Bi-weekly asset allocation: Believe it or not, fiscal policy is tightening

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Confluence Investment Management offers various asset allocation products that are managed using top down or macro analysis. We publish asset allocation thoughts every two weeks, updating the report every other Monday, along with a podcast.

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The US economy and government economic policies have many moving parts, but investors often rely on only one or two indicators or policy initiatives to gauge the direction of asset prices. These days, they’ve focused on consumer price inflation and the Federal Reserve’s plan to raise its benchmark short-term interest rate to combat it. The tightening of monetary policy should help reduce demand, leading to lower inflation, but it will also have a direct negative impact on asset prices. In this report, we argue that investors are not paying enough attention to another aspect of economic policy. Investors may not realize it, but federal fiscal policy is also tightening, which will further weigh on economic growth. This will be an additional challenge for asset prices.

Investors are often exasperated by the huge numbers talked about when talking about government spending, but it’s important to keep in mind that the overall economy is also huge. The gross domestic product (GDP) of the United States was approximately $23 trillion in 2021. In the decade before the coronavirus pandemic, total federal revenue averaged 16.3% of GDP , while federal spending averaged 21.6% of GDP. The budget deficit averaged 5.3% of GDP. However, to cushion the blow of the pandemic from the start of 2020, the government enacted trillions of dollars in emergency spending, ranging from forgivable loans for affected businesses to enhanced unemployment benefits and cash grants. for individuals. As the chart shows, total federal spending in the year ending March 2021 increased 65.7% from the previous year, even though federal revenues were essentially flat.

The extra spending during the pandemic has undoubtedly helped preserve economic activity. It also caused the budget deficit to explode and, amid pandemic supply disruptions, also contributed to the current high inflation. However, the graph above shows that this fiscal stimulus has already reversed. In the fiscal year ending December 2021, expenses were essentially unchanged from the prior year. Due to the rapid economic recovery, government revenues (mainly income taxes) increased by 25.7%. Steady spending in the face of a huge increase in tax revenue has helped reduce the budget deficit to “only” $2.577 billion in 2021, or $771.4 billion less than in 2020. The deficit in 2021 does not was only about 11.4% of GDP, about half of what it was in 2020. .

The $771.4 billion deficit reduction in 2021 dampened the economy, but it wasn’t very noticeable because businesses and individuals had so much pent-up demand. Additionally, businesses and individuals still had plenty of excess cash and savings from stimulus programs at the start of the pandemic. The experience in 2022 could be very different. On the one hand, forecasts from authorities such as the White House Office of Management and Budget and the Congressional Budget Office suggest that the deficit will shrink dramatically again this year. In dollar terms, the deficit is expected to narrow by about $1.3 trillion, primarily due to increased tax revenues and reduced transfer payments to states, local governments and individuals. It’s exactly like taking $1.3 trillion out of the economy, just as many businesses and individuals begin to deplete their savings and face much higher price inflation.

As this chart shows, fiscal tightening that began in 2021 has reduced the annualized US growth rate by more than two percentage points in recent quarters. Removing an additional $1.3 trillion in net federal spending from the economy in 2022 will reduce the rate of growth by several additional percentage points, in addition to other demand headwinds. This fiscal drag will be partially offset by factors such as the Biden administration’s new infrastructure spending and reduced import demand. Nonetheless, we expect it to have a major impact on dampening demand, just as the Fed looks set to impose multiple interest rate hikes. The chart shows that the Fed’s recent rate hike campaigns have all taken place during periods of negative fiscal impacts, but none of these periods have seen fiscal tightening on the scale we are about to see. to see. This simultaneous tightening of fiscal and monetary policies could help ease inflationary pressures. It also means that real economic growth in 2022 could be a bit better than the anemic rates seen in the decade before the pandemic. This will likely limit the rise in stocks and commodities this year. At the same time, it should also limit the decline in bond prices and prevent yields from rising as much as some investors currently fear.

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Initially published by Confluence Investment Management on March 7, 2022.

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This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.

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