According to many economists, one of the main factors that weighed down the US economy in 2013 and contributed to sub-trend GDP growth was the "fiscal drag" caused by government tax increases and expenditure cuts implemented during that year. Although exact estimates vary, it is widely believed that "fiscal drag" subtracted as much as 2.4% from US GDP growth in 2013.
Looking forward to 2014, it is generally believed that the net effect of fiscal policy (federal, state, local) on US GDP will be neutral, or at least that the drag effect will be much reduced. This has caused many economic and financial analysts to become very optimistic about the prospects for US economic growth in 2014 and bullish about US equities as represented by broad index ETFs such as the SPDR S&P 500 (SPY) and the SPDR Dow Jones Industrial Average (DIA). The reasoning behind this optimism is that if the US economy was able to grow at a rate of roughly 2.0% in 2014 despite such a massive fiscal drag, US GDP growth and corporate earnings growth should really take off in 2014 without the burden of this handicap.
Indeed, many prominent Wall Street economists, citing the reduction of fiscal drag as their primary argument, are predicting a major acceleration of US GDP growth in 2014. For example, both Jan Hazius of Goldman Sachs and Torsten Slok of Deutsche Bank are forecasting a major acceleration in US GDP growth to more than 3.0% in 2014, with both stressing that the risks to their forecasts are to the upside.
If the "fiscal drag thesis" (as I will refer to it in this article) cited by these economists is correct there will be extremely important consequences for US fixed income markets, including instruments such as iShares 20+Year Treasury Bond (TLT) as well as for US and global equity markets. This article explores whether widespread economic optimism on the basis of reduced fiscal drag is justified.
Please note that this article is a summary of a more detailed 10-page institutional report available to subscribers of my newsletter.
Analyzing The Fiscal Drag Thesis
Proponents of the fiscal drag thesis tend to make the following sort of argument: "It is estimated that fiscal drag in 2013 is 2.4%. If GDP growth in 2013 ends up being 1.7%, then, if we had not had the fiscal drag, GDP growth would have instead been 4.1% (=2.0% +2.0%)." The assumption here is that the change in government taxation and/or government spending will be reflected more or less dollar for dollar in the change in the rate of GDP growth.
There are many reasons to be circumspect about this line of argumentation:
- Highly conjectural. Any estimate of fiscal drag is fundamentally suspect since it assumes knowledge of what would have happened, if the fiscal changes had not occurred. Furthermore, since changes in economic growth have many causes that are linked in complex ways it is very difficult to estimate what impact fiscal factors had, if any, on GDP growth.
- Little empirical support. My own estimate is that the change in fiscal stance in 2013 was -1.3% of GDP. However, consumption patterns in 2013 relative to 2012 suggest that the change in fiscal stance did not translate into an actual drag on GDP of anywhere near that magnitude.
- No 1-to-1 relationship. Changes in the government's fiscal stance rarely translate 100% into proportional changes in GDP. Multiplier effects vary greatly according to circumstances.
- Consumption smoothing. It is well accepted that households prefer to consume on a relatively steady growth trajectory based upon their projected long-term incomes. Therefore, in any given year, an increase in taxation should not be expected to cause a reduction in consumption growth that is proportional to the reduction in disposable income from the tax increase. Consumers will naturally tend to tweak savings to achieve a smoother consumption growth trajectory. There is indeed evidence that this may indeed have occurred in 2013, as savings rates declined.
- Risk aversion, liquidity preference and hoarding. One of the main lessons learned between 2009 and 2013 is that consumers and business largely preferred to hoard incremental cash flow rather than consume or invest it. While some analysts are confident that consumer and business behavior will finally change in 2014, others believe that the US is still recovering from a "balance sheet recession" in which the process of deleveraging has yet to run its full course. If the later view is correct, this implies that at least a portion of any marginal increase in disposable income that is enabled by the incremental change in the government's fiscal stance might be used to increase savings and/or pay down debt rather than to increase expenditures.
- Consumption demand and production are not the same. Even if changes in the government's fiscal stance translated directly into consumption, this does not imply that the change in gross domestic production will be proportional. Indeed, the significant growth in inventories during 2013 serves a reminder of this. Growth of production outstripped the growth in consumption in 2013, leading to inventory accumulation - it is quite possible that the inverse could transpire in 2014 if businesses throttle back production growth slightly to allow inventories to settle back to previous levels. This would tend to mitigate any presumed benefit from reduced fiscal drag.
A clear implication of the analysis contained above and in my more detailed report is that changes in the government's fiscal stance, in and of themselves, are not good predictors of changes in the economy in any given year. Behavioral factors play a major role in determining what impact changes in the US government's consolidated fiscal stance will have, if any, on GDP growth. The potential impact of behavioral factors, and particularly those that drive liquidity preference, will be among the key subjects that I will develop more fully in my 2014 Economic Outlook, and then later in my 2014 Investment Outlook. In these reports, which will be published through my newsletter in the next couple of weeks, you will find my detailed outlook for bonds, commodities, equity industry sectors, equity styles as well as individual stocks, funds and ETFs.