Deficits Won’t Matter—Until They Do
By Randall W. Forsyth
Interesting times? You can have them. Investors would love to return to those stolid days of yesteryear when volatility was AWOL and stocks moved steadily higher on a path that could be traced by a ruler. Welcome to the world in which the Dow Jones Industrial Average swings hundreds of points, not only from day to day, but also from hour to hour.
On the week, the pogo-stick bounces left the major indexes up, from 1.8% for the Dow to 2% for the Standard & Poor’s 500 index to 2.8% for the Nasdaq Composite. That was after a series of swings in reaction to news that the trade war with China, once looming over the market, now may be off; a strike on Syria with new and smart missiles was imminent, until it wasn’t; and, of course, the ongoing soap opera regarding the president’s alleged misdeeds that occupy so much of the media’s time and space, and don’t need repeating here.
Arguably more relevant to investors was the news from House Speaker Paul Ryan that he won’t run for re-election, which came two days after the Congressional Budget Office forecast that the federal deficit is heading toward $1 trillion annually. That follows the passage of the Tax Cuts and Jobs Act, which Ryan called his proudest achievement in a congressional career in which he has tried to burnish his image as a deficit hawk.
There are clear political and economic implications of these developments. As for the former, Cowen Washington watcher Chris Krueger notes that nearly half of House GOP committee chairmen—10 of 21—are opting out of running for re-election. “There is no precedence for this. It is hard to numerically underscore how bearish this reality is for the tenuous 23-seat House Republican majority,” he writes in a research note. Even more retirements are possible, given that the deadlines by which candidates must file to run haven’t yet been reached in 19 states, he adds.
The flight of putative fiscal hawk Ryan comes as deficits are set to soar. And in his previous roles as chairman of the House Ways and Means Committee and the House Budget Committee, he helped fashion some of the most perverse policies ever. Coming out of the Great Recession and during one of the most tepid recoveries ever, austerity was imposed, including after the debt-ceiling fiasco of 2011 that led to Standard & Poor’s stripping its triple-A rating from the U.S. Conversely, with the economy at full employment, Congress late last year passed $1.5 trillion in tax cuts and boosted spending by $300 billion.
The CBO forecasts a $1 trillion-plus deficit for fiscal 2020, even with bullish economic assumptions that the economy will grow 3.3% this year, up from the 2% previously expected, and that unemployment will average 3.8% in the current fiscal year and 3.3% in fiscal year 2019. Those predictions are more optimistic than those of most private-sector forecasters or the Federal Reserve, according to Morgan Stanley, and pose the risk of wider deficits if the economy falls short of those wonderful numbers.
Trillions are an incomprehensible quantity. Taken as a percentage of gross domestic product, the annual deficit is expected to run at 4% this year, up from 3.5% in fiscal 2017, and rise to 4.6% in fiscal 2019. The Congressional Budget Office sees the shortfall peaking at 5.4% of GDP in fiscal 2022 and levelling off at about 5% after fiscal 2023.
But the CBO’s more realistic “Alternative Fiscal Scenario” is even worse, writes Jim O’Sullivan, chief economist of High Frequency Economics. It points to a deficit above 6% of GDP by fiscal 2022 and debt exceeding 100% of GDP by fiscal 2027. “Moreover, none of the projections allows for a recession at any point, which is highly implausible,” he adds. “At some point, a recession will inevitably make the deficit and the level of debt even higher.”
Trillion-dollar deficits and debt-to-GDP ratios nearing 100% conjure fear of a fiscal crisis. Looking at history, JPMorgan economists find that such crises are anything but rare. Since 1900, one has struck somewhere in the world within five years 30% of the time. But when it comes to countries such as the U.S., the probabilities are far lower. Among developed countries, a debt crisis within five years occurred just 9% of the time.
The United Kingdom was forced to seek a loan from the International Monetary Fund in 1976, when its debt-to-GDP was just over 50%. The key difference was in the currency; the run on sterling pushed up inflation and interest rates, forcing the need for the IMF bailout. Conversely, Japan has a staggeringly high debt-to-GDP ratio—over 250%—but has near-zero interest rates and a strong yen. The difference, explains Tom Clarke, co-manager of the William Blair Macro Allocation fund, is the high level of domestic savings and being a net international creditor.
The U.S., in contrast, has a low savings rate and is the world’s largest debtor, making it dependent on foreign capital. The Treasury’s debts are denominated in dollars, however, which are controlled by the Fed. As the cliché goes, the U.S. can always print greenbacks to pay its debts, unlike Greece, whose obligations are
in euros controlled by the European Central Bank.
“Nevertheless, we should not ignore the lessons from history on the fragility created by debt, and we must recognize some tail risk of a crisis,” the JPMorgan economists write. That’s contrary to former Vice President Dick Cheney’s assertion that Ronald Reagan proved that deficits don’t matter. But that might not hold under Donald Trump, who has dubbed himself the King of Debt, and has the defaults and bankruptcies to prove it.
While the Congressional Budget Office projects trillion-dollar deficits and a federal debt closing in on the size of the U.S. economy, we ought to be enjoying good times now, even if it’s on borrowed money. But according to a new Bank of America Merrill Lynch survey, Americans aren’t going for the buy-now, pay-later ethos. And that’s especially true of millennials, who, contrary to the popular image of their spending everything on avocado toast, are being far more fiscally responsible than their older cohorts, notably Generation X.
BofA ML had anticipated that a third of the respondents to its “Word From Main Street” survey would spend the cash from the tax cuts. Instead, just 16% of respondents said they’d use the money for big-ticket purchases or day-to-day expenses, while 22% said they’d save the tax cuts, and 20% said they’d pay down debt. In other words, close to half of those polled plan to use the tax savings to shore up their personal balance sheets, although the bank suggested that people might be more responsible in surveys than in reality. (Some 20% said they didn’t get a tax cut, although the bank hypothesized that there might have been delays in getting the reductions or that the respondents didn’t notice them.)
Millennials (ages 22 to 37) said they’d be more likely to save the tax-cut money than Gen Xers (ages 38 to 53). Millennials also were less likely to use the windfall for daily spending and more likely to invest or pay down debt, most likely student loans. All of which suggests a “greater sense of responsibility than is often credited to this cohort,” the bank commented.
None of this comes as news to Barron’s readers, who were warned by our longtime pal, MacroMavens boss Stephanie Pomboy, that consumers’ situations are more parlous than the consensus belief. In her interview last month (“How the Fed Will Trigger the Next Crash,” March 22), she shared with our readers what she has been pointing out to her big-bucks institutional clients: Jane and Joe Six-Pack are largely tapped out. And not from spending on fun stuff, either, but on necessities such as food, energy, health care, and housing.
At the same time, the Federal Reserve sees the economy chugging along, with inflation reaching its 2% goal. So the monetary authorities are on track to raise interest rates twice more this year after last month’s quarter-point increase in the federal-funds rate range, to 1.5%-1.75%. Minutes of last month’s Federal Open Market Committee meeting suggest the possibility of faster rate hikes, in part owing to expectations of the tax cuts’ stimulative effect.
For the past three months, however, retail sales have fallen, something that has happened only five times outside recessions, according to the Liscio Report. “As we all know far too well, this is a very noisy series, but any way you look at the trends, they are weakening,” the newsletter’s client note says. That’s even after taking out lumpy automobile and gasoline sales, which largely reflect price changes.
That said, the Liscio Report says, the past three months’ weakness may be “payback for the vigorous spending of late summer and early fall 2017, which may have been driven above trend by storm recovery efforts.” In which case, it’s understandable if consumers would use any extra cash to replenish savings or pare debt incurred as a result of last year’s storm expenses.
All of which makes Monday’s release of March retail-sales data key for investors. The Liscio crew is forecasting both a 0.1% uptick overall and a 0.1% increase, excluding autos and fuel.
That’s below the consensus of a 0.4% overall retail sales rise last month and a similar gain ex–autos and fuel.
Slowing spending growth and rising inflation suggest the worst of all possible worlds. For now, the Fed remains focused mainly on the latter, while investors are ignoring the former. That’s not a good combination.
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