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May Market Update

Economic Data

Stealing the economic headlines this month was the resurgence of the trade war with China. Tariffs on Chinese electric vehicles increased from 27% to 102.5%, and more products were added to the list, including batteries, semiconductors, and solar panels. Overall, the change is more symbolic, only affecting $18 billion in goods (source), compared to the initial 2018 round of tariffs which affected $300 billion in goods (source).

Artificial Intelligence

The focus on AI tech has remained in the world's largest companies, with Google and OpenAI demonstrating their newest technology on back-to-back days. OpenAI announced their GPT-4o model, which besides being better, faster, and smarter, allows users to customize their own chatbot, as well as other features like real-time tutoring as seen here:

Google is focusing its efforts toward Project Astra, a multi-modal chatbot demonstrated here:

They have also focused on deeply integrating AI into their core search business by introducing ‘AI Overview’. Now when you search for something, you will see an AI Overview that has searched and summarized many of the top webpages relevant to your search, with the intent of saving you time. This also means you will visit fewer websites, and those websites will not earn as much in revenue. Given that we are only at the beginning of AI development, this could mark a fundamental shift in the economics of the internet.

Fiscal Dominance

The term ‘Fiscal Dominance’ has recently surfaced in finance circles, as a framework to explain why the interest rate increases by the Fed are not having the desired effect on inflation. Its implications could signal a change in market dynamics that have been present for decades. In its simplest form, money enters the economy via two routes, credit creation by commercial and central banks (monetary) and deficit spending by our government (fiscal).

Over the last 40 years, the US and much of the developed world have been in monetary dominance, a market regime where most of the money creation is coming from new bank loans, and changes to monetary policy are very effective in reaccelerating or slowing down the economy and inflation. Fiscal dominance is when more money is flowing into the economy via deficit spending (the government spending more than it takes in), and thus changes to this fiscal policy will have a more significant impact on our economy than changes in monetary policy.

A simple way to measure the relative strength of monetary versus fiscal components of the economy is to compare the fiscal deficit versus the rate of new bank loan creation over a given period. From 2020 to 2023, the Federal deficit (fiscal) is 8.9 trillion (source), and bank credit (monetary) has expanded by 3.6 Trillion (source), a clear fiscal dominance situation.

What does this mean for the economy and the stock market going forward? Simply put, proponents of this fiscal dominance theory believe that as long as deficit spending remains at its current level, then inflation could become a long-term, structural issue. Currently, non-discretionary government spending (Social Security, Medicare, interest on debt, etc) is at 72% (source), and that does not include military spending, which many would argue is not discretionary. It is tough to see a path where the US reduces its spending, thus inflation should remain a feature of our economy going forward.

Luckily there is no shortage of market data relating to investing during structurally inflationary times. Simply put, you want to own things that are scarce. The stock market, as well as residential real estate, are the largest markets for these assets. This is another feather in the cap of why a well-diversified portfolio of equities, combined with personal ownership of real estate should be a prudent strategy going forward.

For history nerds, below are two examples of fiscal dominance and monetary dominance, both marked by high inflation:

The 1940s was a clear situation of Fiscal Dominance. Due to WWII, we had the largest fiscal deficits (compared to GDP) in history due to various spending programs to mobilize for war, as well as the GI Bill. Inflation peaked in 1947 at 20%, followed by another local peak in 1951 at 10%. Luckily, we were able to grow our way out of the debt we incurred during the war, mainly due to the destruction of industry in Europe and Asia.

Monetary Dominance marked the 1970s. Baby boomers were entering their peak family formation years in the 70s, which (among other things) meant buying houses on credit. While the US was running a deficit in the late 70’s, it was dwarfed by the amount of credit extended to this wave of home buyers. This, combined with the oil supply shocks created a systemic inflation period that lasted from 1973 to 1982. In response to the inflation, Federal Reserve chairman Paul Volcker raised interest rates to 20%. This effectively extinguished the rate of bank lending, and since this was the main source of money entering the economy, it was effective in controlling inflation.

As always if you have any questions, please don't hesitate to give us a call.

Citrus Wealth Management

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Any opinions are those of Citrus Wealth Management and not necessarily those of Raymond James. The information contained in this email does not purport to be a complete description of the securities, markets, or developments referred to in this material nor is it a recommendation. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results.


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