A Broken Record
Tell me if you’ve heard this yet, but the S&P 500 gained last week with more new all-time highs. The S&P 500 has now made a new all-time high this year in all the months that don’t start with an ‘A’ (as in April and August). A total of 47 new all-time highs have taken place already this year, tying it for the seventh most ever. If you extrapolate that number out to a full year, it would be just under 60 new highs, which would crack the top five of the best years ever.
The S&P 500 is also up five months in a row, 10 of 11 months, and six weeks in a row. No matter how you slice it, this has been a great time to be an investor and it’s a pretty good referendum on the state of the economy. Now let’s be realistic — we will have a down week (or multiple) at some point and we will have a down month as well. The good news is the best three months of the year are November, December, and January, so seasonals are still a tailwind. But we want to stress it is important to brace for some well-deserved red out there at any time.
Let the Good Times Roll
“No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.” — Heraclitus, ancient Greek philosopher
First things first, no one knows how much longer this bull market might last, but as we’ve been saying for a long time now, we see no reasons to expect the economy to sink into a recession, nor do we see any major warning signs the bull market is over. The good news is once bull markets make it past their second birthday, they tend to last multiple years longer. 🎂
Here’s a table we shared last week, but we wanted to take a closer look at how long recent bull markets have lasted. The 114% rally after the pandemic didn’t quite make it to two years, but looking back fifty years (so back to 1974), every other bull market has had a lot more left in the tank after its second birthday. There were five bull markets over that time span that made it to the start of their third year, and the shortest one lasted 5.0 years (which actually happened twice). I like to think of this like a cruise ship — once it gets moving, it is hard to stop or slow down.
Here’s another look at things. This table took us a long time to put together, but we like the way it turned out and we think you can learn a lot from it. The biggest takeaway is year three of bull markets does tend to be rather weak, up only 2.1% on average. We guess this shouldn’t be a huge surprise, as usually years one and two tend to see huge gains, so some type of choppy action or consolidation the third year would be normal.
Now take a look at how often bull markets made it to years four and five once they get to their third birthday. Should this bull market make it another year (as we expect), the returns in years four and five are extremely strong, up 14.6% in year four and nearly 19% in year five. That should have bulls smiling indeed.
Go read the quote above by Heraclitus again. We think it applies nicely to bull markets, as no two bull markets are ever the same. We do like to look at the past to get a picture of what could happen in the future, but the truth is all bull markets are different. All we can do is look at the data as we get it and make an honest assessment of what could happen next. And not to beat a dead horse, but we simply see no reason to change the stock overweight recommendation we’ve had in place since December 2022, nor do we see enough cracks in the economy to call for a recession. So how much longer could this bull market last? Maybe many more years, which might surprise many, but history says it is possible.
Election Update: The Biggest Policy Risk for Each Candidate
We are now just over two weeks from Election Day, although over 14 million votes have already been cast through mail-in and early in-person voting. (For context, 158 million votes were cast for president in 2020.) Most of those are mail-in ballots.
The presidential race and race for control of the House remain very close. Republicans do have a clear edge in taking control of the Senate, although we know anything can happen come election day. We won’t prognosticate beyond that. We all know that elections are decided by votes, not poll responses, and we encourage all our readers to vote, whatever your political views may be.
Control of Congress is especially important this time around. That’s because we have a massive fiscal event, or cliff, at the end of next year. If Congress does nothing, a lot of elements of the 2017 Tax Cut and Jobs Act (TCJA, which was signed into law by former President Trump) will expire on December 31, 2025. Most expiring provisions are on the individual side, but there’s some risk on the business side as well. Washington, DC in 2025 is likely to be dominated by tax policy negotiations, which will get ever more feverish as the December deadline approaches.
What Could Upset the Apple Cart? Higher Taxes and Tariffs
This week we thought we would take a look at the key economic and market risk associated with each party’s platform. (We know that these aren’t the only reason people choose to vote for one party or another, but our job is to stay focused on what can impact markets.) These risks don’t just depend on who wins the presidency. Control of Congress can be as important, and even the size of the majorities.
With the race for the presidency and control of the House tight and Republicans favored in the Senate, odds slightly favor split party control of Washington, DC next year, a situation that has historically been positive for markets. (Presidents can’t “go big” on policy changes in one direction or the other, which has often been the more market-friendly approach.) However, the odds of a Republican sweep or, to a lesser extent, a Democratic sweep (given the Republican edge in the Senate) are not insignificant. So, it’s worth looking at the biggest risks associated with a sweep for either party.
Democratic Sweep: The main risk of a Democratic sweep is higher corporate taxes. Harris’s plans include raising the corporate tax rate from 21% to 28%. That would not be as high as it was pre-2017 (35%), but it would still be a drag for equities. However, even if we have a 2022-sized polling error in favor of Democrats, the Senate will likely be close, so this risk here is somewhat low, not as a policy matter but just from the perspective of the most likely election outcomes. Even if the Democrats hold the Senate, there’s likely to be at least 1-2 centrist-leaning senators within the Democratic party who are unlikely to agree to a corporate tax hike, so we think the odds of a corporate tax hike even with a Democratic sweep are quite low.
Republican Sweep: The main risk of a Republican sweep is around tariffs. Tariff policy does not necessarily involve Congress. Presidents can impose tariffs without bringing Congress into the matter, as former President Trump did in his first term. This matters because President Trump has ratcheted up the rhetoric on tariffs. For example, he recently said he’d impose a 200% tariff on vehicles imported from Mexico, which would drive up prices immediately. This may just be campaign rhetoric, but the former president could be emboldened by a sweep, taking it as tacit approval for his tariff proposals.
By itself, this would not be a great scenario for markets. Looking back, the trade war of 2018-2019 created a lot of volatility. The S&P 500 eventually recovered from a near bear market sell-off in 2018, mostly thanks to the Fed pulling back on rates in 2019. However, if inflation surges because of tariffs, the Fed may put interest rate normalization on hold, creating an additional headwind for the economy and markets.
Investment spending, which is what you need for productivity growth, also lagged across 2018-2019, reversing gains made initially in anticipation of corporate tax cuts. The chart below shows new orders for nondefense capital goods (a proxy for business investment) from 2017 through February 2020 (pre-pandemic). The TCJA was strong supply-side policy implementation that encouraged investment, but its impact was considerably dulled by the Trump administration’s trade policy.
Deficit Spending, as Far as the Eye Can See
Both Harris and Trump have put out various tax proposals, and we can’t really know what will be implemented once campaign rhetoric ends and the realities of governing begin. In addition to not knowing who will be in the White House and the make-up of Congress, we don’t even really know how much of this is really just talk to win votes. But nevertheless, the big picture is that for either candidate, deficits are likely to increase.
We think Congress is unlikely to simply do nothing and let all tax cuts expire. That would help control the deficit, but it also has the potential to be a shock to the economy. This “fiscal cliff” is certainly a risk, especially if we get split party control and the different sides can’t reach a deal, but both sides would likely consider such an approach an unforced policy error, not to mention a midterm election error. The prospect of higher taxes across the board in 2026, and lower corresponding household spending, should help clarify the sense of purpose of members of Congress.
At the same time, extending every single expiring provision of the TCJA will increase the federal budget deficit by $5.2 trillion over the next 10 years (2026-2035). With that baseline, let’s look at the impact of the two candidate’s plans, as analyzed by the bipartisan Committee for a Responsible Federal Budget (CRFB). CRFB expresses the potential policy impact of a range, which is very reasonable given the uncertainty that exists around the impact of any policy proposal.
Harris’ plans, according to CRFB’s analysis, would add a median estimate of about $3.5 trillion to the deficit, with an estimate of $0 at the low end, and $8.1 trillion at the high end. Trumps’ plans would add $7.5 trillion to the deficit, with an estimate of $1.5 trillion at the low end, and $15.2 trillion at the high end. The table below is from the CRFB and shows the median estimates for both candidates. None of it is likely to come to pass exactly as you see below, but these will form the outlines of any negotiation. And irrespective of who’s President, or who controls Congress, the path of least resistance is more spending and higher deficits.
Rising Deficits During Economic Expansions Is Rare
The Federal government’s “primary balance” is its revenue minus spending excluding interest payments on Treasury debt. It is one way to measure how much net spending is happening at the Federal level. The chart below shows the primary balance as a percent of GDP. As you can see, prior to the 2010s, the primary balance was always in positive territory as economic expansions wore on. It fell into deficit only during recessions, which isn’t surprising. That’s when economic stabilizers (like unemployment benefits) kick in. Revenue collection also drops during recessions, as there’s less income. In short, US fiscal policy has historically been counter-cyclical, which is what you would expect. The exception to this was the mid-to-late 2010s, when deficits rose even as the economy strengthened (especially after the TCJA was passed). But this new dynamic is likely to continue into the rest of this decade.
Markets May Like Deficit Spending, at Least Temporarily
Deficits can potentially boost corporate profits, assuming it doesn’t crowd out consumer spending or private sector investment. That’s positive for markets, since profits are what matter. There may be longer-term costs from the need for austerity in the future, unwinding shorter term gains, but markets tend to discount a distant and less easily known future. Deficits also can increase inflation risk, although not under all circumstances.
From a national accounting perspective, we can actually see the sources of profit growth by changes in the activity of key economic sectors (the same sectors used in calculating gross domestic product). Profits are increased by high household spending and lower savings; or higher business investment and dividends; or lower government savings and increased spending; or greater demand for US goods abroad and lower US purchases of foreign goods. The relationship between these changes and profits is actually mathematical, so we can look at national accounts and see the story of what has driven profit growth. Any of these areas can increase profits (or decrease them when working in reverse), and it’s useful to see where profit growth has come from at different times.
For example, from a national accounts perspective, profit growth surged over the 2016-2019 period, largely on the back of higher fiscal deficits post-TCJA. Even over the last six quarters of the period, households started saving more (relatively) but corporate profits rose because fiscal deficits started growing again.
All this to say, the risks of a higher corporate tax rate (Harris) or tariffs (Trump) could be countered by rising fiscal deficits, resulting in a net boost to profits. That’s potentially positive for markets.
The main concern with deficit-fueled growth in the near term is whether it leads to inflation. It doesn’t have to, like in 2018-2019, or even more recently over the past 18 months, when deficits rose but inflation eased. However, it’s quite likely that a US economy that is growing and near its productive capacity sees bouts of higher inflation as well. That could put a halt to the Fed’s easing cycle, and at worst, reverse it with the Fed raising interest rates once again. (Ironically, deficits worsen as rates rise because of higher interest costs for the government.)
Nothing is binary when it comes to investing, let alone for the economy. We’ve laid out several potential risks for markets and the economy, under either a Harris or Trump administration. That doesn’t mean these risks have a high chance of materializing. The most important thing to keep in mind is that U.S. companies are amongst the most dynamic in the world and can adapt to temporary headwinds, whether higher taxes or tariffs. That’s ultimately positive for long-term profit growth, which is what drives markets for the most part. What we really don’t want to see is a recession, but that’s far from our base case right now.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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