Be On the Lookout

Market Matrix

It is hard to make sense of some of the indicators above other than having some confidence that the US stock market seems fully valued. It is time to look at what might resolve the situation and serve as catalysts for financial markets. As I look to 2025, four deserve investors’ attention.

1) US Election

The election results will have implications far beyond the equity and bond markets. They are the most significant near-term catalysts because they have implications for some of the other factors I am monitoring. Generally, presidents get too much credit for good economies and too much blame for hostile investment environments. Still, policies will be significantly different if a single party controls all three policymaking branches.

Neither Trump nor Harris has paid lip service to federal debt levels or deficits. Therefore, it is easy to predict that structurally high fiscal deficits are here to stay, and there are no brakes on this runaway train.

Even though the Democratic and Republican candidates proposed several economic policies, it is wise to rule out tail outcomes until I see them materializing as regulatory or legislative vehicles. Even replacing all income taxes with tariffs or taxing unrealized capital gains will require Congressional action, which will be a high hurdle in the next four years. For this reason, I assign low probability to more outlandish proposals while focusing on others that are more ripe for enactment.

2) US Debt Ceiling

In June 2023, Congress and President Biden agreed to suspend the U.S. debt ceiling until early January 2025, which means the Treasury won’t be able to issue net new debt until Congress raises or suspends the ceiling again. Due to policies that Congress enacted over decades, the government remains obligated to spend money and is running structural deficits.

Because it can’t issue net new bonds, the Treasury will draw down its cash levels as it pays out more monthly expenses than it receives in tax revenue. The Treasury General Account is where the Treasury stores its cash balance, which is held at the Federal Reserve. This cash is a liability for the Fed and an asset for the Treasury.

Since the 2008-2009 financial crisis, Treasury’s policy has been to hold $700-$850 billion worth of cash in its TGA. Congress imposed legal constraints on the Treasury so it could not game the system too much to avoid debt ceiling limitations. At the end of October, the TGA is at the target level.

Without a new debt ceiling authorization, the Treasury will have to default on something when the TGA is empty. Social security checks, defense payments, Medicare payments, and a temporary default on Treasury securities are all possibilities because they make up the lion’s share of spending. Historically, Congress acts at the 11th hour to prevent default because of the political consequences.

GOP-controlled Congresses used the debt ceiling bludgeon against Presidents Obama and Biden, but Democrats didn’t use it against President Trump. In our negative partisan times, this pattern could change in the future.

While it is counter intuitive, a debt-ceiling battle can benefit financial markets. While the Treasury draws down its cash levels over several months to keep up with its bills, this can be stimulative for financial markets. As long as it is resolved before reaching $0, it is a net plus for liquidity in the economic system.

Imagine the TGA balance as cash sitting in the cloud. It represents money paid in through taxes and bond issuance but has yet to be spent. As the TGA balance is drawn down, this cash comes back out of the cloud and into the financial system. During a drawdown, the Treasury adds more money into the system than it removes from it in taxes and bond issuance, and this money comes to rest in aggregate bank reserves. It is comparable to the Fed doing quantitative easing.

While the pundits are all focused on tax and spending differences between the candidates, another implication of the election for asset prices is whether there is an $800 billion drawdown from the TGA into the banking system. This is a significant variable to be aware of in the first half of next year.

 3) US Tax Code

President Trump signed his Tax Cuts and Jobs Act on January 1, 2018. This act implemented broad tax cuts for corporations and households, with the most significant impact on the wealthiest top ten percent of taxpayers. Most corporate tax cuts were permanent, while most household cuts expire at the end of 2025 unless Congress renews them.

Congress can’t agree on much of anything these days, but most voters oppose tax hikes and spending reductions. As a result, it is difficult politically for either the red or blue team to reduce the large fiscal deficit meaningfully. When spending or taxes automatically expire, there is a (limited) chance of reducing the deficit because Congress and the President have to compromise and act to keep those cuts in place. The inability to agree in this case would mean that the tax reductions end and tax rates return to the pre-2018 levels. 

During his campaign, Donald Trump vowed to keep the tax cuts in place and further reduce corporate rates. Kamala Harris says she doesn’t want tax hikes for households with incomes below $400,000. Because the tax cuts were skewed to the wealthy, if Harris is elected, there is a greater chance of an aggregate tax hike from this automatic sunset of the TCJA next year.

As I wrote above, structural deficits are here to stay, and I incorporate them into my macro outlook. While the sunset of the TCJA tax rates won’t fundamentally change debt levels, it can make a dent of a few hundred billion dollars a year, which is nontrivial.

Both candidates proposed several fiscal policy initiatives requiring congressional tax or spending approval. I will also monitor those as they become the focus of K Street lobbyists and Hill staffers. At this point, the only tangible fiscal policy agenda item on the agenda is the expiring tax cuts.

4) Bank Lending

Because the US economy is mainly credit-driven, investors must consider the ebbs and flows of bank lending. In 2022-23, credit conditions tightened to levels customarily experienced during recessions as banks hiked standards for industrial and consumer loans.

Because the US is in an era of fiscal dominance, markets, and the economy performed better than expected while bank lending was tighter. While net bank loans are growing, they have been slow this year; the worst seems to have passed. A favorable credit cycle in 2025, on top of the current fiscal situation, would significantly support financial markets. Additionally, private credit is growing and becoming much more significant than it was.

I hope the economy has already witnessed the tightest credit situation for this cycle and that 2025 will be easier. Investors need to monitor signs for a newly emerging credit cycle next year. 

Questions

In the markets you follow, what catalysts will be important in 2025? What are you watching?