Biggest caution on hot U.S. economy? Growing fiscal deficit

A growing fiscal deficit and a couple of presidential candidates who don’t seem concerned about it are the greatest risks to the U.S. economy, says Leonie MacCann, senior multi-asset portfolio manager with Irish Life Investment Managers.

“I don’t see [the deficit] as a near or immediate risk, but definitely a medium-term risk,” she said. “There is general recognition that fiscal positions need to be addressed at some point. Otherwise debt sustainability issues could arise.”

She said the non-partisan Congressional Budget Office has estimated that U.S. debt to GDP could rise to 122% by 2034 and to 172% by 2054 (it later revised the 2054 figure to 166%).

“These kind of debt to GDP levels have only really been evident during wartime previously, and they’re unprecedented outside a recession, given the current low levels of unemployment,” she said.

Furthermore, interest payments are the second largest item in the federal budget and are the fastest growing item — higher than both Medicare and defense.

“And when we look at the current political environment, in terms of the two potential candidates for the U.S. election this year, you’re unlikely to get an agreement to reduce debt in the short term,” she said. “The fiscal policy is likely to stay stimulative.”

Other than that, she said, the U.S. economy is looking very good. Barring downside surprises to growth and inflation, she said the outlook for U.S. equities is positive.

“We still see some upside,” she said, even though “growth is moderating. We’re seeing an increased rate of earnings growth and broadening out of earnings recovery across all sectors.”

Expected rate cuts should be positive for markets — although she acknowledged that markets look toppy.

“Valuations are not cheap, but I don’t think we’re in bubble territory,” she said, adding that U.S. equities are currently showing a price/earnings ratio of 21.2 times.

“That’s versus a peak in the tech bubble of 25.6 times. And if you look specifically into technology, U.S. technology is currently trading on a PE of 29.3 times versus a tech bubble peak of 59.1 times,” she said.

The outlook is improved by the fact that the country is in the middle of an election year.

“Typically, in an election year and the year following that election are positive for equity markets,” she said. “On average, the S&P 500 is up 11% in an election year and up 10% the following year.”

And there are other positives for the U.S. economy.

“You’ve got a robust earnings outlook; you’ve got strong consumer and corporate balance sheets; demographics are more favourable for the U.S. than other developed market regions; and the U.S. is likely to benefit to a greater extent from the AI theme and the deglobalization trend that we are seeing.”

She said the S&P 500, which returned 26% in 2023, blew past expectations for 2024.

“The consensus analyst price target for the S&P 500 at the start of this year was around 5,090, which suggested an upside in U.S. equities for the year of around 8.5% from the end of 2023. If you look at the S&P 500 today, we’ve well shot past that.”

The S&P 500 opened on Sept. 3 around 5,600, up more than 18% for the year to date.

U.S. real GDP growth has averaged 2.1% over the last five years, she said. Other developed markets have averaged about 1%. A similar story is told looking at nominal GDP growth: 6% vs 4%.

“When you look at that strong performance — which is often referred to as U.S. exceptionalism — there’s really been four key enduring factors that have helped drive that,” she said:

1. The U.S. economy is the world’s largest — currently at 26% of global GDP — with the highest GDP per capita.
2. It is the world’s most liquid financial market — not just in equity and debt but also private equity and venture capital.
3. It has favourable demographics compared to other developed markets.
4. It has a deep culture of supporting innovation and investment, and spends more on research and development than other nations.

MacCann said even more factors are currently contributing to a positive outlook for U.S. equities. Among them: the trends of onshoring and reshoring; the country’s growing energy independence; and its flourishing tech sector in an era where tech is a dominant factor.

“That fundamental backdrop — with growth remaining robust, with earnings positive and having more conviction around those earning forecasts, coupled with expectation for rate cuts coming through — should be supportive if a recession is avoided, which would be my base case,” she said.

“So, I do see that there should be further upside in U.S. equities. I don’t think we’ll see the type of return that we saw in the first half of this year, but I think equities can continue to grind higher from here through to the end of the year. But I think we will see more bouts of volatility.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.