Authored by Mike Petrino, Sr. Portfolio Manager
“Markets can remain irrational longer than you can remain solvent.” - John Maynard Keynes
Investors looking past the potential for instabilities in both the economy and capital markets. The current price earnings multiple for the S & P 500 on trailing twelve-month earnings is about 26. This compares to the long-term median multiple of about 15 times trailing twelve-month earnings.
Near-term optimism, driven by the Fed’s largely successful effort to lower inflation will be challenged by new threats to price stability and economic growth, if current economic policies remain in place. The CBO estimates that the Federal Budget deficit for the current fiscal year will be about $1.5 trillion. If current budget policies and spending programs are not altered, the CBO expects an additional $21 trillion to be added to the current Federal debt outstanding over the next ten years. How will this debt be financed?
The Fed could buy the debt and increase the money supply once again. There are some early signs the Fed has stopped reducing liquidity as part of its effort to control inflation. The monetary base which was declining is now remaining stable in the most recent measurement periods. This trend leaves the base about $ 4.5 trillion higher than it was in 2008 when the Fed first began its mission to rescue the economy from a deep decline. Their effort to shed assets was interrupted by an economic collapse driven by policy responses to the COVID-19 pandemic. And now, the Fed may need to choose to maintain price stability or bail out the Treasury.
If the Fed does not step up and finance the debt, an effort to increase tax revenues by raising tax rates may ensue. Based on the data available since the federal income tax was instituted in 1913, raising rates will likely reduce economic activity in the private sector and produce tax receipts well below expectations; the deficit will increase. The most recent data show a decline in personal income tax receipts on a year-over-year basis. Raising tax rates will cause this trend to persist.
Arthur Okun, one of the original supply siders, served as an economic advisor to both JFK and LBJ. He wrote:
“High tax rates, are followed by attempts of ingenious men to beat them as surely as snow is followed by little boys on sleds.”
Reducing the rate of growth of spending below the rate of growth of revenues is unlikely. The CBO has noted the primary drivers of spending include Social Security and Medicare. There is little or no political will to reduce the rate of growth of these entitlements, but Congress may be forced to reduce benefits. The latest report from the Trustees for SS presents the conclusion that SS will not be able to meet its obligations after 2036. At some point, benefits may be reduced as they were when the retirement age was raised to 67, or tax revenues must be raised, but in the near- term, neither of those actions is likely.
The Fed will be forced to choose, finance the deficits, or control inflation. The Fed has chosen the policy that raises inflation for the last 50 years. Since Nixon closed the Gold Window in 1971 the CPI has risen from roughly 40 to 304. The price of gold has risen from about $35 to just under $2000. The price of oil has risen from under $7.00 per barrel to $70.00 per barrel. It may take some time, but inflation will rise to well over the Fed’s target of 2%.
Gov’t Spending/GDP Ratio Chart:
