August 18, 2023 – Markets are starting to face the sober facts. Deficits, high interest rates, and surging Federal spending all matter. Most of all the cost of money matters. It affects what you pay in rent, what you pay for your credit card balances, and how much spending the government can support given its surging deficits. The rising costs to service debt inhibit central bank efforts to reduce inflation.

It hasn’t been a good week for stocks, or for that matter, long dated bonds. Both took a shellacking for the same reasons. Bond yields are rising because of a surge in government issuance and fears that a spike in government spending, including all the handouts of the pandemic era, are feeding an unsustainable surge in economic growth. While the surge avoids a recession at least for now, it hinders the ability of tight monetary policy to defeat inflation for the long term.

Why am I harping about the inability to win the war when inflation has been falling at a steady pace for several months? The decline in the pace of inflation was the catalyst for the sharp stock market rally of June and July. By the end of July, many market forecasters were predicting new all-time highs before the end of this year despite a drop in earnings. While conceding earnings were facing a bumpy near-term road, a soft landing would allow a reacceleration next year sending earnings to new record highs. Without inflation, P/E ratios would move even higher. The combination meant new record stock prices as far as the eye could see.

Is that reality or a fairy tale? Time, of course, will tell. But let me ask the obvious question. How does inflation fall in an economy that adds close to 200,000 jobs per month, that operates with close to 80% manufacturing capacity (anything above 80% is historically inflationary), and with Federal outlays growing at a double-digit rate? Does adding $100 billion each to annual spending on Medicare, Social Security and debt service matter? To date, $757 billion of the $790 billion loaned in the PPP program during the pandemic has already been forgiven. Now, three years later, employee retention tax credits of about $80 billion are adding to the largesse. Hey, handouts are great. Who turns them down? But when you think, why hasn’t the economy reacted yet to all the interest rate increases to date, the answer becomes obvious if you look carefully. The reason there has been no recession to date is that consumers are spending the handouts. And they will continue to do so until the cookie jar is empty.

When will that be? There are signs that we are getting to the bottom of the jar. While spending continues to be strong, credit card balances are rising. So are late payments. They aren’t at alarming levels yet, but they are moving in that direction. Retail sales are still rising. But that is because of inflation. Adjusted, real sales aren’t rising. Homebuilding is robust because of a lack of quality homes for sale. But total home sales are declining. So are prices. Rents had been rising, but with a surge of new apartments coming to market, rental rate increases are slowing and starting to decline in many markets. Isn’t all this deflationary? The answer is yes. But it also suggests economic activity is starting to slow below the surface. Airline travel is still robust. But fares are falling looking ahead, a sign that the robust post-Covid demand is coming to an end. Manufacturing has been on a bumpy road for months. Although oil and gasoline prices are rising, most commodities are in decline. Most of the recent bump in producer prices relates either to higher energy prices or higher labor rates.

What we are experiencing is two tectonic forces pushing in opposite directions. Government spending and handouts are still surging while central banks raise interest rates in an effort to slow the economy and reduce inflation. Logically, the two should work together. But not in a world one year away from a Presidential election.

The battle is reflected in the bond market. Short-term rates are holding steady or rising slowly despite a consensus view, at least until recently, that the Fed is done raising interest rates. Longer-term bond rates are rising quickly, a combination of a belief that rates will stay high for longer, a pending spike in debt issuance by the Federal government, and increasing concern that the Fed can’t win the war against inflation while government spending goes off the charts.

The Biden administration’s answer to rising deficits is to raise taxes. That has no chance, at least not until 2025 and only if Democrats win both the House and Senate. The Republican answer is to cut spending. But where? Any cuts in discretionary spending will get wiped out and then some from mandated increases in entitlements and debt service. As is always the case in government, problems aren’t addressed before a crisis, only after.

With all that said, 70% of our economy is consumer spending. As noted, that has been robust. It has been robust because of accumulated savings during the pandemic, and because 96.5% of the workforce is gainfully employed and, at least for now, has little or no fear of losing one’s job. But at some point, spending beyond one’s income runs into a road block. The excess savings runs out. High interest rates mean credit card debt is expensive. Real expensive. If the rate is 20%, individuals with a $1,000 balance pay an additional $200. It makes one think twice before incurring more debt. Given the cost of credit card debt, it’s the last debt anyone chooses to incur. But, nonetheless, it is rising.

All this sounds bleak, probably bleaker than near-term reality suggests. But the goldilocks scenario the markets gravitated to just a few weeks ago, now has holes given the escalating cost of money. In a world of rising rates, rates that exceed anyone’s prediction of the future pace of inflation, the cost of money inevitably matters. It means growth is going to slow, at a pace to be determined later. Banks are going to become more restrictive lenders. If growth slows enough, job growth will slow. Or stop. That will create more consumer caution.

These fears are beginning to affect markets. They include fears that the Fed may still have to raise rates further. Look for Fed Chairman Jerome Powell to say just that next Friday at the Fed meeting in Jackson Hole. There is no Goldilocks scenario that leads to 2% inflation amid accelerating growth, 3.5% (or less) unemployment, and surging Federal spending. If you get that kind of surge, you get a resurgence of inflation. If you tamp down growth, you risk a recession. You simply can’t have it both ways.

To get back to a normal world doesn’t require a crushing recession. Without an agreement between Republicans and Democrats on spending, a partial government shutdown at the end of September is possible. Spending levels will be a focus, as they should be. Other headwinds will be a resumption of student loan repayments, tighter bank lending restrictions, weaker economies overseas (particularly China), and higher costs to borrow. All this, I view as positive.

The S&P just broke below 4300 today. The current 10-year yield, without any other factors considered, suggests a normal market P/E of 14-16. Let me use 16. Earnings on the S&P 500 this year might be about $215. Again, let me be optimistic and suggest that $240 is possible next year with only a brief recession early in the year. That implies a price of 3840. Add another 10% to that for 2025 and you still only get back to where the market is today. That may be a bit too pessimistic, but the point is that current prices are hard to justify. Said differently, the risk today, despite the recent market correction, is still to the downside.

Actor Edward Norton is 54 today. Robert Redford is 87. Film director Roman Polanski turns 90.

James M. Meyer, CFA 610-260-2220