Third Quarter 2024 Write-Up

During the first nine months of 2024, the Dow Jones Industrial Average gained 12.3%, the Standard & Poor’s 500 Index advanced 20.8% and the Nasdaq Composite added 21.2%. In the third quarter, the Federal Reserve began its long-anticipated rate-cutting cycle amid decelerating inflation readings and neutral to positive economic results. The equity markets reacted positively, and equity gains broadened during the quarter with the Russell 2000 and the S&P Equally Weighted Index (up 9.3% and 9.6%, respectively) taking leadership away from the Nasdaq Composite (up 2.8%). The stock market is anticipating double-digit earnings gains over the next five quarters.

We need to talk about government debt and fiscal responsibility. Well, we should probably just discuss the debt, because there is no fiscal responsibility currently. Economic research by Carmen Reinhart and Kenneth Rogoff (see their excellent book, sarcastically titled This Time Is Different) suggests that economies that are burdened with debt levels greater than 90% of GDP suffer from lower growth, and higher inflation. Deflation might precede the inflation. Stagflation is a possibility. Leveraged systems retard growth, crowd out capital formation and drastically limit fiscal flexibility. Bad things happen when governments are over-leveraged. Currently, U.S. GDP is about $30.0 trillion in nominal terms. Our national debt is currently close to $36.0 trillion. So, our ratio of debt to GDP is over 120%. This is highly irresponsible. In 1982, U.S. debt outstanding was $1.0 trillion. Today, rising interest costs and runaway spending means that we add $1.0 trillion to the national debt every three months, or 95 days. Congress has no appetite to address this situation. In fact, it is getting much worse. In fiscal 2023, total government outlays were $6.1 trillion. In the fiscal year just completed (2024), government outlays were $6.9 trillion. Budget estimates for outlays in fiscal 2025 amount to $7.4 trillion, or 21.3% above 2023 levels. And these outlays do not even include over half a trillion dollars of student debt that is proposed to be forgiven. Looking at the other side of the national ledger, in fiscal 2023 total government receipts were $4.4 trillion. In 2024, they were $5.0 trillion. In 2025, government receipts are estimated to be $5.5 trillion, or 25% above 2023 levels. This is a “money-going-out” problem, not a “money-coming-in” problem.

Exhibit 1: Historic GDP Growth Rates and GDPnow Projection for Q3 2024

Let’s look at some pictures. The first chart in Exhibit 1 shows historic GDP growth. The outlier bars from 2020 through 2021 represent the effects of the Covid shutdown and subsequent fiscal stimulus. A rough reading of the pre-Covid and post-stimulus growth rates suggest that GDP growth has now settled back to approximately the level experienced before Covid. The second chart shows long-term GDP development overlying a 21st century trend growth line. As you can see, the growth trend decelerated after the Great Financial Crisis and never recovered. This is probably reflective of the increase in government debt associated with the GFC. That does not portend well for us. The right side of the lower chart tracks the components of GDP. As you can see, government spending comprises 17.0% of nominal GDP, or about the same as residential and non-residential investment combined. Investment and productivity drive GDP growth. Investment is critical for future growth. Remember, government spending cannot create wealth in the aggregate or provide jobs that pay for themselves. Government spending is a pass-through of taxes and increased debt that must be serviced. Debt that must be serviced is another way of describing future taxes. Taxes that future generations will pay.

Exhibit 2: Federal Government Outlays and Receipts

Cumulative Receipts, Outlays and Surplus/ Deficit through Fiscal Year 2024

The first chart in Exhibit 2 shows the long-term development of Federal outlays and receipts as a percentage of GDP. Even with marginal income tax rates as high as 94%, government receipts seem to find an impenetrable ceiling at around 20% of GDP. People and companies find ways to avoid paying taxes above the 20% of GDP level, and we doubt that will change much. Government outlays do not seem to have any limiting ceiling other than shame, and the chart suggests that shame was repealed sometime around the start of the 21st century. The second chart shows the on-budget receipts and outlays by source and use. Outlays exceed receipts by $1.8 trillion. That $1.8 trillion needs to be borrowed and is thus added to the national debt. At the end of September, the interest rate of all of the government’s debt was 3.32%, up from 1.56% in 2021. That interest rate will increase as low-interest debt comes due and is refinanced. It is instructive to compare the government’s interest expense to other categories of outlays. In fiscal 2024, $882 billion of interest expense was greater than the total defense budget ($874 billion); greater than the cost of Medicare ($874 billion); and greater than the cost of Veterans’ benefits, Education and Transportation combined ($767 billion). Wow. Interest costs will exceed $1.0 trillion in the current fiscal year. As we stated, Congress has no appetite to rein in spending. Unfortunately, neither presidential candidate has shown any indication of addressing galloping deficits. To the contrary, they are locked in a competition of offering tax exclusions and ignoring looming Social Security and Medicare payment cliffs. Something will have to break to force discipline, we fear.

Exhibit 3: Leading Economic Indicators

Perhaps the debt situation is coloring the economic outlook. Exhibit 3 shows two charts incorporating the Conference Board’s Leading Economic Indicator (LEI) Index. The first shows the historical record of the Leading Economic Indicators as a good predictor of recessions. Other than a false positive reading in 1967, the record has been sterling…until now. The LEI went negative in 2022, but we have yet to see the predicted recession. The second chart overlays the LEI with real GDP growth. Recent LEI readings are an historical outlier.

Exhibit 4: Consumer Confidence and Small Business Optimism Index

Exhibit 4 shows two charts about confidence. The first shows a survey of confidence among small business owners. The reading is very pessimistic for a non-recessionary period. The second chart shows the University of Michigan Consumer Confidence Index. The individual components of the Index might offer some clue to the apparent consumer malaise. Consumers in the survey are reasonably constructive about current conditions (dark blue dotted line) but are apprehensive about future conditions (light blue dotted line). GDP growth has been pretty steady for the last two years, and is approximating pre-Covid growth levels. The unemployment rate is low. Yet consumers and small business owners are pessimistic. A recent Gallup poll showed that more than half of Americans (52%) say they and their family are worse off today than they were four years ago, while 39% say they are better off. A Gallup poll done in September of 2020 showed that 55% of respondents thought they were better off versus 33% who thought they were worse off than four years ago.

Exhibit 5: Real Hourly Earnings vs. CPI

Exhibit 5 might offer a reasonable explanation. The first chart shows real hourly earnings. After the Covid stimulus sugar-high, real wages lagged inflation for 25 consecutive months. Prices went up, and earnings did not keep up with a higher cost of living. More recently, workers have experienced 17 consecutive months of real earnings growth. The second chart shows the disparity between the inflation rate the Fed targeted (and workers expected) and the actual realized consumer inflation rate. Even as the CPI inflation rate is decelerating, the price level is still very high (and growing). Until real wages grow enough to fill the gap above the blue line, consumers are likely to feel under the gun.

Exhibit 6

Exhibit 7

The last two exhibits show, respectively, an overview of the S&P 500 Index and its large cap leadership, and a Federal Reserve survey of state coincident indices. We are told that there is an election scheduled soon. It will be interesting to see whether the local economic conditions of some of the battleground states correlate with election returns. It has been a long time since there has been a national consensus. We, however, are optimistic that after the polls are closed, 100% of the electorate will believe that 50% of people voted the wrong way. Stay calm and keep your asset allocations matched to your investment goals.

Sincerely,

Your Team at Baxter Investment Management