sizing the coming fiscal contraction in the US–effect on equities?

raising the debt ceiling

As I’m writing this, the House has already passed a bill that authorizes an increase in the permitted level of Federal government borrowing–one that’s big enough to get the country through the 2012 election; the Senate appears very likely to do the same at noon.  Mr. Obama will presumably sign the legislation into law before the end of the day.  That, in turn, will allow the Treasury to borrow enough to pay all of the $300+ billion in bills that come due this month, not just the $175 billion or so that the government’s income will cover.

addressing the budget deficit

The bill’s provisions (no, I haven’t read the legislation itself, just press accounts) appear to be guided by the usual congressional principle of deflecting blame from the legislators themselves.  It calls for $900 billion in immediate spending reductions.  A bipartisan panel, soon to be appointed, will find $1.5 trillion more over the coming months that Congress will vote on before yearend.  Congress will have no ability to change any of the panel’s recommendations, but must simply say yes or no.  If this second bill doesn’t pass, a pre-determined set of budget cuts, heavily weighted toward the military (which, after all, is the largest item in the budget at 25% of outlays) and entitlement spending (not far behind) will go into effect.

In addition to raising the debt ceiling, today’s bill marks the first step toward addressing two important macroeconomic problems:

–the reemergence of spending in excess of government receipts by Washington after several years of restraint during the second Clinton administration, and

–the resulting sharp rise in the amount of federal debt outstanding.

sizing the issue

GDP in the US is around $15 trillion.  The federal government is currently taking in about $2.5 trillion a year and spending $4 trillion.  See my post last week for a list of the major categories of government spending.

Outstanding federal debt is $14.3 trillion (the debt ceiling).  Of that, about $9 trillion is in public hands; the rest is held by government trusts, predominantly Social Security.

The annual budget deficit is currently about $1.5 trillion.  To cover today’s spending levels, government receipts would have to rise by 60%.   Government spending would have to drop by about a third to be funded by income.

The excess government spending over income is equal to 10% of GDP.

Two conclusions:

–the problem is too big to fix all at once,

–the problem is too big to “grow” out of.  If we assume that tax receipts increase by 5% annually, it would take almost a decade for government income to rise to the current spending level.  Government debt would be about $7 billion higher at that point than it is today.

effect on the economy

The federal budget deficit represents a very large stimulus to the economy, one that in effect shifts economic growth from the future to the present.  Shrinking the deficit means reversing this process. Eventually–and probably sooner than later–we end up with a healthier country.  But while the process is going on, the removal of stimulus will make economic growth lower than it would otherwise be.  …a loss of .5% a year?  Given that the long-term growth rate of the economy is maybe 2.5%, that’s a sizable chunk.

investment implications

Interest rates in the US are likely to stay low for much longer than most people (including me) thought a year or two ago.

This suggests that the appeal of fixed income instruments, especially short-term ones, as yield vehicles will remain limited.  By default, stocks become more attractive.

The recipe for stock market success in the US won’t change much:

–growth stocks over value

–foreign, especially Asian, exposure over domestic

–domestic consumer over domestic capital-intensive

–upscale consumer over the broad market.

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