A Mild Recession and S&P 4,500

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 26, 2023

Very early this year our economics team got a pleasant surprise: Consensus Economics, which collects forecasts from roughly 200 economists around the world, rated us the most accurate forecasters of the United States for 2022, based on our forecasts for GDP and CPI. Unfortunately, we don’t expect a repeat award for 2023.

For 2022, we saw inflation and continued moderate growth. We were right. This past year, in 2023, we anticipated economic weakness late in the year, and put our S&P 500 target at 3,900. Instead, the economy remained resilient and stocks rallied much more than we thought. As we said a year ago: “if it turns out that Chairman Powell and the Federal Reserve have engineered a soft landing – no recession in 2023 and with the market ending 2023 confident of not having a recession in 2024 – then stocks should rally substantially in 2023 and easily beat our S&P 500 target of 3,900.” Today, that’s what most stock market investors are thinking: a soft landing has been achieved and they should therefore be optimistic about the future.

But we don’t think the economy is out of the woods yet. The consensus among economists is now that the economy will continue to grow in 2024, with a soft landing and no recession. We think that’s too bullish and see a mild recession with a -0.5% real GDP print on the way for 2024.

The yield curve has been inverted for more than a year and is likely to remain so well into 2024 and the M2 measure of the money supply is down 3.3% from a year ago, while commercial & industrial loans have also declined. Commercial construction has been temporarily and artificially supported by government subsidies in the past couple of years and should soon start faltering. Payrolls have grown very fast in the past year even with an unusually low unemployment rate, suggesting that businesses have over-hired.

Meanwhile, consumer spending looks set to slow. Government payouts, rent and student loan moratoriums, and temporary tax cuts during COVID led to bloated overall savings for many consumers. In turn, they could relax in 2022-23 and save a smaller part of their ongoing earnings than they normally would. But the artificial boost from these government actions is likely to finally run out in 2024, which suggests to us consumer spending will moderate significantly in 2024.

It's also important to realize how much the federal budget deficit expanded last year. The official deficit was about $1.7 trillion in FY 2023 but would have been $2.0 trillion if it hadn’t been for the Supreme Court striking down much of President Biden’s plan to forgive student loans. But that Court decision didn’t change the government’s cash flow; the Education Department just wrote up the value of its loan portfolio. In other words, the underlying cash flow situation for the federal government was no different than if we had run a deficit of $2.0 trillion, or about 7.4% of GDP. For last year, in FY 2022, excluding the student loan scoring, the deficit was about 4.0% of GDP. That’s a huge one-year spike in the deficit, which temporarily lifted spending.

But this won’t continue. The budget deficit won’t grow again in 2024, given the rally in stocks in 2023, big tax payments are likely due, which takes away this temporary stimulus.

What will happen to inflation? We think it keeps heading down in 2024 and may even finish the year at, or perhaps even temporarily below, the Federal Reserve’s 2.0% target. However, if we do hit 2.0% don’t expect to stay there for long. The Fed is likely to cut rates about as aggressively as the futures market now projects, about 150 basis points in 2024. And, unless the money supply keeps falling, inflation is likely to move back up in 2025 (and beyond); above the Fed’s 2.0% target.

What does this mean for stocks? The good news for stocks is that if the economy is weaker than expected and inflation keeps heading down, long-term interest rates will tend to decline, as well. That’s important because our Capitalized Profits Model takes nationwide profits from the GDP report and discounts them by the 10-year US Treasury yield, to calculate fair value.

If we use a 10-year Treasury yield of 3.50% the model says the S&P 500 is fairly valued, with current profits, at about 4,450. In other words, for the first time in many years, the US stock market is very close to fair value. And, the path of both profits and 10-year Treasury yields, in the next year, is uncertain.

We expect profits to be weaker than the consensus expects in 2024, and with Fed rate cuts of 150 basis points, the 10-year to end the year around 3.5%. Putting this all together, including the fact that the S&P 500 closed on Friday at 4,754, we think it finishes 2024 at 4,500, or lower.

Remember, this is not a trading model, and it doesn’t mean investors should run out and sell all their stocks, it just means investors need to be selective. The past few years have been the most difficult time to forecast in our careers. The US economy has never gone through COVID lockdowns before, plus a reopening, along with such massive peacetime fiscal and monetary stimulus. We understand many think we can do all this with little, or no, significant impact on the economy. We don’t believe this conventional wisdom. 2024 will be a tough year.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Greedy Innkeeper or Generous Capitalist?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 18, 2023

The Bible story of the virgin birth is at the center of much of the holiday cheer this time of year. The book of Luke tells us that Mary and Joseph traveled to Bethlehem because Caesar Augustus decreed a census should be taken. Mary gave birth after arriving in Bethlehem and placed baby Jesus in a manger because there was “no room for them in the inn.”

Some people think Mary and Joseph were mistreated by a greedy innkeeper, who only cared about profits and decided the couple was not “worth” his normal accommodations. This version of the story (narrative) has been repeated many times in plays, skits, and sermons. It fits an anti-capitalist mentality that paints business owners as greedy, or even evil.

It persists even though the Bible records no complaints and there was apparently no charge for the stable. It may be the stable was the only place available. Bethlehem was over-crowded with people forced to return to their ancestral home for a census – ordered by the Romans – for the purpose of levying taxes. If there was a problem, it was due to unintended consequences of government policy. In this narrative, the government caused the problem.

The innkeeper was generous to a fault – a hero even. He was over-booked, but he charitably offered his stable, a facility he built with unknowing foresight. The innkeeper was willing and able to offer this facility even as government officials, who ordered and administered the census, slept in their own beds with little care for the well-being of those who had to travel regardless of their difficult life circumstances.

If you must find “evil” in either of these narratives, remember that evil is ultimately perpetrated by individuals, not the institutions in which they operate. And this is why it’s important to favor economic and political systems that limit the use and abuse of power over others. In the story of baby Jesus, a government law that requires innkeepers to always have extra rooms, or to take in anyone who asks, would “fix” the problem.

But these laws would also have unintended consequences. Fewer investors would back hotels because the cost of the regulations would reduce returns on investment. A hotel big enough to handle the rare census would be way too big in normal times. Even a bed and breakfast would face the potential of being sued. There would be fewer hotel rooms, prices would rise, and innkeepers would once again be called greedy. And if history is our guide, government would chastise them for price-gouging and then try to regulate prices.

This does not mean free markets are perfect or create utopia; they aren’t and they don’t. But businesses can’t force you to buy a service or product. You have a choice – even if it’s not exactly what you want. And good business people try to make you happy in creative and industrious ways.

Government doesn’t always care. In fact, if you happen to live in North Korea or Cuba, and are not happy about the way things are going, you can’t leave. And just in case you try, armed guards will help you think things through.

This is why the Framers of the US Constitution made sure there were “checks and balances” in our system of government. These checks and balances don’t always lead to good outcomes; we can think of many times when some wanted to ignore these safeguards. But, over time, the checks and balances help prevent the kinds of despotism we’ve seen develop elsewhere.

Neither free market capitalism, nor the checks and balances of the Constitution are the equivalent of having a true Savior. But they should give us all hope that the future will be brighter than many seem to think.

(We’ve published a version of this same Monday Morning Outlook during Christmas week, each year, since 2009.)

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

What Should the Fed Do? How About Nothing?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 11, 2023

For the first time in roughly fifteen years, interest rates in the United States are about right. In economics, we call it the “neutral” or “natural” rate. The Taylor Rule says rates should be higher, and our model that uses nominal GDP growth (real GDP plus inflation) says the same thing. But both these models rely on data that is still distorted by COVID.

A simpler approach is to assume interest rates should be “Inflation Plus.” If we judge current inflation using an average of the Cleveland Median CPI (up 5.3% from a year ago) and overall total CPI (up 3.2% from a year ago) we get 4.2%. “Plus 1%” says rates should be roughly 5.2%. And that’s almost exactly where the federal funds rate is today.

This is a big change. Between 2008 and today, the Federal Reserve held the funds rate below inflation roughly 83% of the time. These excessively low rates have created problems.

Banks have hundreds of billions of dollars of mark-to-market losses and government-funded green new deal projects are facing serious problems because they are not profitable at current neutral interest rates. In other words, holding rates down artificially, like the Fed did for years, may make things look OK, but it can’t last forever.

At the same time, the Fed grew the M2 measure of money so rapidly in 2020-21 that inflation was easy to see coming. But now the M2 measure of money is contracting. So, with money contracting and interest rates near normal, it seems appropriate to pause. Especially given the fact that tighter money seems to be helping inflation come back down from its post COVID spike.

But it is certainly not time to claim victory and return to an environment of artificially low rates. That would risk repeating the 1970s, when Arthur Burns cut rates before eradicating inflation. If, as we suspect, the US economy enters recession in 2024, the political pressure on the Fed to cut rates and restart QE will be intense. But it would be a big mistake unless inflation continues to fall and thereby reduce the “neutral” interest rate. All it would do is continue the mistakes of the past fifteen years.

One interesting thing we have observed is how much bank regulators, Fed members, and Treasury officials have shifted their thinking. Back in 2008, Hank Paulson, Ben Bernanke and Sheila Bair religiously adhered to mark-to-market (MTM) accounting. We still blame this accounting convention for the financial panic that ensued. But that panic was used to justify growing the Fed’s balance sheet by trillions of dollars with QE and supporting TARP, which grew the size of the federal government.

These policies were supposed to make the US financial system safer, but they didn’t. Because the Fed became so powerful and flooded the banking system with deposits (at artificially low rates), bank balance sheets now have an estimated $675 billion in losses on them.

Interestingly (and thankfully) banks don’t have to mark these assets to market anymore. It would wipe out almost a third of bank capital. But what happened to all these MTM believers? Did they only believe in MTM accounting when they could blame it on banks? Now that it is clear the Fed’s policies caused the losses, are they trying to avoid blame?

The bottom line is that those who think the Fed can just manage its way out this easily, cutting rates to offset the pain of recession (or avoid one entirely), may not be correct. Many seem to have submitted to “state-run capitalism.” But history shows it has never really worked. The Fed is likely to “do nothing” this week and holding that position in 2024 might not be a bad thing.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Disinflation, Not Deflation

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

December 4, 2023

New home prices are much lower than a year ago. The average price of a new home sold in October was 10.4% lower, while the median price was down 17.6%.

Records on new home prices go back all the way to the Kennedy Administration and never before has the median new home price dropped so much in twelve months, even during the bursting of the housing bubble in 2007-11. Is this a signal that monetary policy has become excruciatingly tight, that deflation – an outright and generalized drop in consumer prices – is about to grip the US economy?

Hardly.

In fact, deflation doesn’t even have a grip on the housing market. New home prices only include the prices for the new homes sold each month, which in the past year has averaged about 55,000 per month. That’s out of a total housing stock of about 145 million homes. In other words, new home prices reflect what’s going on each month with only about 0.04% of all homes.

Another big problem with just looking at prices for new homes sold is that those sold in October 2023 might be very different in size and quality than the new homes sold a year ago. Mortgage rates are higher, so many new home buyers are cropping their appetites, buying smaller homes to reduce their projected future mortgage payments. And builders are reacting to this, building smaller, less expensive homes. As a result, the average and median prices are falling, but not the price per square foot.

Better gauges of national home prices include the Case-Shiller index and the FHFA index, which are designed to adjust for the quality of homes. They also attempt to track the sales price of the same homes over time. These two indexes show home prices up 3.9% and 6.0% in the past year, respectively. In other words, no deflation. Home prices are not really falling.

And, when politics gets involved with economic data, confusion is often the result. When you hear that “inflation is falling” what that means is that prices are still rising, just not as fast as they were a year ago. The PCE price index, the Fed’s favorite measure for inflation, is up 3.0% in the past year versus a gain of 6.3% in the year ending in October 2022. Core PCE prices, which exclude food and energy, are up 3.5% in the past year versus a gain of 5.3% in the year ending in October 2022.

We expect this process to continue, with consumer prices climbing, but at a slower pace. Yes, they might fall in a particular month when energy prices drop, but even in those months core prices will continue to rise.

It’s important to remember that although the M2 measure of the money supply is down 4.5% from the peak in July 2022, that follows the surge of 40% that preceded it. That huge increase is still wending its way into the economy, and it would be crazy to try to take all that money back out. That would cause a massive deflationary problem. As a result, the general price level is permanently higher than the path it was on pre-COVID.

The bottom line is that the stance of monetary policy is tight enough to keep bringing inflation down in 2024. But don’t expect it to stay there so long that general prices start consistently falling. At present, the futures market is pricing in a drop in short-term interest rates of about 1.25 percentage points. We think the rate cuts will be steeper, the front edge of a shift in policy that will eventually cause an echo of the 2021-23 inflation problem in the years ahead. Unfortunately, like the 1970s.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Argentina: Is the Pendulum Swinging, Again?

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 27, 2023

When Argentina entered the 20th Century, its prospects looked bright. On a per person basis, its economy was on par with Canada and Sweden and about two-thirds of the United States.

This all changed in 1946 when the country elected Juan Peron to the presidency. Peron launched plans to foster social justice through economic redistribution. The government sector grew rapidly (spending and money printing) and very high inflation (300%+) became the norm. Standards of living plummeted.

Without a change in policies, inflation could not be eradicated. Then, in the 1990s, Argentina tried a currency board arrangement where each Argentine peso was backed by one American dollar. Like the old-fashioned gold standard before the creation of the Federal Reserve, each unit of Argentine currency was backed by something that held its value. That currency board system worked for about a decade, bringing inflation down to US levels and spurring a decade of solid economic growth.

However, it broke down in 2001-02, largely because government spending never really subsided. When the government couldn’t print new money, it borrowed. Investors (correctly) thought politicians would abandon the currency board and let the value of the peso fall at the first sign of economic trouble. And that’s exactly what happened.

Now Argentina finds itself with another lost decade of growth and hyper-inflation. Recently, Argentina’s per person GDP stood less than 20% of US levels, and below even Russia.

But last month brought a political earthquake: the presidential election was won in a landslide by Javier Milei, a libertarian economist, and an unbridled and outspoken critic of socialism and supporter of free-market capitalism.

Milei wants to end the Argentine peso and central bank completely and just use the US dollar as the country’s currency. That way, re-introducing the peso would be very hard, so Argentines could be confident the government wouldn’t devalue again. He wants to slash government spending, including spending on the social safety net and get rid of lots of government agencies.

Unfortunately, he has his work cut out for him. Although he’s popular with voters he doesn’t come from a political party with widespread support in the legislative branch. As a result, it remains to be seen how much Milei can accomplish.

And yet this isn’t the only big shift at the polls in recent months, with voters in New Zealand and the Netherlands swinging toward leaders seeking some major changes.

The long historic battle between those who support wealth creation and those who support wealth redistribution, continues. The pendulum is starting to swing. We think much of this recent pattern is due to voters getting fed up with governments that are too big. Even the election of Geert Wilders in the Netherlands, ostensibly about immigration has a big government component, due to taxpayer-funded resources that, right or wrong, voters think recent immigrants’ demand.

When governments are already very large, and inflation rises while growth suffers, it’s harder for the left to make bigger government appealing to voters, and easier for the right to make trimming government look attractive.

The pendulum is swinging toward smaller government. If leaders fulfill this desire, investors around the globe will have reason to cheer. While Argentina has followed a different rhythm than many Western countries, the elections of Margaret Thatcher and Ronald Reagan changed the direction of global economic growth. Is it happening again?

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Consumer Spending Set for Slower Growth

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 20, 2023

Now that we’re about to enter the Christmas shopping season, expect even more focus than usual on the consumer over the next several weeks.

We are supply-siders and so usually cringe when we hear analysts and investors dwell on consumption as if it were the ultimate arbiter of economic growth. Ultimately the economy depends on production, which, in turn, hinges on entrepreneurship and innovation, the labor supply, as well as the health of cultural institutions like property rights and freedom of contract.

The government can affect these factors by raising or reducing tax rates, increasing or lowering spending, and adding or cutting regulations. Meanwhile, monetary policy can lead to temporary deviations from these long-run factors, with a policy that raises or reduces inflation.

On top of all this, the wild policy response to COVID – with enormous government checks sent directly to bank accounts – left consumers with more purchasing power than they’d normally have, given output. In turn, that has meant following the consumer is one way to gauge the extra inflationary impulse still remaining in the US economy, as well as the timing of the onset of the tighter monetary policy – the M2 measure of the money supply has dropped 4.4% – that the Federal Reserve began implementing last year.

In the year ending in September, “real” (inflation-adjusted) consumer spending is up 2.4%, no different than the growth rate in the ten years immediately prior to the onset of COVID. However, there are multiple reasons to believe that growth rate should soon decline.

First, much of the increase in spending in the past year has been driven by increases in jobs. Total payrolls are up 243,000 per month in the last year, which is unusually fast given an unemployment rate below 4.0%. A slowdown in job growth should limit the growth in consumer purchasing power.

Meanwhile, consumers have been eating into the excess saving they were able to accumulate during COVID, back when the government was passing out checks with reckless abandon. Immediately prior to COVID, in February 2020, US consumers, in the aggregate, were accumulating savings at a $1.28 trillion annual rate. That’s personal income, minus taxes, minus consumer spending. By contrast, in September 2023, consumers were saving at a $690 billion annual rate.

For the time being, accumulating savings at a slower rate makes sense; the government showered consumers with checks during COVID and so they got used to not having to save for themselves. But eventually we expect that old pace of saving to reassert itself. Even if it takes two years to do so, an increase in the pace of saving back to $1.28 trillion per year should trim consumer spending by about 1.5 percentage points per year. That alone could take a pace of real consumer spending growth of 2.4% per year down to less than 1.0% per year. Ouch!

Then there are student loan payments that have finally re-started. By itself, that’s unlikely to be a major issue; we estimate the effect at about 0.2% of consumer spending. But it should be a small headwind.

None of this means that consumer spending has to plummet anytime soon. But we don’t need consumer spending to drop in order to have a recession. That’s what happened in 2001, for example, when real consumer spending rose a respectable 2.0%, while the unemployment rate rose almost two percentage points, as well.

Some economists are already taking a victory lap because they didn’t forecast a recession and a recession hasn’t started yet. But we think they’re declaring victory too early. Some of them say that we never should have been worried about a recession while inflation fell because the surge in inflation was due to supply-chain issues, and then the reduction in inflation has been due to fixing those issues.

The problem with their theory is that they ignore the link between the surge in the money supply in 2020-21 and the inflation that followed, as well as the drop in money and the reduction in inflation this year. They think it’s a coincidence, but we think they’re going to get a rude awakening in the year ahead.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The Election Outlook is a Tax Outlook

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 13, 2023

We’re now less than a year away from a presidential election and control of the White House, Senate, and House are all up for grabs. One of the biggest issues facing the winners is going to be how to handle the federal budget.

As we set out a couple of months ago, the US is currently running the most reckless budget in the history of the country. Never before has the deficit soared so quickly to such a high level when the US is still at peace and not in recession.

No wonder Moody’s just announced it was downgrading the outlook for US debt to “negative” from “stable.” They claim it’s because of political “polarization” on top of the deficit itself, but that seems odd. Moody’s makes it sound like we’d be better off if no one on Capitol Hill cared at all about the deficit, because then our institutions wouldn’t be polarized! The way we see it, thank goodness there are some politicians focused on the deficit, even if that’s what’s causing more polarization.

For the presidency, we think 2024 is likely to be a rerun of 2020, Biden versus Trump, although retiring Senator Joe Manchin may throw a monkey-wrench into the election if he can find a Republican to run with. At this point, we think Trump would be a slight favorite; but will face constant challenge given how much of the electorate dislikes him. Meanwhile, the House of Representatives is likely (but not definitely) going to go to the party that wins the White House.

The Senate is an easier call, with the GOP in excellent political position to win for fundamental reasons. At present the GOP has 49 seats. But Republicans don’t have to defend any seats in blue (Democratic) states and only have to defend one seat in a purple state, Florida, which is very unlikely to suddenly lurch back toward the Democrats, given the recent popularity of Republican governance in that particular state. In other words, we do not see a route for the Democrats to win any seats now held by the GOP.

However, there are multiple seats where the Democrats are vulnerable. Now that Joe Manchin is retiring, it’s extremely likely that the GOP picks up West Virginia with popular Governor Jim Justice having thrown his hat in the ring. Republicans are also favored to knock off an incumbent Democrat in Ohio, plus have a shot in Montana as well as in Arizona, and Nevada.

In turn, the election will have a major influence on what happens to the Trump tax cuts originally enacted in 2017 and which are set to expire at the end of 2025. We think the odds of a GOP sweep are about 30%, which would probably result in a full extension of those tax cuts and the GOP pushing through substantial reforms to Medicaid as well as major budget cuts outside of national defense. If the Democrats sweep – we put those odds at about 20% – look for substantial tax hikes, on individuals and businesses, alike, and not just on the “rich.”

That leaves a 50% chance of mixed government, in which case expect modest tax hikes, with a slightly higher top rate for individuals, a slightly higher rate on companies, but with lots of talk and little action on cutting government down to size. And without spending cuts, expect negative outlooks to turn into outright and deserved downgrades in the years ahead.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Government Is Too Darn Big

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

November 6, 2023

Two weeks ago, the yield on the 10-year Treasury Note was hovering around 5%, and the S&P 500 was in contraction territory, down over 10%. But last week, the 10-year yield dipped to 4.6%, while the S&P 500 saw a 6% gain. This market volatility is attributed to changing sentiments: 1) There was a belief that the Federal Reserve had lost control, but now, 2) it seems the Fed has achieved a "soft landing," bringing a semblance of stability.

While this may hold some truth, we remain cautious. If we step back and look at the US economy from a distance, things don’t really look so great. Our worries have roots all the way back in 2008, when the Fed altered its approach to monetary policy. The Fed shifted from a "scarce reserve" model to an "abundant reserve" model when it initiated Quantitative Easing, fundamentally changing how interest rates are determined.

In the past, banks occasionally lacked the reserves they were legally required to hold, prompting them to borrow from other banks with excess reserves through their federal funds trading desks, thus determining the federal funds rate through an active market. Today, banks are flush with trillions of excess reserves, eliminating the need for borrowing and lending reserves. Consequently, the federal funds trading desk has become obsolete.

So…if banks are not creating a market for federal funds, were does the rate come from? The answer: the Fed just makes it up. Literally makes it up. And, over the past fifteen years, the Fed has held the funds rate below inflation 83% of the time.

The last time the Fed kept rates artificially low was in the 1970s. The result was inflation, but even more importantly, banks and Savings & Loans lent at rates lower than they should have. The ultimate result was the dramatic downfall of the S&L industry, along with many banks, as the losses incurred from offering high interest rates to depositors while getting low rates from borrowers steadily eroded their capital.

Today, US commercial banks carry an estimated $650 billion loss in their “held to maturity” assets…but they don’t have to mark them to market. Just imagine if this was 2008 and Treasury Secretary Hank Paulson, Fed Chair Ben Bernanke and FDIC Chair Sheila Bair were in charge. They would have insisted on mark-to-market and we would need TARP 2.0 to bail out the banking system.

What the Fed will do is pay these private banks and other institutions roughly $300 billion this year just to hold reserves. Without this payment from the Fed to the banks, profits would be much lower and the losses on their books would be more painful.

The point we are making is that the Fed has made a mess of the banking system. While we've averted major crises thus far, it's the taxpayers who ultimately bear the burden. The $300 billion the Fed pays to banks doesn't appear out of thin air, and unless interest rates decrease significantly, these losses will accumulate. Why isn’t Elizabeth Warren fuming over this?

Like the 1970s and 1980s – because we don’t have mark-to-market accounting on these held-to-maturity assets – the banks can eventually earn their way out of this abyss. So, this doesn’t mean the economy will suffer, other than the fact that banks have less ability to make new loans.

This is exacerbated by the Fed engineering a decline in the M2 measure of money, which has fallen by 3.6% in the past year, the most substantial drop since the Great Depression.

Some of this decline is because since 2008 the Treasury Department has started holding a great deal of cash in its checking account at the Fed. For decades it held just $5 billion as a cash management tool. This number soared after QE started, and as of November 1, 2023, the Treasury General Account (TGA) at the Fed held $820 billion. This money is part of the Fed’s balance sheet, but does not count as M2. So, when the Treasury borrows from, or taxes the private sector, and then puts that money aside in its own TGA, it will lower M2. In other words, the Treasury has helped engineer a decline in M2. The Treasury could use this $820 billion to reduce debt, but it hasn’t, and taxpayers will pay roughly $40 billion per year in interest, just so the Treasury/Fed can hold this cash.

This new method of managing monetary policy appears fraught with risks. Instead of stabilizing banks, it has introduced instability, proved costly to taxpayers, and contributed to the worst inflation since the 1970s.

We aren’t saying that the economy can’t survive, but the idea that everything will turn out perfectly seems like wishful thinking. The government has expanded significantly since 2008, with federal government spending growing from 19% of GDP in 2007 to 25% last year, and the Fed's balance sheet has expanded from 6% of GDP in 2007 to 33% of GDP.

It's evident that we no longer operate in a free-market capitalist system. While government involvement in the economy is not new, it has reached unprecedented levels.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Three on Thursday

First Trust Economics

November 2, 2023

In this week’s edition of “Three on Thursday,” we investigate the most recent IRS tax data from 2020 to gain a comprehensive understanding of the federal income tax landscape in America. Amid the ongoing public discourse, you often encounter discussions about the wealthy not contributing their “fair share” or instances like Warren Buffet paying a lower tax rate than his 20 office colleagues, which some view as evidence of a tax system that’s not progressive enough. But what do the actual data reveal? It may hold some surprising revelations. To offer deeper insights, we’ve included three informative charts below.

The most recent IRS data from 2020 underscores the highly progressive nature of the federal income tax system. Individuals in the top 1% (those with an adjusted gross income of $548,336 or higher) paid an average of 26% of their income to the Federal government. Meanwhile, those in the bottom 50%, (earning $42,184 or less) had an average income tax rate of 3.1%. This significant difference shows that the top 1% pay an average federal income tax rate that’s 8.4 times higher than the bottom half of all taxpayers.

The top 1% is comprised of roughly 1.6 million income tax returns, and make 22.2% of total adjusted gross income, but they shoulder a significant 42.3% of the overall federal income tax burden. Conversely, the bottom half, consisting of nearly 79 million income tax returns, make 10.2% of total adjusted gross income, yet their federal income tax burden is comparatively light at 2.3%. It’s worth noting that the bottom 96% of taxpayers, accounting for approximately 151.2 million tax returns and 64.8% of the adjusted gross income, collectively bear 40.5% of the total federal income tax load. This still falls short of the share carried by the top 1%.

Over the past four decades, those within the highest income quintile have consistently witnessed their portion of the federal income tax burden increase, rising from 65.0% in 1979 to 89.7% in 2019, the most recent year recorded by the Congressional Budget Office. In stark contrast, those in the lower four income quintiles have experienced a different trajectory. The lowest and second quintiles have reduced their tax liability share to -4.8% and -1.6% in 2019, respectively, down from -0.1% and 4.2% in 1979, meaning that now the bottom 40% not only pay no federal income tax, but also receive additional income. The middle income quintile has also experienced a decline, falling to 3.5% in 2019 from 10.7% in 1979. Similarly, the fourth income quintile has decreased to 13.1% from 20.2% over the same period.

Source: Congressional Budget Office, First Trust Advisors. Data from 1979-2019.

This report was prepared by First Trust Advisors L. P., and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

It’s the Same Bear Market

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 30, 2023

The S&P 500 closed at 4,117 on Friday, more than 10% below its recent peak in late July. Some are saying it’s a brand-new bear market for stocks. In this view there was a bear market in 2022, a bull market from October 2022 through July this year, and a new bear market that started in August.

We don’t think this is the appropriate way to look at things. This is not a new bear market. Instead, it’s the same bear market. We had a bear market in 2022, a temporary rally, and then the bear market reasserted itself.

The driving forces behind the ongoing bear market have not changed. Federal policy of easy money and extremely loose fiscal policy during COVID kept a serious recession at bay. That is basically over now. The M2 measure of money is down 3.6% in the past twelve months. Second, the massive episodes of COVID-era government spending/stimulus had to eventually wear off, which is revealing lots of malinvestment and now generating economic headwinds.

We think much of the headwinds from these shifts are still in front of us. Yes, the economy grew at a rapid pace in the third quarter but that includes contributions from consumer spending and inventory accumulation that were unsustainably hot. Meanwhile, business investment should slow as companies can earn robust returns by hoarding cash with little to no credit risk. Speaking of interest rates, they are now above inflation across the yield curve. The artificial boost from artificially low rates is gone.

This is why we remain bearish. At the end of last year we forecast that the S&P 500 would finish 2023 at 3,900 and we haven’t budged since, remaining bearish throughout the rally that took the S&P 500 all the way up to 4,600 this summer.

It hasn’t been easy taking this position. Equities tend to trend upward over long periods of time, as the real economy and profits tend to grow, and the price level rises, as well. We still believe the US future is relatively bright: entrepreneurs are still creating and innovating, and artificial intelligence shows great promise. We are also hopeful that sometime in the next few decades there will be major technology breakthrough in the energy sector. Our natural tendency is toward bullishness.

Clearly, we are not “permabulls” and never have been. From 2009, all the way through 2021 we remained bullish. We didn’t run with the herd of other forecasters worried that the world had come to an end in 2008. And, while we are bearish today, we don’t think it’s the end of the world now.

Eventually, stock prices will reflect fair value. More importantly, we expect the political pendulum to swing back toward the center. Big government directed economies eventually suffer…then recover when policy shifts back.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Growth Surge in Q3 Masks Weak Trend

First Trust Monday Morning Outlook

Brian S. Websury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 23, 2023

We still think a recession is coming, but it definitely didn’t start in the third quarter. Instead, as we set out below, it looks like real GDP expanded at a 4.7% annual rate. If we are right about that number, that would be the fastest pace of growth for any quarter since 2014, with the exception of the re-openings from COVID in 2020-21.

Keep in mind, though that even with growth that fast, the growth rate since the end of 2019 – the pre-COVID peak – would be only 1.9% per year, reflecting an underlying trend that is still slow.

Why do we still think a recession is coming? Because after the surge in money creation in 2020-21, monetary policy started getting tight in 2022. In the past year the M2 measure of the money supply is down 3.7%. Meanwhile the yield curve (we like to compare the 10-year Treasury yield to the target federal funds rate) has been inverted since late 2022 and is likely to stay that way for at least the next several months.

Higher short-term interest rates mean businesses have the ability to lock in healthy nominal returns on cash with minimal risk. In turn, this should lead to a reduction in risk-taking and business investment.

Meanwhile, jobs are still expanding rapidly. Payrolls are up 2.1% in the past year. During the economic expansion that happened before COVID (mid-2009 through early 2020), a pace that fast (2.1% or more) only happened when the unemployment rate was about 5.5%, which meant plenty of workers still available for hire. Now it’s happening when the unemployment rate is less than 4.0%. This suggests employers are out over their skis and vulnerable to any softness in demand.

The bottom line is that the economy grew rapidly in Q3 but Q4 and beyond are likely to be much slower.

Consumption: “Real” (inflation-adjusted) retail sales outside the auto sector rose at a 3.7% annual rate in Q3 while it looks like real services, which makes up most of consumer spending, should be up at about a 4.0% pace. The one weak spot was autos and light trucks, which declined at a 2.5% rate. Putting it all together, we estimate that real consumer spending on goods and services, combined, increased at a strong 4.1% rate, adding 2.8 points to the real GDP growth rate (4.1 times the consumption share of GDP, which is 68%, equals 2.8).

Business Investment: We estimate a 4.5% growth rate for business investment, with gains in intellectual property and equipment leading the way while commercial construction was roughly unchanged. A 4.5% growth rate would add 0.6 points to real GDP growth. (4.5 times the 14% business investment share of GDP equals 0.6).

Home Building: Residential construction is showing some resilience in spite of some lingering pain from higher mortgage rates. Home building looks like it grew at a 7.5% rate, which would add 0.3 points from real GDP growth. (7.5 times the 4% residential construction share of GDP equals 0.3).

Government: Only direct government purchases of goods and services (not transfer payments) count when calculating GDP. We estimate these purchases – which represent a 17% share of GDP – were up at a 1.8% rate in Q3, which would add 0.3 points to the GDP growth rate (1.8 times the 17% government purchase share of GDP equals 0.3).

Trade: Looks like the trade deficit shrank in Q3, as exports expended rapidly in spite of foreign economic weakness. We’re projecting net exports will add 0.5 points to real GDP growth.

Inventories: Inventories look like they grew a little bit faster in Q3 than in Q2, suggesting they’ll add about 0.2 points to the growth rate of real GDP. When a recession hits, we expect inventory declines to play a significant role in the drop in GDP.

Add it all up, and we get a 4.7% annual real GDP growth rate for the third quarter. Look for much slower growth in the fourth quarter.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Big Government Weighing on Growth

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 16, 2023

At the end of October we will get our first look at real GDP growth for the third quarter and it looks like it was very strong. We’ll have a more exact estimate a week from now – after this week’s reports on retail sales, industrial production, and home building – but it looks like the economy grew at about a 4.5% annual rate.

Even if that turns out right, however, the underlying pace of growth is much slower than what happened in Q3. From the end of 2019 through the third quarter, the average rate of growth would be 1.9%. From the end of 2007 – right before the Great Recession and Financial Panic – through the third quarter, the average growth rate would be 1.8%. Both these figures pale in comparison to the growth of the 1980s and 1990s.

Raising the long-term growth rate of the US economy ought to be a key focus of policymakers. Unfortunately, we seem to be moving in the opposite direction, with the government expanding, which means more redistribution.

According to the Congressional Budget Office, federal spending should total $6.131 trillion in the fiscal year that ended on September 30. But that includes the effects of the Supreme Court striking down much of President Biden’s plan to forgive student loans. That decision created a $333 billion “negative outlay” for Fiscal Year 2023. Without that decision, which didn’t affect the government’s cash flow, total federal spending would have been $6.464 trillion. We estimate that would translate to 24.0% of GDP, in a year when the jobless rate averaged 3.6%.

Let’s put that in historical perspective. In FY 2019, the last year prior to COVID, the jobless rate averaged 3.7% and federal spending was 21.0% of GDP. Back in 2000, at the peak of the first internet boom, federal spending was 17.7% of GDP. Some of this increase is due to higher interest costs, but most of it is not and the trend is not good.

In turn, this reminds us of one of our fundamental ways of thinking about the economy. Imagine ten people stranded on an island, living at subsistence, each person using a spear or even her hands to catch two fish each per day, barely surviving. Then two of them decide to risk it all and build a boat. They go out one day and bring home twenty fish. Hallelujah! Enough to feed everyone.

With this bounty, the others use their talents to find easier ways to get their two fish. Some of them climb the trees, bring down coconuts, and trade for fish. Others build fires to cook the fish just right. Others build better huts. And so on and so forth. In other words, the innovation of making that boat and net didn’t just help those original two; it helped everyone. Life is better.

But one of those islanders isn’t happy. He watches all that trading and realizes that the two owners of the boat and net who took the big risk are better off than the rest. It wasn’t like it was before, where all everyone had was two fish per day, barely eking out survival, but at least they were equal.

The unhappy islander – let’s call him Sernie Banders – comes up with a plan to bring “equity” to the island. He gets them to impose an 80% tax on the “rich” boat/netmakers! That way when the boaters bring in their haul of twenty fish, the rest of them get their “fair share” of sixteen (two fish per person, eight other people), with no extra work.

Common sense tells us what happens next. The inventors have little incentive to maintain or repair the boat or fix the net. Why waste your time or take a risk when the rest of the islanders are just going to seize the extra value you’ve created? In the end, the islanders are eventually back where they started. Or maybe worse, because they forgot how to fish.

The US isn't at 80%, yet. But Federal, State and Local spending are already roughly 42% of GDP. If we don’t get spending under control, tax rates will eventually go much higher. Bigger government means less innovation, less investment in and maintenance of capital, and less economic growth.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Crisis Management Government Leads to No Good

First Trust Monday Morning Outlook

Brian S. Wesbury - Chief Economist

Robert Stein, CFA - Dep. Chief Economist

October 9, 2023

Back in 2008, Ben Bernanke and Hank Paulson, using fear of financial collapse, convinced President Bush and Congress to 1) pass a $700 billion bailout of banks (called TARP) and 2) allow the Federal Reserve to pay banks interest on reserves at the same time the Fed moved from a scarce reserve model of monetary policy to an abundant reserve policy. These policies, to spend and print massive amounts of money, were super-sized during COVID.

Both policies proved incredibly damaging. The 2008 financial panic could have been addressed by changing mark-to-market accounting. In the six months following the passage of TARP and the institution of Quantitative Easing, the S&P 500 fell another 40%. Only when mark-to-market accounting was changed in early March 2009 did the panic end.

But, because so few people understood this, the idea that any kind of crisis requires trillions of dollars of spending and money printing became the roadmap for government in a crisis. We fully understand that early on during COVID, fear that we were facing another 1918 flu pandemic was real. But by the end of 2020, there was enough data to show that government shutdowns were harming education, small business, and supply chains, while it was also creating inflation.

But government kept spending and printing money in 2021 and 2022. And then, rather than returning spending back to pre-crisis levels, government spending has ratcheted higher. Between 2000 and 2007, non-defense federal spending averaged 15.3% of GDP, between 2008 and 2019 it averaged 17.6% of GDP, and now from 2020-2023 it is 24.5% of GDP.

For perspective, non-defense government spending was just 10.1% of GDP in the five years between 1965 and 1969. Total government debt is now $33.5 trillion, and with interest rates rising, the total cost of this borrowing is lifting government spending even more.

According to an August 3, 2023 CNN article, “The public remains broadly negative about the state of the country, with just 29% saying things are going well in the US and 71% that they’re going poorly….” We think we know why. Keynesians think government spending can boost growth, but, if so, that extra growth is just temporary. Every dime the government spends is created in the private sector, and the more the government redistributes, the less growth the economy will experience. Potential real GDP growth was roughly 3.5% per year in the 1980s and 1990s…today, we estimate it is just 1.5%.

Meanwhile, monetary policy is a mess. Quantitative Easing signaled a shift to an abundant reserve monetary policy. In 2007, the Fed’s balance sheet was roughly $800 billion. Today it is near $8 trillion. This money creation ended up as deposits on bank balance sheets.

In turn, banks have been forced to hold more deposits than would have existed without QE. And when banks hold more deposits, they also hold more assets. To complicate matters, in an abundant reserve monetary policy, the Fed basically sets rates wherever they want. And in the past fifteen years, the Fed has held short-term interest rates below inflation 84% of the time. In other words, banks (and the Fed itself) are holding assets that they bought at much lower interest rates than exist today.

If the banking system was forced to mark all their assets to market today, many banks would be underwater. In other words, the policies put in place to supposedly save banks have actually created a less safe banking system.

But there are other strange developments as well. One, is that the Treasury Department has a bank account at the Fed, called the Treasury General Account. On October 4 the TGA held $679 billion. The TGA is not new, but for decades through 2007, it held an average of only $5 billion. It was designed as a cash management tool.

Why the Treasury needs hundreds of billions in this account makes no sense. Using an interest rate of 5%, Americans are paying $34 billion a year so that the Fed can hold this cash. The cost of big government just keeps going up and up. It needs to be reversed.

The attached information was developed by First Trust, an independent third party. The opinions are of the listed authors at First Trust Advisors L.P, and are independent from and not necessarily those of RJFS or Raymond James.  All investments are subject to risk. There is no guarantee that these statements, opinions, or forecasts provided in the attached article will prove to be correct. Individual investor's results will vary. Past performance does not guarantee future results. Forward looking data is subject to change at any time and there is no assurance that projections will be realized. Any information provided is for informational purposes only and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The stock indexes mentioned are unmanaged and cannot be invested into directly.  Past performance is no guarantee of future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market.