On Monday, President Obama submitted his 2011 budget proposal to Congress. The long-range budget projections, included within the administration’s proposal, sent shivers down the spines of deficit hawks. By all accounts, our current course is unsustainable, and something must be done. Put bluntly, Americans simply require more out of their government than they are willing to pay in taxes. Absent drastic action to reverse the deteriorating outlook, we should all expect lower living standards for ourselves, our children and our children’s children. But alas, election years are not known for the implementation of painful decisions. We fully expect another year of unheeded warnings, deferral of tough decisions, and unchecked spending. All the while, however, the voices at Tea Party rallies grow steadily louder. Are we nearing the day of reckoning, or can we afford to defer fundamental reform indefinitely. Only time will tell.
Perhaps the most striking aspect of the administration’s outlook is the sheer magnitude of government debt we are expected to accumulate over the next 10 years. But first, let’s take a look at where we stand now. At the end of the 2009 fiscal year, gross government debt outstanding was $11.9 trillion, with $7.5 trillion of that debt held by the public. The difference between these two figures ($4.3 trillion) represents debt that has been issued by the government to other government agencies, such as the Social Security trust. Effectively, this is money that the government has borrowed from itself (in an effort to lessen its dependence on the public markets and keep borrowing costs down), and it will have to be paid back if we are to fulfill the obligations of our entitlement programs. In any case, gross government debt and debt held by the public were 83% and 53%, respectively, of GDP at the end of the fiscal year. For some perspective, debt held by the public had averaged under 36% of GDP over the prior 40 years.
Now let’s fast forward to the year 2020. Based on the administration’s budget figures, federal government debt held by the public is projected to increase to over 77% of GDP by the year 2020. If we include the debt issued by the government to other government agencies, the ratio is projected to increase to 107% of GDP by 2020. If these figures are right, the government will need to borrow a net additional $11 trillion from the public over the next 10 years in order to fund the deficits. Interest on the debt alone will balloon to $840 billion in 2020 (from $187 billion in 2009) and will represent 15% of total government spending (up from 5% in 2009).
We would note that these figures include some pretty optimistic assumptions, without which the budgetary figures would look even worse. First, the administration is projecting that GDP will grow at a real average rate (adjusted for inflation) of 3.8% over the next five years. Most economists will tell you that this assumption is aggressive in light of the continuing headwinds in the economy. The consumer must save more for retirement given huge losses of wealth and massive amounts of debt, unemployment is expected to remain high, the housing market remains a mess, and banks are not lending freely. A lower GDP assumption would mean lower tax revenues, potentially more stimulus outlays, higher budget deficits and more debt than already projected.
Secondly, the government is assuming that the yield on the 10-year Treasury note will not exceed 5.3% over the next 10 years. We would find this assumption especially aggressive given the administration’s forecast for strong GDP growth over the next several years. Moreover, the need to raise an additional $11 trillion to fund deficits over the next 10 years will certainly lead to higher borrowing costs. In fact, some central banks (read: China) have already expressed concern over the sheer magnitude of new debt issuance. Others are demanding more issuance of TIPs (Treasury Inflation-Protected Securities) so they can protect against a surge of inflation brought on by massive injections of monetary stimulus. Simply put, these prospective buyers will want to be compensated as the risk of owning increasing amounts of US government debt continues to rise.
Third, the government is not including as debt the over $5 trillion in mortgages either owned or guaranteed by Freddie Mac and Fannie Mae, the two companies that were effectively nationalized during the throes of the financial crisis. The scale and scope of government support for these entities would argue that the government should consolidate their assets and liabilities – something the administration would like to avoid for obvious reasons. But the reality is that the federal government is on the hook for a massive amount of mortgages. These mortgages are going bad at a record pace, and the government may wind up owning a lot of residential real estate when it’s all said and done.
The figures in the President’s budget are alarming. America is skating on thin ice. Creditor nations understand that we must spend money now to revive our economy, and there are few safer alternatives to the US dollar and US government’s securities. However, there is a tipping point somewhere out in the future. Nobody knows where this tipping point is, but it is safe to say the we are getting close. The days of avoiding difficult decisions out of political expediency may be drawing to a close as the public begins to more fully appreciate our predicament.
We continue to recommend sticking with the high-quality, defensive and reasonably-priced stocks that have lagged the overall market during the 60%+ surge since March. In general (and in contrast to both the consumer and the federal government), corporate balance sheets are in good shape following a difficult period of lay-offs and restructuring. This is especially true of the large-cap multinationals that we favor for our client portfolios. Moreover, valuations and growth expectations remain reasonable for these defensive investments.