Watermark Wire: Q1’24 Economic Commentary

According to data from the Bureau of Labor Statistics, the Producer Price Index (PPI), an important indicator of wholesale inflation, experienced a 2.1% increase over the 12 months ending March 2024, up from a 1.6% gain in February. While the 2.1% increase was lower than economist’s estimates of 2.3%, the uptick in the prices producers pay for goods and services points to the persistence of inflation in Q1 of 2024, the bumpy path to bring it lower, and reinforces concerns that interest rates may remain elevated for an extended period. See a summary of lagging and leading economic indicators below.

Lagging Indicators as of April 2024

	Real GDP Growth	Unemployment Rate	Consumer Price Index % Change	PPI Index % Change	Federal Funds Rate
2021 Average	5.9%	5.4%	4.7%	10%	0.08%
2022 Average	0.7%	3.6%	8.0%	6.40%	1.68%
2023 Average	1.6%	3.7%	3.2%	1.10%	4.58%
Q1 2024 Actual	1.4%	3.8%	3.5%	3.60%	5.25%
2024 Projected	1.6%	4.2%	2.6%	N/A	4.60%

Leading Indicators as of April 2024

	1 Year U.S. Treasury	Building Permit % Change	% Change in Durable Goods	Manufacturing Jobs	Stock Market (S&P 500)
2021 Average	0.1%	13.3%	18.5%	1.55%	26.89%
2022 Average	2.8%	-5.9%	-0.4%	3.93%	-19.44%
2023 Average	5.1%	1.9%	1.1%	0.10%	26.29%
Q1 2024 Actual	5.1%	1.5%	-2.7%	-13.50%	30.60%
2024 Projected	4.8%	1.4%	N/A	N/A	N/A

Source: Bureau of Labor Statistics, March 2024

Takeaways. The odds of at least one 25bp cut by the end of the June meeting declined from over 50% to less than 8% currently, representing the most pessimistic forecast since last October.  A takeaway is that macro uncertainty must be factored into business planning. Timing considerations, always a key factor in strategy and M&A, are even more important in today’s rapidly changing macro environments.

The government continues to stimulate the economy through significant deficit spending, exponentially increasing national debt levels. U.S. national debt currently exceeds $34 trillion with $1 trillion in additional debt being added every 100 days!  Foreign entities hold $7.6 trillion of U.S. debt in treasuries, indicating that debt escalation could drastically increase interest payments to foreign creditors. National debt interest expense is projected to surpass the marginal increase of nominal GDP annually, putting the U.S. economy in a vulnerable position[5]. The Congressional Budget Office has forecasted that the debt-to-GDP ratio, which stood at 97% at the end of the previous year, is likely to escalate to 156% by the year 2054. These issues have prompted Fitch to downgrade the credit rating of the nation’s long term credit score from AAA to AA+, citing concern over the government’s ability to address the debt issue[6].

JPMorgan CEO Jamie Dimon states in his annual letter to shareholders that interest rates could soar to 8% in the coming years if the government continues its high deficit spending, citing fiscal policy, remilitarization of the world, the green transition, and increased energy costs as culprits. Dimon says, “the economy is being fueled by large amounts of government deficit spending and past stimulus. This may lead to stickier inflation and higher rates than markets expect.” [7]

Takeaways.  The economic impact of the soaring US debt levels will have several implications. In the short term, the stimulus spending may artificially boost economic growth by adding jobs, but in the long run the high levels of debt will have the opposite impact as the government will need to raise taxes to offset the spending. As the national debt increases, there also will be an upward pressure on interest rates, making borrowing more expensive for consumers and businesses and discouraging economic activity. Finally, high levels of debt might impact the strength and stability of the US dollar, otherwise known as “de-dollarization.” This has a higher chance of occurring due to decreased confidence of investors in the US government’s ability to pay debt and against a backdrop of high national debt and interest rates, the U.S dollar is becoming more expensive for foreign nations.  These forces are working against businesses and must be taken into account as macro factors that will influence your businesses’ performance.

Despite the Federal Reserve’s delay in rate cuts and hawkish repricing of monetary policy, the stock market has been resilient. The S&P 500 gained 10.6% in Q1, taking total returns to just below 30% over the last 12 months.  Gains were dominated by technology stocks due to the strong performance of large caps with a key driver being artificial intelligence (AI).  A primary concern among investors is the soaring valuations of tech companies, driven by exuberant AI sentiment and speculative fervor.  Although these companies have shown impressive growth potential, their lofty valuations raise concerns about their sustainability and vulnerability to a potential market correction. This also points to the concentration risk present in major stock indices, characterized by a few companies having a disproportionate impact on overall market performance. For example, NVIDIA was the single largest contributor to S&P500 performance with a return of 83% in Q1 alone. A downturn in a small number of influential stocks triggers wider market repercussions, heightened volatility and an increase in loss potential.

Takeaways. Overall, investors remain vigilant even as the potential for rate cuts has diminished. Additionally, slightly over 70% of S&P 500 companies that issued guidance for the first quarter of 2024 gave “negative” EPS guidance or expectations for earnings to contract. This is the second-highest percentage of companies issuing negative guidance since Q1’16, although it is tied with Q2’19. However, a similar scenario occurred in Q1’23, after which the S&P 500 still managed an annual return of 24.8%. Similarly, following Q2’19, the S&P 500 concluded the year with an 11.4% gain[8]. So, despite the pessimistic sentiment of these S&P 500 companies, the last few times this happened, it appears that the market largely overlooked the negativity, and continued to perform robustly.   Therefore, a takeaway is to closely monitor these macro-economic issues and instill into your company highly adaptable, executable strategies to protect your competitive advantages despite the uncertainties of the stock market.

The current macroeconomic environment will have a large impact on the 2024 Presidential Election as voters assess President Biden and former President Trump’s ability to navigate looming economic issues. As demonstrated historically in the US, the Central Bank has significant autonomy to control monetary policy.  However, some economists call into question whether the Federal Reserve’s policies will be swayed by one side of the political spectrum before November, especially considering the opposing economic agendas of the candidates. The incoming president will oversee the expiration of several provisions of the Tax Cuts and Jobs Act (TCJA), originally passed by Trump in 2017. Upon the TCJA expiration in 2025, there will be a restoration/increase of the top marginal tax rate for high income earners from 37% to 39.6%. President Biden has called for repealing these tax cuts for the wealthy to reduce the budget deficit while imposing new taxes on businesses, as demonstrated in the table below.  If Trump wins the election and the Republicans secure Congress, it is more likely that the provisions of the TCJA benefiting businesses and high-income earners would be prolonged.

Tax increases

New Taxes Proposed
Unrealized Capital Gains Taxes	Biden administration wants to impose a tax of up to 25% on unrealized capital gains which would redefine income taxes.
Corporate Tax Rates	Biden administration wants to increase the federal corporate income tax rate from 21% to 28%.
Realized Capital Gains Taxes	Biden administration wants to double tax rate on long term capital gains and dividends from a current top rate of 23.8% to a top rate of 44.6%. States add their own cap gains taxes on top of federal cap gains taxes.
Surtax on Small Business Income	Biden administration would extend the net investment income surtax to profits earned by small businesses. The tax on small business income would phase in between $200K - $400K, depending on filing status.
28% Withholding Tax	Biden administration would prohibit companies from deducting compensation paid to top earners in the calculation of taxable corporate income. The 28% federal corporate tax rate would be layered onto individual wage taxes. An extra 28% tax would be paid by the business for the privilege of paying high-income individual wages.
Stock Repurchases	Biden administration would increase a 1% excise tax on stock buybacks to 4%.

Takeaways. The electoral battle between Trump and Biden holds significant implications for the U.S. economy and business.  The tax agendas of the two candidates differ significantly. Most of these tax increases would impact small and big businesses, entrepreneurs, investors, and job and wealth creators.  Such tax proposals described above would be detrimental to the M&A marketplace.  However, if divided government continues, the odds of all these proposals goes down.  The capital gains implications alone would likely drive many owners contemplating an exit to expedite such plans ideally before tax changes could be implemented.  This may mean a flood of M&A after the November elections, which would temporarily make the M&A market more competitive.