The Congressional Budget Office released its Interim Economic Projections yesterday. Although the projections aren’t out of line with many other estimates we’ve been seeing, it was still a rather sobering report. The CBO expects real (inflation-adjusted) GDP to contract at a 5.6% rate in 2020, which will be the worst contraction (by far) since 1946. But the bad news doesn’t stop there. The CBO also says that “the four pandemic-related laws enacted since the beginning of March are projected to increase the federal deficit by $2.2 trillion in fiscal year 2020.”
Naturally, we wanted to see how bad the GDP contraction might look in the absence of this incremental deficit spending. Our methodology was to subtract the value of the incremental deficits ($2.2 trillion, converted into 2012 dollars) from the CBO’s estimate of GDP for 2020 (also in 2012 dollars). By adjusting all dollar amounts for inflation to the 2012 dollar, we are able to compare figures from different years without the distortions of inflation. The result was that real GDP might have contracted by closer to 16% this year if not for the massive fiscal response from the federal government.
It is important to note that the CBO’s estimates “incorporate the assumption that current laws generally remain unchanged and that no significant additional emergency funding is provided.” Although the $3 trillion stimulus bill recently passed in the House of Representatives has little chance of becoming law, the assumption that no further stimulus is needed may be a bit over-optimistic. At the very least, it appears as though the federal government may need to provide support to states and cities that are struggling with large budget deficits. How many more trillions are we talking about exactly? This is starting to add up!
The continued federal government economic support will lead to more increases in federal debt, which had already reached $25 trillion on a gross basis (includes intragovernmental holdings) at the end of April. As a share of expected 2020 GDP, the April-ending debt came to 122%. That ratio has more than doubled since 2001, and it’s likely to go higher still. You may be asking, why does this matter? The federal government can borrow for 10-years at a rate of 0.70% right now. Shouldn’t we just take this opportunity to borrow as much as we can and, in the process, defeat COVID-19, renew our infrastructure base, invest in green energy, cut taxes, jumpstart the economy, and do whatever else we can think of?
A 0.70% borrowing rate is indeed incredibly attractive. And we have consistently advocated that the US Treasury lock in these great rates by refinancing its expiring debt with longer-dated bonds. But remember, there is a huge source of demand for US government debt that may not be there forever. The Federal Reserve is absorbing the lion’s share of new Treasury bond issuances again this year. The central bank’s balance sheet has ballooned to nearly $7 trillion already compared to a little over $4 trillion at the end of 2019. When the Fed stops buying (or, God forbid, starts selling), will there be enough alternative demand to absorb all this debt? Will interest rates spike as the Fed crowds out private investment? Will the stock market swoon the way it did when the phrase “taper tantrum” was first coined?
The great experiment continues apace. We can only hope that the powers that be are not digging us into an even bigger hole by pulling out all the stops.
Investment markets seem heartened by the news of potential vaccines and the re-opening of American life. That stocks are down just 8% so far this year is somewhat startling given the ongoing contraction in the economy and unemployment claims that are still increasing by millions. The bullish argument is that the trillions of stimulus dollars from the Treasury Department and the Federal Reserve are sufficient to sustain the economy and share prices that look through the current unpleasantness to a recovered US. Our strategy for investing through this era of unknowns is to have a high quality portfolio of defensive companies with strong, liquid, not over-leveraged balance sheets that are executing well along with some opportunistic holdings that also have strong balance sheets and management teams but are suffering in share price as they await a more normal economic environment. We remain dispassionately and doggedly disciplined. Please stay safe and healthy and call us if we can be helpful in any way.