Let’s look beyond the imminent failure of the Super Committee, and examine implications of the U.S. fiscal picture and debt to GDP ratio by looking at three areas:
- The U.S. fiscal profile
- “Financial repression” as a way out
- The roadmap to (avoiding) a AA rating
The Super Committee’s wranglings are not the main event. Low debt rates, inflation, growth and entitlement reform are the linchpins that could lead to a viable long-term U.S. debt solution.
Without austerity, the U.S. fiscal profile looks daunting; the debt/GDP ratio will worsen even more than the government predicts because GDP growth rate projections are too high; they don’t properly account for the resultant fiscal slippage from the savings targets. Policymakers should target $6trn to secure our ‘Aaa’ rating; but where will the savings come from? Further cuts in discretionary spending are unrealistic since discretionary spending is already declining to a historical low level of GDP. Letting Bush tax cuts expire may also not do the trick because tax revenues are unlikely to rise as much as projected. Without entitlement reform, the fiscal profile probably cannot be stabilized since entitlements’ share of GDP is set to keep rising as the U.S. population ages and healthcare costs grow.
Thus, the question is how do you stabilize debt/GDP? Some combination of financial repression and long-term growth may be a way out. Significant debt reduction was achieved from 1945 to 1975 by keeping average interest costs below nominal GDP. Where does the US stand today? On the positive side, interest rates are low – which reduces the government’s long-term borrowing costs – and the Fed is keeping them low. On the negative side, large primary deficits driven mainly by entitlement costs are rising faster than inflation and an aging population along with cutting edge technology are creating ever higher healthcare costs. Realistically, inflation at 3%, with a 2.5% GDP growth for 10 years could lead to the equivalent of a $1.3trn deficit reduction; far lower than the required $6trn but a step in the right direction. A higher inflation rate of 5% would go much further toward deficit reduction, but may not be palatable to investors and the Fed. To deftly reach the full $6trn, some combination of low inflation along with pro-growth policies, tax reform, and entitlement spending cuts will be required.
Meanwhile, the market implications of sequestration are not good, but in reality, it may never come to pass. Sequestration is probably the worst possible outcome for near-term growth. Under it, automatic spending cuts trigger in 2013 and will be equally split between defense and non-defense, although Medicare will not see more than a 2% annual reduction. Expiring provisions, payroll tax holiday, and unemployment benefits, if not extended, could pull fiscal consolidation forward. Thankfully, sequestration may be delayed and eventually overruled by Congress.
Are we on the way to AA? According to the debt rating agencies Moody’s, S&P and Fitch, fiscal slippage in 2012 coupled with economic weakness would be a negative. A further downgrade to AA could occur if the debt to GDP ratio rises to 90%; however, there is only a medium risk of a near-term negative change. Nonetheless, because the sovereign crisis in Europe has caused the universe of “risk-free” assets to decline sharply, Treasuries will remain in high demand even as the supply of U.S. government debt has increased. Investors are likely to give the U.S. more benefit of the doubt as U.S. fiscal issues are more medium term in nature and the U.S. dollar remains the reserve currency.
In November, we believe the equity, fixed income and commodity markets will focus on the U.S. Super Committee, possible solutions to the European debt crisis and Chinese growth.
Michael Ashley Schulman, CFA
Hollencrest Capital Management