The Coming Fiscal Derailment – Why FY 2019 Will Sink The Casino

Since last November 8th the Russell 2000 has risen by 30% and the net Federal debt has expanded by an astounding $1.0 trillion dollars.

In a rational world operating with honest financial markets those two results would not be found in even remotely the same zip code; and especially not in month #102 of a tired economic expansion and at the inception of an epochal pivot by the Fed to QT (quantitative tightening) on a scale never before imagined.

And we do mean exactly those words. By next April the Fed will be shrinking its balance sheet at $360 billion annual rate and by $600 billion per year as of next October.

Altogether, the Fed’s balance is scheduled to contract by upwards $2 trillion by the end of 2020. And it’s apparently on a path that is so locked-in—-barring a recession—that Janet Yellen affirmed in her swan song that the Fed’s giant bond dumping program (euphemistically called “portfolio runoff”) would no longer even be mentioned in its post-meeting statements.

So the net of it is this: The Fed will sell more bonds in the next 3-4 years than had been accumulated by all of the central banks of the world in all of recorded history as of 1995!

That prospect alone might give a rational stock market at least some cause to pause. After all, the Fed’s $2 trillion bond selling campaign (likely to be joined by the ECB in 2019 when a German replaces wild-man Draghi) is on automatic pilot unless there is a recession.

So stock prices are either going to be battered by slumping profits if the business cycle hasn’t actually been abolished; or, in the alternative, rising bond yields will sharply inflate the carry cost of $12.5 trillion of US non-financial business debt (e.g. a 200 basis point increase in rates would lower pre-tax business profits by $250 billion or 15%) even as PE multiples shrink and stock buybacks are sharply curtailed.

And that’s not all, as the late night TV man says. There is literally a fiscal red ink eruption heading straight at the Fed’s balance sheet shrinkage campaign that will rattle the rafters in the casino.

As detailed below, Uncle Sam’s borrowing requirements are likely to hit $1.25 trillion or more than 6% of GDP in FY 2019 owing to the fact that the tax bill is so heavily front-loaded and the GOP’s wild spending spree for defense, disasters and much else.

Needless to say, this impending bond market collision has not fazed the dip-buyers in the slightest. Financial markets are in the blow-off stage of the third great central bank bubble of the present era and are therefore entirely in the grip of momentum chasing robo-machines and day traders. The latter are processing price action alone—-to the complete exclusion of a swelling tide of facts and threats which sharply contradict the bullish mania of the moment.

For instance, the now booming Russell 2000 (RUT) wasn’t exactly a laggard when the Trump Trade incepted in the wee hours of election night. At that point it traded at 1190 and was already up by 230% from the March 2009 bottom.

But at yesterday’s record 1549 close, these small and mid-cap domestic companies had a combined market cap of $4.45 trillion. That represented not only 440% of the RUT’s $1.0 trillion market cap at the March 2009 bottom, but also reflected utterly absurd multiples of the current earnings and dividends attributable to its constituent companies.

To wit, the RUT companies generated just $60 billion of dividend payments during the LTM period ending in September. In what sane world does a GDP-hugging basket of main street companies trade at 74X  their dividend?

Worse still, the RUT companies are apparently borrowing money to pay even that miserly 1.35% dividend.

That’s right. Net income during the LTM period was slightly under $42 billion or just two-thirds of the RUT’s dividend payout. So this also means that America’s main street businesses are being valued at a preposterous 107X earnings.

These absurd valuations would be troublesome enough if the fiscal and monetary context were stable rather than heading for a thundering dislocation. But there is no other word for a fiscal equation which is unraveling at lightening speed as we head for the onset of FY 2019 next October 1.

Under the CBO’s baseline projection of last June, the picture was already bad enough. Federal outlays were projected to rise from $4.0 trillion in the year just ended (FY2017) to $4.38 trillion in FY 2019. Notwithstanding revenue growth of 11% under current law over the two year period, the resulting baseline deficit still computed to nearly $700 billion.

But Trump has already signed into law a defense authorization bill which will raise baseline outlays from $625 billion to $700 billion. And on top of that, the House yesterday approved an $81 billion disaster aid supplemental for the hurricanes and wildfires, which will bring total spending for this year’s disasters to a staggering $133 billion.

That’s vastly more than the $51 billion spent for Hurricane Sandy or the Katrina outlays of $60 billion. More importantly, the Congressional Republicans are not contemplating any off-setting cuts elsewhere in the Federal budget—-a sharp reversal from their traditional insistence to that effect.

Indeed, the disaster fix is already in and will be attached to the next two-week installment of the FY 2018 continuing resolution (CR).

The fact that the Federal deficit is soaring and was already up by 75% in the year just ended compared to FY 2015 has apparently not registered with the Republican leadership. And that’s to say nothing of horrific timing: Upwards of half of the $133 billion of disaster aid will hit in FY 2019 at the exact time that the GOP’s front-loaded tax cut ($280 billion) will also arrive with full force.

As Bloomberg noted with respect to the disaster aid bills, fiscal rectitude is not the GOP’s flavor of the month. For instance, the “ask” of $61 billion for disaster aid from conservative Texas governor Gregg Abbott is more than has ever been spent on any previous disaster in US history.

Likewise, the Florida GOP is seeking $1.5 billion for damages suffered by the citrus industry when Irma came roaring across the peninsula. That’s especially rich because hurricanes are surely a known cost of doing business in Florida, and orange and lemon producers ought to buy insurance or self-insure, not ding taxpayers in Fargo North Dakota.

In any event, as Bloomberg explains below, the GOP’s stalwart conservatives from Florida, California and Texas are on the case because this time is apparently different:

The aid likely would be attached to a government spending bill that must be passed this week to keep the government open after Friday. The disaster spending is being pushed forward by Republicans from Texas, Florida and California who threatened to oppose the spending bill if hurricane relief wasn’t included……“The dollar figures I hear are fine,” said second-ranking Senate Republican John Cornyn of Texas. “How it’s distributed may need some changes”.

House Rules Committee Chairman Pete Sessions of Texas predicted that conservatives will support the bill, despite a lack of offsetting spending cuts, because they understand the urgent need for aid. The Texas port on the Gulf of Mexico, through which military armaments pass, is “still in shambles”, he said.

Florida has requested $1.5 billion to help its citrus industry recover from hurricane Irma. Texas Governor Greg Abbott has requested $61 billion in aid for his state, while officials in Puerto Rico have sought $94 billion.

Still, there are at least two more budget shoes to drop just around the corner, as well. The first is the House GOP leadership’s plan to bust the sequester caps for defense via a rider on the Christmas Eve CR, but to leave the cap on domestic appropriations frozen at existing levels.

Needless to say, it won’t fly. The Dems have already rejected what they are calling Ryan’s defense and disaster plan—-yet the sheer vote math in the GOP caucus is prohibitive on a strictly partisan basis. This means that to raise defense spending by about $75 billion per year or 12%—either in the current CR extension or the next one in early January—will ultimately require at least a $25 billion or 5% increase in domestic appropriations in order to obtain at least some democratic votes.

Like in so many other cases, the Speaker will lose votes from among the 40-50 member Freedom Caucus owing to the lack of off-sets for the giant disaster relief rider and would simultaneously face defections from the 50-member Tuesday Club if defense appropriations are raised by 12% while domestic appropriation for education, community development, health services and research etc are kept frozen at sequester levels.

So we expect that he will end up cobbling together a majority by pacifying the GOP moderates and buying off the requisite Dems to obtain the needed 218 votes to keep the government open—-even if only a few weeks at a time.

That baleful outcome is more or less baked into the cake based on how McConnell auctioned off the votes for the tax bill in the Senate. Specifically, he made an ironclad promise to Senator Collins to fund the ObamaCare insurance subsidies at around $20 billion per year.

Yet given that his majority will dwindle to just 51-votes after Alabama, he has no way to renege. That’s because the RINO from Maine was negotiating for Senator Alexander and a handful of other GOP Senators who insist on “stabilizing” rather than repealing ObamaCare. But when the insurance company bailout comes back to the House, there will be huge defections by the anti-ObamaCare stalwarts of the Freedom Caucus.

In all, then, we expect FY 2019 outlays to rise by upwards of $200 billion from CBO’s most recent baseline projection. That would include $75 billion for defense, $65 billion for disaster aid, $25 billion for increased of domestic appropriations above the sequester cap, $20 billion for the ObamaCare subsidies and another $15 billion for interest on higher spending and lower revenues.

And that get’s us to the tax bill and what the Wall Street Journal has dubbed “Sunset Boulevard”. What that means is the biggest tax cut occurs on the front-end in FY 2019. Thereafter, the tax bill devolves into an endless sequence of gimmicks, sunsets and implausible out-year revenue raisers that were designed to shoehorn the 10-year cost into the $1.5 trillion deficit allowance which enabled a 51-vote reconciliation process.

Those kinds of spending increases are now virtually certain, and will take total FY 2019 outlays to around $4.575 trillion. That happens to be nearly 20% more than the $3.85 trillion spent during FY 2016 during the run-up to the presidential election—-when the GOP politicians loudly denounced the runaway spending of the Obama Administration.

So the Sunset Boulevard depicted below amounts to the most blatant and dishonest abuse of the budget reconciliation process since its enactment in 1974, and we will elaborate on that in greater detail tomorrow.

But suffice it to say here that the “cliffs” built-into the graph below are not going to happen in the real world. Instead, they will soon lead to political conflicts and fiscal food fights that will make the 2012-2013 tax expiration “cliffs” look like small potatoes in comparison.

For instance, the only semblance of honesty in the claim that the bill is a “middle-class tax cut” is the 2-3 points of downward adjustment in the 7 marginal rate brackets compared to current law and the doubling of the child credit to $2000.

In the sunset year of 2025, however, those measures would save taxpayers $250 billion. compared to current law. Yet if there is any certainty in this world at all, it is that a legislative and political bloodbath will ensue when the Congress comes check-by-jowl with a quarter trillion dollar per year tax increase on 150 million individual taxpayers in 2026.

Likewise, the $53 billion per year cut for pass-thru businesses expires in 2025—-even as the corporate rate cut to 21% (at a cost of $150 billion per year) stays on the books forever. That’s not going to happen in a month of Sundays, either.

From the other side of the equation (i.e. payfors), the limit on interest deductions for business debt tightens sharply in the outyears. This causes the “payfor” gain to nearly double from $20 billion per year to $37 billion (2027), while at the same time a whole new regime of amortization of corporate R&D rather than 100% expensing incepts in 2022—raising a projected $120 billion in the final six years of the bill.

Since the K-Street lobbies and business PACs essentially wrote the current bill, we have little doubt that they will have the clout to “un-write” what amounts to $200 billion in phony revenue increases in the outyears when the time comes.

In short, we will demonstrate that the true 10-year cost of the GOP’s tax bill folly is in the order of$2.5 trillion on a honest accounting basis, and that under current circumstances it doesn’t have a snowball’s chance in the hot place of paying for itself with higher growth.

But for the moment, however, the FY 2019 budget disaster also explains why coping with this fiscal monstrosity in the outyears in the context of baseline deficits which already total $10 trillion over the period will be next to impossible.

As is evident below, the FY 2019 revenue loss from the final conference bill will total $280 billion, thereby reducing Uncle Sam’s collections to just $3.40 trillion compared to the aforementioned $4.575 trillion of spending.

So there you have it: An FY 2019 budget deficit of $1.175 trillion—and you need to add another$100 billion for off-balance sheet programs that add to the borrowing requirement.

Even under the CBO’s generous estimate of nominal GDP for FY 2019 ($20.7 trillion), the Treasury’s total borrowing requirement of $1.275 trillion would amount to 6.1% of GDP.

But here’s the thing. That would be during months #111-125 of the business expansion that started in June 2009. As we have frequently noted, the US economy has never been there before—with the longest previous expansion during the far more benign 1990s totaling only 118 months.

And that is to say nothing of the fact that this purported record business expansion would be occurring at a time ultra-late in the cycle when the Fed is shrinking its balance sheet by an unprecedented rate of $600 billion per year.

In a word, something’s going to give.

We’d bet a fair amount that one of those “somethings” will be a casino so delirious with momo madness that it is valuing the RUT main street businesses of America at 107X peak earnings.

 

Former Congressman David A. Stockman was Reagan’s OMB director, which he wrote about in his best-selling book, The Triumph of Politics. His latest book is The Great Deformation: The Corruption of Capitalism in America. He’s the editor and publisher of the new David Stockman’s Contra Corner.

This article was originally published by TalkMarkets –

Copyright © 2017 David Stockman

 

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