Getting the Fiscal House in Order

One of the largest issues this election cycle will be the deficit. In my opinion, it hasn’t received nearly enough attention even though it has received a good amount. The fiscal situation in this country trumps (pun intended) anything to do with the border or democracy.

The problem comes down to a fundamental shift in the last 5 years. Debt, historically, and deficits as a percentage of GDP, have fallen during peacetime and strong economic growth, and risen to war time and recession.

In the last few years, despite a strong economy and relative peace, we have continued to ramp up spending. Tax receipts have risen nearly twice the rate of inflation since 2020 and yet spending has risen nearly 3x. That is clearly an unsustainable path.

2023 Saw A Deficit ‘Perfect Storm’

The budget deficit in fiscal 2023 was a MASSIVE $2 trillion or approximately 7.5% of GDP. That is more than double the 50-year US average of 3.7% of GDP. Revenues fell by 9% while spending increased 11%, according to CBO.

In the last year, we’ve added a new issue. Skyrocketing interest costs. Interest rates were rock bottom in 2020 and 2021 so interest on that large sum of debt was minimal. However, rates rose from 1% to 5% in short-order causing interest costs to surge. Just in 2023 alone, net interest spending by the US on its debt alone increased 39% from the prior year ($475B to $659B). It is conceivable that by 2026, interest costs alone could rise to $1 trillion.

Here are some disturbing facts:

• If interest rates were at 6% for the next five years, 50% of US tax receipts would have to go to interest expense alone.
• If interest rates were at 10% (very low probability), for the next five years, 100% of all US taxes would go to interest expense. No Medicare. No Social Security. No defense.

Troubling Trajectory

Without a change, the US will double its debt over the next two decades at the same time demographics are pushing up non-discretionary spending. This mainly comes from the baby boomers starting on Medicare and Social Security.

What are the implications for investors? We are likely done with the zero-interest rate environment of the post-2008 period. Investors will demand more compensation on longer-term bonds over the coming years.

Many have asked me if this means the end of US dollar dominance. My answer to that would be ‘no’. There is really no competitor to the US dollar and higher rates of interest will means capital will flow TOWARDS the US, not away.

Currencies are a choice in relative comparisons. You cannot look at the US dollar in isolation but instead, against another currency. The euro is the second most used currency in the world but by relative standards, is a VERY distant second.

Most of the closest competitors to the US dollar are facing the very same challenges the US is facing, or worse. This retention of dollar dominance means that interest rates are unlikely to rise substantially from here. As comparison go, the US will remain the ‘cleanest dirty shirt’ in the global economic closet.

The Path Out

I see a 2010 ‘sequester’ like outcome in the near term regardless of the winner of the 2024 election. At some point, Congress will get its butt in gear and recognize spending as an existential problem and start to reign it in.

Honestly, it won’t take much. Simply slowing the rate of spending growth, not even an actual cut in spending, will reduce a lot of the pain. A simple solution is to keep the deficit as a percentage of GDP below that of nominal GDP growth.

To make that understandable, I can compare it to individual retirement spending. If you spend 4% of your portfolio but the portfolio growth by 6%, then the overall size of the portfolio did not shrink. If you spend 5% of GDP in excess of tax receipts generated, but the size of economy grew nominally by 7%, then your debt to GDP ratio overall, fell.

The solutions to this problem are not all that difficult. Reducing the growth in spending for several years will do it. A cut would accelerate the righting of the fiscal ship.

Sincerely,

Mark J Asaro, CFA