Big changes that are unexpected have the power to dramatically affect markets, and that's been the story of the U.S. economy these past four years. The U.S. economy is in much better shape today than was expected four years ago, and the federal budget outlook is significantly better today than was expected four years ago. As a consequence, the expected future burden of federal taxes has declined, and the need for painful spending austerity has receded. All of this translates into very good news for risk assets, and goes a long way to explaining the equity market rally that began four years ago and continues today.
The first chart above shows federal revenues by month for the past four years. Revenues have been on a moderately rising trend since late 2009. Note, however, the huge increase in April 2013 revenues, the likely result of 1) higher taxes paid by those who accelerated income and capital gains realizations into the final months of 2012 in order to avoid an expected increase in taxes this year; 2) the end of the payroll tax holiday; 3) higher income taxes on the rich; and 4) ongoing growth in the U.S. economy, which continues to lift personal income. The second chart above shows that the bulk of the increase in federal revenues -- about 70% -- came from individual income tax receipts. That further suggests that a good portion of the April surge was a one-time occurrence, the result of accelerated income and cap gains realizations late last year. Nevertheless, higher income taxes on the rich, and ongoing growth in the economy, personal incomes, and corporate profits, should continue to provide a marginal boost to revenues for the remainder of the year.
April's revenue bonanza was equivalent to an annualized 0.42% of GDP, lifting 12-month revenues to 16.75% of GDP, which is about two percentage points better than the late-2009 low of 14.6%.
The main driver of higher revenues is simply the ongoing growth of the U.S. economy, which in turn has boosted incomes. corporate profits, and capital gains. The bigger story, however, is the huge decline in federal spending relative to GDP, which has fallen from a high of just over 25% to now just over 22%. As the first of the above charts shows, this is all due to flat growth in federal spending; no actual cuts were necessary to reduce the burden of government spending by over three percentage points in just four years.
With spending flat and revenues up, the burden of the federal deficit has fallen by almost half, down from a high of 10.5% to 5.4% last month. In dollar terms, the 12-month deficit is down from a high of $1.47 trillion in 2009 to $856 billion as of April. I'm reminded of my May 2009 post on how awful the federal budget outlook was, and in which I commented:
Let's be optimistic and assume the economy is already beginning to grow again, but it's hard to see a recovery in revenues that is much stronger than what we saw coming out of the 2001 recession. What was then the "jobless recovery" is going to be replaced by a recovery that has to climb a wall of higher taxes. That means that revenues probably won't turn up meaningfully for another couple of years. Meanwhile, we know that spending is on track to reach $4 trillion next year. The amount of debt that will need to be sold over the next few years is thus absolutely staggering.
...the prospect of massive Treasury supply is being ignored as a threat because that same supply will bring with it a massive increase in taxes, which will in turn keep the economy weak for the foreseeable future, which will in turn keep inflation low.
"Trillion-dollar deficits for as far as the eye can see" were the par for the course for most economic forecasts four years ago. Back then, hardly anyone was prepared to believe the U.S. economy was on the cusp of a recovery.
In a post in November 2008 I reasoned that "the current level of spreads on investment grade bonds implies that about 9% will be in default within five years, and fully 70% of speculative-grade bonds will be in default." As the chart above shows, high yield credit default swap spreads reached a peak of over 1,800 bps in March 2009, a level which suggested that defaults over the next five years would be almost catastrophic. Today, just four years later, actual corporate bond default rates are historically low, and spreads on high-yield CDS have collapsed.
In the same November 2008 post I noted that "the stock market is assuming that corporate economic profits [will] decline by at least two-thirds over the next few years. Any way you look at it, the pricing on corporate bonds and stocks today implies that the next several years will be the most disastrous in the history of the U.S." As we now know, instead of plunging, corporate profits are now almost double what they were at the end of 2008. Instead of years of deflation, we have had four years of relatively low and average inflation. Instead of an extended recession/depression, we have had four years of 2% annualized GDP growth.
In short, the future has turned out to be dramatically better than expected, and that is why risk assets are rallying. Moreover, with the very impressive improvement in federal finances, the specter of crushing tax burdens and wrenching austerity measures has receded significantly. Where once there was no hope whatsoever, there is now reason to be optimistic.