Good morning. The topics Unhedged has been focused on lately were in the news yesterday. In the morning, there was a very poor new home sales report for May, showing units falling 11 per cent from April, missing expectations badly. Given the rising inventories of unsold homes that Unhedged discussed yesterday, does this mean new home prices must soon fall? And perhaps rent inflation could be next? In the misshapen US housing market, don’t count on it (homebuilder shares were unmoved by the news, which tells you something).
In the afternoon, Micron, one of the chip stocks that has benefited from the AI rally, provided a sales forecast that merely met expectations, rather than exceeding them. The shares fell 8 per cent in after hours trading. Email me: robert.armstrong@ft.com.
Deficits and stocks
The Federal budget deficit has people spooked. On Bloomberg yesterday, Bill Dudley, former New York Fed president (Unhedged interview here) pointed out the Congressional Budget Office’s recent estimate that the federal deficit will rise to $1.9tn in fiscal 2024. That is double the level of 2019. Dudley waves away concerns that all the required Treasury bill issuance will snarl the short-term debt markets. The real worry, he says, is that Treasury investors will rebel, driving Treasury yields up sharply, making the deficits more expensive to finance, and triggering a spiral:
The more it borrows, the greater the chance it’ll end up in a vicious cycle, in which government debt and interest rates drive one another inexorably upward . . . It’s impossible to know when investors will decide that such risks are too much to bear, as the bond vigilantes famously did in the 1990s. When it happens, it tends to be sudden and brutal.
Here is the director of the CBO, Phillip Swagel, as quoted in the FT back in March, saying that we saw a preview of what such a rebellion would look like in 2022 in Liz Truss’s UK:
“The danger, of course, is what the UK faced with former prime minister Truss, where policymakers tried to take an action, and then there’s a market reaction to that action,” Swagel said in an interview with the Financial Times. The US was “not there yet”, he said, but as higher interest rates raise the cost of paying its creditors to $1tn in 2026, bond markets could “snap back” . . .
“We have the potential for some changes that seem modest — or maybe start off modest and then get more serious — to have outsized effects on interest rates, and therefore on the fiscal trajectory,” Swagel said.
As a citizen, deficits concern me. But Unhedged is unconcerned about civics. Unhedged is worried, instead, about the market implications of deficit reduction. The first order effect of a bond vigilante uprising would be big losses for holders of Treasuries and other long-duration assets, with nasty repercussions for rate sensitive sectors from housing to insurance. All of this is well understood, though there would be surprises along the way.
What is less talked about is the implications for stocks. A higher long-term interest rate makes stocks less valuable by increasing the discount rate on their cash flows but, as this newsletter has pointed out with grinding repetitiveness, all else is rarely equal. More nervous-making is what happens if the government responds to a bond investor rebellion by actually closing the budget gap.
(I know, I know: this will not be the first thing the government tries. Restarting Fed bond buying or encouraging banks to load up on Treasuries will come first. But imagine that doesn’t work, perhaps because inflation picks up again. Imagine, in other words, a situation where the government exhausts every other option, and is forced into an experiment with fiscal responsibility.)
I think that closing the budget gap would probably be very bad for stocks. Many investors don’t think this way. The reason they don’t, I would guess, is that most have become wealthy by being financially responsible people (or so they believe). So the idea that government, by acting responsibility, could destroy wealth is hard to grasp. But the mechanism by which this would happen is not terribly complicated. Widening budget deficits push money into the private sector. This money finds it way to risk assets, increasing their prices. Narrowing deficits have the opposite effect.
Joseph Wang, of the “Money on Macro” blog, put this to me most simply: when the Treasury issues a bond or bill to cover a deficit, it is creating money, or something very much like money. If I buy the bond, my net worth is unchanged, and the government now has cash that it turns around to give to someone else, increasing their net worth. There is more money in the system, and unless it is absorbed by tax collections and a narrowing deficit, some of that money will chase financial assets, driving up prices.
But liquidity is not the only channel through which deficits can support stocks. Another is that the money created by deficit spending is used to purchase goods and services and is thereby transformed into corporate profits. This explains why the extraordinary expansion of deficits since the pandemic has been accompanied by an equally extraordinary expansion in corporate profits:
An analytical framework for thinking about this is the Kalecki-Levy profits equation, an accounting identity that Unhedged has written about before. One arrangement of the equation looks like this: Profits = Investment – household savings – foreign savings – government savings + dividends. To put it another way, if deficits rise (government dissaving) profits must rise if investment, household savings, and foreign savings don’t change. And historically, it has very often been true — however you rearrange the equation — that deficits on one side pop up as corporate profits on the other.
Robert King, of the Jerome Levy Forecasting Center, sent me this chart that simplifies the components of the equation into corporate profits, government dissaving and private profits sources (investment, foreign dissaving, dividends), from 1947 through the end of the first quarter of this year. It includes state and local deficits, rather than just Federal ones:
As you can see, the relationship between profits (the black line) and deficits (red) is not direct or simple. Part of the reason for this, as King points out, is that deficits often rise in recessions, when private investment is crashing. But notice the pattern of the past decade or two: deficits stay quite high even when the private sector is pulling its own weight, resulting in rising profits. A similar pattern was visible in the 1960s and again in the late 70s and early 80s.
If there is a shift from the high deficit regime to one of budgets that approach balance, there will be many dislocations, whether the change is achieved with higher taxes or lower spending or both. Stock prices will not be spared.
One good read
Solar power is exciting.
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