By Justin Pawl, CFA, CAIA, CFP®
Two important developments occurred over the last two weeks that were not widely covered by the media but are already moving markets. One development explains why President Biden is suddenly willing to negotiate a lower infrastructure spending bill, and the other helps explain why interest rates are moving lower despite higher-than-expected inflation.
Early last week, the Senate parliamentarian (the official advisory committee on the interpretation of Senate rules and procedures) clarified an earlier ruling that the Democrats can only use reconciliation one more time in 2021. As recently as April, Senate Majority Leader Charles Schumer thought he could pass two more reconciliation bills this year, already having used one fast-track procedure to pass the $1.9 trillion American Rescue Plan in March. The new ruling complicates the Democrats’ plans to fast-track President Biden’s remaining $4 trillion economic agenda without Republican support.
As a result, aides believe there’s now more pressure on Biden to negotiate a scaled-down infrastructure plan with the Republicans. Last week Biden made considerable concessions to win Republican support in his latest proposal. First, he reduced new spending in the bill from $2 trillion to $1 trillion. Second, he pledged to leave the 2017 Tax Cuts and Jobs Act (TCJA) in place, stepping back from a negotiating “red line” for Republicans. Even if a deal gets done, the TCJA is not safe, as the Democrats are likely to use the reconciliation process later this year to pass a tax-and-spend stimulus package that would receive little GOP support. Priorities in the reconciliation package are likely to include raising the corporate tax rate, repealing the cap on state and local tax deductions (SALT), tax breaks for clean energy, and hundreds of billions of dollars for social programs. It’s worth noting that reconciliation is not a lay-up for the Administration. Democrats hold only thin majorities in the Senate and House, which is why financial markets are discounting how much of Biden’s remaining $4 trillion stimulus plans will come to fruition.
What’s interesting is that even if Biden is successful in pushing an additional $4 trillion into the economy, his Administration is only forecasting a short-term boost to economic growth. Released quietly on the Friday before Memorial Day, President Biden’s $6 trillion fiscal 2022 budget showed a two-year GDP mini-growth boom of 5.2% in 2021 and 4.3% in 2022. However, GDP growth is expected to decline to 2.2% in 2023 and then average less than 1.9% annually for the next eight years.
The White House’s forecast stands in stark contrast to Biden’s “Build Back Better” slogan of higher long-term growth. Indeed, the projection concedes that spending now is borrowing from future growth, as the debt will need to be repaid through growth-inhibiting higher tax rates and tighter monetary policy, both of which are featured in the forecast.
As so often happens, bond markets seem to be way ahead of economic policy and even budget negotiations. Despite higher-than-expected inflation in the economy, the “smart money” is pricing in subdued economic growth and tepid inflation beyond the next couple of years. After rising sharply in the first quarter, the yield on the benchmark 10yr UST has settled into a tight trading range of 1.5% – 1.7%.
Sources: Bloomberg L.P. and Covenant Investment Research
Slower growth in a few years is, to some degree, baked in the cake. Our pre-pandemic thesis of “Good, But Not Great” economic growth was based on an aging U.S. population, immigration trends, and demographic headwinds reducing the potential output of the U.S. economy. The massive wave of stimulus put that thesis on pause, but it did not change the fundamentals underpinning the thesis. Short of a substantial increase in productivity, the U.S. economy will not be able to escape the gravitational pull back to the 2%’ish growth rate that preceded the pandemic.
From an investment perspective, this forecast implies a continued struggle for savers who rely on traditional fixed-income investments for a significant portion of their income. Lower starting interest rates also reduce bonds’ ability to provide the level of portfolio protection investors have relied upon historically for the next economic downturn or equity market collapse.
Last Week Today.
- Institute of Supply Management. The ISM Manufacturing and Services Indices confirmed that the economy is booming. For May, both indices remained above 60, which on its own is “rare air,” but the Services index rose to 64.0, the highest reading since the index’s creation in 1997. Survey respondents reported difficulty in finding workers along with raw material shortages as the primary bottlenecks to increasing production.
- Labor Market. Reports of a shortage in available labor fly in the face of the May payrolls report, which was weaker than expected, with nonfarm payrolls rising by 559K. With 7.5 million fewer people working than in April 2020 but a record number of job openings, those not working work don’t appear overly eager to take a job. And why would they? The WSJ recently reported that in 19 states, the maximum benefits for a family of four equate to $100,000 a year in salary. Not working is a logical economic choice for many. We’ll see in a few months if steps taken by states to eliminate federal unemployment supplements increase hiring pace.
- G-7 Minimum Tax. Secretary of the Treasury Janet Yellen successful negotiated a minimum corporate tax rate of 15% with G-7 finance ministers over the weekend. However, it remains to be seen how impactful this agreement will be. First, local taxes rates for most of the G-7 countries exceed 15%, so they really aren’t giving up much. Second, all of the countries, including the U.S., must follow their respective political processes to pass the minimum tax as law. Third, the G-7 countries are only a small part of the larger global community, and many countries outside the G-7 don’t support the proposal.
- Summertime Rolls. Defying the old Wall Street “sell in May” adage, equity markets rolled into the first official month of summer with widespread gains. Developed international markets and the U.S. indices recorded gains of ~0.6%, while Emerging and Frontier Markets rose 1.6% and 2.1%, respectively. Value reasserted its outperformance over Growth indices, gaining 0.8% vs. 0.3% and extending their YTD lead to 19.3% vs. 6.7%. It’s not unusual for Value stocks to recover faster than Growth stocks coming out of a recession. While the pandemic-induced recession was different from any that preceded it, the Value/Growth axiom is thus far following script. Longer-dated USTs joined the rally as well, pushing the benchmark 10yr UST down to 1.55%. The inflation-adjusted (“real”) rate on the 10yr UST is now -0.84%. Oil continued its run higher, gaining 5% on the week, with WTI Crude closing at $69.62 per barrel. For more detailed asset class performance, click on the table below.