We would describe the current environment as strange and bifurcated, marked by significant disparities in the health and strength of consumers, companies, sectors, and countries. Despite considerable uncertainty, the market has continued to reach new highs. In this letter, we will explore the components of the Gross Domestic Product (GDP) equation, the upcoming election, government debt, and market trends.

The GDP Equation

Second quarter GDP remained strong, bolstered by a surge in investment spending (“I”) and robust government spending (“G”), which continues to outpace the headline Real GDP growth rate. Let’s take a moment to examine the U.S. economy through the “C” (Consumption) + “I” (Investment) + “G” (Government) equation.

Government Spending: A Stabilizing Force

Government Spending (“G”) plays a crucial role in economic stability. In the GDP equation, the “G” component makes up 17% of GDP. In 2023, “G” grew faster than any other GDP component, deferring the onset of a recession. That 17% of GDP does not include government spending that is categorized under “C” and “I” in the GDP calculation. Currently, federal government spending is 24.1% of GDP. Including state and local spending (excluding federal aid to avoid double counting), the number becomes 34% of GDP. This exceeds the long-term average, indicating a significant reliance on government spending for GDP growth, even in a relatively healthy economic environment. Earlier this year, we concluded it would be difficult to see a recession with this level of government support.

However, net interest outlays are rising significantly and do not contribute to GDP growth. These outlays surpassed defense spending this year and are expected to exceed Medicare in 2025, becoming the second-largest budget outlay (table below). CBO estimates government spending, excluding net interest, will contract in 2025, complicating efforts to sustain the growth trajectory of the last two years due to increasing interest expense.

Source: Congressional Budget Office June 2024 Budget Outlook

Over half of spending is at the state and local level, much of which includes temporary COVID-era aid that is set to diminish by year-end. State budgets for 2025 are already enacted and expected to shrink. The National Association of State Budget Officers projects a 6% drop in total general fund spending from fiscal 2024 levels, following a 13% increase from 2023 to 2024.

As we approach the upcoming election, the trajectory of government spending remains uncertain. Neither candidate’s platform includes deficit reduction. Both plans are likely to increase the budget deficit, exacerbating fiscal concerns. Spending may not change until the market forces the change; however, ballooning interest expenses may hinder growth, suggesting “G” is unlikely to drive growth next year, consistent with CBO projections.

The Role of Consumer Spending

At 69% of GDP, “C” is vital to economic growth. While consumer spending remains resilient, some notable weakening is emerging—particularly in durable goods, signaling a potential shift in consumer priorities.

Financial strain on households is becoming more evident. Consumers have relied on pandemic savings to sustain growth; however, these savings, which peaked at over $2.3 trillion in 2022, have fallen to below 3% of disposable personal income. Debt has been the other support, with credit card balances and auto loans at record highs. Although mortgage balances are substantial, most loans have fixed rates below 4%. Those with rates above 7% are beginning to refinance, which may provide some marginal relief.

However, debt servicing costs are increasing as a share of consumer’s wallets, leaving less remaining to spend. Rising delinquencies in credit cards and auto loans, and a growing percentage of mortgages 30 days past due, indicate potential challenges ahead (Chart 2).

Chart 3 shows slowing disposable personal income growth (blue line). Beyond rising debt and depleting savings, personal transfer receipts—government social benefits such as Social Security, Medicare, Medicaid, Unemployment Insurance, etc.—are supporting spending. This year, growth in personal transfer receipts (red line) has been robust, representing approximately 17% of consumption. While cost-of-living adjustments contributed to this increase, they do not tell the whole story.

This reliance on government support underscores the precarious financial position for many consumers and highlights their dependence on the government assistance for spending growth to continue. However, wealthier households are in a much healthier situation. They significantly contribute to “C” and are likely to keep growth positive, albeit at a slowing pace. This will remain the case unless the labor market weakens further or a substantial stock market selloff impacts consumer confidence which is already weak.

The labor market presents a mixed picture. Recent surveys reveal small business hiring, which supports about half of private sector employment, has stalled. Direct and indirect government hiring has been a key growth driver over the past year. Preliminary payroll data revisions indicate a significant downward adjustment in job creation (nearly half of jobs created over the last year), highlighting the labor market’s fragility.  Most revisions were concentrated in private, cyclical sectors such as construction, manufacturing, professional/business services, and leisure and hospitality. Adjusting for these preliminary revisions as well as the massive growth in multiple job holders, employment growth over the past year may have been below 0.50%.

While actual layoffs remain low, hiring has stalled, quits are below pre-crisis highs, and job openings have declined significantly. We expect employers to retain staff longer into any slowdown given the challenges they experienced finding qualified workers. However, if the economic outlook worsens, unemployment claims are likely to rise, which would impact future growth in “C”.

Investment: A Volatile, but Meaningful Component

“I”, comprising roughly 18% of GDP in the second quarter, has demonstrated positive momentum this year. Residential housing, particularly new homes, exhibited strength. R&D and software spending have been, and should remain, robust. Government support bolstered growth in manufacturing, power, communication, and technology.

However, we do anticipate some weakness in corporate investment spending in Q3 and the first half of Q4 as companies navigate election uncertainty. According to the latest CFO survey, 21% of firms postponed investment plans in Q3, 15% scaled down plans, and 8% delayed plans indefinitely due to election uncertainty—a 9% increase from Q2. The election outcome may impact corporate investment decisions moving forward.

The Impact of the Upcoming Elections

Historically, markets have performed well under both Democrat and Republican presidents, but divided governments tend yield the best market returns and foster stronger economic conditions. The upcoming election is crucial for our nation, given the current geopolitical fragmentation and limited fiscal flexibility.

Cyclical and secular economic factors typically influence the markets more than politics. However, the last several decades experienced tailwinds from increasing globalization, low inflation, falling bond yields, and falling tax rates as well as room on the fiscal side to maneuver.  These tailwinds are less likely to be present this time around, which may mean politics play a more pivotal role in shaping our economic trajectory going forward. Current geopolitical tensions and fiscal challenges add further complexity.

Several trends are likely to persist regardless of the election outcome. Geopolitical tensions are rising, and both candidates support varying degrees of de-globalization and onshoring initiatives. The deficit is on an unsustainable path. Spending from the Inflation Reduction Act spending is likely to persist, regardless of which party holds power, particularly as much of the money is being directed to red states. Fiscal stimulus and immigration bolstered growth over the last year and a half and, while the future trajectory of these factors is contingent on the upcoming election outcomes, it is unlikely that either factor will exceed 2023 levels, complicating future comparisons.

If presidential candidate Kamala Harris wins, but there is a divided government she may allow some of the tax cuts for higher earners to expire. We could see a continuation of the legislation of recent years, including further action on the CHIPS and Science Act and Child Tax Credits. We may see changes to corporate R&D deductibility which could significantly impact “I”. We could also see increased anti-trust scrutiny.

If presidential candidate Donald Trump wins, but with a divided government, we expect immediate changes to trade policy. Tariffs on China are likely to increase to the 60%, while other tariffs are less certain. We may see changes to US foreign and energy policies. Extending the Tax Cuts and Jobs Act of 2017 (TCJA) would be complex in this scenario, requiring bipartisan support if Democrats control the House.

In a blue sweep scenario, initial uncertainty may prevail unless candidate Harris further clarifies her platform. Next year we would expect to see many provisions of the TCJA expire. We would also expect to see proposals on raising corporate tax and proposals on further increasing taxes on the wealthy, possibly including unrealized capital gains and higher capital gains rates. Heightened regulation is a strong possibility which could dampen corporate sentiment and investment. In the CFO survey, regulatory policy is most important to firms, followed by corporate tax policy and then individual tax policy. The stock market is likely to react very negatively to the blue sweep scenario given concerns on the impacts to corporate profitability, labor markets, and consumption. This may have an outsized impact on smaller businesses as well. Municipal bonds could do very well in the most extreme of these scenarios as their tax-equivalent yields become more attractive.

A red sweep scenario would also introduce significant uncertainty.  We would expect actions to be to trade policy with the implementation of tariffs on China and potentially the rest of the world. This coupled with other foreign policy measures could impact geopolitical uncertainty, oil, the dollar, defense stocks, inflation and gold. Beyond the immediate impact, fiscal debt management is more likely to become a concern. With a full extension of TCJA, it is estimated that primary deficits could increase by about $4 trillion over the next decade. Market impacts in this scenario are harder to predict and would depend on Trump’s actions in office. An increase in yields will make the country’s fiscal position more concerning. Additionally, with foreigners holding about 30% of our publicly traded Treasury debt, a trade war could entice lead them to divest their holdings.

Government Debt Outlook

The ongoing strength in government spending has surprised us, especially considering the relatively healthy economy of the past two years. Much like the consumer, our government is spending more than it is earning—historically common, but now at an accelerated rate (Chart 4).

Net interest outlays expected to rise, potentially exceeding forecasts if yields do not decline as expected.  This year, the deficit is projected to reach -7% of GDP, with the possibility of widening depending on the election outcome. It will be harder for “G” to continue to grow above 3% year over year like it has for the past year and a half. Over half of the spending has come from the state and local side, but much of that money is still temporary covid era aid to states that should fade by year end as surging revenue, record spending and historic tax cuts end. Assuming no change in legislation, we anticipate a slowdown in government spending growth.

Market Outlook—Are These Risks Priced In?
We have participated well in the year-to-date market rally, benefiting from a broadening of performance beyond the Magnificent Seven. Key areas of the market where we have large positions such as utilities, defense contractors, and infrastructure have delivered strong results along with quality and low volatility factors. Our gold position has contributed positively.  

Index concentration has reached a degree not seen in fifty years, with over 31% of the S&P 500 in the Technology sector and the top 10 companies comprising a record 35% of the market. When the dominant firms do well, heavy concentration can drive gains for passive investors. But momentum can shift quickly and historically a reversal of momentum has benefited active management.

We view the market as expensive, even excluding the top 10 names. While there are areas of opportunity, the risks today are substantial and abundant. The market appears priced for perfection, disconnected from economic realities. Earnings expectations for the fourth quarter seem robust. For the market to sustain its rally, both earnings and the overall economic outlook must improve. We believe that any future market appreciation is likely to come from less expensive market segments.

The current market landscape presents both opportunities and risks. There are areas of the market we like a lot and believe selectivity will be rewarded in this type of environment. It will be important to understand the risks being taken within portfolios, make sure valuations compensate investors for taking these risks, and make sure the risks being taken are appropriate for the evolving environment.

Conclusion

We anticipate a slowdown in most components of GDP growth over the next twelve months. However, much of this outlook hinges on the outcome of the upcoming election. Our perspective will adapt as new information comes to light. We are diligently monitoring developments and adjusting client portfolios as the environment changes. Our economic outlook and significant risks present today are at odds with current market valuations and earnings expectations. Consequently, we recently lowered our equity positioning back to the lower end of our equity ranges. We are currently focused on downside protection while also investing in opportunities as they arise.

If you have any questions or would like to discuss your portfolio in more detail, please do not hesitate to reach out.

Thank you for your continued trust in us.

Kasey

One Seven (“One Seven”) is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. Services are provided under the name Stone Creek Advisors, LLC, a DBA of One Seven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value.