Market Update - September 2023 | |
There is a lot of fear surrounding the national debt. After all, it seems to grow larger every single year without fail. But is it big enough to jeopardize the country? Let's look at the data and draw our own conclusions. | |
- Markets fell across the board as labor market strength implied Fed rate cuts are far into the future.
- The bond market is trying to put in a bottom as inflation continues to slowly ebb.
- The equity market appears to have peaked for now as investors digest the interest rate situation and its implications for economic growth going forward.
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Table 1: Market performance estimate as of 8/31/2023 (LIMW) | |
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Nearly every key asset class declined during the month of August. Energy stocks rallied and inventories fell, while every other sector in the S&P 500 fell. Utilities and Consumer Staples sectors did poorly and we used this weakness to increase exposure in our portfolios. Small cap and emerging market stocks declined dramatically.
There is a serious economic slowdown developing in Europe, Japan and China. Manufacturing economies like these are very cyclical and susceptible to high interest rates. Service economies like that of the USA respond slower to changes in interest rates, but there are increasing signs of a recession developing here.
Many investors were focused on the Federal Reserve's conference at Jackson Hole mid-August as they sought new insights to future Fed policy. Alas, Fed Chairman Jerome Powell reiterated the Fed's message that their focus on reducing inflation was unchanged. Many leading indicators are hinting of an imminent recession, but there are stubborn signs of inflation in the slow changing housing and labor components. What this means is that the economy must experience more pain before the Fed reduces its interest rates. There are already signs of this as earnings fall, banks fail and debt deliquencies increase.
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Why bother discussing the national debt? | |
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Debt is a tool. Used wisely, it can bridge the gap between income and spending to enhance one's circumstances. For example, many people buy cars and houses using loans and mortgages to convert a large lump-sum expense into a monthly payment that is affordable. Used unwisely, it leads to constantly increasing debt that eventually falls into default. Think about someone using a credit card to pay for living expenses. Because of the high interest rate, this is not a long-term solution for anyone.
It is this last case that worries people about our national debt. It is clear we as a nation borrow money to pay for ongoing expenses. The question is whether this is sustainable in the new higher-for-longer interest rate environment.
Taxpayers fear this gets resolved with tax increases, program cuts or sustained inflation. Investors fear higher taxes that cut company earnings power or an erosion of interest income value from inflation.
Many people own bonds in their portfolio and are rightly fearful of how our government manages money. This analysis is primarily focused on the debt situation over the next few years and how it will affect the outlook for bonds as an investment.
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Total debt levels over time | |
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Total US government debt has increased dramatically over the years, with most of the change occurring in recent decades. Here is a simple chart of our national debt over the last 20 years denominated in trillions of US Dollars (2024 and 2025 are forecasts). The problem of rising debt has been decades in the making; the pandemic just aggravated the problem.
Figure 1: Total government debt over last 20 years (LIWM, Chris Chantrill)
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Where do deficits come from? | |
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Where do budget deficits come from? The math is very simple. When spending exceeds revenue, the government borrows money to fill in the difference.
Most revenue comes from payroll and individual income taxes. The middle class pays the bulk of the tax burden. Social security and health care consume a large portion of the budget. These are non-discretionary budget items that get funded without debate.
Figure 2: Where do deficits come from? (LIWM)
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Spending consistently exceeds revenue
Except for one brief period during the Clinton presidency, spending typically exceeds revenue. Depending on the economy, it can be a small or big difference. In the next two figures, I show the key revenue and spending amounts for the federal, state and local governments for 2022 and 2023.
The deficit is merely the mathematical difference between revenue and spending.
Figure 3: Total revenue in trillions of dollars (Chris Chantrill)
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Figure 4: Total spending in trillions dollars (Chris Chantrill) | |
Large deficits are forecast for many years | |
Low growth, high inflation and high interest rates mean our budget deficits will grow for many years. Long-term, the current rate of spending is unsustainable, but for the next 5-10 years, it is manageable. | |
Figure 5: Expected Federal deficits over the next 5 years (Chris Chantrill) | |
It is not as bad as it looks | |
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It is depressing to look at these numbers and comprehend the size of the debt. However, you have to remember that the economy has grown along with the debt and government revenue has grown alongside spending.
Let's look at these key variables as a percentage of GDP. That will give us a chance to see how they have changed relative to the economy over the last 100+ years.
Figure 5 shows that revenue as a percentage of GDP, grew steadily from 1900-2000 before leveling off.
Figure 6: Revenue as % of GDP 1900-2024e. Recessions of 2000, 2008 and 2020 annotated. Federal, State, Local (LIWM, Chris Chantrill)
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Similarly, spending as a percentage of GDP rose 1900-1990 before leveling out. Note the spikes in spending during WW1, WW2, 2008 and 2020. Even with the increased outlays from recent legislation, overall forecast spending is not too far off the historical norm.
Figure 7: Spending as % of GDP 1900-2024e (LIWM, Chris Chantrill)
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Revenue - Spending = Deficit | |
If we look at the deficit as a percentage of GDP, the results are much less alarming. There were hugh increases in deficit spending for WW1 and WW2, but as a percentage of GDP, today's deficits seem more manageable. The size of government stimulus during the 2008 and 2020 recessions is a new development compared to the experience of 1900-2000. | |
Figure 8: Total deficit as % GDP 199-2024e (LIWM, Chris Chantrill) | |
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So far, the spending, revenue and deficit numbers seem manageable as a percentage of GDP. What this means is that theoretically, the economy can safely carry the change in debt. This is analogous to carrying more debt as your salary increases; as long as you keep making more money, there is no problem servicing the debt.
Unfortunately, we are in a new inflation and interest rate regime. The government must borrow at a market rate of interest, just as we all do. The Fed's current interest rate policy and bond market pricing means that the interest on the national debt will increase substantially over the next few years.
Historically, this all happened before during the late 1970s and 1980s. You can see down below interest expense as a percentage of GDP rose to 4% at one point during the 1990s as the Fed kept rates high to suppress the inflation built up during the 1970s.
Based on current forecasts, we do not expect interest expense on the national debt to be a devastating blow to the country over the next few years. That doesn't mean we have to like it, but we can survive it.
Figure 9: Government interest expense as % GDP. Federal, State, Local (LIWM, Chris Chantrill)
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Long-term this is unsustainable | |
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The Congressional Budget Office (CBO) has done an excellent job summarizing this situation. Their long-term assumptions are fairly reasonable and realistic: low growth, high inflation and high interest rates for many years. (CBO 2022 Long-Term Budget Outlook)
The problem is that interest on debt compounds, meaning it grows every year. Borrowing money to pay off prior debts implies the current budget arrangement cannot last forever. At some point the net increase in debt must stop or at least stabilize. Historically, this has happened during periods of economic growth.
Figure 10: Long-term deficits situation with debt induced from interest expense separated from the primary budget deficit (CBO)
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Current market commentary | |
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The bond market continues to muddle along close to its multi-year low. Bond investors are focused on growth and inflation. Good economic growth usually means high inflation; high inflation is a bad environment for bonds.
Our view is that the slowing economy will reduce inflation pressures creating a good fundamental platform for rising bond prices. It appears the bond market just re-tested its October 2022 low, a potential positive sign. We don't expect zero percent interest rates this cycle, but it is conceivable falling rates induce a 8-13% rally in the underlying bonds.
Figure 11: Key bond market sector performance from the 2017 (LIWM)
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The equity market was weak in August as hopes that the Fed would begin cutting rates were pushed further into 2024. The Fed has stated they are focused on the inflation problem, not growth or labor. This implies higher interest rates for longer. In the meantime, the news on the economy continues to indicated weakness: earnings, revenue, credit and labor and all trending lower. Remember, this is what the Fed wants.
The stark difference in outlook between bond and stock market investors is contradictory, but not without precedent. There were similar situations in 1999 and 2006 when interest rates rose, the economy appeared to be resilient, only to fall into recession as higher interest rates changed the financial landscape. As in other cycles, banks are curtailing lending and business models built around low interest rates are failing. This may eventually translate into lower consumer spending, weaker earnings and falling stock prices.
Figure 12: Current equity market situation over the last 12 months (LIWM)
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We enjoy discussing our research and how it relates to our investment strategies. Feel free to give us a call. It is important to consider your allocation if you are overweight stocks; the market is giving you a "graceful" opportunity to rebalance and prepare for our next recession.
We look forward to hearing from you!
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Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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