Congressional Guns and Butter
Today’s market decline, in our view, reflects concerns over the discretionary spending cap increases of nearly $300 billion written into the two-year bi-partisan budget agreement. The two-year spending cap increases would bring discretionary spending in fiscal year 19 to a level nearly 25% greater than the roughly $1.2 trillion of discretionary spending in fiscal year 17. Of the total increase, approximately $165 billion goes to military spending. This will represent the biggest increase in defense spending since 2003—during the Iraq war. Non-defense spending will increase $131 billion including $20 billion of new infrastructure spending. Importantly, this measure suspends the debt ceiling for a year until March 1, 2019. The senate and house will vote on this package today—Thursday—in order to beat the midnight deadline for keeping the federal government open.
Congress’ Open Wallet Approach
Investor concerns reflect the open wallet approach this Congress adopted in its spending approach. In fiscal year 17, the budget deficit reached $666 billion. The tax reform bill will add approximately $1.5 trillion over ten years to that budget deficit. This budget agreement further adds to the budget deficit and will likely bring the federal deficit to over $1 trillion in fiscal year 2019. That deficit level represents the same level incurred coming out of the 2008 financial crisis. Investors may understand such a substantial deficit after a financial crisis. However, in a period of economic growth, it seems difficult to reconcile that growth with a trillion-dollar deficit. As a reminder, Congress will still be considering a $1.5 trillion infrastructure spending package. Simply put, Congress needs to do a fiscal exam of our federal government spending.
Concerns over unfettered federal government spending leads many investors to assume a higher probability of increasing long-term interest rates this year. In our past commentaries, we looked to the second half of this year to be the key test period to determine whether the Fed’s increased Fed Funds rate and quantitative tightening programs would begin to bite. Our view already assumed that interest rates, both short and long, would likely increase—more so in the second half of 2019. This budget proposal would likely increase the probability of that occurring earlier and the interest rate curve steepening more than even our expectations. In this likely financial environment, investors should look to continue to shorten the duration of their fixed income investments and also consider adding alternative investment products.
Andrew J. Melnick, CFA
Chief Investment Strategist