CBO's Updated Projections

Last month, the Congressional Budget Office (CBO) updated their Budget and Economic Outlook for 2024-2034, revealing some startling projections. The 2024 deficit estimate has increased by $400 billion, a 27% rise from their estimate five months ago. The deficit for 2024 is expected to be $2.0 trillion, which is 7% of our Gross Domestic Product (GDP). This is projected to be 6.5% of GDP in 2025, and then fall to 5.5% by 2027, only to rise again to 6.9% by 2034.

These numbers are alarming, especially considering that the budget deficit averaged 2.8% of GDP from 1970 through 2019. For the next decade, the deficit is expected to be double that half-century average. Disturbingly, these numbers may still be overly optimistic. The CBO forecasts no recession for the next decade, yet the U.S. has never gone 14 years without entering a recession. Recessions typically cause budget deficits to widen as revenues fall and expenditures rise. Furthermore, the CBO estimates that inflation will moderate to 2.2% over the next decade, and they predict long-term interest rates will peak at 4.5%, staying at or below 4% for the next decade. Given the current amount of government spending, these estimates for inflation and interest rates seem overly optimistic, if not downright delusional.

IMF's Warning

Last month, Gita Gopinath, the International Monetary Fund’s Deputy Managing Director, warned the U.S. and other developed nations about runaway fiscal spending. In the IMF’s April Fiscal Monitor, they estimate that the U.S. deficit will be 7.1% of GDP in 2025, over three times the 2% average for other advanced economies. Gopinath cautioned that large deficits in the U.S. and China pose significant risks to the global economy and need to be addressed. The IMF's criticism of U.S. spending since the COVID pandemic is well-founded, as Gopinath points out that the U.S. is running its economy more like an emerging market than an advanced economy. The U.S. deficit resembles that of a developing nation, while advanced peers are running much smaller deficits or even surpluses, as in the cases of Ireland and Denmark.

Source: Bloomberg

This information should concern every American. Runaway fiscal spending is highly inflationary, and the surge in government debt issuance will continue to press interest rates higher. Historically, during recessions, large deficits result from increased government spending as tax receipts fall and unemployment soars. Recessions are inherently disinflationary, which helps to offset the inflationary aspect of increased government spending. Thus, when we are not in a recession and yet government spending is out of control, we should not be surprised when inflation takes off.

Cumulative Cost Increases

The COVID-induced recession was deep but one of the shortest on record, lasting from February to April 2020, yet we never stopped the elevated government spending. Consequently, since 2020, inflation has dramatically increased with prices continuing to head higher, heavily impacting American households. As evidence, shown below are various categories within the Consumer Price Index and their cumulative inflation increase over the last five years. Few consumers have seen their incomes grow by 40% to 100%, which is why many feel their standard of living is slipping away.

Source: BLS

Plunging Income Worries

Every month, the University of Michigan releases its Consumer Sentiment report, which includes questions about consumer spending habits, job prospects, buying intentions, and income growth expectations. The June report revealed troubling insights into the consumer outlook. The expectation that incomes will grow above the rate of inflation over the next five years has fallen to the lowest level on record at 25.3%. This means 75% of the country believes their standard of living will decline over the next five years, after already experiencing a decline over the last four years.

(Click on image to enlarge)

Source: Bloomberg, Financial Sense Wealth Management

We have observed a dramatic decline in consumer sentiment surveys over the past few months. We believe this decline is due to the exhaustion of excess savings from pandemic stimulus checks provided by the government. Initially, these stimulus checks shielded consumers from the impact of dramatic price increases, as they were spending the government's (taxpayers') money rather than their own savings. The Federal Reserve Bank of San Francisco estimates the excess savings was exhausted as of March, and now that these funds have been depleted, consumers are feeling the full brunt of these devastating price increases.

Signs of a Labor Market Downturn

It is not only the consumer that is being squeezed by elevated prices but also businesses. When businesses begin to see their sales moderate, they attempt to protect their margins by addressing the biggest line item in their budget: payrolls. The typical payroll/business cycle begins with employers cutting temporary workers, the easiest to let go and the least trained, followed by reducing hours, forcing full-time workers into part-time status. The last measure, should sales/demand not rebound, is to start reducing payrolls through layoffs.

As stated above, the first sign of a labor downturn starts with temporary payrolls, and this has already begun, with the peak in temporary payrolls occurring in March of 2022. Since then, temporary payrolls have fallen by 515,000 workers. We have also clearly seen the turning point in full-time versus part-time workers, which occurred in June of 2023. Since then, full-time workers’ payrolls have gone down by 1.5 million jobs while part-time workers have risen by 1.7 million. Red flags of a coming recession are a decline in temporary payrolls and growth of part-time workers outpacing full-time workers, and we clearly have both. What we do not yet have are outright payroll declines, but that may be coming sooner than we think.

Downward Revisions

Economists look backwards to look forwards, by examining the past and then extrapolating prior trends forward. Consequently, they never catch the turns in the economy, whether the peak or the trough. This becomes clear with hindsight when their initial data estimates get revised heavily down or up, and it is these large data revisions that help to make clear when a turn is at hand, and we are likely staring at one right now.

The Legislative Analyst’s Office (LAO) of California came out last month with revised estimates for job growth in the country’s most populous state. California has thirty-nine million people, nearly one-third larger than the second-largest state, Texas, so what happens in California matters. What the LAO reported argues not everything is shiny in the Golden State, as revised data shows job LOSSES in the fourth quarter of 2023, not 117K job growth as originally reported, meaning there was no net job growth for the entire year!

Consumers Cutting Back

Faltering job growth and exhausted pandemic savings are clearly weighing on the consumer, and it is beginning to show in results from corporations. The consumer products company Helen of Troy reported disappointing first-quarter earnings earlier this month, sending the stock down nearly 28% on July 9th and continuing to decline to a 10-year low. The company produces well-known consumer brands like Hydro Flask, Oxo, Vicks, Braun, Revlon, and Drybar, all tied to the consumer. Their comments during their earnings release do not paint a picture of a strong consumer, as highlighted below:

"As has been widely reported, the macro environment and the health of consumers and retailers has worsened. Consumers are even more financially stretched and are even further prioritizing essentials over discretionary items. Specific to our business, we have seen some areas become more challenged over the last three months. For example, an unexpected slowdown in the global outdoor category impacted sales of our packs and accessories. There was also more pressure in the specialty beauty channel and mass beauty overall, especially in beauty tools under $100. Also, more discretionary household items like dry food storage continue to trend down…"

"We've heard broadly from mass retail that traffic overall is slower throughout the country and promotional pressure is increasing. In reaction to these dynamics, retailers are managing inventories more closely to account for the slowdown, and some are implementing new systems to allow for just-in-time inventory management. All of this exposes us to more volatility and less visibility into order volumes and timing."

Window of Vulnerability

The specter of a recession is why we have remained neutral in our risk allocation and have not shied away from taking profits in highly extended positions. While economic risks are building, we do not yet have clear-cut evidence of a recession underway, and there remain strong liquidity supports for financial assets stemming from two main sources: the government’s checking account at the Federal Reserve and liquidity support from the Fed’s reverse repo facility. Timing a recession accurately is crucial for success; exiting too early can result in missed gains from risk assets and moving to cash prematurely if a recession does not occur. Our firm studied the stock market’s reaction to Federal Reserve rate cycles and recessions dating back to the early 1970s using the S&P 500 as a proxy. What we observed is that the stock market typically rallies after the last Fed rate hike through the onset of a recession. However, once a recession begins, the stock market has seen declines as little as 9% (1980 recession) to as great as 54% (2007-2009 recession) but falling every time and typically bottoming during a recession, with the 2001 recession being the only exception in the last half-century.

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Source: Bloomberg, Financial Sense Wealth Management

Whether the U.S. economy slows down or slips into a recession, we expect the Federal Reserve to respond with rate cuts to address the weakening job market, despite high inflation. According to Bloomberg estimates, the market anticipates one rate cut at the Fed’s September 18th meeting, with an 86% chance of at least two more cuts by year-end.

The growing belief in upcoming rate cuts has driven gold prices to a new all-time high, nearly reaching $2,500 an ounce. Our portfolios, which have strong exposure to precious metals, should benefit from a Fed rate-cutting cycle that typically pushes the U.S. dollar lower. While our stock market exposure remains close to neutral, we will significantly reduce our positions if it becomes clear that a recession and bear market in stocks are underway.

Balancing Risks and Opportunities

We are also aware of the upcoming November elections, which could impact the financial markets. Before the 2016 presidential election, small business sentiment was at recession-level lows. However, sentiment saw a significant rise after President Trump’s victory, driven by his pro-business platform. The stock market also rose post-election. The National Federation of Independent Businesses (NFIB) monthly survey indicated that one out of every four respondents cited government regulation and red tape as their greatest concern, which declined rapidly after Trump took office. A similar rise in small business optimism and investment could occur if Trump wins in November.

Given the potential impact of the election and the risk of a recession, our exposure remains neutral at present. We are ready to become more defensive, if necessary, should a recession develop, however if the economy can remain on a growth path in the face of incoming changes to monetary, fiscal, and regulatory policy, we will not hesitate to move back into a more aggressive risk posture.

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