ex-shelter prices has been a mere 2.1% for the past year. Given the past behavior of housing prices, headline inflation is very likely to continue trending down. See this post for more information on why this is a valid point to make.

Chart #6

My no-recession-for-now call is not without risk, as Chart #6 suggests. The recently-released Small Business Optimism survey of employment intentions has deteriorated markedly in recent months, approaching levels associated with past recessions. 

Chart #7

Chart #8

Fortunately, financial markets to date show no sign whatsoever of any deterioration in the outlook for corporate profits. That's the message of Charts #7 and #8. Credit spreads on corporate bonds remain quite low.

Although the Fed's tight monetary stance is applying unnecessary pressure to the economy, it has not yet reached critical levels. And given that all signs point to a continuing disinflationary process (see my last post for more details), the Fed essentially has only one choice to make: when and by how much to lower interest rates. They are dragging their feet, but eventually they will figure this out. 

In the meantime, I think we'll need to worry more about external threats to global peace than about the US economy. Unfortunately my crystal ball holds no special insights into the minds of Vladimir Putin and Xi Jinping.


Tom said...

grave news that policy since 1970, and probably before, encourages people to leave the workforce and become dependent on government largess, paid for of course by the remaining workers. Only national bankruptcy can correct that.

As for the worrisome growth trendline, could that be corrected quickly by the Fed reverting to its pre-2008 policies? Surely anyone would recognize that 3.1% growth beats 2.3% growth, year over year. Personally, I would abandon the Fed entirely and restore 5% growth, which would help everyone, but let's just say that even a 1% gain in growth year over year would help average Americans immeasurably.

Salmo Trutta said...

Thanks for your work. Looks like N-gDp will be too low after JULY.

Jeff F said...

Based on these charts and those of the last couple of postings it seems like things are normalizing and the economy and the stock market should continue moving higher. What hasn't been shown is the increase in govt spending, the increase in debt during this time. And what also hasn't been shown is govt interest costs. It looks like some inflection point is on the horizon relating to ability of the govt to continue to increase spending and run large deficits.

With the possible exception of the small business optimism index, nothing indicates any concern of the markets to this potential issue.

Scott Grannis said...

Jeff F: I'll do a post on government spending and debt in a few days, following the release tomorrow of the June numbers. But the conclusion will be the same as it has been for the past few years: spending is indeed huge, as is total debt. But the burden of debt (interest costs as a percent of GDP) is not unprecedented—it was worse several decades ago, and we survived. I'd be willing to bet that a Trump administration will want to impose fiscal discipline in a big way.

Shane said...

I'll take the bet that the gov't under Trump does NOT impose fiscal discipline. He will instead, provide tax cuts to the rich, again, and claim it will reduce the deficit. It never does. Don't drink the kool aid. Both sides of the aisle simply can't stop spending. If you want that, you need a 3rd party that is fiscally conservative.

PerformanceSpeaksForItself said...

Thought exercise I'd like to hear opinions on:

Start with the assumption that the below is politically possible...

Why don't we use taxes to slow or stimulate the economy instead of (or in conjunction with) interest rates? The (govt-spending-induced) boom we just had could have been tapped to decrease federal deficits/debt.

cactus flower said...

Scott I enjoy your stats, even though I disagree with your right-wing take on them. You don't give the US any credit for getting back to the pre-COVID growth path, a feat unmatched by any other economy. https://www.federalreserve.gov/econres/notes/feds-notes/why-is-the-u-s-gdp-recovering-faster-than-other-advanced-economies-20240517.html

Also, PRIME-AGE labor force participation close to all time high levels:

Also, I would agree that the size of the budget defecit is problematic. I support not renewing the Trump/Ryan tax cuts. This will reduce fiscal stimulus and the interest burden and allow the Fed to cut rates, further reducing the interest burden.

Please don't cite Arthur Laffer, the biggest fraud in economic history.

Also I would be intersted in your take on the Argentine economy since Javier Milei took over as president.

Adam said...

Thanks Scott for your comments.
KKR makes the point that productivity has moved up, after being low for last 14 years.

Salmo Trutta said...

I don't think much of his KKR cycle. Money flows never turned negative.

Salmo Trutta said...

Zerohedge: ""surprise to the downside as it catches down to stale lagged real-time data, even as rents are actually rising right now... but the BLS won't observe this until early 2025."

Henry H said...

2nd quarter US EV sales up 11% YOY.

Pete S said...

Scott: you wrote that "The federal deficit is now almost 100% of GDP." Should that be "The federal debt is now almost 100% of GDP"?

Scott Grannis said...

Pete S: many thanks for catching that error! Now corrected.

Scott Grannis said...

Re "Arthur Laffer, the biggest fraud in economic history." I've known and studied Art Laffer for over 40 years, and I'll simply say that anyone who believes he is a fraud is manifestly ignorant.

Gerry F said...

Scott, ditto on Art Laffer!