Washington's rough week
Fiscal policy uncertainty adds to market volatility.
Equity market strategist Mark Twain wrote that October is the most dangerous month to speculate in stocks. While that still might prove prophetic this year, September has been the market’s worst-performing month since March 2020, with the S&P 500 declining nearly 6% from its record high Sept. 2 to this morning’s intraday low. That’s in line with our forecast that stocks could correct by 5-10% over the August-through-October period, due to a variety of monetary and fiscal policy headwinds out of Washington.
Yields on benchmark 10-year Treasuries have soared over the past fortnight, from 1.3% to an oversold 1.55%, and the volatility index (VIX) spiked midmonth from 16 to an overbought 29, though it’s settled back down to 22. The situation in Washington is fluid, to be sure, so the near-term direction of stocks, bonds and volatility will likely be driven by policy developments in coming days.
Looming Fed leadership transition It’s reasonably clear that the “transitory” versus “sustainable” inflation debate has been settled. Due to sticky increases in food, shelter, energy and wages, the core Personal Consumption Expenditure index (the Federal Reserve’s preferred measure of inflation) has grown 3.6% on a year-over-year basis over the past three months through August, which is a 30-year high and a level well above the Fed’s long-term 2% target. Consequently, we expect the Fed to announce the start of its tapering program at its next policy meeting on Nov. 3 and anticipate rate increases to begin before the end of next year.
But at this critical inflection point for monetary policy, the financial markets are anxiously awaiting President Biden’s decision on how he plans to remake the Fed’s Board of Governors. Sen. Elizabeth Warren (D-Mass.) publicly rebuked Fed Chair Jerome Powell earlier this week, calling him a dangerous man and vowing to oppose his re-nomination, perhaps providing some cover for other Congressional liberals and progressives. Financial markets hate uncertainty, of course, so the perception of an impending change in central bank leadership could unsettle markets.
Government shutdown averted President Biden temporarily defused this ticking time bomb by signing a bipartisan continuing resolution last night to keep the federal government temporarily funded and running through Dec. 3. Funding had expired on Sept. 30 (the end of the federal government’s fiscal year).
Ongoing debt-ceiling dilemma Congress’ two-year suspension of the federal debt ceiling expired on July 31 at $28.5 trillion. Treasury Secretary Janet Yellen has been employing extraordinary measures to continue paying the government’s bills, but she warns that she’ll run out of money on Oct. 18, though she can probably stretch that into early November. While there is little chance that the U.S. government will default on its debt obligations or that Congress will fail to lift or suspend the debt ceiling in a timely fashion, this issue has become a political hot potato, with Democrats and Republicans playing a dangerous game of chicken.
When’s the vote? Over the summer, the Senate worked closely with Biden and passed a bipartisan $1.2 trillion “hard” infrastructure bill, which includes roads, bridges, rail, ports, broadband expansion and upgrading the electric grid, among other desperately needed projects. Importantly, the bill is fully paid for by repurposing $1 trillion in unspent funds from the CARES Act last year and another $300 billion in unneeded funds from the American Rescue Plan this past March.
To create political leverage to pass Biden’s “human” infrastructure bill in the House, Speaker Nancy Pelosi originally scheduled a vote on the $1.2 trillion bill for this past Monday, Sept. 27. Lacking the votes to pass it, however, Pelosi moved the vote to yesterday. But she still hadn’t corralled enough support as of last night, so she moved the vote to today. As of this writing, the infrastructure vote still hasn’t happened, so the formal vote could very well be suspended indefinitely, which could unnerve markets.
Paring Biden’s Build Back Better plan In July, 11 Democrats on the Senate Budget Committee drafted a $3.5 trillion social-spending proposal, paid for with sharply higher tax rates on corporations and wealthy individuals and with more debt. But this less-popular bill hasn’t generated enough traction in Congress to date.
According to the Committee for a Responsible Federal Budget, Biden’s $3.5 trillion price tag is really $5.5 trillion. Given the expected increase in taxes and debt needed to pay for the package, inflation will likely rise further, GDP growth will slow, job creation will decline, wage growth will decelerate, corporate profits will decline and share prices will fall.
Biden originally pitched the bill as necessary to lift the economy out of recession. But the National Bureau of Economic Research has since declared that the pandemic recession ended in April 2020, and the GDP output gap was fully closed in the second quarter of 2021, thanks to the powerful V-bottom economic recovery that commenced in last year’s third quarter.
So Biden shifted course, arguing that we should reshape American society much like FDR’s New Deal in the 1930s and LBJ’s Great Society in the 1960s. While that’s a perfectly valid aspiration, the bill as written lacks the broad mandate needed to pass it.
More recently, Democrats have argued the cost of the bill is free, meaning that corporations and the wealthy will pay for it. But the multiplier effect associated with slower economic growth, rising inflation, less good-paying jobs and weaker financial markets are costs everyone will bear.
Critics argue that Biden’s bill is a redistribution of wealth from corporations and the top 10% of America to the bottom 90%, and that the bill needs to be considerably smaller and much better targeted to widen the social safety net for those Americans who truly need the assistance, rather than an unnecessary expansion of cradle-to-grave entitlements.
To that point, the Census Bureau reported earlier this month that 9.1% of Americans were living below the poverty line (the lowest level since record-keeping began in 1967), down from 11.8% in 2019. By excluding major pandemic-related aid programs, the poverty level was at 11.4% of the U.S. population. The government defines the poverty level as income of $30,000 for a family of four, compared with the median household income in the U.S. last year at $67,500, down 2.9% from 2019.
Sen. Joe Manchin (D-W.Va.), who has been a critical holdout for the Democrats as part of a centrist problem-solvers’ caucus in the Senate, is proposing a scaled-down package of about $1.5 trillion, with a better-targeted, less ambitious program paid for with less debt and lower taxes. That’s 72% less than Biden and his progressive base had originally asked for, which could be an appropriate starting point to salvage both the infrastructure bill and the social-spending package.