We’re finally at the moment of truth, the Presidential election. For those of us in Pennsylvania it will also mark the end of the endless barrage of distorted ads that by now have no chance of changing anyone’s mind. By Friday evening over 71 million Americans had already voted. By the end of today, half of those who will cast their ballots will have already voted.
Once again, this has been an election between two flawed candidates. Too many of us are choosing the lesser of two evils for the third consecutive election. Both campaigns have been decidedly negative although each is giving a last minute attempt at positive spin. If Trump loses, it will likely be his inability to stay on message. If Harris loses, it will be because she hasn’t been able to articulate a Kamala message. When asked persistently how she might be different from Biden, a President with an approval rating barely above 40%, her answers have been non-answers. Regardless, most of all, I hope the voters choose the winner, not the courts. As always, my comments that follow will only focus on economic issues.
To start, all the campaign promises of new freebies, tax credits, tax exempt tips, no tax of Social Security, etc. are almost all dead on arrival. Both candidates are willing spenders while neither has a cogent plan to pay for all the spending. Who pays, at least partially varies with the two. Trump wants to cut taxes on the wealthiest, while through tariffs or a VAT tax, he wants to have lower income groups pay where today, they often pay nothing at all. Harris wants to exempt the bottom 98% from any tax increase getting whatever additional income she can from the upper echelons. Changing tax structures requires Congressional approval. Tax legislation starts in the House. Control likely won’t be decided by Wednesday morning. But as Republicans have shown over the past two years, slim majorities rarely can find consensus without some help from the other side of the aisle. Republican leadership could never corral a rogue group of “my way or the highway” Freedom Caucus members. Should Democrats gain control, AOC and her squad are unlikely to cozy up to the more moderate House members very often. Once again, some consensus across aisles might be necessary to get anything done.
Even if legislation gets through the House, it faces a tough road getting through a Senate where the majority is likely to control 52 seats or less. While tax legislation can pass under reconciliation with just a majority, the Senate is likely to be more fiscally responsible than the House.
The real bugaboo is that arcane item called the debt service. You may notice that the words debt service haven’t been uttered on the campaign trail. Trump would rather talk about Arnold Palmer’s anatomy. Harris simply repeats ad nauseum about lifting the middle class.
But our nation has now accumulated over $35 trillion in debt. Investors should have noticed that both gold and bitcoin are at new highs while the 10-year Treasury is up from 3.5% in September to 4.3% today, even after the Fed cut rates by 50 basis points in September. While some might say markets are moving higher as Trump’s odds improve (investors love the twin thoughts of lower taxes and less regulation), that could explain the stock market. But the bond market’s message is quite different. Growth may or may not be better under Trump, but tariffs, any sort of VAT, lower taxes, and excessive stimulus combine to form the perfect recipe for a return of inflation. That means higher interest rates.
Bond cycles are long. From the early 1950s until Paul Volcker invoked two recessions to tame inflation, the trend in bond yields was steadily higher. From 1982 until 2022, the opposite occurred. Bond yields fell steadily. As the Federal Reserve anchored the Fed Funds rate near zero for over a decade, 10-year yields fell from double digit levels to under 1.5%. Only after the Fed determined that inflation wasn’t simply a transient event and started to raise the Fed Funds rate did QE take a back seat to reality.
Today debt service is near $1 trillion. It exceeds total defense spending. Within another year or two it will exceed Social Security and soon thereafter Medicare. And that assumes deficits can be sustained well below $2 trillion per year. For years, foreign buyers, notably in China and Japan, have been huge buyers of U.S. Treasuries. But China’s holdings today are down over 25% from their peak. Bond prices, like everything else, march to the laws of supply and demand. Not only does Treasury have to borrow to fund additional deficits over the next several years, but it must also refinance all the debt coming due.
Some will argue that since the dollar is the world’s reserve currency, Treasury can simply print more money if there are insufficient buyers. True. But at what cost? The ramifications of higher debt service costs go far beyond the Federal budget. Bank loans that must be marked to market will be worth less. Higher rates mean borrowers can only afford to borrow less. How far can a consumer let his credit card balances run if rates are well over 20%?
While the Fed Funds rate, now below 5% and likely to fall another 25 basis points when the FOMC meets this week right after elections, bank prime rates today are 8%. And many small businesses dependent on bank financing must pay a premium to the prime rate. All this with inflation below 2.5% today.
I don’t mean to be a Cassandra, but there is a day of reckoning somewhere in the future. Next week? Next year? Next decade? No one will know until it happens. But the faster the next administration runs up the debt and deficit, the sooner that day will come. There don’t need to be 20 or 30 deficit hawks in the Senate. 5 will do the trick. Someone will ultimately fill Joe Manchin’s shoes.
Shrinking government is hard. Debt service and entitlement requirements make that even harder. Less spending means some people or businesses get paid less. It’s hard for any politician to vote for that.
The Fed, therefore, will have to be the anchor against the wind. Whereas a year ago there was talk of the Fed Funds rate getting back below 3% by the end of 2025, it might not even get below 4% anytime soon. For sure FOMC members will watch GDP growth (still a healthy 2.8% at last reading), and employment data, but any uptick in inflation or a rise in the 10-year Treasury yield back to or above 5% will raise many eyebrows.
What happens in 2025 is made more uncertain by the changing of the guard in the White House. If Harris is elected, she almost certainly will try to fulfill all her campaign tax giveaways. How different she will be from Biden is still an open question, but she isn’t likely to become a fiscal conservative. If Trump wins, some sort of tariffs are likely early. As for his tax giveaways, their only chance of success will be if the vast majority of Republicans buy into whatever scheme is developed to fund the giveaways. Remember 8 years ago when Mexico was going to fund a wall from the Pacific to the Gulf of Mexico and ObamaCare was going to be repealed? What we ultimately are likely to see from either will bear only vague resemblance to what we have been hearing on the campaign trail for months.
The Federal Reserve meets Wednesday and Thursday this week. While we will still be focused on the election outcome, what Jerome Powell says Thursday may have more bearing on markets than the Presidential election, at least over the short-term. Powell won’t speculate about what may happen economically after January 20. Rather, he is likely to say that our economy is in a good place today with inflation still falling, employment numbers decent and economic growth better than expected. But will he warn whoever wins that the battle against inflation requires responsible fiscal policy? Frankly, if the outcome is still in doubt Thursday, that would be a great time to issue such a message. The message wouldn’t be just to the presumptive President-elect; it would be for Congress as well. Monetary policy works best in sympathy with sound fiscal policy.
If markets believe that Congress and the next President can act reasonably, stocks could move higher in 2025. Better earnings will lift markets if 10-year yields remain well below 5%. But if markets start to fear Washington is not only overspending but is doing so at a pace that exceeds the past few years, all financial markets could be in big trouble. Think of all the commercial real estate debt that must be rolled over or refinanced over the next two years. Think about the impact of higher rates on bank balance sheet assets. Think about how small businesses will do after paying double-digit interest on borrowed money. Is it just an old man losing his marbles that moves Warren Buffet to almost completely exit an enormous position in Bank of America? I would bet on Warren still making logical sense.
Either candidate could ultimately take the fiscally responsible road. Either could spend first and hope for the best. The campaign is now over. Debt service matters. Name calling doesn’t. 160+ million Americans will vote by tomorrow evening. Markets will vote over the next few months, not based on campaign promises, but on a sober look at what the next President’s fiscal agenda looks like.
Today Mathew McConaughey is 55. Fittingly, on this election eve, it is worth noting that it is the anniversary of the birth of Walter Cronkite.
James M. Meyer, CFA 610-260-2220