US Deficit and Obama Fading

Two years ago James Carville correctly forecasted the Republican Primary race and the Presidential election. Standing at a cocktail party, James said, “Three points: Romney (pronounced Rom-in-ey) wins. Period. Number two: Romney can’t beat Obama. CAN’T. Three: Obama can beat Obama if he really messes something up along the way, and I give that about a 30% chance.” We doubt that even Mr. Carville could have envisioned the current confluence of IRS-gate, Benghazi, and Associated Press phone records. Our friend Greg Valliere suggests that the President’s agenda doesn’t have a chance in this environment.

Amidst anemic economic growth, there is a marvelous development: the deficit is shrinking big-time. According to the Congressional Budget Office, the U.S. will run a budget deficit of $642 billion for the fiscal year ending September 30, 2013 – the smallest such deficit in five years. This figure is down sharply from the $1.087 trillion deficit reported for fiscal 2012, and it is also well below the CBO’s previous estimate (February, 2013) of $845 billion. The reasons for the estimate reduction are 1) better-than-expected tax revenues; and 2) higher-than-expected dividend payments from Freddie Mac and Fannie Mac, both of which are in conservatorship.

While the news about this year’s deficit is undoubtedly welcome, we would caution that it’s not time to break out the bubbly. First of all, these estimates assume current law remains in place. This means nothing will be done to reduce the effects of sequestration, expiring tax breaks, and cuts in Medicare doctor fees. The numbers start to look different if you take away these assumptions.

But second, and more importantly, the real looming crisis in the U.S. is the issue of entitlement spending (Medicare, Medicaid, Social Security) and the long-term structural deficits that the entitlement programs produce. Perversely, the good news on this year’s budget might turn out to be bad news if lawmakers become complacent about the real issue and are less likely to enact legislation that addresses the long-term structural deficits. An article in today’s Wall Street Journal said, “Earlier this year, a bipartisan effort was under way to lock in more deficit cuts, particularly later in the decade, but those talks have stalled in recent weeks, in part because of the shrinking deficit.”

In my estimation, the improvement in the budget situation is partly illusionary and may be dangerous. Yes, this year’s budget outlook has improved somewhat due to the expiration of payroll tax cuts, a tax hike on wealthier Americans, unsustainably high dividends from Freddie & Fannie, and unsustainably low interest rates. But interest rates will not remain this low forever, and the ticking time bomb of an aging work force has the potential to wreck havoc on our longer-term budget situation. It is most unfortunate that it takes a severe crisis to get anything done on Capitol Hill, but we fear that a new one will be required to effect material change.

Expensive markets can become more expensive. Alan Greenspan talked about “irrational exuberance” in late 1997 after the Dow Jones Industrial Average had just reached 6,000. Stocks gained another 2,000 points in the next eight months and a total of more than 5,000 points over the next three years. Quality stocks with strong balance sheets make sense to us.