Econosights - US fiscal policy in 2018/19 - making sense of the recent changes

Introduction

The complex US budget process usually starts with the President proposing a Budget around February each year before the fiscal year begins in October. Congress then debates, chops and changes the details of the budget over the next few months. Because of this, any adjustments to government spending usually look substantially different to the initial proposal. Changes in spending are then legislated through appropriations bills and disagreements over these bills can cause issues like government shutdowns. There have been numerous important changes to US government spending recently. We outline the recent changes and discuss their impacts on US fiscal policy. 

Spending bill to keep the government funded

US Congress approved a spending bill recently to keep key government departments funded which ended a very short government shutdown. A government shutdown means that non-essential workers cannot be paid for that time (but will be back paid after the shutdown ends). 

The latest agreement passed gave a temporary spending deal until March 23 which means that the risk of a government shutdown is still on the cards in March if no deal is reached on the “Dreamers”. But, financial markets have largely looked through the impacts of government shutdowns lately (mostly because they have been so short and their impact is minor). 

US debt ceiling

The US debt ceiling is a limit on the amount of debt that can be issued by the US Treasury, which impacts how much money the Federal Government can borrow. If the limit is reached, the US would have to prioritise its debt payments to avoid going into a technical default. A technical default by the US economy could trigger a credit rating downgrade and would cause a negative reaction in markets (it has never happened before!). The latest deal by US Congress has suspended the debt limit until March 2019. A suspension allows the US Treasury to borrow as already agreed upon by Congress.  

US budget and spending cap increases

President Trump’s initial proposal for the FY2019 was released this week. At the headline, it would appear that Trump is slashing spending across a number of domestic areas (cutting the deficit by $3trillion over ten years and cutting $1.8trillion over ten years for mandatory spending). But, investors should not pay close attention to the detail in the budget because it has little chance of becoming law in its current form. 

The actual legislated changes in fiscal expenditure were the spending caps deals that were recently agreed upon. US Congress approved an increase of $300 billion (over two years) in defence and non-defence spending (defence gets around half of spending). Around $10 billion pa was allocated towards infrastructure (includes highways, water and rural broadband).  

This additional lift in government spending over 2018 and 2019 is large and will contribute around 0.3-0.5 percentage points to growth. But, government spending has a long lag time and this additional spending may not get fully reflected this year. Taking into account legislated taxation reform, the US economy is set to grow at ~3% over the next two years which is well above its potential at 2% per annum). The additional government spending will put pressure on the budget deficit, which is headed towards 5% of GDP (see chart below) over the next few years, from 3% currently.   

Stronger economic growth will provide an offset to increased spending through lifting government revenues. A higher budget deficit will also put upward pressure on public debt which has been growing since 2009. The willingness of the Republican Party to increase the budget deficit under Reagan, Trump and Bush indicates that the party may not be the “fiscal hawks” that commentators usually indicate.

Infrastructure

President Trump and the Republican Party have been talking up the need to lift infrastructure spending for some time. The latest infrastructure plan released from the President advocates for a $1.5 trillion infrastructure package (over ten years) but only provides a $200 billion commitment from the federal government with the aim that this would kick start investment across other levels of governments and the private sector. Key components of the plan include: shortening the approval time for projects, addressing rural infrastructure and providing states and local governments with financial incentives to lift investment (similar to the Australian Asset Recycling Program) which shifts responsibility for funding projects from the federal to the state government.  

It does make sense to lift infrastructure investment in the US, given years of underinvestment (see chart below that shows government investment declining as a share of growth).

The quality of current US infrastructure is also deteriorating (see chart below for an indication of road quality). Estimates suggest that the infrastructure funding gap in the US is around $2 trillion by 2025 across all sectors of infrastructure. 

A big boost to infrastructure spending is not ideal at this stage of business cycle when the economy is firmly on a growth uptrend and is already being supported by lower tax rates. A big lift in investment risks causing unnecessary wage and inflation pressures and an overheated economy.

 The chances of an infrastructure package being approved in its current form is unlikely for now as Congress debates Budget measures over the next few months.  

Tax reform was passed by the process of “budget reconciliation” which allows for specific legislation to pass the Senate with a simple majority (51 votes) rather than the usual supermajority of 60 votes . But the budget reconciliation process cannot be used to pass legislation like infrastructure. And, it is unlikely that the Trump proposal will get Democrat support. There is also talk of an increase in the gas levy to pay for infrastructure, but this is unlikely.

Tax package

The tax reform package will continue to positively contribute to economic growth over the next two years. Corporate earnings growth remains strong and is set to rise by ~11% per annum over the next two years. Earnings season in early 2018 has even seen numerous companies revising up earnings growth and indicating higher bonus payments for employees as lower tax rates free up profits.

  Household pay slips will also start to be positively adjusted from now which may give sentiment a boost, as the majority of households believed that they would be getting a tax hike.

What will be the impact on the economy?

The US economy running significantly above its potential over the next two years could mean that the US Federal Reserve may need to raise interest rates faster than market expectations to stop the economy from overheating if inflation and wages growth takes off. 

As mentioned, the increase in government expenditure is lifting the budget deficit from its current 3% level towards around 5%. Higher budget deficits add to the debt burden for the government which means that the government has less flexibility in a crisis.

Implications for investors

 Stronger US GDP growth is generally a positive for corporate earnings in the near-term and equities as a result. But in the longer run, a solid lift in growth means a higher risk of inflationary pressures building up, which could mean more aggressive Federal Reserve rate hikes that would be negative for equities. 

 A rising US budget deficit also means that bond yields are likely to move higher. Bond yields are already rising as deflation fears have receded and inflation is showing clear signs of increasing and the US Federal Reserve is shrinking its balance sheet.

 For now, we remain at a point in the investment and economic cycle that still favours equities. But, rising bond yields, budget deficits and an eventually overheated US economy are issues for investors to keep an eye on.