Client Newsletter Example: Inflation May Be the Only Way to Reduce the US Deficit - How It Should Impact Stocks - Updates On All Major Financial Instruments

Published on November 4, 2024 @ 6:45am

Major indexes still remain near-term suspect heading into tomorrow's elections. The same goes for oil, Bitcoin, gold, Treasury yields, and most of the important financial instruments to these markets. Here's why, along with micro and macro updates on all of them, as well as why forward inflation may be the only way to reduce the US deficit, and how that should end up impacting stocks in the years to come:

Must Read - Inflation May Be the Only Way to Reduce the US Deficit - How It Should Impact Stocks - Updates On All Major Financial Instruments

Back in the late 1990s, the US deficit was approaching very concerning levels, and then came along the Internet boom, a massive revenue-generating accident for the administration at the time that allowed it to balance the budget in a way that brought the deficit back down to what most believed to be reasonable levels. Since then, the US deficit has once again become a very concerning issue for not only the biggest investors on the planet but just about every American out there who cares enough to pay attention.

So how does the US economy once again get the deficit back under control? Inflation. Inflation can reduce a government deficit through a few mechanisms, primarily by increasing nominal tax revenues and decreasing the real value of debt. Here's how it works:

1. Higher Tax Revenues: When inflation rises, prices and wages typically increase, leading to higher nominal incomes for individuals and businesses. This boosts tax revenue from income, corporate, and sales taxes, as people pay more in taxes based on their higher nominal incomes, even if their purchasing power remains the same or falls. If government spending doesn't increase at the same rate, this extra revenue can help reduce the deficit.

2. Decreased Real Value of Debt: Inflation reduces the real value of existing government debt. For debt with fixed interest rates, the government pays back what are essentially "cheaper dollars" as inflation reduces the purchasing power of each dollar. Although the nominal amount of debt remains unchanged, its real cost is lower, effectively making it easier for the government to service its debt without increasing the deficit.

3. Bracketing Effects (Fiscal Drag): In countries without inflation-adjusted tax brackets, inflation can push taxpayers into higher income tax brackets even though their real income hasn't increased. This "fiscal drag" leads to higher effective tax rates and, consequently, more government revenue, potentially reducing the deficit.

However, this effect has limits. If inflation is too high, it can raise government expenses, especially if the government spends on inflation-sensitive areas like Social Security or inflation-indexed bonds. So, moderate inflation can help reduce the deficit, but high inflation may complicate fiscal management.

I bring this up today because no matter who becomes the next president of the United States, they are going to have to do everything in their power to slowly start reeling in a rapidly growing deficit. And I can assure you that no matter what the media spews in the months and years ahead, whatever happens with the US economy will actually not end up being the sole responsibility of whoever is president. In other words, the next president is going to be inheriting a problem that has taken a few decades to develop.

So if inflation does end up being the only way to reel in the deficit, the bigger questions are how is that going to affect interest rates, and, more importantly to everyone here, how is that going to potentially impact stocks?

First, we saw back in the late 1970s and early 1980s, when inflation was a serious problem, stocks simply moved higher. As a matter of fact, from 1975-1987, the S&P 500 continued to make more and more new all-time highs before the big crash in October of 1987.

How is this possible? Again, if everything costs more money, as long as the higher-quality names that make up the markets continue to figure out how to profit from higher prices, earnings go higher, and thus stocks move higher. It really can be that simple, especially if the AI growth theme really starts to take hold, and enterprises other than big tech start to benefit from the technology.

As you have just read, this is all a very long-term economic theory that is either going to end up proving correct or not. However, based on what we're seeing with the very long-term charts of the major indexes, and many of the more important financial instruments out there right now, this theme may once again end up proving correct - much in the same way stocks have managed to go higher and higher while inflation has continued to remain a concern over the last few years.

Still, from a very short to mid-term trading perspective, there are going to be minor and major selloffs, but my point to all of the above is we should use those selloffs to position ourselves in very high-quality names and ETFs for the long haul.

With that, provided here are updated weekly charts of the NASDAQ 100 (QQQ), S&P 500 (SPY), Dow Jones Industrial Average (DIA), and Russell 2000 (IWM), and as you can see, all had rough weeks last week. And while they could potentially have the same this week, the longer-term technicals on all of them do still remain bullishly intact.

Even oil looks to be somewhat stabilizing around current levels. And again, if inflation does actually end up being the way out of an out-of-control deficit, it too could end up maintaining fairly high price levels. Provided here is a weekly chart of Light Crude Futures, and as you can see, there's no bearish divergence developing here yet.

Bitcoin, on the other hand, does continue to suggest it's going to break out at some point soon enough, while gold continues to make new all-time highs of late. As you can see here, despite backing off after testing its all-time high last week, Bitcoin does continue to suggest an inevitable breakout. And if that happens, our previous suggested allocation to Bitcoin and IBIT should do well. As for GLD, the primary ETF tracking gold, you can see here it just continues to make new all-time highs. We just wouldn't be buying it here now.

And finally, what are arguably the most important financial instruments to these markets, Treasury yields. Provided here are monthly charts of the 10 and 30-Year Treasury yields. I previously mentioned that both are now around levels that should start to bring them back down again. And if that happens, stocks may or may not come back down with them for a while.

But again, if inflation is actually going to end up being the future way out of the current deficit, Treasury yields will likely normalize around much higher levels than what we were used to between 2015 and 2022. As a matter of opinion, this is precisely what it seems Fed Chair Jerome Powell continues to try and do. While everyone seems to have an opinion about him these days, he actually does appear to be doing a good job.

The bottom line is that, while there are still going to be some extremely strong hiccups along the way, and possibly even some nasty bear markets, your more deserving stocks and ETFs should end up going net higher when it's all said and done because, without inflation, the U.S. economy may have no other way out of bringing its rising deficit back down to reasonable levels.

We just have to continue to consider all of the above within the context of time, meaning buying more aggressively when stocks become cheap and selling more aggressively when they've become expensive, because if there's one thing we are sure to continue experiencing over time, it's that stocks will go up and stocks will go down.

Call me a voice of reason, or even disagree with me if you'd like, but with so much polarizing nonsense out there in the media, on social media, and even in most books these days, I do think it's very important that we stick to the facts. As Sgt. Joe Friday used to say on the popular 1950s TV show Dragnet, "Just the facts, ma'am."

I truly hope today's newsletter edition calms some fears out there, because it's my very humble opinion that the United States of America is going to be OK--no matter who is elected the next president of the United States.

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John Monroe - Senior Editor and Analyst