Going through my regular reading this week I kept coming across articles and quotes that brought to mind a recent piece by Tom McClellan titled Presidential Cycle Effects With A New President. In the article, he compares the current stock market pattern to that of 1980, revealing:
…in the 30 years I have been doing this, I have seen a repeating theme where a new president typically spends the first 2 years “discovering” that things are even worse than he told us during the campaign. Each week there is a new revelation of some crisis condition left to him by the prior administration, and a claim that the “only solution” to these myriad problems is whatever package of taxes, tax cuts, spending, reform, etc. that the new guy wants to get Congress to pass. This is important because investors tend to get bummed out by hearing that things are worse than we all thought. And that makes people incrementally less interested in investing.
This seems an especially insightful take on today’s environment. Certainly, the incoming administration has already made it very clear that, as Kevin Warsh puts it in an op-ed for The Wall Street Journal, “The Trump administration is inheriting a fiscal and monetary mess.”
On the fiscal side, both federal spending and the national debt have risen 50% over the past five years, as Warsh points out. Interest costs on that debt have tripled to $1 trillion per year. With interest rates rising, it’s not a surprise to hear more talk of a “death spiral,” as J.D. Vance put it a few months ago. That concept is catching on inside the beltway as the message from the bond market gets clearer with every basis point the 10-year yield rises.
“The bond market is telling Congress that if we don’t get our fiscal house in order, everybody’s mortgage rates, everybody’s credit card rates, everybody’s auto loan rates, are going to continue to go up,” as Republican Representative Andy Barr puts it to Reuters. Apparently politicians are finally getting the bond vigilante’s message.
That message is in regards to the, “sea change in the fiscal policy,” as Bloomberg’s Simon White writes, which has created a situation in which, “the ‘Fed put’ has become the ‘fiscal put’ as governments increasingly take on the role of provider of first resort.” In other words, the central bank has enabled and encouraged a degree of fiscal irresponsibility that threatens to create a “debt spiral.” Furthermore, the risk of such an outcome would only be exacerbated by the incoming administration’s proposed tax policies.
Which brings us to the monetary side of the mess that the incoming administration is inheriting. In providing that “fiscal put,” which requires monetizing the amount of debt that cannot be easily absorbed by market participants, the central bank has failed in its mandate to ensure stable prices. In fact, five years after inflation first broke out above the Fed’s 2% target it has still not fallen back near that level.
Moreover, there are few signs that it is poised to do so anytime soon. Coming back to Simon White: “The underlying pressures for a reacceleration in price growth are there.” Those price pressures can be seen in rising food and energy prices which White reminds us, “was one of the big supply shocks in the inflationary 1970s.”
With important measures of the breath of inflation, such as median CPI and trimmed mean CPI, still hovering around 3 to 4%, a “reacceleration in price growth” poses a very clear risk to the Fed’s ability to meet its mandate in the near future. Furthermore, the pro-cyclical tax policy and protectionist trade policy proposed by the incoming administration also threaten to exacerbate any nascent reacceleration in price pressures that is already underway.
So there is a great deal of truth to the idea that we currently face a fiscal and monetary mess that needs fixing. Additionally, it seems everyone knows exactly what that fix requires. As Chris Jeffery, head of macro strategy at the UK’s biggest asset manager, tells Bloomberg, “the incoming Treasury Secretary has talked about aiming for a 3% deficit in 2028. Bond investors have no reason to go on strike if the Federal government adopts such aspirations.”
Obviously, this begs a number of questions investors should be asking right now including (via Stephen Jen), “if the US embarked on a fiscal consolidation program to bring its fiscal deficit down from the current 6-7 percent of GDP to the Maastricht limit of 3 percent of GDP, which is what many non-European countries consider the threshold of tolerance in the absence of major recessions, what would its GDP growth rate be, and where would the FFR need to be? Where would the dollar trade?”
In other words, ‘what would the loss of government spending equal to 3 to 4% of GDP do to the economy, inflation, interest rates and the dollar?’ Well, incoming Treasury Secretary Scott Bessent told Congress this week that a failure to merely extend the tax cuts implemented in 2017 and set to expire at the end of this year would trigger, “economic calamity.” Of course, there is some exaggeration for political purposes likely happening here.
However, there is at least a grain of truth to it. Over the past decade, pro-cyclical fiscal policy has boosted both the economy and the deficit to no small degree, beginning with Trump’s tax cuts and ending with Biden’s IRA. Any backing off of that policy now risks downside economic consequences. And that would be before any discussion of any counter-cyclical policy like cutting spending, let alone spending equal to 3% of GDP (roughly $1 trillion) which would have far greater downside consequences.
To whatever degree the economy would be slowed by such policies, both inflation and interest rates would likely fall commensurately. The dollar, too, would thus decline due to the slower growth and less attractive bond yields. In short, all of the things that have driven the dramatic outperformance of U.S. equities relative to the rest of the world in recent years would go into reverse.
This brings us back to the message from the bond vigilantes. What the recent rise in interest rates, in direct contradiction of Fed policy, is likely reflecting is that politicians either need to address the fiscal mess today or the bond market with force them to deal with it tomorrow by way of an outright buyer’s revolt.
Facing such a situation creates a major incentive for the incoming administration to deal with it immediately so that the blame can be placed at the feet of the prior one which, as McClellan notes, has a long political tradition. For this reason, all the talk of “economic calamity” may not be mere talk. It may, in fact, be laying the foundation for a policy shock, represented by the widespread use of tariffs and spending cuts (along with a reversal of immigration policy), that could bring about such an outcome to one degree or another.
That is not at all what the stock market is discounting right now but may help to explain why McClellan’s presidential cycle price analog could prove eerily prescient today.
