The Perils of Ballooning Deficits

Transcription

1 The Perils of Ballooning Deficits September 11, 2009 Northern Trust Global Investments 50 South La Salle Street Chicago, Illinois northerntrust.com James D. McDonald Chief Investment Strategist Daniel J. Phillips Investment Analyst The global financial crisis has led to vast deterioration in government budgets, with the International Monetary Fund (IMF) estimating G-20 fiscal deficits in 2009 and 2010 at 5.5% of gross domestic product (GDP) above their pre-crisis levels. Around one-third of this increase is due to crisis-related expenditures, with the remainder cyclically driven. This is expected to lead to a surge in debt ratios of the G-20 countries of about 40 percentage points by 2014, a level not experienced since World War II. The ballooning deficit projections are being driven by a combination of cyclical pressures and secular problems, ranging from the loss of tax revenue during the recession to the looming crisis of health care and social security entitlement commitments. Yet the near-term impact on economic growth and the markets has so far been mild; while the dollar has been weakening, it has supported exports and can be helpful to long-term rebalancing of global growth. To properly manage the deficit levels going forward, countries need to articulate their plans to restore fiscal solvency after the current efforts to restore economic growth gain traction. Otherwise, the negative implications for economic growth, interest rates and currencies can be substantial. Chart 1 Source: Congressional Budget Office, The Budget and Economic Outlook: An Update, August 25, 2009.

2 Causes Investors have known for years about the looming deficit problems tied to the healthcare and social security entitlement programs: the new prescription drug benefit plan (Medicare Part D); President Bush s tax cuts; and the wars in Iraq and Afghanistan. So while the tipping point associated with healthcare and social security expenditures has moved closer, it isn t unexpected news. What has exacerbated the problem is a combination of current cyclical pressures on tax receipts in the wake of the global financial crisis, and an undisciplined spending environment in Washington, D.C. The cyclical downturn we are experiencing is far worse than normal, and the magnitude of the global financial crisis has increased (and will continue increasing) the debt burden outstanding. Reinhart and Rogoff, in their 2008 paper, The Aftermath of Financial Crises, demonstrates that a significant deterioration in government finances should be expected in the wake of a financial crisis, as this has been the case for more than a century. The explosion in debt issuance, which averaged 86% over a three-year period, is a result of tumbling tax receipts in combination with government stimulus spending. You will not be proud to learn that the United States will clearly join this club with our performance this decade. Noting the $5.035 trillion debt held by the public at the end of 2007, the Congressional Budget Office (CBO) estimates an increase of 76% by the end of 2010 and 94% by the end of Chart 2 Source: Reinhart and Rogoff, The Aftermath of Financial Crises, December 19, Beyond the effects of this cycle, we face the issue of entitlement spending within our aging population. And this is not just an issue for the United States, as the populations in many developed countries are aging. According to the European Commission s recent Ageing Report, current pension, health care and long-term care spending in the European Union is 2

3 expected to grow by about 1.9% of GDP over the period , and a further 2.9% of GDP from In the United States, Medicare and social security expenses, when measured as a percent of nominal GDP, are expected to more than double between now and 2050! With expected increases in Medicare representing the lion s share of this growth, health care reform is essential. Unfortunately, the current debate in Washington seems more focused on the expansion of coverage (certainly a worthy goal) than on reducing costs. Until there is serious legislative reform aimed at reducing the growth of Medicare spending, this will remain a considerable budgetary problem. Chart 3 ENTITLEMENT PROGRAMS AS A % OF NOMINAL GDP Medicare/Medicaid Social Security 20% 15% 10% 5% % Source: Congressional Budget Office. Investment Implications of Ballooning Deficits Rapidly rising deficits raise the risk of inflationary pressures, rising interest rates, currency weakness and reduced economic growth. There is disagreement within the economic community about the certainty of the crowding out effect where increased borrowing by the federal government crowds out the ability of private borrowers, which then lowers economic growth and the standard of living. A review of the relationship between real longterm interest rates and the budget deficit does find a correlation of 0.40 meaning that real interest rates have tended to rise when the federal budget worsens. 3

4 Chart 4-10 THE BUDGET DEFICIT/SURPLUS (% OF GDP) VS REAL INTEREST RATES - % Budget Deficit/Surplus as a % of GDP (Left Axis - Inverted) Real Interest Rates (Right Axis) /31/ /31/ /31/ /31/ /31/ /31/2008 Source: Bloomberg, Ned Davis. Annual data through 2008; 2009 data through June 30. International Monetary Fund (IMF) work on the impacts of deficits on interest rates and growth presents a similar, and worrisome, picture. According to their calculations, a 10 percentage point increase in government debt ratios would lead to a 0.40% increase in real interest rates and a 1.3% decline in real GDP. Considering they forecast a 25-percentage point increase in the debt/gdp ratios of the G-20 countries between 2007 and 2014, this would be a real headwind to growth. Interest Costs of the Building Deficit Interest costs on the deficit can be affected by both investor concern about the risk of inflation thereby demanding a higher interest rate and a country s ability to pay the interest without having to issue additional debt. There is also increasing concern about the cost of refinancing the current debt outstanding. Interestingly, total interest cost has only risen from $241 billion in 1998 to $253 billion in 2008, while debt held by the public during this period has increased from $3.7 trillion to $5.8 trillion. There has clearly been a benefit from a lower cost of debt; a simple calculation of the effective interest rates shows a favorable decline from 6.5% to 4.4% over this 10-year period. Table 5 shows the interest expense forecasted by the CBO over the next 10 years. In these projections, the CBO assumes a substantial increase in short rates (with the three-month Treasury bill rising in yield from 0.2% to 4.7%) and an increase in long rates (with the 10-year note yield increasing from 3.3% to 5.5%). While we think these rate increases may prove too high, they do illustrate the vulnerability we face toward rising interest rates. Based on the 4

5 CBO forecasts, interest expense is estimated to increase from $177 billion in 2009 to $722 billion in 2019, representing an increase from 1.3% to 3.4% of GDP. Chart UNITED STATES GOVERNMENT OUTLAYS - NET INTEREST COST Net Interest Cost - $Billions (Left Axis) Net Interest Cost as a % of GDP (Right Axis) Source: Congressional Budget Office. Annual data through 2008; estimates beginning in Can the dollar withstand the debt surge? The experience of the United States over the last 40 years shows that the dollar has a clear tendency to weaken during periods of budget deterioration. During the periods where our budget deficit was improving (52% of the time), the dollar gained an annualized 1.1% based on the Dollar Index. In the period where the budget deficit was worsening (48% of the time), the dollar fell at a 3.3% annualized rate. The ability of the United States to finance its deficits has benefited tremendously from the dollar s status as the reserve currency. While there is much discussion about the need for an alternative reserve currency, the practical reality is that there really aren t viable alternatives on the near-term horizon. The Euro may take an increasing role in diversified foreign currency reserve portfolios due to the size of its economy, but the demographic and political outlooks for Europe don t best those for the United States. The Japanese yen seems to benefit primarily from the relative steady state (or slow pace of change) in the Japanese economy and political process over the last 10 years. But the demographic and economic challenges facing the Japanese economy have finally led to a change in political party power. It remains to be seen whether the newly elected Democratic Party of Japan, which unseated the Liberal Democratic Party after ruling for all but one of the last 54 years, will materially change the bureaucratic nature of Japanese politics. 5

6 Chart DOLLAR VS THE BUDGET DEFICIT/SURPLUS Budget Deficit/Surplus - $Billions (Left Axis) Dollar Index (Right Axis) /31/ /31/ /31/ /31/ /31/ /31/2008 Source: Bloomberg, Ned Davis. There is also a risk that the process of global central banks unwinding their various stimulus programs will precipitate higher interest rates earlier in countries other than the United States, leading to strength in those currencies and corresponding weakness in the U.S. dollar. Unquestionably, the role of the United States as the primary driver of global growth has changed, and this will likely lead to increasing interest in investing in assets outside the United States. This trend, along with the projected U.S. budget deficits, leads us to conclude that the dollar is likely to continue to depreciate, but at a measured pace. To the extent it can be managed by the key parties involved, orderly currency revaluations are strongly desired. Certainly the Chinese and Japanese governments don t want to see their positions in U.S. Treasuries hurt by dramatic dollar weakness (with a resulting strength likely in their currencies). Which are the rich countries? Due to both improved economic performance and a change in policies after the emerging market debt crises of the last 20 years, the fiscal positions of emerging market countries have improved markedly. Starting in 2003, the collective debt position of the emerging market countries (as a percentage of GDP) has improved relative to the advanced economies. In this analysis, the advanced countries include the usual suspects (the United States, Japan and economies in Western Europe) while the emerging economies are Brazil, India, Indonesia, Hungary, Russia and Saudi Arabia. This improved fiscal position has been one of the drivers of the relative outperformance of emerging market equities over the last year. It is also an encouraging signal about the ability of the emerging economies to increasingly replace the U.S. consumer as a source of global growth over the next decade. 6

7 Chart 7 Source: Horton, Kumar and Mauro, The State of Public Finances: A Cross-Country Fiscal Monitor, July 30, Who will buy all this debt? To date, our profligate ways have been supported substantially by overseas investors who ran significant trade surpluses, experienced building currency reserves, and had an interest in managing the level of their currencies (i.e., suppressing their rise). Add that dynamic to the U.S. dollar s status as the global reserve currency, and we have easily financed our rising deficit. At the time of this writing, the U.S. Treasury continues to find great demand for its debt issuances, as reflected by successful debt auctions and low nominal interest rates. China and Japan have been very important, high-profile buyers of new debt over the last decade, and they collectively hold 21% of our debt outstanding. Chart 8 HOLDERS OF UNITED STATES PUBLIC DEBT ENTITY, NOMINAL AMOUNT ($ BILLIONS), % OF TOTAL Other Countries, 1314, 18% Federal Reserve Holdings, 657, 9% United Kingdom, 580, 8% Japan, 712, 10% Other Domestic Holdings, 3136, 44% China, 776, 11% Source: Bloomberg, Federal Reserve. Data as of June 30,

8 If the U.S. savings rate continues to rise over the next 10 years, domestic investors likely will be increasing buyers of U.S. debt. As Chart 9 shows, the U.S. savings rate currently sits at around 4% (it did spike to 6% earlier this summer), but is well below the average of 6.7% of the last 35 years. If you assume that the United States returns to an 8% savings rate over the next five years, as Baby Boomers try to rebuild some of their lost wealth from the housing and stock market downturns, there likely will be increased domestic purchases of Treasuries. Each 1% increase in the savings rate equates to roughly $100 billion in investment power and if you assume a conservative 50/50 mix between stocks and bonds, the move to an 8% savings rate would create $200 billion in incremental, annual buying power. Some of this bond allocation will undoubtedly go to municipals, and the remainder will be helpful, but not sufficient, to cover increasing issuance. Therefore, it looks likely that we will remain hostage to foreign capital flows. Chart 9 US PERSONAL SAVINGS RATE AS A % OF DISPOSABLE INCOME /31/ /31/ /31/ /31/ /31/ /31/ /31/ Source: Bloomberg. Annual data through 2008; 2009 data through July 31. What is the way forward? An IMF study from March 2009, The State of Public Finances: Outlook and Medium-Term Policies After the 2008 Crisis, concluded that a rise in government debt levels caused by a financial crisis doesn t, by itself, have to lead to serious solvency problems. The real key is that the governments demonstrate understanding of the problem and show the markets a path toward improvement. The esteemed economist Woody Brock reaches a similar point with his conclusion that the initial jump in debt outstanding after a crisis isn t usually catastrophic, it is whether the debt continues to climb in subsequent years. With the important focus on debt levels as a percentage of GDP, the key levers will include reduced spending growth and 8

9 increased revenue through tax receipts, hopefully through increased growth and not just higher marginal rates. There are reasons to be concerned about government s path forward, as highly visible episodes in Germany and Japan in the first half of the last century resulted in hyperinflationary environments. Yet of the 12 major episodes of major debt accumulations and reductions found by the IMF since 1795, these were the only two solved solely by hyperinflation. The other debt accumulations were solved through some combination of economic growth, fiscal adjustments and inflation. There are also reasons to be humble about our ability to reasonably forecast budget deficits over a 10-year period. A somewhat extreme, but relatively recent, example occurred in the 1990s when expectations of increasing deficits in January 1997 turned to forecasts of major surpluses by July This seems to principally reflect the bias of near-term news as the budgetary picture for started to improve significantly, those trends were extrapolated over the forecast period. The forecasted 2009 budget surplus of $400 billion, made in July 1999, was only $859 billion off from the eventual deficit of $459 billion! Chart 10 Source: Federal Reserve Bank of San Francisco. A true, lasting solution to our deficit problems will require changes in three main areas: entitlement reform, tax reform, and economic growth. Entitlement reform will give global investors confidence that fiscal responsibility is being demonstrated in Washington. Social security is likely easier to tackle (at least financially) through adjustments to retirement ages, 9

10 contribution rates and cost-of-living adjustments. The much larger Medicare spending problem is more nettlesome, but the current path of expanding coverage before reining in overall program growth is not being well received. Martin Feldstein, the Harvard economist, is promoting the importance of raising tax revenue by eliminating distorting deductions as opposed to increasing marginal tax rates. He asserts that abolishing the exclusion from taxable income of employer payments of health insurance premiums would increase tax revenues by $3 trillion over the next decade and also give the insured incentives to contain health care costs. Finally, growth in the overall economy will be a critical component to balancing our ability to service the debt and stabilize the debt/gdp ratio. A sensible approach to immigration policy that balances the concerns of the current populace with a welcoming administrative approach is in order. After all, economic growth comes through increases in the working population plus gains in productivity. The declining population in Japan, tied to both domestic demographics and weak immigration trends, remains a huge barrier to that nation s growth outlook. Additionally, we need to ensure that market reforms we enact in the wake of the financial crisis don t do more harm than good. A perverse bookend to the changing global growth order would be if the United States moved away from a capitalist model just as emerging nations such as India embraced it. What about our portfolios? As we review the longer-term economic outlook for the global economy, we have a base assumption that growth will be constrained by the negative impacts of increasing deficits. This leads us to favor those regions, such as emerging markets, with stronger fiscal positions, but always with an eye toward valuation. In addition to reducing the growth potential of economies of countries with high debt levels, the deficit challenges represent potential inflation and currency problems. With respect to inflation, our base case outlook calls for a manageable inflation outlook over the next five years due to overcapacity and high levels of unemployment. But we think that portfolios should have some inflation insurance in case our sanguine view on inflation proves wrong. As we reviewed in detail in a recent report, Don t Hang Up on the Inflation Insurance Salesman, a portfolio allocation to real assets commodities, real estate, and inflation protected securities may make sense. Within the real asset category, we favor those assets most directly tied to the growth in emerging markets (commodities), and are less enamored with those more tied to mature economies (real estate). Inflation-protected securities, as represented by Treasury Inflation Protected Securities (TIPS) in the United States, make sense as a portion of a bond portfolio to provide the typical safety of a government bond with the additional benefit of insurance against unexpected inflation, which tend to hurt traditional government bond holdings. Our current expectation is that the increase in savings occurring in the United States, along with relatively tepid growth, will lead to a benign interest rate environment. Therefore, there is no need to significantly underweight government bonds today. However, we are making the 10

11 first moves to pare exposure here, as current interest rate levels provide little cushion for an unexpected deterioration in the inflation or fiscal position. When analyzing the negative impact of the rising deficit on the U.S. dollar, we focus on both the economic impact as well as the implications for investment program management. From the economic impact angle, a continued moderate decline in the dollar could actually be a positive economic event. We have been importing too much over the last 20 years in both goods and capital, and the global economy is in transition toward a more-balanced growth picture, with reduced U.S. imports and increased exports. A more competitive currency would help in that rebalancing, but the risk is a dollar crash that would stoke inflation and lead to a jump in interest rates. We addressed the investment program management implications of dollar weakness earlier in the year in a report entitled Stop Worrying about the Dollar! Its key message was that many U.S.-based investors overstate their vulnerability to dollar weakness, since there is probably a small imbalance between the currencies of their assets (investments) and liabilities (debts and spending patterns). In fact, in many cases it is more likely they are actually structurally short the dollar through allocations to international equities and commodities that may represent a greater percentage of their assets than do their non-dollar liabilities. Of course, this is a topic well suited for individual discussion with your portfolio or investment program manager. IRS CIRCULAR 230 NOTICE: To the extent that this communication or any attachment concerns tax matters, it is not intended to be used, and cannot be used by a taxpayer, for the purpose of avoiding any penalties that may be imposed by law. For more information about this notice, see LEGAL, INVESTMENT AND TAX NOTICE. Information is not intended to be and should not be construed as an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Clients should under no circumstances rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. 11