Federal Deficits & Debt: What’s an investor to do?
Kurt Brouwer May 14th, 2009
In an email, one of our readers asked this excellent question:
Given the unsustainable nature of this, where does an investor position himself over the next 10 years? I think it’s safe to say that we’ll see gov’t spending even greater than the charts illustrate over the next 4 years, certainly, and perhaps the next 8.
The chart he referred to was this one from the Heritage Foundation’s 2009 Book of Charts:
Source: Heritage Foundation
Federal spending is a recession-proof growth industry as this chart shows. Through good times or bad times, our government just keeps gobbling up more and more of our money.
Heritage’s annual Book of Charts has tons of great visual information on government spending, debt, taxes and growth in entitlements such as Social Security and Medicare.
In case anyone wonders why this is important, just look at the chart again and consider what this will look like in 10 years. If government spending continues growing far faster than household incomes, then government taxes will have to consume an increasing percentage of those incomes.
Given that government deficits are growing, government debt and financing needs will also grow:
The following chart is one we posted a while back and it has also been included on many other blogs. The point it makes is startling and subsequent events have shown that the CBO estimates used in the chart are now the consensus even at the White House.
The government is incurring debt and ‘printing’ new money at a faster rate than we have seen since World War II. One likely result of this will be budget deficits and pressure for higher taxes - income taxes, corporate taxes, gas taxes and sales taxes. Assuming we have higher tax rates, this will have a negative impact, as it always has, on future economic growth.
This chart from the Washington Post illustrates what we have in store when it comes to Federal budget deficits. The right side of the following chart compares the CBO’s projection for future budget deficits with the White House projections. The left side shows the deficits for previous years, many of which seemed very high at the time. Now, they seem pretty modest by comparison.
Source: Washington Post
Given that government’s financing needs are growing — actually soaring — then interest rates on Treasury bonds are likely to go up over time simply because the Treasury is trying to issue so many bonds. It’s that archaic and outdated supply and demand thing that musty economics books discuss.
From this report on the U.S. Treasury web site, dated April 29, 2009, we find a clear and concise description of what is to come [emphasis added]:
…Yields on the 30-year bond have risen as of late and are probing their highest level since Autumn 2008. With inflationary pressures scant, the rise in long-dated rates largely is a by-product of the Treasury’s outsized funding needs in the period ahead.
Those outsized funding needs reflect the lackluster outlook for economic growth and the expansionary budgets being pursued by Congress and the Administration. Tax receipts are collapsing amid economic malaise. Revenue is down by nearly 14% in the first half of FY09 and April receipts are tracking their weakest level in years. At the same time, public expenditures continue to surge as automatic stabilizers (unemployment compensation, food stamps, etc.) kick in and the government plows resources toward stabilizing financial firms and domestic demand. In sum, fiscal outlays have increased by over 30% on a year over year basis.
Treasury’s net borrowing needs likely will total about $2 trillion this year, a staggering one-seventh of GDP. Given the outlook for the economy, the cost of restoring a smoothly functioning financial system, and the pending entitlement obligations to retiring baby boomers, the fiscal outlook is one of rapidly increasing debt in the years ahead. Given the outlook for the economy, the cost of restoring a smoothly functioning financial system, and the pending entitlement obligations to retiring baby boomers, the fiscal outlook is one of rapidly increasing debt in the years ahead. While unlikely to materially affect real long-term interest rates today, such a fiscal path could force real rates notably higher at some point in the future…
In other words, the current deflationary trend is still holding Treasury interest rates back, but a few years from now, watch out. Also, the report used the term ‘real rates’ which refers to inflation-adjusted rates. The likelihood is that inflation will be making a comeback in the next few years as well.
As investors, we have to deal with the present deflationary trend, but also be ready to pivot when inflationary trends begin to take hold. The current rise in prices for oil, gold and other commodities may be a harbinger of inflation immediately ahead or these price increases may just be a reaction to the extremely low prices of late last year.
In terms of investing for income, in a deflationary climate, Treasury bonds and other high quality fixed income investments have generally done well. Right now, I believe intermediate term bond funds are extremely attractive with good yields and even some capital gains potential. Pimco Total Return (PTTRX) is an example. I’m not a big fan of Treasury bonds now because yields are going up. As Treasury yields go up, the spread between them and corporate bond yields or mortgage-backed bond yields will narrow.
I believe portfolios will have to evolve over the course of the next year or two to be responsive to this new environment. Bonds, especially those with longer maturities, have done poorly in past inflations. Treasury Inflation Protected Securities are one solution. Intermediate term bond funds are another solution as are short term bond funds. Equities have historically been decent, although imperfect, inflation hedges. Other opportunities that should benefit from rising inflation would be energy and commodity-related investments.
Inflation is coming in my opinion and it could go above the levels we had gotten used to over the past 10 years or so. However, I still believe we are in the deflationary or disinflationary phase of this cycle and that inflation is going to remain at moderate levels for a couple of years.
Full Disclosure: Kurt Brouwer owns shares in Pimco Total Return Bond Fund (pttrx)
- Business , Economy , Geopolitics , Investing , Money , Mutual Funds , Personal Finance , debt , income taxes , inflation
- Comments(6)
Did you enjoy this article?
Interesting comment. With the new CPI numbers out this morning I am not so sure about a continued deflationary environment - I’d be interested in your comments about why you think we are still in a deflationary phase.
I do think inflation will roar back (Inflation - government’s answer to its own high debt). Given the recent attempted abrogation of contracts with the Chrysler bondholders, are you concerned that the Treasury may try to do something similar with TIPS? In other words, TIPS act as a constraint on the ability to inflate its way out of high debt. Or is the TIPS market not that broad compared to general Treasuries?
Carol–Good points. Inflation is with us right now as we saw in the core inflation results that were just released. Deflation is with us now in that prices for many things — can you say commercial real estate — are going lower. My concern is not for ‘normal’ inflation in the 2-3% range, but much higher inflation. Normally, government monetary and fiscal actions such as we’ve seen would be highly inflationary. However, we are still in the throes of a recessionary economy with much lower-than-normal demand. That, and the reverse wealth effect, have caused people to cut back on spending a bit and to increase savings quite a bit. So, far the two trends — deflation vs. inflation — seem to be in a rough balance. Once the economy comes out of recession, we will probably see much higher inflation unless the Fed is very nimble and smart.
Kurt,
Where can I, as an individual investor, buy a CA Revenue Anticipation Warrant? I’d like to have one just for the potential confiscatory yield once the voters reject the ballot proposals tonight.
I understand that Comptroller John Chiang can be criminally prosecuted if he defaults on those RAWs. Is that correct?
Brad–I’ve never purchased a revenue anticipation note (RAN) or a revenue anticipation warrant (RAW) so that’s a good question. Because RANs are issued in very short-term maturities, muni bond funds typically are the main customers. RAWs can have a slightly longer maturity, but I believe the main buyers would still be institutional.
I never heard about the idea that the State Controller could be criminally prosecuted for a default. Seems unlikely though.
Kurt,
How much did federal spending increase in real terms PER HOUSEHOLD between 1970 and 2008? Just another one in a series of the Heritage Foundation’s utterly useless charts.
By the way, inflation is almost certainly not on the way (more on that later).
Mark–I agree that inflation is not on the way — it’s already here. Admittedly, it’s low now, but inflation is running about 1% (annualized) for all items and 2.5% for all items less food and energy. I’ll look forward to seeing your thoughts on inflation.