The Agriculture Improvement Act of 2018 (“farm bill”) is expiring this year. Congress has until September 30 to reauthorize it.
Cost concerns coupled with partisan provisions will likely spark more debate than usual this year.
Depending on the outcome, the bill could have near-term implications for the Consumer Staples and Consumer Discretionary equity sectors, but also longer-term benefits for sectors impacted by climate provisions.
In our view, there is low default risk for states, though headline risk around the topic could increase volatility for some lower-quality issuers in the near term.
We reiterate our favorable rating on municipal bonds, which historically have been supported by perceived safe-haven demand during economic downturns.
Investors are being confronted with a more challenging investment environment created by a worsening fiscal outlook in the next 10 years.
Investment implications of an eroding budget outlook
call out The most telling sign of fiscal deterioration under the CBO projections would be a near doubling of net interest payments as a share of revenues to 17% without policy changes by the government.
The long-term budget outlook released last month by the Congressional Budget Office (CBO) put the spotlight on a deterioration more fundamental than the debt-ceiling debate overshadowing it recently, with potentially more far-reaching implications for economic growth, inflation, interest rates, and investment performance.
Behind the budget’s structural deterioration
call out Government interest expenses as a share of revenues are approaching the 14% threshold associated with past compromises on budget austerity. Agreement on deficit control would likely ease worries about the negative correlation between interest expense and financial market performance.
The bottom line to the CBO’s latest projection is a $3.4 trillion increase in cumulative 10-year deficits from a forecast made less than a year ago, including a $950 billion rise in fiscal years 2023 and 2024 ending on September 30. Behind the increase are these structural weaknesses making it difficult to bring deficits, debt, and borrowing needs under control without tax and spending reforms:
Deficits averaging a recession-like 6% of gross domestic product (GDP) from 3.3% in the 20 years prior to pandemic-related stimulus beginning in 2020, partly on government spending averaging 24% of GDP from a 20% historical norm.
Debt propelled by outsized deficits rising 65%, to $51 trillion, 10 years from now, equivalent to nearly 130% of GDP from 97% in fiscal 2022.
Federal net interest payments — the most uncontrollable spending line item — averaging nearly 17% of revenues in the coming decade, nearly double its share in the previous 10 years. That debt-financing ratio is expected to be lifted by the combination of rising debt, projected interest rates more than 1.5 percentage points above their pre-pandemic 2009 – 2019 norm, and by the debilitating effect of higher interest on economic and federal revenue growth.
Worsening budget performance since last summer has foreshadowed that deterioration, capped by a near-70% increase in the rolling 12-month deficit and a near-42% rise in net interest payments to a 20-year high of 11% as a share of revenues.
What it means for investors
However, we believe projections like these, based on unchanged policies, can be offset by the government’s tendency to enact budget austerity when government net interest payments exceed the projected 14% of federal revenue, to be reached as early as late in 2023 or early in 2024.1 Added relief could come from improvements in productivity and from other growth-enhancing changes covered more thoroughly in our report “Paying America’s Bills,” updated in November 2022.2
Chart 1. Government austerity typically responds to rising interest costsSources: Strategas Research Partners and Wells Fargo Investment Institute (WFII). Annual data. Historical data, 1968 – 2022. Data displayed for all years for which data is available. Projection for 2023 is by WFII, calculated as the rolling 12-month sums of net interest payments, in ratio to total federal revenues from the U.S. Treasury. Note: *Average impact of every tax cut or hike for the first two years after enactment as a percent of GDP.
There’s more to fiscal policy’s impact on financial-market outcomes than just the rise in interest rates. Our long-term preferred portfolio allocations anticipate somewhat higher interest rates. Deficit control through tax and spending changes can have an important impact on sector strategy in the stock market too. The table below offers a selected list of budget measures potentially forming part of a long-term austerity plan and tied to an identifiable market sector or industry impacts. Among the more pervasively exposed sectors in the summary table are Industrials, Health Care, and Information Technology (IT). The ultimate effect elsewhere in the equity market would likely depend on the mix and scope of austerity measures. For that reason, the budget debate has had only a limited impact on our sector recommendations over the coming 12 to 18 months, though we are monitoring for industry and sector effects in what is likely to be an extended and highly contentious fiscal debate.
Table 1. Sectors and industries exposed to potential budget austerity measures
Managed Care, Hospitals
National Institutes of Health
Medical Tools, Devices
General gov't spending
IT, Industrials, (Commercial Services)
Direct farm support
Renewable Energy, Industrials, IT
IT, Communication Services, Financials, Energy
R&D tax-credit patch
Industrials (Defense), IT
Tax Cuts and Jobs Act
Industrials, IT, Health Care
Sources: Wells Fargo Investment Institute, March 13, 2023. R&D = research and development. Notes: **Tax increases and tax-expenditure cuts, ***Inflation Reduction Act, Infrastructure Investment and Jobs Act, and the CHIPS and Science Act
1 Dan Clifton, “Interest Costs Pressuring Entitlements,” Strategas, March 8, 2023
2 “Paying America’s Bills,” Wells Fargo Investment Institute, November 2022
Every five years, Congress sets national agriculture policy through the farm bill. Historically, the bill has received bipartisan support, but that may not be the case this year.
The next five years
call out Since the 1930s, the U.S. Congress has enacted 18 farm bills.
Every five years, Congress passes legislation that sets national agriculture, nutrition, and conservation policy, commonly called the “farm bill.” Since inception in the 1930s, farm bills have focused on farm commodities and crop insurance. In 1973, the bill’s scope was expanded to include nutrition. This year, several Democratic lawmakers are seeking to add climate provisions to it.
Historically, the bill has received bipartisan support; yet, with a divided Congress, that may not be the case this year. Expiring pandemic-related increases in Supplemental Nutrition Assistance Program (SNAP) benefits coupled with efforts to attach climate funding to the bill could spark more partisan debate than in the past. Depending on the outcome, the final bill could have near-term implications for the Consumer Staples and Consumer Discretionary sectors, but also longer-term benefits for sectors that would be impacted by clean-farming and climate-policy provisions.
Setting policy priorities
call out In 2022, more than 41 million Americans participated in the SNAP program.
Source: National League of Cities, February 2, 2023end call out
The farm bill is expiring this year. The bill sets priorities for agriculture, including crop preferences and production methods. It is split into mandatory and discretionary spending programs. Mandatory programs generally dominate congressional debate and the lion’s share of funding. Although the 2018 farm bill contained 12 sections (titles), four of them dominated 99% of mandatory spending: nutrition (primarily SNAP), commodities, crop insurance, and conservation. The remaining mandatory outlays were authorized to receive discretionary funds.
In terms of budget, the CBO baseline provides a projection of future spending on mandatory programs (assuming current law continues). The 2018 bill was initially projected to cost $428 billion. An updated baseline with five- and 10-year projections for 2023 will be published this spring. For now, the best indicator is the February 2023 baseline projection of $709 billion through fiscal year 2028.3 The relative proportions of title spending have shifted over time. For example, in the 2023 projection, nutrition is 85%, compared with 76% in 2018 and 67% in 2008. The recent increase reflects pandemic-related adjustments to SNAP benefits, which are subject to change.
Without reauthorization by September 30, many mandatory funding programs would terminate. A few essential programs, like crop insurance and SNAP, are exempt from cessation due to funding structure and would continue. Others would revert to laws established in the 1930s and 1940s.4 Cost concerns combined with provisions like reinstating work requirements for SNAP recipients and climate funding will likely create strong partisan positions this year. Bipartisanship in both chambers will be essential to passing the 2023 farm bill.
Economic and investment implications
In 2021, agriculture, food, and related industries contributed roughly $1.26 trillion (5.4%) to U.S. GDP. The output of U.S. farms contributed $164.7 billion (0.7% of GDP).5 The U.S. Department of Agriculture expects this year’s net cash farm income to reach $150.6 billion, topping the 20-year inflation-adjusted average.6
The farm bill makes a sizable economic impact through its nutrition title, particularly for lower-income households. Today, over 75% of funding is allocated to nutrition programs, including SNAP. Crop insurance, another key title, is a risk management tool for farmers to recoup financial losses from poor harvests and price declines. In 2022, crop insurance programs supported 1.2 million policies covering 493 million acres.7 To help contain costs, the U.S. Government Accountability Office has recommended reducing crop insurance subsidies to high-income participants and adjusting compensation to insurance companies to align with market rates. Congress has yet to respond.
Near term, the expiration of emergency allotments of SNAP benefits (an additional $95/month per household) from the passage of the Consolidated Appropriations Act, 2023, will impact nondiscretionary spending but could also shrink discretionary purchases as household spending is reallocated from discretionary to nondiscretionary. Tactically, we are unfavorable Consumer Discretionary and neutral Consumer Staples.
Potential climate and clean-farming provisions could include things like climate-friendly soil enhancements and carbon sequestration. They may also comprise measures to mitigate greenhouse gas emissions through climate-smart farming and irrigation methods, low-carbon fertilizers, and electric vehicles. Longer term, these potential changes could benefit several sectors, including Industrials, Materials, Energy, and IT.
3 “Farm Bill Primer,” Congressional Research Service, February 22, 2023
4 “The Complicated Road for a Farm Bill to Pass Through Congress,” Agdaily.com, January 13, 2023
5 U.S. Department of Agriculture, January 26, 2023
6 U.S. Department of Agriculture, February 7, 2023
7 U.S. Government Accountability Office, February 16, 2023
call out Post-pandemic factors, including an influx of federal stimulus, allowed state and local governments to realize their first budget surpluses since 1978.
Despite a clear erosion in COVID-19-fueled budgetary surpluses, we believe state and local finances remain historically well positioned. In our view, fading pandemic tailwinds will likely be offset by fiscal conservatism heading into our forecasted recession.
What do eroding budgets mean for municipal bond investors?
call out States held a record $134.5 billion in rainy-day funds during the past fiscal year, according to the National Association of State Budget Officers.
Plentiful fiscal stimulus bolstered the finances not only of U.S. households but also of state and local municipalities in the aftermath of the pandemic. An influx of federal rescue dollars, along with spending restraint and increased tax revenues, resulted in the first budget surpluses since 1978. In fact, in their latest fiscal year, 33 states reported greater-than-expected revenue, according to the National Association of State Budget Officers (NASBO).
Admittedly, these tailwinds are now abating. Federal aid is winding down, and costs — including debt service and wages — are simultaneously rising. Numerous governors utilized excess funds to boost spending and cut taxes ahead of last November’s midterm elections. Additionally, higher-income-tax states are more exposed to what will likely be disappointing tax receipts this April due to last year’s $9 trillion loss in shareholder wealth. California’s record $97 billion budget surplus from 2022 is poised to evaporate this year, flipping to an estimated deficit of $22.5 billion.8 We believe these trends signal budgetary erosion as the economy slows.
Chart 2. States' rainy-day funds are poised to cushion budget strains in the near termSources: The Pew Charitable Trusts, the National Association of State Budget Officers, and Wells Fargo Investment Institute. Annual data, 2000 – 2022. Data as of October 18, 2022.
However, we view state and local finances as historically well positioned. The deterioration should be kept in perspective — budgets are contracting in a cyclical reaction from unusually large surpluses tied to pandemic-related windfall gains. States held a record $134.5 billion in rainy-day funds during the past fiscal year, according to NASBO, while a more comprehensive measure of state reserves is estimated to surpass 24% of total spending in fiscal year 2023 — well above the average of less than 9% in the two decades leading up to the pandemic.9 We believe elevated reserve funds combined with fiscal conservatism will offset fading pandemic tailwinds, leaving state and local governments well equipped to weather our forecasted economic downturn.
Even if the economic slowdown proves deeper or lasts longer than we currently anticipate, we view it more as a headline risk for the near term. The labor market is the biggest unknown variable for states, as income taxes are their largest source of revenue. However, we are forecasting only a shallow rise in unemployment this cycle, given the tight labor market tied to lingering pandemic imbalances. By comparison, local governments derive 75% of their tax revenues from home values. Housing prices have soared since 2019, and local property tax revenues have historically lagged changes in home values by roughly three years, leaving local finances bolstered in the near term.10
We believe municipal bond defaults remain a low probability, given their historical precedence of weathering more protracted economic downturns, such as the Great Recession of 2007 – 2009. Trading volatility could increase for some lower-quality municipal issuers, however, especially if our forecasted recession takes hold during the second half of this year.
Overall, we reiterate our favorable rating on municipal bonds due to a positive supply/demand backdrop, federal infrastructure spending, and some lingering support from COVID-19 relief packages. We view absolute yields on municipal bonds as attractive compared with pre-pandemic levels. One-year AAA-rated municipal bonds are yielding around 2.72%, versus a 10-year average of 0.77% (as of March 13, 2023). Furthermore, higher-income investors can benefit from the tax advantage provided by most municipal bonds, and like U.S. Treasuries, these securities tend to be viewed as a safe haven during economic pullbacks. The period leading up to the April 18 tax-filing deadline could constitute an attractive entry point, as some investors tend to sell municipal bonds this time of year to fund tax liabilities.
We retain a stable outlook on state general obligation (GO) bonds rated AA or higher, along with a stable outlook on local GO bonds and essential-service revenue bonds rated A or higher.
We retain a negative outlook on the health care sector as hospitals continue to grapple with greater budgetary and liquidity issues tied to COVID-19 and related worker shortages.
8 “States Propose Billions in Tax Relief Despite Economic Uncertainty,” The Wall Street Journal, February 28, 2023
9 “States Are Flush With Cash, Which Could Soften a Possible Recession,” The Wall Street Journal, February 5, 2023
10 “State Fiscal Outlook is Deteriorating Faster Than Consensus Realizes,” Strategas, January 26, 2023
Article written by:
Lawrence Pfeffer, CFA
Equity Sector Analyst, Industrials/Materials
Michael Taylor, CFA
Investment Strategy Analyst
Investment Strategy Analyst
Forecasts, estimates, and projections are not guaranteed and are based on certain assumptions and views of market and economic conditions which are subject to change.
Different investments offer different levels of potential return and market risk. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve.
Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities.
Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility.
Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation, and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income.
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