Catastrophic default and other stories
It is that time of the year and we are heading for another episode of the debt ceiling drama. Secretary Yellen used the words “catastrophic default” recently while referring to her estimate that the treasury will run out of money in August when Congress is in recess. Thus, she needs Congress to raise the debt ceiling by July 31st so we can service existing debt by issuing more debt.
If Republicans want to play spoiler, the stars are aligned for an opportunity.
The Democrats can either “suspend” the debt ceiling or they can raise it by a few trillion dollars. The problem is that suspending the debt ceiling is the preferred option but will require support from at least 10 Republican senators. On the other hand, the debt ceiling can be raised through the (wildly misnamed) “reconciliation” process that doesn’t require republican votes. Unfortunately, attaching dollars to the vote is not seen as a good option because it has carried political costs in the past. Several red-state Democratic senators such as Tester, Manchin and Sinema have said that they want to see a suspension rather than a raise of the debt limit. That will need some horse-trading.
Meanwhile horse-trading is already in full swing with the bipartisan $1.2 T physical infrastructure package in limbo. The Democratic core is concerned that the larger social programs (aka “human infrastructure”) package will fall by the wayside if the physical infrastructure package passes first. So they are threatening to kill the physical infrastructure package unless they can see the social spending as a sure thing.
But the bipartisan process may have come too far for Democrats to back away without looking bad politically. This is probably why progressives never wanted to go the bipartisan route. Still, they may sign on to the bipartisan deal if red-state Democratic senators swear blood oaths that they will support a subsequent social package. That may be the minimum that the left has to give to get Manchin and Sinema to pass debt ceiling later through the reconciliation process.
Normally a compromise on taxes would have been the thing traded to get Republicans to sign on a debt ceiling increase, but the Democrat mood on taxes is positively kamikaze. So, taxes on corporations, incomes over $400K and capital gains on households earning over $1 million are all set to go up - come what may. Even repealing Trump’s repeal of SALT tax breaks is going to be very watered down if it happens at all.
We are likely looking at a $1.2 trillion infrastructure bill this summer and in the fall a larger $3 T or so social spending bill - about half paid for with tax increases.
There is a viewpoint that markets are not sufficiently pricing in these taxes, but we can’t say we agree with that. What we are heading for is re-distribution, where a corporate tax increase lowers earnings per share, but on the other hand earnings rise because money is moved to lower income groups where it is spent (rather than saved). Also, spending will be more than taxation with the balance going into new debt. One should expect this to be beneficial for equities.
Perhaps that is why none of this will move the needle on income inequality. Higher income groups will likely benefit more than they lose due to stock market gains linked to redistribution. Lower income groups will gain from entitlement spending and perhaps wage inflation, but also lose due to commodity inflation. Inequality will stay the same, while treasury debt goes up.
Speaking of commodity markets, I don’t exactly endorse the “new supercycle” theory, but I’ll be darned if the prospects don’t look good. Both the physical infrastructure bill and the social package are inflationary for commodity prices. This is because the lower income demographic has a zero or negative savings rate and their consumption is tilted towards basic commodities such as food and energy. Meanwhile, physical infrastructure spending would support industrial metals and energy.
The physical infrastructure bill has $580 billion in new spending spread over 10 years. Given the $20 T US GDP, does this even matter? Depends how you think about it. Additional spending can be quite important if focused in specific sectors that directly receive the money. An interesting case in point is steel prices. Steel coil futures were moving sideways through March and April, but since mid-May they are up 7%. Will steel be the new lumber? It could.
Another oft forgotten point is that even though only $580 billion out of $1.2 T is new, the rest is still spending. Equities and commodities react differently to that. Stock markets naturally price in expected spending over many years, but commodities do so to a lesser extent because they are consumables and storage capacity is limited. Ergo, one can still find opportunities in commodities that may be elusive in stocks.
The story looks very growthy. With some deft shepherding by the Fed, the US could transition from the current stagflationary pressures into a high growth, medium inflation scenario. In that case, investors may continue to benefit from positions in cyclical equities and commodities.
Having said that, we need to heed the multiplying risks outside the US due to the Delta variant of the coronavirus. It is likely there will be many shocks due to Delta over the rest of the year in Africa and Asia. I would watch China in particular. There is still considerable vulnerability there in terms of lack of exposure to the virus and all bets are off if Delta manages to get through the defenses erected by the government.
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