Market Update: Public Sector Stimulus — The

December 24, 2014
Market Update
Public Sector Stimulus — The 2015 Growth Surprise?
Joe Tanious, Investment Strategist
•
One potential surprise for investors in 2015 could be public sector efforts that boost U.S.
growth and cyclical assets
•
A more supportive economic and fiscal backdrop as well as political need lead us to see
the potential for stimulus
•
Stronger-than-expected growth seems more likely to be the sum of many small actions
rather than any single major stimulus package
As we think about 2015 and what might surprise
consensus expectations — and in turn move
financial markets — one possible catalyst that
has caught our attention is the U.S. public sector.
Specifically, could we see U.S. GDP stronger than
expected, with related support for U.S. cyclical
assets, emerge in part because of governmentrelated efforts?
Certainly, after recent years of heightened
dysfunction in Washington that included the first
government shutdown since the 1990s, effective,
bipartisan policymaking would be a surprise to
some. But we see at least two strong arguments
for more public sector stimulus in the year ahead:
a friendlier economic and fiscal backdrop and
political need.
On the economic side, it is noteworthy that the
U.S. budget deficit has narrowed more quickly
than many expected; indeed, it is projected
to reach 2.6% of GDP in the coming year, the
best outcome since 2007. The resistance to
fiscal stimulus has receded, at least for now.
Meanwhile, U.S. politicians are aware of their
generally lackluster opinion-poll approval ratings
and are looking for ways to gain support going
into the 2016 elections. (Recent polls have put
Congressional approval ratings at a mere 14%,
while President Obama’s approval rating — at
42% in mid-December — was near his presi­
dency’s lows.) Fiscal stimulus, supporting the
economy, would be one way to improve voters’
perceptions. Interestingly, looking back at past
U.S. electoral cycles, the year before a presidential
election has regularly seen relatively greater fiscal
stimulus, regardless of the party in power or
whether it was a president’s first or second term.
So what public sector efforts might unfold in
the coming year? Below, we look at possible
steps — on the federal, state, and local levels, as
well as indirect stimulus via regulatory changes.
Overall, the potential for incremental public
sector growth support next year seems more
likely to be the culmination of many small steps,
rather than one large fiscal leap.
Market Update: Public Sector Stimulus — The 2015 Growth Surprise?
Fiscal Snapshot
Budgetary Trends and Impact
Consistent with the public’s diminishing focus
on the federal budget deficit, Exhibit 1 provides
a historical perspective of the government’s
finances. As discussed in our recently released
year-ahead Quarterly Investment Perspective:
What Really Matters in 2015, we believe a few
additional forces could help federal spending
pick up in the coming year. Following stimulus
measures taken during the financial crisis,
Congress reduced the budget deficit by $907
billion over the past five years via stronger tax
revenues and decreased spending through the
2011 Budget Control Act (BCA). Over the last
five years, this increase in revenue and decrease
in spending has provided a 7% headwind to
economic growth. Over these five years, the
shrinking government deficit has provided a 7%
headwind to economic growth, with the heaviest
fiscal drag occurring over the past 2 years.
We see fiscal policy turning the corner in 2015 and
potentially becoming additive to GDP, fueled by
Congress’s recently passed “CROmnibus” package.
This package extends the base discretionary
budget through September 30, 2015 (fiscal year
2015) at levels set by the Ryan-Murray agreement
(a two-year agreement reached in December
2013) for 11 of the 12 appropriation bills (known
as an omnibus). However, this budget would
only fund the Department of Homeland Security
through February (via a continuing resolution or
CR), which will then allow the GOP-led Congress
to seek to defund the president’s immigration
executive order via the budget process early in
2015. Indeed, under this CROmnibus package,
fiscal drag looks set to significantly diminish in the
year ahead.
Assuming the government does nothing to
change current projections, economic growth
should notably accelerate in 2015 as the private
economy becomes less encumbered by govern­ment
Exhibit 1: Federal Budget Deficit
% of GDP
%
0
2004
2006
2008
2010
2012
2014
2016
2018
2020
2022
(2)
(4)
(6)
(8)
(10)
6.9% Fiscal Drag Over 5 Years
(12)
As of August 27, 2014. Years reflect fiscal year budgets as a percent of GDP. 2015-2027 are Congressional Budget Office estimates.
Source: Congressional Budget Office
2
2024
Market Update: Public Sector Stimulus — The 2015 Growth Surprise?
Exhibit 2: Fiscal 2015 Federal Budget
Net Interest: $251bn
Discretionary
Defense: $551bn
Other: $302bn
Discretionary Non-defense:
$638bn
Corporate Taxes: $389bn
Other: $415bn
Social Insurance Taxes:
$1,065bn
Social Security: $887bn
Mandatory
Income Taxes: $1,526bn
Healthcare: $1,009bn
Outlays
Revenues
As of December 13, 2014. Revenue estimates reflect the Congressional Budget Office’s 2015 baseline.
Source: Congressional Budget Office
contraction. As Exhibit 2 depicts, the 2015 Federal
budget projects spending to exceed revenues by
$470 billion, equating to a 2.6% deficit in fiscal
2015 under current law. Relative to the massive
-2.7% and -1.2% fiscal drags in 2013 and 2014
alone, a federal budget deficit around 2.6% of
GDP should provide a minimal if somewhat
immaterial headwind of only -0.2% to growth in
2015. Nevertheless, this also creates a very low
hurdle of only $38 billion in additional spending
or tax decreases needed for a stimulative federal
government. While not our base case, we see the
potential for additional spending, which, in turn,
could potentially flip the federal budget to a net
positive for 2015 GDP growth.
2015 Fiscal Surprises?
While, under current law, the fiscal drag expe­ri­
enced over the past few years will most likely
decrease in 2015, the current political and
economic environment may be setting the stage for
a potential increase in government spending. This
would not come as a surprise; historically, there
has been a propensity for the federal government
to increase the fiscal deficit in the third year of a
president’s term (Exhibit 3). Nevertheless, while
we always approach “average” estimates with
a degree of caution, the stage seems to be set for
upside fiscal surprises in the year ahead and does
make some sense looking backward. After all,
an incumbent president looking to get re-elected
or have his party re-elected would want happy
voters. Stronger economic growth — to the degree
it translates into more jobs and income — tends to
put smiles on voters’ faces and reward the party in
power that supported those growth efforts.
Exhibit 3: Average Annual Increase in the Federal Budget
1975-2013
%
0.1
Reducing deficit =
drag on GDP
0.0
(0.1)
Greater deficit =
boost to GDP
(0.2)
(0.3)
Year 1
Year 2
Year 3
Presidential Year
Year 4
As of December 13, 2014.
Source: Congressional Budget Office, Bureau of Economic Analysis
3
Market Update: Public Sector Stimulus — The 2015 Growth Surprise?
Potential Upside Surprises
state and local spending). The last time the U.S.
Congress passed a repatriation bill was in October
2004, and it is estimated that roughly $362
billion was repatriated in the one-year “holiday”
window (through the end of 2005). While this
would have a modest impact on the economy,
studies from the 2004 repatriation showed that
shareholders were the biggest beneficiaries — in
other words, repatriation helped U.S. equities.
Federal (39% of Government Spending, 7% of GDP)
While Republicans will take control of both
chambers of Congress in January, they still don’t
have the numbers to overcome a presidential veto
on contentious items. As such, we would look for
potential progress (and upside surprises) on those
issues that have some bipartisan support. Here is a
closer look at those issues:
•
Repatriation holiday: Over the past few years,
•
Defense: While federal spending has come under
pressure during the past few years in general,
defense spending in particular has decreased by
$105 billion since the peak in 2011 (Exhibit 4),
primarily due to the sequester (a product of the
above-mentioned BCA) as well as the winding
down of multiple wars. Notably, these actions
have negatively impacted both the base defense
budget, which is capped by the BCA, and overseas
contingency operations (OCO), the latter outside
the budget and used to fund wars. While the
OCO spending has come down over the past
few years, this may ultimately not be the case in
2015 as the president seeks additional funding
for the war on the Islamic State of Iraq and Syria
(ISIS). It is worth noting that Ashton Carter,
the president’s nominee for Defense Secretary
Republicans have pushed to reduce corporate
taxes, while Democrats have sought to ramp
up infrastructure spending. One concept to
address both issues which has been gaining
bipartisan support is that of a tax repatriation
holiday. As it currently stands in the tax code, a
company that earns a profit overseas and wants
to bring the cash back to the U.S. (repatriate)
would have to pay taxes in both countries. As
a result, many companies have decided to leave
their cash abroad, an amount estimated to equal
$2.5 trillion. One solution would be to enact a
repatriation tax — which would be meaningfully
lower than current tax rates — on funds brought
from overseas, with the taxed portion used to
fund infrastructure projects (thereby enhancing
Exhibit 4: Real Government Consumption and Investment
Annual % Change
%
15
After years of contracting,
government spending seems to
be finally turning a corner
Defense
10
Non-defense
5
0
State and Local
(5)
(10)
2000
2001
2002
2003
As of November 25, 2014.
Source: Bureau of Economic Analysis
4
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Market Update: Public Sector Stimulus — The 2015 Growth Surprise?
to replace outgoing Secretary Chuck Hagel, has
been quoted as saying the defense budget has
been hit too hard and the sequester is bad policy.
The combination of the growing global threat
level, coupled with increased bi-partisan support
to overturn the sequester caps, could ultimately
lead to a higher defense spending package in
2015 than is widely anticipated.
•
Other: Republican leaders have indicated that
one of the first items on their agenda for 2015
is energy reform. Specifically, they are hoping to
approve the Keystone pipeline (which would then
go to the president for his signature/veto) and
revisit the ban on crude oil exports. As Keystone
is a privately financed, $8 billion project, its
approval could have a macro impact. Also, the
president’s recent actions lead us to another issue
that has the potential to benefit the economy over
time — immigration reform. As we highlighted
in a recent Market Update, immigration reform
could lead to improvements in productivity and
stronger consumer demand, which would, in
time, likely lead companies to boost production,
thereby creating more jobs and capital and
increasing the wage rate and GDP in the long
run. While we acknowledge that the potential
impacts on GDP from energy and immigration
reform are longer term in nature, we do believe
that legislative progress on these issues could still
support growth sentiment, which in turn could
prove helpful for cyclical U.S. assets.
State & Local (61% of Government Spending, 11% of GDP)
In contrast to federal spending, state and local
spending has expanded at a 0.8% annual pace over
the past six quarters (Exhibit 4), helping to reduce
some of the fiscal drag discussed above. However,
while spending by municipalities has historically
led the more volatile federal spending categories,
consumption estimates for the year ahead can be
difficult to ascertain given the idiosyncratic nature
of each state’s financial position.
Still, general improvement in state finances and
the need for additional infrastructure investment
since the recession set the stage for longer-term
spending projects at the state and local level.
(Data from a 2012 Council on Foreign Relations
report suggested that U.S. public infrastructure
investment, at 2.4% of GDP, had been cut in half
versus levels seen 50 years prior.)
In the meantime, we continue to see improvements
in state payroll growth, which can serve as a very
rough proxy for municipality spending intentions.
Indeed, state and local governments have added
85,000 jobs to the U.S. labor force year to date,
representing 88% of total government employment
and helping to reverse the nearly 300,000 in state
and local payroll cuts since 2011 (Exhibit 5).
Exhibit 5: Government Employment
Annual Change, Thousands
%
100
50
Federal Employment
State and Local Employment
0
(50)
(100)
(150)
(200)
(250)
(300)
2011x
2012x
2013x
YTD 2014
As of December 5, 2014.
Source: Bureau of Labor Statistics
Mortgage Lending
In addition to possible spending on the federal and
state side, there are other policies from Washington
that might lift growth. Policy changes around
the housing market in particular bear watching
as mortgage lending still appears very tight. The
director of the Federal Housing Finance Agency
(FHFA), Melvin Watt, has been working on several
5
Market Update: Public Sector Stimulus — The 2015 Growth Surprise?
policies to help expand the availability of credit to
homebuyers and ultimately stimulate the housing
market. While there are several proposals and
policies in the works, two recent announcements
caught our attention.
The first of these two recent proposals relates to
what defines a Qualified Residential Mortgage
(QRM). A QRM is a mortgage that financial
sponsors can securitize and sell into the market
without the need to retain risk in the loan. The
need for underwriters to keep some “skin in the
game” and retain risk (at least 5%) in all their
loans goes back to Dodd Frank, in response to
the excessive lending practices that are believed
to have fueled the financial crisis. When the initial
rule was proposed in 2011, it was believed to be
far more onerous on financial institutions than
what was recently decided. Most notably, it was
initially proposed that in order for a loan to qualify
as a QRM, buyers had to put a minimum down
payment of 20% towards the purchase price. This
requirement, of course, limited the number of
loans that would qualify as a QRM, and further
restricted lending in the housing market. While
the new rules are set to go into effect in a year,
and we have yet to see how financial sponsors will
modify their lending practices, having more clarity
around these regulations certainly bodes well for
the housing market.
In addition to clarifying these rules, expanded
guidelines around Fannie Mae and Freddie Mac
have recently been announced in an effort to
help further stimulate the housing market. Most
notably is the proposal to reduce the required
down payment from 5% to 3% for qualified
buyers. While the details are not yet ironed out,
we do know that minimum credit scores and other
forms of mortgage insurance will be required, as
the goal is to expand credit but avoid a repeat of
lending practices that led to the financial crisis.
6
All of these policies, while clearly a balancing act, are
part of Director Watt’s plan to help expand credit
in the housing market and reach buyers that have
lim­ited access to capital. As experienced in previous
dec­
ades, a tight housing market and accretive
home values have the potential to unlock additional
spend­
ing. While housing investment represents
only a minimal 3% of GDP, it accounts for 24%
of household assets and a dis­pro­por­tion­ate 60% of
assets for the bottom half of the income distribution.
Simply put, a stronger housing market in the year
ahead has the potential to increase household con­
sump­tion, which is the engine of the U.S. economy.
Putting It All Together
As we head into 2015, the U.S. fiscal deficit is
clearly in a better position relative to where it
has been over the past five years, and is no longer
the most pressing issue facing Congress. More
importantly, if current law stands, we should see
very little, if any, fiscal drag heading into next year.
This clearly bodes well for U.S. economic growth
and risk assets.
Since 2009, the U.S. economy has faced an average
annual fiscal drag of 1.7%, yet has managed to
grow at an average pace of 2.2%. Without this
drag, it should be clear to see why growth rates
above 3% are now achievable.
The risk to the upside, we believe, is that addi­
tional spending measures could be announced,
possibly leading to fiscal thrust heading into 2015.
These measures, while relatively small on their
own, have the cumulative potential to stimulate
economic growth. This asymmetric risk supports
our constructive outlook on the U.S. economy and
overweight position in U.S. equities.
Many thanks to Tom Healy III, director of Client
Portfolio Analysis at Bessemer Trust, and Anthony
Wile, Investment Strategies associate at Bessemer
Trust, for their contributions to this piece.
Market Update: Public Sector Stimulus — The 2015 Growth Surprise?
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