WEEK AHEAD

"Planes don't stay in the sky forever.  They do land.  I expect a relatively soft landing, but a landing it will be."

– Glenn Hubbard, Former Chair U.S. Council of Economic Advisors, The Economic Club of New York, June 2, 2024. 

The Gathering Storm 

Winston Churchill's six-volume history of the Second World War was published in 1948. The first volume, The Gathering Storm, recounted the events leading up to the beginning of the war. Churchill argued that the British government ignored Germany's easily observed preparations for aggression. The government was preoccupied with domestic issues and had little incentive to turn its attention to developments on the European continent. 

Currently, the U.S. is faced with a "Gathering storm" that presents somewhat different risks but significant risks. There are military conflicts in Ukraine and the Middle East, the U.S. budget deficit is large and persistent, the course of monetary policy remains unclear, and significant increases in corporate tax rates and capital gains tax rates appear to be inevitable. In the face of these threats to economic stability, the S&P 500 price-earnings ratio on trailing twelve months' earnings is about 25, well above the historical mean of 18. 

Some of the largest stocks in the Index are selling at lofty multiples: Amazon's PER is around 96, Nvidia's PER is 75, Tesla's PER is 44, and Lilly's PER is about 116. Valuations at these levels are consistent with a high degree of confidence that economic growth will be sufficient to sustain rising earnings far into the future; however, investors appear to be focused only on the near term when establishing investment strategies. 

Quarterly earnings announcements and any data that might shed light on the Fed's near-term monetary policy are shaping the outlook for most investors. Monthly CPI data give an accurate reading on whether the Fed is making progress in its effort to reduce inflation to its 2% objective. The consensus among investors is the Fed will lower interest rates and increase liquidity once inflation is reduced to the objective. There is evidence the Fed has begun increasing liquidity without reaching the 2% inflation objective. The growth rate in the Monetary Base, high-powered money, turned positive in September of 2023.  

While recently released data may support expectations for a rising stock market and sound economy in the short term, the data relevant to developing expectations for the economy's medium—and longer-term performance reveal threats to real economic growth and a stable inflation rate. 

The CBO estimates the Federal budget deficit in fiscal year 2024 will be $1.6 trillion, and it will grow to $1.8 trillion in fiscal year 2025 and grow further to $2.6 trillion by fiscal year 2034. The deficit as a percentage of GDP will be about 6% on average from 2024 through 2034. Since the Great Depression and the end of WW II, the U.S. has experienced deficits at this level only during the 2007-2008 financial crisis and the coronavirus pandemic. 

Social Security and Medicare are the primary drivers of government expenditures, totaling 50% of the federal budget. Despite the estimate of the Social Security trustees that the programs will not be able to provide the scheduled benefits beginning around 2033, there are no plans and no willingness to reduce the rate of growth of spending for these programs. 

The CBO estimates for large deficits have prompted a response on the part of the Biden Administration, which is proposing significant tax rate increases with the expectation that the increased tax rates will produce increased tax receipts and smaller deficits. On balance, the proposed tax rate increases will make tax rates on U.S. corporations and individuals among the highest in the OECD. With the Biden Administration's proposed increase in tax rates, the U.S. combined corporate tax rate will be the highest in the OECD. The U.S. tax rate on capital gains will be the second highest in the OECD. The U.S. tax rate on personal income will move well above the OECD average, 46.3% versus 42.5%.  

There is ample empirical evidence to support the conclusion that raising tax rates will not produce the anticipated increase in tax receipts. The rate increase will lower real growth, and lower corporate and personal income will follow. Presidents Hoover, Roosevelt, Eisenhower, Nixon, Bush, Clinton, and Obama implemented increases in tax rates with the expectation that tax receipts would increase. In each case, receipts were below expectations, and in most cases, a recession followed the rate increases.  

As the large deficits become a reality, the Fed will be faced with a choice of monetizing the debt or maintaining its effort to keep inflation at the 2% level. In the past 53 years since President Nixon closed the gold window, the Fed has chosen to monetize the debt. As a result, inflation rose well above the 2% target. Since 1971, the CPI has been eight times higher than at the beginning of the period, the price of gold has been approximately 68 times higher, and the price of a barrel of oil has been approximately 25 times higher. If the Fed behaves as it has since 1971, the economic environment will deteriorate as inflation increases and real GDP growth falls.  

Economic dislocations can be avoided, and the Gathering Storm might dissipate, but a prudent investor might consider buying an umbrella.