The Tsunami Builds

In last week’s Market Commentary, we discussed the profligate fiscal policies of the last generation and the predicament that those ill-conceived policies have left us in. The stage is now set for the 2024 Presidential election, and there still appears to be no appetite to address the growing national debt – now well over 120% of GDP – and the economic headwinds it creates.

We as a country have not yet had to pay an economic price for our fiscal irresponsibility thanks to the historically low interest rates that have been in place since the Global Financial Crisis. Last week I asked, rhetorically, “could all that be about to change?” The odds of a “yes” response to that question are rising rapidly, and I want to explain why.

The above chart shows the gross national debt, and the below chart shows the interest expense on that debt, both measured as a percentage of GDP. Their expression as ratios is important because, similar to a household, debt and the interest payments necessary to service that debt can comfortably increase as long as the capacity to service the debt is manageable. Therefore, for our purposes, we can think of GDP as household income. 

Is a $300,000 mortgage (at the current market rate of about 7.0%) that requires annual payments of $24,000, most of which goes to interest in the early years, too much for a household to handle? It depends. If that family is earning, say, $120,000 per year (upper middle class), the numbers seem manageable. The mortgage payments only take up about 20% of income, leaving plenty for other expenses. If, however, the family brings in income of only $60,000 per year, those mortgage payments would come to 40% of income – well above levels that most financial advisors would consider “manageable.”

Now, let’s consider a couple different scenarios. The first is that the lower-income family is able to somehow increase its income to $90,000 per year. Doing so would reduce the proportion of household income that must go to mortgage payments from 40% to 27% – much more manageable.

The second scenario is that interest rates drop dramatically, taking the market rate for a 30-year fixed-rate mortgage from 7.0% to 3.5%. Under this scenario, the proportion of income that goes to mortgage payments drops to the same 27% even with no increase in income. The lower-income family would simply call its friendly mortgage broker and ask to re-finance its loan (at a small fee, of course).

Here is where comparisons of household budgeting to national fiscal policy diverge. Households that own their own homes are entitled to refinance their mortgages without prepayment penalties. Doing so with a 30-year fixed-rate mortgage locks in their cost of owning that home for the next 30 years. The federal government, on the other hand, has no ability to refinance its debt and lock in low rates for 30 years without paying market prices to retire its existing debt. This isn’t to say that the U.S. Treasury couldn’t have (and it should have) been much more aggressive about extending the maturities of its new debt when interest rates were super low. Doing so would have locked in lower interest rates for longer and reduced the severity of our current predicament. But my point here is to show that there is a limitation to the comparability of household and federal government finances, and the primary difference is the right to prepay mortgages.

Back to reality. Federal government deficits soared during and after the COVID recession as tax receipts dried up and massive stimulus was injected into the economy to avert disaster. That creates enough problems on its own (and to be clear, I’m not arguing for or against the stimulus many Americans relied upon; I am simply stating the fact that that those policies create problems that must be addressed). But to make matters much worse, interest rates have soared at the same time that deficits have been blowing out. The combination of the two results in the federal government spending nearly twice as much (relative to the size of the economy) on interest payments compared to just eight years ago (2.4% in 2013 compared to 1.2% in 2015). And that percentage is projected to rise to nearly 4% over the next 10 years to levels well above anything since the Great Depression.

We will very shortly (like this year) be spending more on interest to service the national debt than we spend on defense. And, unfortunately, much of that debt will have to be financed at market rates since so much of the current debt is concentrated in short-term bonds and T-bills that will be maturing in relatively short order.

The CBO projects that interest on debt will double again (on a dollar basis) over the next decade, and to be quite honest, the CBO’s projections are, to my mind, pretty rosy. With deficits of $1.5 trillion to $2.6 trillion per year every year for the next 10 years, the CBO’s assumption of an average rate paid on that debt holding at 3.5% seems optimistic; if the appetite for U.S. debt wanes and interest rates rise even more (that is, the Treasury must pay higher interest rates to entice more people to buy the debt), then this picture just gets worse.

At a governmental level, service on the debt will preclude the U.S. from responding to future crises with the “shock and awe” of our response to COVID. While the fiscal largesse demonstrated during COVID was arguably too much and the costs we must pay will be high, the response also saved businesses, saved families and, at a very basic level, saved lives. Yet even if one argues all of the response was necessary (and that is a debate I will leave to others), the costs mean we don’t have the ability to respond in as robust a manner to the next crisis, be that another pandemic, an economic crisis or a geo-political conflict.

There are many highly levered companies that will suffer as the government sucks up all available credit in the years ahead. The implications for investing are varied and profound, and I expect we will drill down into more of those issues in future Market Commentaries. The big takeaway for investors for now is that fundamentals matter. Strong balance sheets to limit exposure to debt markets, competitive moats to generate highly predictable revenue streams and cash flow and creative management teams to navigate evolving challenges will be even more critical in years to come. Our disciplined approach and dispassionate research guide us towards those companies that can not only endure, but thrive as the macroeconomic environment evolves.