Economic Perspectives: Federal Debt: A Fiscal Year End Update
FAQs on the Markets and Economy
What does the strong jump in Q2 Gross Domestic Product (GDP) mean about the economy?
Q3 GDP grew 2.6% after declining in the two previous quarters.
The gain more than offset the decline in the year’s first half. The quarterly change helped maintain the annual rate at 1.8% (see chart). The underlying details were not very encouraging. Most of the gain came from a narrowing of the trade deficit. Construction activity fell at an accelerating rate, with residential plunging 26.3% and nonresidential down 15.3%.
The report reveals that the economy is probably not in a recession now. But the pace of growth is losing momentum – housing is contracting, and consumer spending is slowing. This, of course, is the intended consequence of the Fed’s actions. This week, the Fed raised its policy rate by another 75 basis points, to between 3.75% and 4.00%, with Chair Powell warning “incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected.” We believe there is a 60% chance of a recession in the next 12 months.
What are we learning from Q2 earnings season?
U.S. equity markets have rallied recently, as Q3 earnings have in large part exceeded expectations.
Despite several high-profile tech misses, with a little over half of the companies in the S&P 500 having now reported, 75% have delivered consensus-beating results. However, some perspective is in order. These better-than-expected results have come against notably lowered estimates. As recently as May, Q3 S&P 500 earnings were forecast to rise by 10.5%. By the end of Q2, that number was down to 2.8%, Moreover, if the energy sector was excluded, the index’s overall earnings growth rate would fall to -5.1%.
Corporate America continues to have several headwinds working against it, including slowing economic growth, rising cost pressures amid high inflation, ongoing supply chain issues, geopolitical instability in Europe and Asia, and significant currency drag from a very strong dollar. As a result, company revenue projections are now slowing and still elevated margins are beginning to experience more and more pressure.
Over the last couple of months, we have argued that earnings estimates would likely be revised lower to reflect the more challenging macroeconomic backdrop and rising recession risk. While earnings growth forecasts for next year have declined recently to 6.7% from about 10% at the start of the year, we continue to think they remain too optimistic. In a scenario where the economy enters a mild recession next year, we would expect earnings growth to stagnate or even contract.
Given this, we continue to recommend caution over the near term. Although equity valuations are adjusted over the first half of the year, the earnings adjustment process likely has a ways to go. Bottoming will be a process that could take some time to play out, and further swings in sentiment are likely as investors gain greater clarity on the outlook, particularly with rate hikes and inflation, and weigh their implications for the economy and corporate profits. In particular, we suspect further downward earnings revisions could be a catalyst for additional market declines ahead before a sustainable recovery in equity prices can begin.
Is the federal debt returning to normal levels with the pandemic behind us?
The federal government’s fiscal year ended on September 30.
This past year the government had a deficit of $1.4 trillion; it was cut in half from $2.8 trillion the year before. Revenues increased in all the major categories, particularly from individual income taxes due to the vibrant labor market. Spending declined significantly due to the reduction in pandemic stimulus programs. Back in 2019, before the pandemic, the deficit was $1.0 trillion.
The 2022 deficit would have been closer to $1.0 trillion, but a couple of outliers pushed it up. An estimated $379 billion for the long-term cost of the president’s student loan forgiveness program and $62 billion in benefits that would usually be spent in October but with the 1st falling on a Saturday had to be paid in September.
How are higher interest rates impacting the Federal Reserve’s income?
As rates rise, the Federal Reserve is paying out more to financial institutions than the income it earns. This may not immediately impact government finances, but long-term repercussions are unavoidable.
The Fed’s operating model is simple. It accrues operating expenses and receives income from its portfolio and any leftover “profit” is paid to the U.S. Treasury each year. These transfers have always been positive, but the structure is becoming more complicated considering the breadth of quantitative easing and the shift toward balance sheet reduction.
The Fed’s balance sheet has climbed from $1.0 trillion to $8.3 trillion over the past 14 years, the average interest rate it receives is approximately 2.0%. Annually, this equates to a cash flow of around $167 billion. But as the Fed raises interest rates, its expenses are increasing as the interest it pays on reserves and its overnight reverse repurchase program (RRP) is climbing. Currently, this equates to annual expenses of about $185 billion, a shortfall of $18 billion. Considering the projections for interest rates, the Fed will post an annual loss of over $80 billion next year.
After the 2008 crisis, the Fed studied this phenomenon. The proposed solution is to write an IOU in the amount of the shortfall to the Treasury classified as a “deferred asset.” The IOUs will continue to accumulate if income remains negative, and once net income becomes positive, the Fed will start paying off the deferred obligation. Essentially, the Fed is offsetting current losses by pledging its future earnings for repayment.
Given the Fed’s status as a monetary institution, it cannot become insolvent, but the U.S. Treasury will be accruing a liability. If left unfunded, the Treasury may be forced to issue more debt and it will become an eyesore to Congress, which will generate negative public headlines. While the Fed’s ability to conduct monetary policy under these conditions is not in question, the situation may pressure the tools designed to facilitate market liquidity, most notably its repo operations and the interest paid on excess reserves.
It will be important to watch the market response and the Fed’s reaction while it continues to tighten financial conditions.
Important Disclosures
The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial infor-mation. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been inde-pendently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
There are inherent risks with equity investing. These include, but are not limited to, stock market, manager or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.
Investing in international markets carries risks such as currency fluctuation, regulatory risks and economic and political instability.
There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with in-vestments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.
Investing involves risk, including the loss of principal.
As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.
Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
Non Deposit Investment Products are: Not FDIC Insured, Not Bank Guaranteed, May Lose Value
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Readers are cautioned that such forward-looking statements are not a guarantee of future results, involve risks and uncertainties, and actual results may differ materially from those statement. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.
Past performance or performance based upon assumptions is no guarantee of future results.
Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.
This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment adviser and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.
INDEX DEFINITIONS
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading pub-licly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.
Muni Bond: A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. These bonds can be thought of as loans that investors make to local govern-ments.
Bloomberg Barclays U.S. Corporate High Yield Bond Index: measures the USD denominated, high-yield, fixed-rate corporate bond market.
Dow Jones Select Dividend Index: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio and the trading volume. The components are then weighted by the dividend yield.
CBO: A collateralized bond obligation (CBO) is a type of structured debt security that has investment-grade bonds as the underlying assets backed by the receivables on high-yield or junk bonds.
Moody’s: Moody’s Corporation (MCO) is the holding company that owns both Moody’s Investors Service, which rates fixed income debt securities, and Moody’s Analytics, which provides software and research for economic analysis and risk management. Moody’s assigns ratings on the basis of assessed risk and the borrower’s ability to make interest payments, and its ratings are closely watched by many investors.
Penn Wharton Budget Model: Penn Wharton Budget Model’s (PWBM) tax policy simulator allows policymakers, members of the media, and the general public (“users”) to see the impact that potential reforms to tax policy will have on many the economy and the federal budget.
NDMC: National Drought Mitigation Center (NDMC) The National Drought Mitigation Center’s mission is to reduce the effects of drought on people, the environment and the economy by researching the science of drought monitoring and the practice of drought planning.
NOAA: The National Oceanic and Atmospheric Administration (NOAA) is an American scientific and regulatory agency within the United States Department of Commerce that forecasts weather, monitors oceanic and atmospheric conditions, charts the seas, conducts deep sea exploration, and manages fishing and protection of marine mammals and endangered species in the U.S. exclusive economic zone.
USDA: The United States Department of Agriculture (USDA) is the federal executive department responsible for developing and executing federal laws related to farming, forestry, rural economic development, and food.
The SIFMA Municipal Swap Index: The Securities Industry and Financial Markets Association Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obli-gations (VRDOs) with certain characteristics. The Index is calculated and published by Bloomberg. The Index is overseen by SIFMA’s Municipal Swap Index Committee.
CalPERS: The California Public Employees’ Retirement System, also known as CalPERS, is an organization that provides numerous benefits to its 2 million members, of which 38% are school members, 31% public agency members, and 31% state members.
4Ps: The 4P analysis is a proprietary framework for global equity allocation. Country rankings are derived from a subjective metrics system that combines the economic data for such countries with other factors including fiscal policies, demographics, innovative growth and corporate growth. These rankings are subjective and may be derived from data that contain inherent limitations.
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