Let’s Make a Deal

Third quarter earnings continued to roll in with S&P 500 earnings-per-share (EPS) tracking about 37.5% higher year-on-year. Heading into earnings season, expectations were for EPS to rise by about 28% year-on-year. With 279 companies in the S&P 500 having reported, 82% have posted better-than-expected earnings and 75% have reported a positive revenue surprise.

A key metric of the U.S. manufacturing sector weakened, but continued to show solid demand. The Institute for Supply Management’s manufacturing index fell a touch from 61.1 to 60.8 in October. Perhaps more important was the drop in the new orders component, which is a leading economic indicator. That component slipped from an elevated 66.7 to 59.8. While still a strong reading, it is possible that new orders for goods are coming back down to Earth as prices rise with the prices paid component climbing from 81.2 in September to 85.7 in October. Combined, the business survey suggests that logistical headaches continue amid solid demand.

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The late and great Monty Hall hosted an American television variety-game show called “Let's Make a Deal” for over 30 years. In that game, guests would wear comical outfits and play games of chance where they were often pitted against other audience members where one’s gain was often someone else’s loss. At the end of the show, the various winners would be asked if they were willing to risk their current prize for a chance at the “big deal of the day,” which was hidden behind one of three doors. If the contestant picked the right door, they would walk away with lots of prizes. If they got it wrong, they would walk away with nothing or what the game show called a “zonk.”

Washington, DC is currently engaged in its own version of “Let’s Make a Deal” with Democratic Senators, Representatives, and President Biden in tense negotiations with conservative and progressive Democrats often pitted against one another. This has left investors wondering exactly what will be found behind door number 1 when it is finally opened. Will it be the “big deal of the day” or a “zonk?” The answer is looking like it may be something in the middle with the original proposal being scaled back significantly from its original $3.5 trillion price tag to the $1.75 trillion price tag that President Biden outlined in his Build Back Better framework last week.

As the plan currently stands, it includes $1.75 trillion in social investments and an additional $100 billion earmarked to reduce immigration backlogs and to speed up asylum processing. The framework also includes almost $2 trillion of offsets (raising taxes on the wealthy, closing tax loopholes, and bolstering tax enforcements). See figure 1 for key framework details:

Importantly, a framework does not make a deal. The support of key Senators like Bernie Sanders (D-VT), Joe Manchin (D-WV), and Kyrsten Sinema (D-AZ) is still needed, and it is unclear if the framework Biden laid out is sufficient to gather the support of every Democratic Senator, which will likely be needed to pass the legislation via the budget reconciliation process. It is also unclear if the $100 billion in immigration reform spending can be passed as it requires approval from a Senate adviser, known as a Senate Parliamentarian. Thus far, Senate Parliamentarian Elizabeth MacDonough has rejected the last two attempts from Democrats to include provisions that would put undocumented immigrants on the path to permanent residency. She reasoned that the proposals do not comply with the Byrd rule, which limits the types of measures that can be included in a reconciliation bill.

Currently, there are two separate infrastructure bills being considered. One is a traditional infrastructure bill (roads, bridges, etc.) and the other is a “social” infrastructure bill. The former bill has already passed in the Senate with a 69-30 vote to pass a $1 trillion bipartisan infrastructure bill (H.R. 3684, the INVEST in America Act) that includes $550 billion in new spending on highways, waterways, transit, airports, the electric grid, and broadband. That bill has been less controversial but has yet to be passed in the House with progressive Democrats stating that they want to see the social infrastructure bill’s framework after it is presented to the Senate before voting for the traditional infrastructure bill. While Democrats continue to struggle to get Biden’s heavy agenda off the ground, Citi Research’s U.S. economics team thinks there is still about an 80% chance that both bills pass before yearend.

Perhaps the most striking difference between this new framework and the original proposal is that it abandoned plans to raise the corporate tax rate, top marginal income tax rate, and capital gains tax rate in order to gain support. Instead, the focus is now on alternative measures like an adjusted gross income (AGI) surcharge on the extremely wealthy, a 15% minimum tax rate on “book” earnings, and a 15% minimum tax on global multinational corporations. While this reduces the risk of a broad, modest hit to FY2022 corporate earnings-per-share (EPS), some large-cap firms in the technology and healthcare sectors could still be stung by higher taxes (see figure 2). Likewise, banks could be disproportionally impacted by the 1% excise tax on stock repurchases that has been proposed as a method to help offset the cost of climate and early childhood program spending. In 2019, banking industry buybacks totaled $156 billion with the six largest banks accounting for 60% of that total. The Biden Administration estimates that such a tax could generate about $125 billion over a decade – or $12.5 billion each year. On the flipside, the bills could serve as a tailwind to infrastructure company earnings. Although much of this may already be priced into markets with the Indxx U.S. Infrastructure Development index outpacing the S&P 500’s year-to-date returns by a little more than 8.0% (see figure 3).

This bar chart shows a number of S&P 500 companies by sector with over $2 billion in net income with an effective tax rate below 15% in 2018, 2019, or 2020.

This line chart shows the S&P 500 vs. the Indxx U.S. Infrastructure Development Index (Year-to-Date % Return) for 2021.

Growth Slips Amid Supply-Side Constraints

Apart from Congressional negotiations, U.S. gross domestic product (GDP) slipped to its lowest expansion rate since the start of the pandemic recovery last week, clocking in at an annualized rate of just 2.0% in the third quarter (see figure 4). Personal consumption expenditures, otherwise known as consumer spending, grew by an annualized rate of 1.6% in the quarter. This was not far from our expectations (please see our Weekly Market Update | An Abnormal Return to Normal piece).

It was clear from the report that supply-side constraints are weighing on growth with durable goods consumption falling by an annualized 26.2% in the third quarter as spending on autos, furniture, and recreational goods all fell as shortage and delivery delays limited consumption (see figure 5). The auto industry is a perfect example of this with auto sales running at an annualized rate that is about 3.6 million units below the pace witnessed in the second quarter of 2021 (see figure 6). Combined, the sharp decline in goods consumption shaved off 2.7% from topline growth.

Importantly, even with the decline, goods consumption is still 23% above pre-pandemic levels. Services consumption, on the other hand, rose at a solid clip of 7.9% in the quarter. While still below pre-pandemic levels, we think a further normalization in service consumption should support growth in coming quarters. If supply constraints ease some, economic growth should rebound with Citi Research’s economists looking for growth that is north of 5.0% in the fourth quarter of 2021.

This bar chart shows the U.S. Real Gross Domestic Product, Quarter-On-Quarter Seasonally Adjusted Annual Rate from fourth quarter 2019 to third quarter 2021. Supply-side constraints weighed on 3Q 2021 growth

This bar chart shows the Durable Goods Consumption Quarter-on-Quarter Annualized Rate from fourth quarter 2019 to third quarter 2021.

This line chart shows Auto Sales (Seasonally Adjusted Annualized Rate, Millions of Units) from 2015 to 2021 Year-to-Date.

We expect the Federal Reserve to acknowledge this weaker pace of growth at their upcoming Federal Open Market Committee (FOMC) meeting on November 2-3, but still think that the Committee will move forward an announcement to taper their bond purchase program with an intent to end purchases completely by mid-2022. The Fed has been adamant that financial markets should separate tapering from rate hike expectations, but the forward-curve structure has been pulling forward expectations with the curve now signaling two rate hikes in 2022 with one in June and another one in September (see figure 7).

This line chart shows the number of Fed rate hikes expected by December 2022. The market now expects the Fed to hike rates right after tapering ends.

This line chart shows the U.S. Yield Curve (10-Year Treasury Yield Minus 2-Year Treasury Yield) from January 2021 to 2021 Year-to-Date. The U.S. yield curve has been flattening as investors pull forward rate hike expectations.

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