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By Chase Fowler, CFP®, Financial Advisor
*Certain content and opinions were sourced from Wells Fargo Investment Institute, Inc.(WFII). Please see below for links to original WFII reports.
Thrive amidst potential federal debt impacts
The U.S. has run deficits on a consistent basis going back to 1929.
Some amount of deficit spending is likely sustainable, but as the population ages it will become an increased burden on the government budget and resources.
While deficit spending is something to be concerned about, it is a normal part of managing economic cycles.
The base case for a majority of investment houses is a soft landing, with higher for longer rates compared to the past decade - making it even more crucial for a comprehensive plan that accounts for inflation assumptions.
We cannot control everything our governments choose to do fiscally, but we can choose to have our house in order by making sure our personal plan accounts for various scenarios ahead.
How will legislative policy, economic indicators, and company earnings drive the markets?
Choppy seasonality within the markets, along with an election, will possibly increase volatility during this period and as investors we should be aware that this is normal. The unpredictability of who will be President of the United States, who will win the majority for the Senate and the House of Representatives will push uncertainty in the short term but will likely smooth out as we pass through election day. As investors we have to constantly be nimble with the opportunities that we’re given.
We do not believe a debt crisis is imminent, but we do believe a plan of action needs to be put in place. We believe in the power of sound businesses with long-term competitive advantages, and the long term health of the U.S. markets. If you’d like to discuss this topic further or would like to revisit your comprehensive long-term plan, please reach out to your financial advisor.
Read more on what to expect on the markets post-election here.
The highly publicized debt crisis of Chinese property giant Evergrande in 2021 highlighted the broader issue in China of excessive borrowing and unsustainable growth in the real estate market. Unlike China, there is more stability in the US real-estate market in terms of transparency and valuation (read more on China's market).
How does federal debt impact the markets?
One of the issues that either candidate will have to take on is the rising federal debt along with consistent deficit spending, in the United States.
The Congressional Budget Office (CBO) expects that the budget deficit will rise to nearly $2.0 trillion in 2024.
This deficit is expected to reach $2.9 trillion in 2034.
This results in the rising interest costs and greater spending for programs that provide benefits to elderly people, thus increasing the federal deficit to 6.9% of gross domestic product (GDP) by 2034.
This is significantly higher than the 3.7% averaged that deficits have averaged over the past 50 years.
The current trend is obviously unsustainable, but there is still time for the government to make corrections before an imminent crisis would emerge. The longer the U.S. waits to act, the more drastic action required to solve the growing issue.
The U.S. is not alone in facing these challenges, especially after post-pandemic spending. Our economy is the largest and most diversified in the world, and the U.S. dollar is the globe’s primary reserve currency.
Why doesn’t the federal budget balance?
There’s often a lot of confusion around the federal budget, as most people would argue that we should just spend less for a period of time to alleviate federal debt pressures.
Our lawmakers have very little room to reduce expenditures. Even though federal spending is hotly debated on our legislative floors, only about one-quarter of government expenses are discretionary, meaning they can be easily reduced. The bulk of government spending is considered mandatory, and these entitlement expenses would be difficult to lower as they are very unpopular.
Entitlement expenses (mandatory expenses above), from 4.5% of GDP in 1966 to 14.7% of GDP in 2024.
This number is expected to grow to 15.3% of GDP in 2034 if entitlement programs payout formulas remain unchanged.
Two of the major factors causing this increase are:
the rising average age of the U.S. population and
growth in federal health care costs per beneficiary.
Some amount of deficit spending is likely sustainable, but as the population ages it will become an increased burden on the government budget and resources.
While deficit spending is something to be concerned about, it is a normal part of managing economic cycles.
The U.S. has run deficits on a consistent basis going back to 1929.
In economic theory we would expect deficits to grow during recessions as the government increases spending to stimulate economic activity and as tax revenues decline. In good economic times the opposite should occur potentially resulting in surpluses.
Behind the Numbers
More than $34 trillion in debt is massive, but with the size our country and the dominate nature of our economy we need to see that the basic numbers don’t tell the full story.
The U.S. government debt figures also includes debt the government owes itself. This type of debt is similar to you taking a loan from yourself.
Defaulting on a loan to yourself would not result in a default to your creditors and does not need to be financed to the public debt markets. The government holds its debt in various trust funds, such as Social Security and highway trust funds.
Who owns our federal debt?
Countries are often measured by their public debt-to-GDP ratio, as a measure of the ability for the government to be able to pay its debt. If a country’s debt was equal to its annual GDP, the ratio would be 100%.
In 2020, the U.S. ratio surpassed 100%, the highest levels since World War II. Although it’s declined to 97% since, we are still in a historically high position. According to CBO projections, we could reach 116% in 2034 and 166% in 2054. The question will be if this will increase the risk that investor might doubt the government’s ability to pay off public debt. The downside of this would be interest rates rising and major spending measures being needed to maintain creditor support of the government’s debt.
While the U.S. debt level is high from a historical point-of-view, we feel that the near-term is not something to be concerned over, but changes are needed to maintain creditor support over the long term.
Who is buying the bonds?
As we can see from the chart above, the largest percentage of U.S. debt is held by U.S. investors. Typically, when a county’s own citizens own the majority of a government’s debt, it decreases the likelihood of selling pressures and makes a higher debt-to-GDP level more manageable.
How does the economy affect the debt?
Countries like the United States of America that have higher economic growth and broader diversity in their economy have a greater ability to pay back debt and the market will generally allow greater debt-to-GDP levels.
How can this debt be managed?
Reforms will be needed in order to control growing deficits, along with economic growth in order to maintain investor support over the long-term. There are actions that the government can choose to take in order to assist this:
Cutting spending: Given what we discussed before, a significant portion of any cuts would have to come from social programs (Social Security, Medicare, Veteran Affairs, etc.), which would be challenging for any political party to get passed.
Raising revenues through higher taxes: Similar to cutting spending, raising taxes would likely be unpopular with certain parts of our population. It would counter current policies which aim to simplify the overall tax code.
Implementing policies to increase economic growth: In theory, the best way to reduce debt-to-GDP, as we discussed, is to grow the overall GDP. This would mean that the U.S. would need to reach and maintain a growth rate in excess of the mandatory spending increases over the upcoming years.
In the short-term we can make assumptions based of the current debt levels in how we choose to allocate our portfolios. The base case for a majority of investment houses is a soft landing, with higher for longer rates compared to the past decade. It becomes even more crucial to have a comprehensive plan that accounts for inflation assumptions, and realistic long term returns. We cannot control everything our governments choose to do fiscally, but we can choose to have our house in order by making sure our personal plan accounts for various scenarios ahead.
We do not believe a debt crisis is imminent, but we do believe a plan of action needs to be put in place. We believe in the power of sound businesses with long-term competitive advantages, and the long term health of the U.S. markets. If you’d like to discuss this topic further or would like to revisit your comprehensive long term plan, please reach out to your financial advisor.
If you’d like to discuss this topic further or would like to revisit your comprehensive long term plan, please reach out to your financial advisor.
*For more information on charts & visuals shown, click below, links.
Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
Information in this report was prepared by WFII. Those opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
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