Good morning. We hope everyone is enjoying their summer. With the summer coming to a close, we see a growing number of client questions on policy issues impacting financial markets. Below we outline the latest state of play on the bipartisan infrastructure package, the $3.5 trillion spending budget and legislation, a potential government shutdown, the debt ceiling, and the reappointment of Fed Chairman Jay Powell.
The recent news from Afghanistan, notwithstanding its geopolitical implications, sets the background for what appears to be a confluence of fiscal and monetary decisions that need to be made in a short timeframe this Fall. President Biden’s approval ratings went underwater over the weekend.
Biden’s political capital started falling before Afghanistan and was driven by the rise in inflation and the recent wave of COVID. The Afghanistan withdrawal is compounding these more structural headwinds to Biden’s political capital. As such, House and Senate leadership is pushing for expedited passage of $4 trillion in new spending and more than $1.5 trillion of tax increases by October 1st all while trying to prevent a government shutdown and raise the debt ceiling. It is hard to overstate how much the policy agenda will take over in the coming weeks.
The current set-up looks almost identical to Labor Day weekend 2013.
- The S&P 500 was having a great year, up 14.5 percent through August 31 and ultimately finished +30% for the year despite the 4Q noise.
- The Federal Reserve was on the eve of implementing its QE3 tapering and debating how to structure and when to implement that taper.
- Like today, the deficit was coming down rapidly, which makes tapering more of a readjustment to net Treasury issuance rather than an outright tightening.
- President Obama was set to name a new Federal Reserve Chair even as the uncertain tapering process was ready to start in the next few months.
- President Obama was dealing with a brand new geopolitical crisis in Syria as a red line was crossed on chemical weapons that was denting his political capital on the eve of major fiscal policy in Congress.
- Political agreement on the US budget was nearly impossible with the Obamacare ACA exchanges about to go live. A government shutdown was quite possible on September 30th.
- The debt ceiling needed to be raised sometime in early 4Q with no political agreement on government spending likely.
- The Affordable Care Act exchanges were set to go live as was a new round of automatic spending cuts, both on October 1st.
Despite pressure building among FOMC members, the Fed decided not to announce a tapering of asset purchases on the eve of a major fiscal showdown at its September 2013 meeting (keep this mind as you think about the current tapering schedule). Ultimately, the US government went into a shutdown on October 1st. Investors began to price in more risk of a US default given the lack of political consensus on the budget for the next weeks. The rollout of the ACA exchanges was a complete disaster at the same time.
The Fed held an emergency video conference meeting on October 16th to discuss its response should the US government default. This turned out to be a lagging indicator as public pressure built so much to re-open the government, it created the pressure to also raise the debt ceiling. We needed a government shutdown to create the political will for the debt ceiling increase, something that should be useful in thinking through the current scenarios. The agreement also paved the way to relax some of the planned austerity by setting up a new budget process. The Fed did not announce its taper at its late October meeting and ultimately announced the tapering in December.
There are some important differences this time around as no two situations are the same:
- COVID is a completely different variable which impacts everything from employment to school re-openings to hospital capacity and looms large over the current political and policy environment.
- Investors are more comfortable with tapering than in the past given recent experiences of tapering not being fatal.
- A Bloomberg article over the weekend noted that Treasury Secretary Yellen supports the re-appointment of Federal Reserve Chairman Jay Powell.
- The US cleared its fiscal drag in 2012 before these events. The US is undergoing quite a significant fiscal drag currently as stimulus wears off and disappointing economic data comes in.
- In 2013 Congress was a divided government. This time around, Democrats have complete control and some greater flexibility in dealing with some of these policy issues. Still, most of these budget issues require 60 votes in the Senate and Republicans are unwilling to entertain these issues with Democrats proposing $3.5 trillion in new spending and at least $1.5 trillion in tax increases.
- Congress is on the verge of passing new legislation which raises taxes and increases spending. This proposal is the largest spending package since the Great Society and the largest fiscal expansion since Reagan’s first term if it is enacted. My personal view is that passage of this legislation is a bearish event, all else being equal, with immediate tax increases and no real benefit from the spending.
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by FactSet.
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