Apparently, the hard-working analysts at the Congressional Budget Office threw in the towel on Friday afternoon. They were scheduled to release their estimates of the budget deficit for July but, late in the day, the CBO website announced that the numbers would be coming out today instead.
It’s hard to blame them. Balancing the national checkbook is challenging at the best of times and, no doubt, the pandemic is complicating their operations. Added to this, they have to incorporate the impacts of the numerous fiscal measures already enacted to reduce the severity of the recession. They may also have wanted to put in a long weekend before adding the effects of the next coronavirus relief bill to their bulging spreadsheets.
We do still believe that such a bill will be forthcoming in the next week or two.
Negotiations appeared to break down late last week and the President announced executive actions on some of the contentious issues. However, for all practical purposes, the President does not have the authority to cut taxes or increase spending without the consent of Congress and the stop gap measures announced over the weekend will need to be replaced by a more comprehensive bill.
We continue to believe that this bill will include a partial extension of enhanced unemployment benefits, further one-time checks to taxpayers, some more money for state and local governments, some legal protection for businesses reopening during the pandemic and a continuation of moratoriums on evictions and foreclosures on properties with at least partial federal financing. The total cost of the measure will likely be between $1 and $2 trillion, on top of the roughly $2.4 trillion already approved for coronavirus relief. In addition, after the election, a further fiscal support measure is likely, likely costing a further $1 to $2 trillion, until, hopefully, the need for such relief diminishes in 2021 with the widespread distribution of a vaccine.
Most investors, and, for that matter, most Americans, are focused on the timetable for getting past the pandemic and returning to normality. However, it is important to recognize the further major damage that this recession and relief measures are inflicting on the public finances and consider the implications of that damage for investing going forward.
In broad numbers, in fiscal 2019, which ended on September 30th of last year, the federal government ran a deficit of $984 billion, or 4.6% of GDP. It should be emphasized that this implies a very serious structural budget deficit, even before the pandemic, since the economy was essentially at full employment in the 11th year of expansion. The federal debt in the hands of the public at that time was $16.8 trillion, or 79.2% of GDP.
We now expect deficits of roughly $3.5 trillion in fiscal 2020 and $3.0 trillion in fiscal 2021, bringing the debt to $23.3 trillion or 106.5% of GDP by September 30th, 2021, just below the 108.2% of GDP peak reached in 1946 as the U.S. government faced the colossal debt racked up in fighting World War II.
Many worry that this level of debt will result in a fiscal crisis.
It doesn’t have to – provided that, once the pandemic is over, the federal government acts with discipline, the Federal Reserve maintains a relatively dovish stance and inflation remains low.
In rough numbers, in the decade starting in fiscal 2022, if the U.S. was able to achieve about 5% annual nominal GDP growth, if the federal budget deficit was held to no more than $1 trillion per year, and if interest rates on the federal debt stayed at the roughly 2% level that prevailed in 2019, the debt to GDP ratio would fall from 106.5% in fiscal 2021 to 93.3% in fiscal 2031. This improvement, while still not getting us anywhere close to our position of 10 months ago, might be sufficient to sustain the confidence of global investors in both U.S. government debt and the value of the dollar.
However, there are a number of difficult “ifs” in that statement.
First, achieving 5% nominal GDP growth would be no mean feat, once the economy had regained most of the job losses from the pandemic. In practice, it would mean achieving 3% real GDP growth, since it is hardly likely that a 2% interest rate on government debt could be sustained for long in an environment of more than 2% inflation. However, this, in turn, would require much stronger labor force growth than seems likely given the continuing retirement of the baby boom and recent declines in immigration. Comprehensive immigration reform that actually boosted the number of skilled immigrants entering the United States would seem to be a prerequisite for achieving that 3% real GDP target.
Second, holding the budget deficit to $1 trillion a year would also not be easy. Even at a 2% interest rate, interest costs on the national debt would rise from $350 billion last fiscal year to an average of almost $600 billion per year over the next decade, accounting for roughly half the budget deficit, and requiring the Administration and Congress to come very close to achieving balance between revenues and other spending.
Finally, a benign outcome would need the Federal Reserve to maintain very low short-term interest rates throughout the decade. This, in turn, would require a certain amount of luck on inflation and the dollar, as any spike in the former or plunge in the latter would make it very difficult to sustain such a policy.
Unfortunately, it is quite possible to predict a less benign outcome.
If nominal GDP growth was just 4% per year, federal deficits averaged $2 trillion per year and the average interest rate on government debt was 4%, the debt-to-GDP ratio would surge to 133.6%. Moreover, the annual interest cost on servicing that debt would balloon to $1.7 trillion in 2031, requiring an even tighter fiscal policy at the end of the decade than under the more benign scenario.
These are very serious issues for the Federal Government, the Federal Reserve and for investors.
For the Federal Government, it is imperative that, as the economy recovers from the pandemic, it has the discipline to reduce the federal deficit. This will require both reductions in the growth in spending and increases in taxes and will be necessary, not just to control the growth in debt, but also to make sure that the economy does not overheat as it once again approaches full employment. It will also be essential to adopt measures designed to increase the pace of long-term economic growth, including encouraging private investment and growth in the skilled labor force.
For the Federal Reserve, it will require a reassertion of independence. Jay Powell and his predecessors have normally, and correctly, eschewed providing advice on fiscal matters, leaving the details of taxation and spending to elected officials. However, it is important for the Fed not to be perennially seen as “the lender of first resort” to the Federal Government, a role which it has adopted in this pandemic recession. If politicians see it as so, then they will always assume that the consequences of reckless fiscal policies can be delayed until after the next election - which is a recipe for disaster. While the Fed does not need to push against unrestrained fiscal expansion, it does not need to enable it either.
For investors, while it is nice to be positioned to take advantage of a best-case scenario and important to be protected against a worst-case scenario, it is crucial to see the most probable path with clarity. That probable path, in the aftermath of the pandemic, is one of somewhat higher inflation, somewhat tighter monetary policy and somewhat higher taxes. Moreover, these challenges may present themselves sequentially.
Higher inflation could come first and, on its own, would tend to be a negative for cash and bonds, neutral for equities and positive for real assets.
A tighter Fed, in response to higher inflation, should hurt the bond market more while the generally higher interest rate environment it would create should be most damaging to equities selling at high multiples of current earnings and thus with more of their value embedded in cash flows to be received far into the future.
Higher interest rates would, of course, further undermine the federal finances and would likely lead to higher taxes. Given the current preferential treatment of stocks in the U.S. tax code, higher taxes could be most damaging to equity returns.
A logical investment strategy to meet these challenges would seem to favor both real assets and stocks trading at low earnings multiples both in the U.S. and overseas. And this is particularly important to recognize in the midst of the pandemic, as financial markets have tended in the opposite direction so far this year.
It would be nice to believe that we will elect politicians with both the intelligence and the backbone to tighten fiscal policy once the pandemic has released its icy grip on the U.S. economy. However, in case we don’t, it is important for investors to be prepared for the consequences of an unrestrained surge in federal debt.