Thoughts on the Budget Crisis

Last week the Congressional Budget Office released its revised estimates for the federal government budget over the next ten years. It should come as no surprise that the outlook has deteriorated even since the CBO’s last report just five months ago. Specifically, the projected deficits over the 2010-2019 period have risen by $2.7 trillion since the March report. Here are some additional highlights from the latest report:

  • The budget deficit is expected to be 11.9% of GDP in 2009 before gradually falling to 3.7% in 2012; Between 2013 and 2019, deficits are projected to range from 3.1% to 3.4% of GDP, well above the 2.4% of GDP that they have averaged over the past 40 years.
  • Federal government debt held by the public (excludes borrowings from the Social Security trust), which was as low as 33% of GDP in 2001, is expected to reach 54% of GDP in 2009 and grow to 68% of GDP by 2019.
  • These projections assume the expiration of tax reductions in 2011 (enacted in 2001 under the Bush administration) and provisions that have kept the alternative minimum tax (AMT) from affecting many more taxpayers. They also assume that future annual appropriations are held constant in real (inflation-adjusted) terms, resulting in projections of discretionary spending that would be low, relative to GDP, by historical standards. If these assumptions are removed, the deficit in 2019 would equal 8.5% of GDP rather than the CBO’s current estimate of 3.4%.
  • It is also important to note that the CBO projections do not include another round of stimulus, which many economists believe may be necessary to get the economy growing on a self-sustaining basis.

At the end of the CBO’s summary report were the following warnings: “Over the long term (beyond the 10-year baseline projection period), the budget remains on an unsustainable path. Unless changes are made to current policies, the nation will face a growing demand for budgetary resources caused by rising health care costs and the aging of the population…Unless revenues were increased correspondingly, annual deficits would climb and federal debt would grow significantly, posing a threat to the economy. Alternatively, if taxes were raised to finance the rising spending, tax rates would have to reach levels never seen in the United States. Some combination of significant changes in benefit programs and other spending and tax policies will be necessary in order to attain long-term fiscal balance.”

Source: Congressional Budget Office

Long-term investors should be asking themselves how to position their portfolios for an environment of soaring federal government deficits and debt. We have just ended a decade in which bonds outperformed stocks as interest rates declined and stocks floundered. Looking forward, high government deficits are likely to result in the a weaker dollar, higher inflation, and higher interest rates. This type of environment is negative for bond investors. Stocks, on the other hand, offer somewhat of a hedge against inflation. In addition, we believe the federal government will increasingly provide incentives to save and invest for retirement, which could provide support to stock prices over the long term.

The paradigm has shifted. A stunning $14 trillion in wealth has been erased from the aggregate consumer balance sheet since late 2007. Baby boomers are ill-prepared for retirement and must work to rebuild their savings. Stocks, with their superior long-term historical returns and built-in inflation protections, offer an important way for boomers to achieve their goals for retirement. At current levels (and after a 50% rally off the March lows), stocks still only trade at a price-earnings multiple very close to the long-run average (on expected 2010 earnings). While estimates for 2010 may be too high and we might reasonably expect a pull-back following this massive rally, it would not be unreasonable to expect total returns of about 8% from stocks over the long term from today’s levels. We arrive at this estimate by assuming 1) we maintain a P/E multiple at today’s long-run average; 2) earnings grow (from today’s depressed levels) at a 5-6% pace over the long term; and 3) the dividend yield remains constant at today’s level of about 2.6%. While 8% returns compared unfavorably with the long-run average for stocks, we believe these returns will compare very favorably to the returns possibly through other asset classes. For example, the yield on the 10-year Treasury bond currently stands at just 3.3%.