A Supreme Court Battle Lowers the Odds of Vital Fiscal Support

By John Banks

A U.S. Senate battle royale over who gets to fill a U.S. Supreme Court seat is bearish for markets. That is a key reason why bearish feeling has intensified this week, with asset prices dropping across the board.

The cause-and-effect mechanism here is not direct, but indirect. It has to do with fiscal support.

The real U.S. economy – meaning Main Street rather than Wall Street – is still in danger of collapse due to ongoing pandemic fallout.

In the early months of the pandemic, we avoided economic devastation via trillions in fiscal support. It was not just the Federal Reserve that kept things together, but the Federal Reserve acting in concert with Congress providing direct-to-consumer “helicopter money” – think stimulus checks, the Paycheck Protection Program (or PPP), and topped-up unemployment benefits – that kept the economy afloat.

But now those funds are running dry, and the real economy is far from healed. Metaphorically speaking, Main Street is still in intensive care, and still in need of life support. But to the extent Congress is consumed by a no-holds-barred political battle, the odds of vital fiscal support are reduced.

The fiscal taps have been shut off for weeks now, with severe economic pain points starting to materialize as a result. A knock-down, drag-out Supreme Court fight means the taps could stay shut off until the election, and even, potentially, the months afterward).

This lack of fiscal support puts Main Street in grave danger, which endangers the stock market, too. If the real economy collapses, white collar workers get laid off, too. If that happens, 401(k) accounts stop getting auto-funded, and passive investment flows go into reverse. No bull market could survive that, let alone a precarious retail mania fueled by call-option buying. 

With regard to economic impacts, the upcoming presidential election offers the greatest policy divergence since 1980. Depending on who wins control of the White House – and not just the White House, but the Senate — the outlook for various parts of the market will diverge wildly.

Various volatility instruments, like CBOE Volatility Index (VIX) futures contracts, were already pricing the 2020 presidential election as one of the biggest event risks in market history.

The closeness of the 2020 election, and a sideshow drama with China, only add to investor worries at this point. And so, with the battle royale for a Supreme Court seat now underway — and both parties threatening extreme measures — we are getting an advance preview of what the election could mean.

For the stock market, and markets in general, the concerns are still economic and monetary, rather than legislative. Markets did not swoon this week in reaction to the prospect of conservative or liberal court rulings.

Instead, as mentioned, the problem is fiscal support, or rather, an ongoing lack of fiscal support due to an all-consuming focus on Supreme Court issues in Washington.

Perhaps you recall December 2018, when the Dow Jones Industrial Average had its worst month in 70 years. That violent market move was a message to Fed Chairman Powell.

By late 2018, Powell had assumed it was safe for the Federal Reserve to move away from easy monetary conditions, and to start the transition back to normalcy in terms of monetary policy.

Investors panicked over this prospect, causing a dizzying market drop. December 2018 was a mini-meltdown because investors feared premature tightening from the Fed would be catastrophic.

Powell, not being a fool, immediately reversed his stance as a result of the market drop, and put the Federal Reserve back on a dovish footing. The stock market then did a bullish U-turn, and booked stellar gains for 2019.

But now, in 2020, the market needs to grab the attention of Congress, not the Federal Reserve, because, in the “monetary plus fiscal” equation, the monetary side is already maxed out.

That is to say, the Federal Reserve is already at maximum dove levels. They have provided so much liquidity and so much backstop support for credit markets, there is little more they can do.

And yet – this is very important to understand – the Fed cannot help the real economy directly, and the real economy is still at death’s door.

Powell himself knows this, which is why his prepared congressional testimony for Sept. 22 includes the statement that small and medium-sized businesses may need “direct fiscal support.” Translation: The Fed has done what it can. Uncle Sam has to do the rest, which means another helicopter drop.

The United States is still deep in the throes of a painful recession, bordering on a depression, far worse than anything investors have seen in their lifetimes (barring the handful of 100-year-olds who remember the 1930s).

Then, too, for tens of millions of Americans, their Great Depression is now. The economic reality of Main Street, for at least a third of the population if not more, is 1930s-level distress, right down to eviction notices, boarded-up businesses, and long lines for food banks.

The distress point is easy to miss because, at this very moment, U.S. household net worth just hit an all-time high. How is this possible?

Because trillions of dollars in fiscal stimulus and central bank support, coupled with an online trading mania, have created record-busting levels of paper-asset inflation. The real economy is not the stock market and vice versa.

Not only did the Federal Reserve do a huge amount this spring, the U.S. government swooped in with trillions as noted. In the second quarter of 2020, U.S. government debt rose at a pace of 59% annualized! That is a tremendous amount of money. A lot of it helped people pay rent and buy food with businesses shuttered and jobs vaporized. But a lot of those funds also went straight to Wall Street.

Why is this super-important to understand right now? Because, again, the U.S. economy, far from being “on the road to recovery,” is still wholly dependent on fiscal support. Monetary policy can’t help.

The Federal Reserve can’t get money to Main Street, nor keep tens of millions of Americans from being evicted for lack of ability to pay rent, or millions more businesses from shuttering. Only the U.S. government can do that, with another round of fiscal help.

Without additional help from the U.S. government, the real economy is likely to collapse. This is just an observation based on the numbers. When one considers the number of small and medium-sized businesses still facing permanent closure, and the number of Americans facing food insecurity or a loss of the roof over their heads, the data is staggering.

And this helps explain why Wall Street is succumbing to bearish fear, and a Supreme Court battle royale has a direct and bearish impact on the stock market.

It goes like this:

  • The thing that saved the U.S. economy in 2020 was not the Federal Reserve alone, but Federal Reserve actions combined with historic spending from the U.S. government. It was not just monetary policy, in other words, but monetary policy plus fiscal policy, with the fiscal part equating to government spending of the “helicopter money” variety, sending checks directly to households and businesses.
  • As long as the U.S. government remains committed to propping up Main Street and the real economy, Wall Street gets a free ride – and paper assets can do well – because the firehose of fiscal stimulus, in conjunction with near-zero interest rates, means Wall Street gets a huge paper-asset boost.
  • But if the U.S. government stops providing aid to Main Street – if the fiscal taps suddenly go dry while the real economy is still on life support – there is a real risk of follow-on deflationary collapse. The service sector, including food, travel, retail, and other key pillars of the real economy, have been hit so hard by the pandemic that, if the government stops helping, a tsunami of bankruptcies, evictions, and commercial loan defaults will follow.
  • When Republicans and Democrats are engaged in fierce partisan battles, the odds for future stimulus – for ongoing fiscal support – tend to decline, because nobody can agree on terms and political leaders are consumed by the fight at hand. This means that, as the parties hold the equivalent of an Ultimate Fighting Championship cage match for who will fill (or won’t fill) a vacant Supreme Court seat, they forget to pay attention to the real economy, which is in real danger of imploding.

We are now in crunch-time conditions for keeping the real economy afloat. Bankruptcies, evictions, domino-chain business failures, and empty food cupboards are a harsh reality materializing right here, right now, across the nation as you read this.

And yet a deal for additional fiscal stimulus (help for a suffering real economy) is nowhere in sight, and the odds of an extended Supreme Court fight – which could consume the attention of Congress even after the election – means that additional rounds of fiscal help for a collapsing real economy could be off the table for months.

Wall Street genuinely fears that outcome, and rightly so, because if the Main Street economy collapses, the party being thrown on Wall Street cannot continue.

Without that ongoing fiscal boost, consumer spending dries up, small and medium-sized businesses start to go bust at an alarming rate – in a way we haven’t seen yet, because the initial rounds of stimulus prevented that – and Wall Street loses its “free rider” status because there aren’t any funds to free ride upon if the fiscal taps are shut.

Making matters worse, it is not just the nations’ small and medium-sized businesses that are in trouble now, but the banks.

Why the banks? Because the banks are facing a massive wave of commercial loan defaults. We have already seen the major banks set aside record levels of loan loss provisions, to the tune of tens of billions per quarter.

If the banks are setting aside record levels of loan loss provisions, they are hunkering down and preparing to take a major hit. And that means the banks are not lending to anyone except those with pristine credit, meaning the strongest businesses and the most financially stable individuals.

That, in turn, means the bottom 90% of the economy is being cut off from access to loans and credit, because the banks aren’t providing it. To wit, if your credit is pristine you are fine; if it isn’t, and you or your business needs to borrow funds, too bad.

This leaves most of the country, and most of the real economy, gasping for air.

And so, if you take away all manner of fiscal support – or rather, if you let the multi-trillion fiscal support pool provided months ago run dry – you get economic implosion.

To use another metaphor, getting the U.S. economy all the way through the pandemic is like crossing an economic desert. Conditions in that desert are so inhospitable to economic life that an emergency water supply is needed. That emergency water supply is fiscal support.

If the economy runs out of water (fiscal support) too early, it dies of thirst, because the banks aren’t lending, the profits aren’t flowing, and the landlords are in trouble just like the tenants. 

But Washington isn’t seeing this because the headline numbers look superficially positive – e.g., record levels of household wealth based on paper-asset inflation – and because crisis avoidance via the last rounds of stimulus created a sense of complacency, and because Republicans and Democrats are now too busy fighting over a Supreme Court seat.

As a result of this fiscal lack, the outlook for severe loan defaults and impairment of bank balance sheets becomes much darker.

The bottom line is that politicians in Washington simply do not understand the profound vulnerability of the U.S. economy right now. But the market is starting to get it.

Politicians do not understand the stark reality that, while the first round of fiscal support did a good job of keeping the real economy from collapsing, a second round is now needed, not because the U.S. economic engine is broken, but because banks have shut the lending window, and the devastating impacts of the pandemic are still in play.

In 2019, we said that the 2020s, as a decade, would look like a combination of the 1920s and the 1930s. Unfortunately, we are seeing what that means, as the 1930s aspect of the equation hits home.

Then, too, the impact of the 2020 election will only intensify many of the trends we are seeing now. The difficulty lies in knowing which trends will be intensified, because it depends on who wins, not just at the presidential level, but the Senate level, too.

It will be the most important election since 1980, and possibly the most important election in our lifetimes, in terms of divergent policy extremes and direct market impacts.