The Budget's Economic Assumptions And Their Future Impact On Stocks

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 |  Includes: DIA, IEF, IVV, LQD, QQQ, SPY
by: The Financial Lexicon

The White House recently released the 2013 budget, which is not only filled with all the details regarding spending but also has a fascinating set of economic assumptions for the coming years. The assumptions are based on information available as of mid-November 2011. When referencing economic data, years refer to calendar years, not fiscal years. Let's take a look:

GDP: The budget assumes nominal GDP growth of 4.5% in 2012, 4.7% in 2013, 5.3% in 2014, and 6.0% in 2015 before gradually slowing to what the budget calls "trend values" around 4.3%. Real GDP is forecast to be 2.7% in 2012, 3.0% in 2013, 3.6% in 2014, and 4.1% in 2015 before gradually slowing to "trend values" around 2.5%.

The budget also has this to say regarding long-term growth:

In the 21st century, real GDP growth in the United States is likely to be permanently slower than it was in earlier eras because of a slowdown in labor force growth initially due to the retirement of the post-World War II "baby boom" generation, and later by a decline in the growth of the working-age population.

Inflation: The budget assumes inflation will remain around the Fed's implicit target of 2% per year. Specifically, CPI is assumed to average 2.1%, and the GDP chained price index is assumed to fluctuate between 1.6% and 1.8% from 2012 through 2022.

Unemployment Rate: The budget assumes a steady decrease in the unemployment rate, eventually reaching 5.4% in 2019 from an annual average of 8.9% in 2012. Given that we started the year with a U3 rate of 8.3%, the 8.9% might prove too pessimistic.

Interest Rates: The budget assumes the following average interest rates for 91-day T-Bills and the 10-year Treasury note:

91-day T-Bill

Year

Interest Rate

2012

0.10%

2013

0.20%

2014

1.40%

2015

2.70%

2016

3.80%

2017

4.10%

2018

4.10%

2019

4.10%

2020

4.10%

2021

4.10%

2022

4.10%

Click to enlarge

10-Year Treasury Note

Year

Interest Rate

2012

2.80%

2013

3.50%

2014

3.90%

2015

4.40%

2016

4.70%

2017

5.00%

2018

5.10%

2019

5.10%

2020

5.10%

2021

5.30%

2022

5.30%

Click to enlarge

Given that the Fed is now expected to keep interest rates at ultra-low levels through 2014, it's hard to imagine the 91-day T-Bill averaging 1.4% in 2014.

Domestic Corporate Profits: The budget assumes domestic corporate profits will decline over the coming decade both in absolute terms and as a percentage of GDP. In 2012, the budget estimates domestic corporate profits at $1.782 trillion, rising to $1.973 trillion in 2017 before declining to $1.678 trillion in 2022. A steep drop in profits is assumed to occur between 2020 and 2022, falling from $1.842 trillion to $1.678 trillion, or 8.9%. In the words of the budget:

The share of domestic corporate profits was 9.8 percent of GDP in 2010. Profits dropped sharply in 2008-2009, but have recovered in 2010 and 2011. In the forecast, the ratio of domestic corporate profits to GDP falls to about 6.5 percent by the end of the 10-year projection period as the share of employee compensation slowly recovers.

Employee Compensation: The budget makes an assumption that employee compensation will rise from $8.595 trillion in 2012 to $14.587 trillion in 2022, an increase of 69.71%.

Wages and Salaries: The budget makes an assumption that wages and salaries will rise from $7.025 trillion in 2012 to $11.850 trillion in 2022, an increase of 68.68%.

Each of us will have an opinion on which parts of these assumptions, if any, have a realistic chance of coming true. I would like to spend a moment commenting on the relationship between corporate profits, employee compensation, and interest rate assumptions.

If the budget's assumptions on corporate profits come true, it will bode poorly for the stock market. For investors already scratching their heads about the S&P 500 (NYSEARCA:SPY) trading roughly 15% below its all-time high despite record earnings, it is important to understand that a sustained decline in corporate profits over a number of years (peaking in 2017 and still declining in 2022) will further demand lower multiples for the major indices.

Companies have done quite a job increasing profitability through cost cutting measures over the past few years. If costs begin to rise on the back of increasing employee compensation and revenue growth does not offset this, we will be lucky to see any growth from today's levels on a capital appreciation basis in the Dow Jones Industrial Average (NYSEARCA:DIA) or the S&P 500 (NYSEARCA:IVV).

The Nasdaq (NASDAQ:QQQ) might be a bit of a wild card in terms of future performance as Apple (NASDAQ:AAPL) has become such a huge weighting in the Nasdaq 100 that this index's future is likely tied to the ability of Apple to continue growing at a breathtaking clip. Furthermore, Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) and their rather large number two and three weightings in the Nasdaq 100 will also have an abnormally large impact on the future of this index. Together, Apple, Microsoft, and Google currently have a 31.26% weighting in the index, despite only representing 3% of it.

One question I have for the team putting these economic assumptions together is why they believe companies will hire workers and increase employee compensation at a clip that will damage corporate profits. After all, over the past few years, companies have shown a tendency to do the exact opposite in order to protect profits.

Furthermore, if we combine the effects of lower corporate profits over a multi-year period with rising interest rates, stocks would likely see downside pressure not just from falling (or at least non-rising) price-to-earnings levels, but also from extreme competition out of the fixed income space. After years of ultra-low interest rates and tens of millions of baby boomers desperately searching for income, if the 10-year Treasury (NYSEARCA:IEF) is yielding 5%, and many investment grade corporate bonds (NYSEARCA:LQD) are therefore likely yielding over 6%, certainly there would be additional selling pressure on stocks. Add to this a 91-day T-bill at 4.1%, and it's hard to imagine keeping money in a market with declining profits, versus parking it in T-bills yielding over 4%.

The combination of declining corporate profits and rising interest rates is not a scenario that will be friendly for the stock market. Despite the fact that this budget has virtually zero chance of making its way through Congress as is, if you believe the economic assumptions from this year's budget are realistic, plan accordingly with regard to your investments.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.