Stocks gave back a little ground yesterday after setting record highs on Monday. The 10-year Treasury yield also slipped a bit. The IMF raised the forecast for U.S. growth this year to 6.4%. It is likely to be significantly higher than that. A few Democrats have begun to question the wisdom of raising corporate taxes back to 28% from the current statutory rate of 21%. Given that the White House likely will need every Democrat to sign on to get anything done, it would appear that 25% is the new ceiling. It is still early, but reaction to last week’s monumental infrastructure ask suggests this bill will be changed significantly before anything can be passed.
Congress has already passed a $1.9 trillion bill. The request made last week is for another $2.3 trillion, and at least one more multi-trillion-dollar bill is likely to be requested. That third bill will almost certainly contain proposed tax increases on high-net-worth individuals. All this is on top of multi-trillion bills already passed in response to the Covid-19 pandemic.
You have read my thoughts many times that the pandemic accelerates change. Clearly, President Biden looks at the aftermath as a springboard for his version of a New Deal, one that not only provides economic and health care support related to the physical and economic ravages of the past year, but also begins to cure the problems Democrats perceive that plague lower and middle class Americans. This letter isn’t a forum on the worthiness of such an effort, rather it acknowledges it. Over time it is our collective job to assess the economic impact of these plans, the likelihood of passage, and the effect on financial markets.
In that regard, it is difficult to discount what we don’t know. We do know the ask, at least the infrastructure part of the ask. There are requested items which can and will gain bipartisan support. We all know that road and bridge repair has lagged. Many would like users to pay a higher burden through tolls, gasoline taxes or other methods tied to road usage. The Biden approach is to tax corporations, a tax that will likely be treated as a general cost to be passed through to customers in general. Other parts of the ask also have bipartisan support, including increasing Federal R&D spending, support for accelerating supply chain changes, and incentives to move manufacturing back to the U.S. Other social agenda items, including $400 billion for additional support for seniors and the disabled, face greater challenges.
If you look back to prior administrations, there were many requests that never saw the light of day. At the same time, major events that shake the nation’s core have been springboards for broad new legislation. The financial crash of 1907 ultimately led to the creation of the Federal Reserve a few years later. The Great Depression led to the New Deal. The assassination of President Kennedy was a catalyst for the passage of Medicare and a host of bills that increased civil liberties. Covid-19 is such a seminal moment, although how much can still get done is still unknown.
What we do know are two things. First, the U.S. is having a growth surge. As it continues, it will benefit more and more Americans. There are still close to 8 million fewer workers than before the pandemic began. But new job creation in the months ahead, as labor intensive sectors of the country reopen such as restaurants, airlines, and hotels will close that gap quickly. Stimulus checks will lend support to those most in need. Other protections like unemployment benefits and foreclosure protection remain in place at least through the rest of this year. While it is true that investors and home owners are reaping outsized benefits, almost everyone is participating to some extent. That is showing up in the economic data. Clearly, the stock market is reacting in a positive manner.
The second thing we know is that current monetary and fiscal policy is on a flight path never taken before. Never before has the Fed pumped so much money into an economy that could be growing at a rate approaching 10%. Never has the Federal government spent so much money so fast. How is this possible? It is all being done with borrowed money. As recently as the 1990s our nation actually generated a surplus when stock market gains provided extraordinary capital gains receipts. Now we are running $3+ trillion annual deficits. With a majority of the nation soon to be vaccinated against Covid-19 and everyone having availability to shots within weeks, the pandemic should be fading rather rapidly. Yes, I get the modest surge underway and the risks posed by mutations. But Moderna and others can alter vaccine formulations within days to counter the mutations. Scientific tools do amazing things!
Massive debt isn’t a problem with zero interest rates. In fact, if rates stayed at zero (or below) across the entire duration curve, borrowings, in theory, could be infinite. The Fed has been doing its part. By buying $120 billion of bonds each month, it basically cuts the Treasury’s borrowing burden almost in half. However, most Fed watchers assume that as the economy continues to gather strength, the Fed will eventually slow its pace of bond purchases. There is also a general assumption that inflation will rise along with increased demand. 10-year Treasury yields are still negative in real terms, in large part related to Fed policy. But they are almost double what they were in December. They could double from here over the next year or so.
If Federal debt, excluding holdings of the Fed and other government agencies, soon reaches $25 trillion, that means every 1% increase in borrowing costs is equal to an additional expense of $250 billion. This is a real number. Yes, our government can print money to pay the bills. But deficits on the order of $3 trillion cannot be funded fully by American bond buyers. They require foreigners to buy as well. As with any debt, the buyer will assess the credit worthiness of the borrower. Acknowledging that the U.S. can pay its debts, the ultimate question is the future value of the debt. Germany collapsed after World War I when its paper became worthless. In the Civil War, confederate dollars had no value. No one, including myself, is insinuating that the dollar is about to collapse. But there may be consequences of too much debt when interest rates rise to an undefined level. There are members of Congress in both parties who, therefore, believe that there are limits to unfunded investment. As noted many times, approving spending is easy for Congress. Raising taxes to pay the bills is hard.
With all this said, investors react to what they know and fret a bit about unintended consequences. At the moment, with interest rate rises slowing, if only for a few weeks, and earnings surging, stocks are on a joy ride. There is no better combination than surging earnings without inflation. Add in the ongoing flood of new money coming from the Fed, and investment excitement only increases. At times it has gotten excessive. We have seen pockets of irrationality, but they seem to be waning at the moment, at least in the stock market. Surging home prices are probably diverting some money into real estate. The birth of non-fungible tokens (NFTs) has the art market and other collectible markets aflutter. Digital images with tokens attached that make them unique are suddenly selling for millions of dollars. I suspect that as new artists race to participate in this new world, prices will quickly settle down. The bottom line is that with so much money flooding markets, euphoric pockets will appear, surge and then wane. Money will chase the surges whether they be IPOs, SPACs, NFTs, or whatever comes next. Only when the dust ultimately settles will we know what’s real (some) and what’s not (a lot). For now though, surging earnings are the story and the tales will be told individually by company managements over the coming weeks as they report first quarter earnings.
Today, Russell Crowe is 57. Jackie Chan turns 67.
James M. Meyer, CFA 610-260-2220