Listen to Notes on the Week Ahead
The Investment Implications of a Rising Federal Deficit
In an idealized world of medical practice, you would go to the doctor, describe a few symptoms, undergo a few tests and then listen carefully to the doctor’s diagnosis, prognosis and prescription. The diagnosis might well be due to something entirely out of your control and the prescription would often be a pharmaceutical. However, very frequently, the prescription would be in the form of advice on life-style changes. In an idealized world, you would take that advice and implement it.
In the real world of medical practice, you arrive at the doctor’s office having googled your symptoms on the internet. The information, or rather misinformation, comes in two flavors – overly scary or overly reassuring. Your ailment will either lead to your quick demise or can be entirely resolved through the consumption of a magic pill. At your doctor’s office, you endure the droning on of your learned physician on the topics of diet and exercise while you impatiently wait for a prescription for the magic pill to be sent to your pharmacist. Meanwhile, in the background, the over-stretched medical industry is slowly adapting to your behavior, building facilities and hiring professionals to deal with the consequences of your inevitable health problems.
A similar narrative can be woven around the topic of our federal finances. Few issues appear to haunt American investors more than the rising federal deficit. However, there is massive misunderstanding of what is causing it and what it is likely to do to the economic and investment environment. In an ideal world, democratic representatives would enact better policies that would slowly fix the problem and we would only elect people who would do so. However, assuming that such a political nirvana is not around the corner, investors need to adapt their strategy to the implications of a rising federal deficit.
The Short-Term Deficit Outlook
The current fiscal year ends this Saturday and we now expect the federal government to run a deficit of over $1.7 trillion, or roughly 6.5% of GDP. The federal debt in the hands of the public, (that is money owed by the federal government to investors and the Federal Reserve but excluding money owed to federal trust funds), should amount to roughly $26.2 trillion, or 98.1% of GDP.
These are ugly numbers. They are up from a deficit of 5.5% of GDP and a debt of 97.1% of GDP in fiscal 2022. Moreover, they are likely to get worse. We expect the government to run a deficit of almost $2.0 trillion in the upcoming fiscal year with the debt-to-GDP ratio rising to 100.6% and with both numbers rising steadily in the years that follow. Moreover, this is all occurring at a time when the unemployment rate has been below 4% for the best part of two years. Any recession, war or national crisis is quite capable of triggering a further lurch upwards in our debt and deficit numbers.
Before thinking about the investment implications of this swelling ocean of red ink, it’s worth taking a look at some short-run and long-run deficit dynamics.
A good starting point for this analysis is fiscal 2019. In that fiscal year, which ran from October 2018 to September 2019, the unemployment rate averaged 3.7%, the average interest rate paid on government debt was 2.5%, holding the net interest cost of funding the federal debt to a modest $376 billion, and the Federal Reserve provided the federal government with $53 billion in profits to defray interest costs. Even with this, the federal deficit amounted to $984 billion, or 4.7% of GDP and the debt at the end of the year was $16.8 trillion or 79.8% of GDP.
This is important to bear in mind since it confirms that the U.S. government was running a heavy structural deficit before the pandemic. At the turn of the century, in fiscal 2000, the federal government ran a surplus of $236 billion and ended the year with debt of $3.4 trillion or 33.7% of GDP. From then on, however, the federal finances deteriorated, partly because of higher spending on mandatory programs but mostly due the impact of three major tax cuts, two recessions and the cost of fighting wars in the Middle East, none of which was paid for.
The pandemic recession and the federal response to it caused a further surge in red ink, with deficits of $3.1 trillion and $2.8 trillion being experienced in fiscal 2020 and fiscal 2021 respectively. In fiscal 2022, the deficit fell sharply to under $1.4 trillion, despite an accounting entry of $379 billion for the President’s proposed partial write-off of student debt. This fiscal year, despite a $330 billion credit due to the Supreme Court’s rejection of this plan, the deficit appears to have soared to over $1.7 trillion.
The primary deficit for this fiscal year, that is the deficit excluding net interest costs, is likely to come in at just over $1 trillion or about 3.9% of GDP, compared to a primary deficit of 3.6% in fiscal 2022 and 2.9% in fiscal 2019. Removing the impact of Federal Reserve payments to the federal government and the accounting adjustments for student loans gives primary deficits as a share of GDP of 3.1% in fiscal 2019, 2.5% in fiscal 2022 and 5.1% in fiscal 2023. While not as dramatic as the overall deficit problem, the primary deficit problem is continuing to grow.
The Long-Term Deficit Outlook
This will probably worsen further in the years ahead. Congressional Budget Office forecasts, released in May of 20231, projected a drop in the deficit in fiscal 2026 assuming the 2017 tax cuts were allowed to expire on schedule. However, in the likely event that they are extended2, and partially adjusting for the overshoot on both the primary deficit and interest payments in fiscal 2022, both the deficit and the debt-to-GDP ratio are likely to trend higher. In 2019, the prospect of trillion dollar deficits stretched out as far as the eye could see. Today, the prospect is for two trillion dollar deficits turning into three and a half trillion dollar deficits by 2033. Meanwhile, under this scenario, the federal debt would grow from just over 100% of GDP in fiscal 2024 to 133% of GDP by fiscal 2033.
Impacts on the Economy and Markets
From an economic perspective, this would provide very little net stimulus to the economy. Broadly speaking, the economy experiences fiscal stimulus when the primary deficit rises as a share of the economy and fiscal drag as it shrinks. However, in this scenario, even as the debt climbed relative to the size of the economy, the primary deficit would be relatively stable at between 4% and 5% of GDP.
Moreover, higher real interest rates caused by the federal deficit could drag on the economy.
During the pandemic, the impact of federal deficits on market interest rates was offset by massive Federal Reserve buying of Treasuries. The largest amount of borrowing from capital markets outside of the Fed prior to the pandemic was $1.2 trillion in both 2018 and 2019. This jumped to $1.9 trillion in fiscal 2020. However, finding buyers for Treasuries in the midst of a global recession is not difficult. This measure then fell in fiscal 2021 before rebounding to $1.7 trillion in fiscal 2022 and, we estimate, $2.5 trillion in the current fiscal year and $2.7 trillion in fiscal 2024.
This is a huge ask of global capital markets. While commentators frequently ascribe the recent rise in Treasury yields to rising optimism on economic growth and fears that inflation will not fall fast enough for the Fed, the sheer volume of both current and expected Treasury supply is likely also playing a role.
Of course, these higher interest rates are applying some braking pressure to the economy. Recent housing data have turned softer and the rising cost of financing will likely hamper both vehicle sales and small business borrowing going forward. We still expect inflation to moderate to the Fed’s 2% objective by the end of next year and, if this is accompanied by a slide into recession, long-term interest rates will likely decline. However, investors should only expect a modest capital gain if this occurs. While the 10-year Treasury yield could fall from 4.5% to 3.5% or even 3.0% in the event of a mild recession, huge Treasury borrowing may limit any further decline and cause rates to move higher as the economy begins to revive.
For investors, this suggests that while Treasury bonds can continue to provide solid income and some insurance against recession, their ability to provide strong capital gains in the medium term is likely limited. Moreover, while we are still likely very far from a point where long-term interest rates would spike or the dollar crash due to a global loss of faith in Treasury debt, that risk is growing, particularly if some future administration tries to strong-arm the Federal Reserve into re-expanding its balance sheet to help alleviate the pressure. This continues to add to the case for international diversification in portfolios.
The Week Ahead
There will, of course, be plenty of talk about the federal deficit in the week ahead, as a standoff in Washington threatens the nation with another government shutdown. However, it is very unlikely that any of this talk or any eventual compromise will change the trajectory of the federal budget. The reality is that politicians won’t cut Social Security, Medicare, Medicaid or Defense and won’t raise taxes because, if they did, they wouldn’t get reelected. Even a cursory glance at the budget shows that it will be impossible to alter the basic path of debt and deficits without taking one of these steps.
A government shutdown, and/or a widening of UAW strikes could further reduce economic momentum heading into the fourth quarter. Investors will be keeping a close eye on this in the week ahead, as well as economic indicators including consumer confidence on Tuesday, durable goods orders on Wednesday and unemployment claims on Thursday.
Finally, economists will be reassessing the recent behavior of the economy with the Bureau of Economic Analysis producing revised GDP data for the past decade on Thursday and Friday. This will tell us a lot about the depth of the pandemic recession and the strength of the recovery both in output and productivity. However, it is unlikely to change the short-term outlook for slowing growth and inflation or the need for investors to position themselves for the prospect of a further worsening of the public finances in the years ahead.
1 See An Update to the Budget Outlook: 2023 to 2033, CBO May 12th, 2023
2 See Budgetary Outcomes Under Alternative Assumptions About Spending and Revenues, CBO May 16th 2023
Start every week by listening or reading commentary on the markets and economy to help you stay informed for the week ahead.
Dr. David Kelly
Chief Global Strategist