Bob’s Journal 5/22

The Costs of the United State’s Perpetual Deficits Increase

The federal government no longer is a triple-A credit risk, according to all three prominent credit rating firms.

Triple-A is the highest credit rating and implies debt issued by the debtor is as close to risk-free as possible.

S&P Global Ratings downgraded U.S. debt from triple-A back in 2011. Fitch Ratings followed in 2023 after the pandemic spending surge. Moody’s Ratings stopped being the final holdout last Friday.

Moody’s basically said that it finally realized that it didn’t matter who controls Congress or the presidency. There’s no agreement on ways to reduce the annual budget deficits or if there even is a need to reduce them.

The negotiations on the tax and spending bill making its way through Congress indicate there won’t be meaningful reductions in the annual deficits and might not be any reductions. The only disagreements are over tax and spending measures that affect the deficits by small amounts.

To an extent, the ratings downgrade doesn’t matter. Buyers of treasury debt don’t consult the ratings. They already look at the annual deficits and what’s happening in Congress.

That’s a major reason intermediate- and long-term interest rates continued to rise after the Federal Reserve stopped raising short-term rates in 2023 and didn’t decline much after the Fed started reducing short-term interest rates in 2024.

Investors are demanding higher interest rates on treasury debt because the annual deficits are so high and there’s no sign they will be reduced by any significant amount.

Also, during the pandemic, Congress was able to significantly increase deficit spending because the Fed was buying all the debt the Treasury would issue. After that process ignited inflation, the Fed reduced its bond buying. Interest rates had to rise to attract other buyers.

Congress was able to spend freely when interest rates were low, because the government’s interest expense was close to zero. After interest rates spiked in 2022, the federal government’s interest expense increased by a significant amount.

Higher interest rates alone increased the deficits significantly. Add in additional spending, and the deficits are at levels previously seen only during wars.

A likely consequence of perpetual deficits is that interest rates will remain at current levels or increase.

The United States is in a damaging feedback loop. Higher interest rates increase the annual deficits. Higher annual deficits cause market interest rates to increase. And so on.

Higher interest rates negatively affect stock prices. Investors will pay less for stocks when yields rise on lower-risk investments.

Higher rates also reduce business investment, because businesses increase the minimum rate of return that is required to justify an investment.

The perpetual deficits also make the United States less attractive to investors in other countries. That’s one reason the U.S. dollar has declined against many other countries in 2024, and overseas stock markets have outpaced U.S. indexes.

Investors should minimize exposure to U.S. Treasury bonds. They also should diversify internationally, reducing exposure to the U.S. dollar and stocks.

What the President’s Executive Orders Means for Prescription Drug Prices

President Donald J. Trump issued an executive order on May 12 that he said would reduce prescription medicine prices by 30% to 80% “almost immediately.”

The executive order directs the Secretary of Health and Human Services (HHS) to take action to reduce medication prices.

The HHS Secretary is supposed to help cut out middlemen, such as pharmacy benefit managers, by facilitating direct-to-consumer purchasing programs under which manufacturers sell directly to patients.

In addition, the order tells pharmaceutical manufacturers to bring prices in the United States to the same level as prices in other countries, a concept it calls “most-favored-nation lowest price.”

The HHS Secretary is ordered to communicate price targets to drug companies within 30 days. If companies don’t meet the price targets, the government will respond with “additional aggressive action.”

The executive order, however, has a lot of rhetoric but is short on specific actions. It’s unlikely the administration has the authority to order companies to reduce prices or to take actions that will convince them to cut prices.

President Trump issued a similar order during his first term. Lawsuits prevented the government from taking any action under the order.

It appears that one of the goals of the executive order is to force other countries, especially European countries, to pay more for the medications. But it’s not clear how the order will do that.

At the same time, the administration continues to threaten to impose tariffs on imported medications, which would raise their cost to consumers.

Some observers say the ideas and actions in the latest executive order have been discussed or tried before. Administration officials said that we’ll have to wait for details on the initiatives listed in the order.

Walmart Says Retail Prices Will Increase

The giant retailer Walmart (WMT) said that it won’t be absorbing most of the cost of tariffs on goods it imports.

Walmart officials said that beginning in late May and continuing through the summer, it will increase prices to reflect tariffs on goods it sells.

The extent of the price increases isn’t known, because the level of tariffs has shifted. The highest tariffs have been suspended. But a 10% universal tariff is in effect, as are higher tariffs on goods from China. Higher tariffs could be imposed after the pause ends.

Many analysts believe the announcement from Walmart will lead to more businesses announcing price increases due to tariffs.

But not all retailers are following Walmart’s lead.

Home Depot (HD) said it doesn’t plan to increase prices in response to the tariffs. Target (TGT) said it has “many levers to mitigate this impact” and increasing prices is “the very last resort.”

The impact of the tariffs on prices and consumer buying won’t be known for a while yet.

Walmart’s Chief Financial Officer John David Rainey said that in the latest quarter sales rose steadily. But he cautioned that he couldn’t forecast how higher prices from tariffs will affect sales.

Some businesses will be hurt more than others by the tariffs. If prices rise generally across the board because of tariffs, consumers who don’t have a commensurate increase in income will make choices. They could spend less on some goods and services, save less money or draw down existing savings.

The effect of the tariffs on inflation also is hard to forecast.

Tariffs probably won’t start to affect inflation data until sometime during the summer.

One reason the effect on inflation is hard to estimate is that the level of tariffs keeps changing.

In addition, businesses might find alternatives to goods with high tariffs.

For example, a number of businesses said in their latest earnings calls that they’re changing suppliers or working with suppliers to source goods in countries with lower tariffs. Many said they are pressuring suppliers to absorb the tariffs.

For these reasons, it’s hard to find economists willing to forecast the effect of tariffs on inflation.

Most economists believe the inflation hit will be a one-time surge. But they are cautious about that view because of the erratic tariff announcements so far.

Consumers also need to keep in mind that the dollar has declined against most other currencies this year. That means imported goods’ prices were likely to increase before considering any tariffs. That should start to show up in inflation data soon.

The Fed has decided not to try to anticipate the effects of the tariffs. It’s likely to do nothing about interest rates or monetary policy until the effects on inflation and the economy are clearer. That could mean the Fed does nothing the rest of the year even if inflation spikes to the levels of 2022 or higher.

The Data

The mid-month Consumer Sentiment Index from the University of Michigan fell to 50.8 in May, the lowest level since June 2022, from 52.2 at the end of April. The May level also is the second lowest in the history of the index.

The components of the index declined across the board, including a surge in inflation expectations.

The Leading Economic Index from The Conference Board declined by 1.0% in April to 99.4. That’s the largest monthly drop since March 2023.

Despite the fall, the index isn’t signaling a recession, The Conference Board reported. The index is forecasting growth will be less than 2.0% in 2025.

Retail sales increased 0.1% in April. The March increase in retail sales was revised higher to 1.7%. Sales were 5.2% higher over the 12-month periods ending in both April and March.

After excluding gasoline and vehicle sales, retail sales increased 0.2% in April and 1.1% in March.

The Empire State Manufacturing Index fell to -9.20 in May from -8.10 in April.

The Philadelphia Fed Manufacturing Index was -4 in May after being -26.4 in April.

Industrial production was unchanged in April, which followed a 0.3% decline in March. Over 12 months, production was up 1.5% through April and 1.3% through March.

Manufacturing production declined 0.4% in April after rising 0.4% in March. The 12-month increase in manufacturing production was 1.2% through April 0.9% through March.

The Housing Market Index from the National Association of Home Builders was 34 in May, the lowest level since November 2023 and a decline from 40 in April.

Housing starts increased 1.6% in April after declining 10.1% in March.

The Producer Price Index (PPI) fell 0.5% in April after being unchanged in March. Over 12 months, the PPI increased 2.4% through April and 3.4% through March.

The core PPI, which excludes food and energy prices, fell 0.4% in April following a 0.4% increase in March. The 12-month rise in the core PPI was 3.1% through April and 4.0% through March.

New unemployment claims were unchanged at 229,000 in the latest week.

Continuing claims, which lag a week behind new claims, increased to 1.881 million from 1.872 million.

The Markets

The S&P 500 rose 1.02% for the week ending with Tuesday’s close. The Dow Jones Industrial Average gained 1.37%. The Russell 2000 increased 0.22%. The All-Country World Index (excluding U.S. stocks) added 1.81%. Emerging market equities advanced 0.76%.

Long-term treasuries lost 0.54% for the week. Investment-grade bonds increased 0.16%. Treasury Inflation-Protected Securities (TIPS) added 0.22%. High-yield bonds fell 0.16%.

In the currency sector, the U.S. dollar declined 0.72%.

Energy-based commodities lost 0.51%. Broader-based commodities dropped 0.83%. Gold gained 1.37%.

Bob’s News & Updates

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