“500 million dollars here, a billion dollars there, soon you’re talking about real money.”
Senator Everett Dirksen, late 1960s
Earlier this year, I read a commentary about deficit spending. The author noted that the US government was projected to spend $1.6 trillion more than our revenue in fiscal 2020, during peacetime and despite a growing economy. He warned of the dangers. Imagine if the Feds had to respond to a genuine crisis. Why, the deficit might exceed $2 trillion per year!
What a difference a few months and the spread of a tiny microbe makes. The Treasury announced yesterday that it expects to borrow $2.99 trillion this quarter. As of March 31, 2020 total US Treasury debt equaled more than $23 trillion. Total deficit spending in fiscal 2020 looks sure to exceed $4 trillion this year, which will raise our debt to at least $25 trillion.
Should we be worried? Absolutely, possibly, and probably not. It depends of what lens we’re looking through. Let’s unpack this a bit, starting with the most optimistic case.
Why should we worry? The dollar is the world’s reserve currency and we have no trouble financing our borrowing at low rates. Deficit spending to lessen the brutal impact of a once-in-a-century pandemic is clearly well within the government’s necessary role as understood by most economists across the political spectrum. The CARES Act provides support both for the financial security of ordinary Americans (tax rebates, unemployment insurance supplements) and for businesses. (Though most of the benefits of the Paycheck Protection Program have gone to mega-businesses, not mom-and-pops on Main Street.) Interest rates are historically low (0.70% on the ten-year Treasury), and thus borrowing costs well below our trend rate of GDP growth. This means that, absent annual deficits, the size of our national debt compared to our annual GDP will decline over time. We can afford both this year’s deficit and our overall debt.
Or should we maybe worry? After all, the US doesn’t balance its federal budget under normal conditions. Quite the contrary. We’ve run an annual deficit every year since fiscal 2001, and it has recently grown larger in relation to our national income. So debt to GDP won’t decline gradually, it will grow inexorably even during peacetime and even if the economy recovers and then resumes growing. (No guarantees there.) Neither party in Congress has any stomach for constraining spending. Clearly the Trump administration cares nothing about the size of the deficit, or anything else beyond the election on November 5??. So the trend is likely to be one of growing debt-to-GDP ratio, with a likewise growing share of the Federal budget devoted to interest costs. Combined with the already growing real costs of entitlement programs for older Americans, this means the discretionary budget for everything else, including public health, education, military spending, basic research, and so on, becomes ever-smaller. We will no longer be able to keep either ourselves or the world safe, from dangers from microbes to terrorists to rogue states, and in the long run that’s a huge problem.
And that’s the “maybe worry” case. Here’s why we should absolutely worry. The need for financing an unprecedented level of government debt is immediate and urgent, not long-term and theoretical, and it is not limited to the United States. The huge demand for borrowing will potentially put upward pressure on interest rates, which in turn would drive down bond prices. On the other hand, monetary stimulus may trigger inflation. Further, the demand for government credit is likely to cripple the availability of borrowing to a private sector that is already highly leveraged. Sub-investment grade credit spreads (the premium over Treasury rates) have risen between 3.5% and almost 7% this year. Rates on oil patch debt, for example, are now above 13%. In the long run, risk is risk. Lower prices on debt risk assets (high yield bonds) will lead to lower prices on equity risk assets (common stocks).
What are the implications for us as investors?
Investment grade bonds as an asset class, unless short-term, offer a poor risk/reward trade-off. Rising rates would be negative for bonds, and the room for rates to rise is an order of magnitude higher than for rates to fall. Quality bonds are radioactive.
On the other hand, the returns of lower-quality bonds have surged. Those willing to lend to riskier corporations are getting paid much more than they were even three months ago. High yield bonds are not part of our target portfolios, though some of our active managers do look for opportunities in such bonds.
The flood of free money into the financial markets has buoyed equity prices. We’re now up more than 25% from the March 23 low, and stocks are trading at prices similar to summer of 2019. Yet corporate earnings are likely to fall by 25% or more, and remain depressed for a year or longer. Does the stock market’s valuation really reflect much lower earnings and much higher risk and uncertainty about all aspects of economic reality?
Overall, we observe that markets are narrowly focused on the most optimistic scenarios for both the pandemic and the economy. We believe the chance of a more difficult set of outcomes is real. We remain cautious and retain a dynamic cash position.