Government Shutdown | ITK With Cathie Wood

Key Concepts

• Government Shutdown: The US government shutdown's impact on economic reporting and market behavior.
• Employment Revisions: Significant downward revisions to past employment figures.
• Federal Reserve Policy: Interest rate cuts, balancing inflation and employment concerns.
• Fiscal Policy: Deficit reduction targets, tax reforms (OB3), and depreciation incentives.
• Monetary Policy: M2 growth, CPI trends, and the velocity of money.
• Economic Indicators: Yield curve, GDP growth, manufacturing and non-manufacturing activity, employment rates, job openings, personal savings rate, housing market data, capital spending, trade balance.
• Market Indicators: Dollar strength, S&P 500 earnings, commodity prices, gold, Bitcoin, high-yield spreads.
• Innovation and Technology: AI, robotics, and their impact on productivity and employment.
• China's Economy: Shift in focus, technological advancements, and trade dynamics.

Summary

Economic Overview and Policy Landscape

The current economic climate is characterized by a US government shutdown, which, despite initial concerns, has historically coincided with stock market upticks. A significant downward revision of 911,000 jobs in March 2025 has highlighted a deteriorating employment situation. The Federal Reserve has responded by cutting the Fed funds rate by 25 basis points, attempting to balance persistent inflation, which remains stuck between 2.5% and 3% due to tariffs, with weakening employment. The ADP payroll report indicated a decline of 32,000 jobs, with a downward revision for the previous month as well, signaling a more significant employment slowdown than previously understood. This weakening is attributed to both cyclical factors, as employment is a lagging indicator, and a potential shift towards a "rolling recovery" that could evolve into a productivity-driven boom by next year, potentially timed for midterm elections. The administration's early implementation of "tough medicine" is seen as a strategic move for future economic performance.

Fiscal Policy and Tax Reforms

Fiscal policy is focused on deficit reduction, with a target of 3% of GDP by the end of the Trump term, and projections suggest it could shrink below this mark due to stronger-than-forecast growth. A key initiative, referred to as OB3 (One Big Beautiful Bill), introduces significant tax incentives for manufacturing. For the next three years, manufacturing structures built in the US will be fully expensed in year one, a departure from the typical 30-year depreciation schedule. This includes government refunds for companies based on their capital expenditures. Equipment, domestic R&D, and software are also fully expensed in year one. While the statutory tax rate remains at 21% (down from 35%), the effective tax rate, considering these depreciation benefits, is projected to drop towards 10%, making US corporate tax rates among the lowest globally. This is expected to attract substantial foreign direct investment and spur a manufacturing boom, potentially reversing decades of manufacturing decline since China's WTO entry. However, this manufacturing resurgence is anticipated to be highly automated, driven by AI and robotics, potentially making the US a more efficient manufacturer than China in terms of unit labor costs.

Monetary Policy and Inflation Dynamics

Monetary policy is navigating a complex environment. M2 year-over-year growth has accelerated to 5%, placing it within the historical average. Inflation, measured by CPI, remains sticky around 2.5% to 3%. Despite significant tariff increases, this stable inflation rate is considered a better-than-expected outcome, with businesses absorbing tariff costs more than consumers, forcing them to adopt productivity-enhancing measures like automation and AI. While tariffs are viewed as regressive, their combination with tax changes and deregulation is seen as potentially beneficial for returns on invested capital in the US. The expectation is that CPI will decline next year, driven by productivity gains, which historically correlate with lower inflation, contrary to fears of a boom leading to supply chain issues and inflation. Real-time inflation measures also suggest that tariffs are not significantly pushing up prices, and inflation is expected to trend downwards towards 0%.

Velocity of Money and Yield Curve

The velocity of money, a measure of how quickly money circulates in the economy, has flatlined after a period of expected decline due to economic uncertainties. If velocity remains flat, nominal GDP growth is projected to be around 5%. If velocity declines, nominal GDP growth will be lower. The yield curve, specifically the 2-year Treasury yield minus the 3-month Treasury yield, is inverted, indicating that monetary policy is perceived as too tight. Historically, this has preceded recessions, but in the context of a "rolling recession," it suggests the Fed should continue cutting rates. Another yield curve measure, which did not steepen significantly during the COVID-19 stimulus, is interpreted as the bond market recognizing deflationary undercurrents driven by technology. This is supported by "Wright's Law," which posits that costs decline by 50% for every cumulative doubling in production of certain technologies, such as industrial robots, electric powertrains, DNA sequencing, and AI. AI training and inference costs are experiencing astonishing declines, with AI inference costs dropping by 85-98% annually.

Economic Indicators and Sector Performance

Real GDP growth has been supported by government spending and sectors like education and healthcare, as well as high-end consumer spending and capital expenditures related to AI (data centers, power sources). However, these growth vectors are facing policy changes. A significant slowdown in GDP growth is anticipated, followed by a turnaround driven by productivity, potentially reaching 5% or higher and being sustained unlike in past recoveries. Manufacturing activity has been in a slump for approximately three years, indicative of the rolling recession, and non-manufacturing activity is also showing signs of weakness, with the ISM for services dropping to 50, the demarcation point between expansion and contraction. New orders in services have stalled, and prices paid remain elevated, with companies attempting to pass on tariff-related cost increases, which may be contributing to the slowdown in orders as consumers resist price hikes.

Employment Trends and Automation

The monthly unemployment rate is being artificially suppressed by baby boomer retirements and immigrant departures. The unemployment rate for recent graduates has risen from 5% to 6.5%, influenced by cyclical factors and the impact of AI limiting entry-level job growth. The quit rate has declined to recessionary levels, and the duration of employment has increased, indicating a structural shift where individuals face longer waits for new opportunities. This trend is exacerbated by automation. Job openings continue to decline, a pattern typically associated with recessions. However, companies are not suffering margin declines due to AI and productivity-enhancing tools, which has prevented a collapse in capital spending outside of AI.

Consumer Behavior and Housing Market

The personal savings rate has fallen to near record lows, contrary to expectations during the rolling recession. This is attributed to many individuals living paycheck to paycheck, while higher-income consumers have benefited from rising stock markets and home prices. Home buying intentions remain high, but buying conditions are perceived as poor, even worse than during periods of double-digit mortgage rates. This is due to a "lock-in" effect where homeowners with low mortgage rates are reluctant to move, as new mortgages would significantly increase their payments. Pending home sales are very low, though new home sales have seen a recent jump. Both new and existing home sales volumes are at historically low levels relative to the population. Builders are accumulating inventory of new homes and are resorting to tactics like buying down mortgages, effectively a price reduction, to clear stock. Existing home sale prices are beginning to decline, and these decreases are expected to impact CPI inflation with a significant lag.

Capital Spending and Trade

Capital spending on non-defense capital goods (excluding aircraft) has been in a slump, with recent upticks driven by data centers. This trend is expected to reverse dramatically due to new depreciation schedules and investment incentives. Real structures related to data centers have seen a significant increase in activity since late 2022, though the year-over-year growth rate has moderated. Manufacturing structures also saw a burst in response to supply chain shocks, but this has rolled over. Data centers now constitute 18% of all manufacturing structures, and this share is expected to increase slightly. The rest of manufacturing is anticipated to enter a strong period due to foreign direct investment and incentivized capital spending. The trade balance has improved, but this is partly due to a drop in imports following tariff implementation. A trade deficit is viewed not as inherently bad but as the other side of a capital surplus, and significant foreign direct investment is expected to lead to increased imports.

Market Indicators and Global Sentiment

The US dollar's performance against 26 countries (trade-weighted) does not show the collapse seen in other metrics, suggesting a more nuanced picture than some headlines indicate. S&P 500 earnings per share expectations for the next 12 months are rising, partly due to the dollar's impact on multinationals and corporations' efforts to boost productivity through innovation. Commodity prices have been relatively flat, with recent low volatility despite policy uncertainties. The metals to gold ratio suggests underlying issues, possibly a deflationary bust in China, though this is debated. Gold and Bitcoin have both performed strongly, seen by some as hedges against fiat currency debasement. Geopolitical risks, tariffs, and visa programs are contributing to a sense of fear and a desire for hedging. The S&P 500 relative to crude oil is trending upwards, suggesting a positive outlook, unlike the 1970s. The 10-year Treasury yield is levitating, potentially due to foreign investors reducing US exposure, but is expected to decline if economic expansion materializes. High-yield spreads are low, indicating minimal risk, though concerns exist regarding private credit and private equity in leveraged, mature companies. The uptrend of Bitcoin relative to gold has not been broken, and both are seen as plays on fiat currency debasement.

China's Economic Trajectory

There is a cautious return to investing in China, focusing on AI and autonomous mobility. This shift follows a period of withdrawal due to government policies. A key indicator of change was President Xi Jinping's pivot from "common prosperity" to "new productive forces," emphasizing technology. China is making strides in robotics and is building its capabilities in other tech sectors, potentially importing talent. The concern is whether China will commoditize everything and eliminate margins. Recent statements from Chinese leadership suggest a move away from "anti-involution" and a focus on preventing destructive internal competition, particularly in the EV sector, to preserve industry pricing structures. The possibility of a "Nixon in China" moment, leading to a fair trade deal, is also seen as a rising probability.

Conclusion

The analysis suggests that despite widespread pessimism about the US economy, driven by headlines and drama, the underlying policies and innovations are poised to lead to positive surprises. Expectations are for higher-than-anticipated economic activity and lower-than-anticipated inflation over the next few years, driven by productivity gains and technological advancements. The government shutdown and employment data present challenges, but fiscal and monetary policies, coupled with significant tax incentives for manufacturing and rapid technological progress, are creating a foundation for a potential productivity-driven boom. The global economic landscape, particularly China's evolving economic strategy, also presents both challenges and opportunities.