President Biden is expected to issue his first budget to Congress on Friday, expanding federal spending to levels not seen since World War II.

Photo illustration by Sarina Finkelstein; Biden: Anna Moneymaker/Getty Images

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President
Joe Biden
is expected to issue his first budget to Congress on Friday, expanding federal spending to levels not seen since World War II. Markets have shrugged off details of the plan that leaked on Thursday.

Biden is aiming for a $6 trillion budget for the 2022 fiscal year, and deficit spending could top $1.3 trillion annually for a decade under his plans, according to media reports. His plan would also raise capital-gains taxes on incomes over $1 million, retroactive to April, and apply a new estate tax on unrealized capital gains with a $1 million exemption, according to a report in The Wall Street Journal.

The president also aims to ramp up nondefense discretionary spending, looking for a 16% increase to $769 billion. His agenda includes big increases for infrastructure, clean energy, education, housing, and other social programs, some of it previously outlined in the American Jobs Plan and American Families Plan that the administration is pursuing.

The yield on the 10-year Treasury note initially rose on the eye-popping numbers but ended the day flat at 1.60%. Stocks held their ground Thursday with the S&P 500 up 0.1% to 4200.

The muted reactions reflect a few things. The details of the budget proposal, while huge, aren’t new. Biden has pitched his spending priorities for months and the markets perceive them as largely aspirational, says Chris Senyek, chief investment strategist at Wolfe Research.

Republicans, meanwhile, have dug in against those priorities, forcing gridlock in the Senate where Democrats have to use razor-thin majorities to pass a budget. That makes it likely that the final figures of Biden’s budget will be winnowed down as moderate Democrats such as West Virginia’s Joe Manchin wield power.

“The market loves gridlock, and there’s a perception that there may be enough to stymie some of these spending plans,” says strategist
Ed Yardeni,
head of Yardeni Research. “Lawmaking is like watching sausages being made and most investors prefer not to watch it.” 

The markets may also be calming down about inflation—a concern if so much additional spending overheats the economy. Bond yields are well above levels from five months ago on fears that inflation won’t prove as transitory as the Federal Reserve expects, thus triggering interest-rate increases and tapering of asset purchases sooner than expected.

The inflation data has been worrisome. But bond yields have taken a breather since March, hovering around 1.6% on the 10-year Treasury. One reason may be that gross domestic product forecasts for the second quarter have fallen lately, going from 10.1% annualized growth on May 18 to 9.1% on May 27, according to the Atlanta Fed’s GDPNow measure. Jobs growth has paused, as the April employment report indicated, though that could just be a lull.

A 9% GDP growth rate would be the highest in decades. It won’t last, of course, but even a 4% rate would be about twice the pace of recent expansions, providing plenty of support for equities to keep rallying.

“We shouldn’t underestimate the influence of incredible profits and economic growth,” says
Jim Paulsen,
chief investment strategist at Leuthold Group. “It’s one thing to have this level of spending and deficits in an economy growing at a 2% rate. But say it sustains at 4%. That would make quite a difference in the deficit math and help overall.”

Commodity prices have softened and inflation expectations embedded in 10-year Treasury inflation-protected securities, or TIPS, have declined, also soothing inflation fears.

Strong earnings and economic growth are outweighing a few bearish signals that have cropped up, says Yardeni. Even more supportive of the market is the flood of liquidity since the pandemic started, amounting to $4 trillion. That has effectively killed any lasting equity-market corrections.

“The liquidity is probably the best explanation for why this market doesn’t seem to be reacting to bearish fundamentals,” Yardeni says. “The market is drugged up on insanely stimulative fiscal and monetary policy. When you’re inebriated, it’s hard to think clearly.”

Granted, a $6 trillion budget would put federal spending at more than 25% of U.S. gross domestic product, the highest peacetime levels since World War II. Government debt is also escalating as tax revenues fall far short of spending.

The federal deficit is coming in at $2.3 trillion this year, according to the Congressional Budget Office. That would be 10.3% of gross domestic product, the second-highest level since 1945, topped only by the the14.9% shortfall last year.

Deficit spending should decline as the economy recovers and tax revenues increase. But Biden’s proposals, including infrastructure and other spending plans, could push annual deficits over $1 trillion over the next decade, depending on how tax revenues and economic growth come in.

Near term, an infrastructure plan could be inching closer to a resolution. Republicans put forth a $928 billion counteroffer on Thursday to the White House’s $1.7 trillion plan. Biden has said he wants a deal by Memorial Day.

However, both sides are still far apart on core issues such as care for the elderly and disabled, a $400 billion priority for the White House. Also contentious is how to pay for it, with Biden aiming to increase corporate and capital-gains tax rates, and Republicans pushing for additional revenues from prior stimulus funding and fees on electric-vehicle users, among other measures.

As with the budget, an infrastructure package will likely come in well below the White House wish list.

Nonetheless, these levels of spending are uncharted territory for the economy. Even institutional investors may not know what to make of them.

“We’re seeing a lack of conviction among our institutional clients,” says Tavis McCourt, institutional equity strategist at Raymond James. “Any data point could be an overreaction. Your opinion might seem out of left field today and could be right two months later. It’s a very strange environment.”

For now, Biden’s spending plans are testing the market’s resolve. The stock market is betting that companies and the economy will benefit from higher spending and deficits. The bond market is taking the opposite tack, fretting over inflation and higher rates, which would also kill the stock party.

The outcome will hinge on how the Washington drama plays out.

Write to editors@barrons.com

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