- The United States is at risk to enter a credit crunch
- We are expected to run a $1T deficit for the next 3 years, representing 5% of GDP
- The debt is sapping out the growth potential of the nation
Let’s talk about debt.
The Suspension of the Budget Deficit: United States of Debt
The United States has not had a budget surplus since 2001. We carried debt to finance the country out of the Tech Bubble and the Great Financial Crisis. President Obama oversaw the largest dollar increase in debt, and before that, Franklin D. Roosevelt saw the largest percentage increase in debt at 1,048% which he used to finance the Great Depression and World War II.
On February 9th of 2018, President Trump made the decision on to suspend the budget deficit until March 1st, 2019. This essentially allows the government to borrow an unlimited amount of money over that time period. The Committee for a Responsible Fiscal Budget (CRFB) estimated that debt would surpass $22T by March of 2019. However, the government beat that estimate by a whole year, as less than a month later on March of 2018, the US deficit exceeded $21T, far exceeding the estimates of the CRFB. (For real time debt updates, check out the Debt Clock here.)
In 2016, President Trump “pledged to eliminate the national debt “over a period of eight years.” He then signed a $1.5T tax cut bill and a two-year spending deal that could push annual deficits above $2.1T, according to the CRFB.
For the rest of his term, Trump plans to add $8.282T more to the federal deficit, which will push the national debt to about $30T in total. That represents a 41% increase from the $20.245T debt under the Obama administration. Trump will add as much debt in four years during a time of economic prosperity, as Obama did in eight years while fighting a recession. That will make Trump the second biggest contributor to debt in history.
Source: Peter G Peterson Foundation
Trump instated the Tax Cut and Jobs Act and enacted tariffs on several countries. The tax cuts alone are expected to increase the deficit by $1T over the next 10 years, according to the Joint Committee on Taxation. And for the tariffs to be effective in reducing the deficit, as Trump has claimed, we would have to impose a 33% tariff on every single thing that we import which would be statistically impossible, and completely destroy any trading relationship that we have with any country.
Our record deficit occurred in 2009, during the peak of the Great Financial Crisis, at $1.4T, representing 9.8% of GDP at the time. There was extreme government spending and lower tax receipts, primarily due to the Great Financial Crisis. We aren’t in a Great Financial Crisis right now – we are in a time of “economic prosperity”. So why is our deficit so large?
The Impact of the Tax Cut on the Deficit
The average current account deficit for advanced economies should hover between 2-4%. Currently the US has a current account deficit of about 5% of GDP. When GDP is growing above 2-3% (as it has) deficit spending should stop. There should be a least a semblance of a shift towards saving that money for recessionary time periods. Times of prosperity should not consist of instating a tax cut, spurring an already overheated economy further into the fire.
The best thing about debt is that you have to pay interest on it – the price paid for borrowing money. Countries have to pay interest on debt as well. The cumulative deficit from 2018 is expected to be almost $2T higher, with $1.3 as a direct effect from legislation (i.e tax cuts) and a contribution of $0.6T simply from increased interest payments, according to the Peter G. Peterson Foundation. Debt as a % of GDP is expected to hit 111% as a result of the Tax Cut and Jobs Act, which is higher than any time in history.
Source: Peter G Peterson Foundation
No achievable amount of economic growth will be able to finance that. The cost of the entire tax bill is expected to be around $5.5T. Repealing deductions is the only saving grace in the entire act. The total debt impact will push the debt-to-GDP ratio up far beyond default territory.
What the Government Thinks the Deficit Looks Like
As the Committee for a Responsible Budget pointed out, the estimated $1.085 trillion deficit for 2019 is double the $526 billion that the administration estimated in its own projections as part of the FY 2018 budget. The last time the nation experienced deficits that surpassed a trillion-dollars (which was during a serious economic downturn) lawmakers took the issue seriously – “PAYGO laws were established, a fiscal commission was formed, new discretionary spending caps were implemented, and policymakers entered a multi-year debate on how best to bring down long-term debt levels” according to the CRFB.
Now, they lowball the deficit by about half a billion dollars. There is no discussion about the debt. It’s like throwing gasoline onto a fire at this point.
What All That Debt Really Means
According to the World Bank, the Debt-GDP ratio is preferable at around 77%. If it exceeds that, lenders worry if it is safe to buy that country’s bonds. Also, for every point above 77%, it costs the country approximately 1.7% in economic growth.
The risk of default on debt is high when it surpasses 100% of GDP. Global debt hit a record high in 2017 of $247T, which represents 318% of global GDP. That means that the world is extremely leveraged right now.
Source: International Monetary Fund
Advanced economies debt-GDP has plateaued since 2012, but still sits around 105% of GDP (similar to World War II Levels) and far above the recommendation of the World Bank. Emerging Markets have reached 50%, which is around 1980’s debt crisis levels. Since 2009, average maturities on debt have increased by 1.4 years in high income countries and 1 year in Emerging markets. It has become easy to finance growth with debt – these countries have debt levels that are approaching crisis periods, for no foreseeable reason other than easy lending and irresponsible borrowing.
Despite the increase in debt carried by emerging markets, the US and Japan account for a large portion of the debt increase. However, China outpaces everyone, accounting for 75% of the increase in global private debt, and they are continuing to borrow.
This graph displays that difference well. With China, EM debt represents almost 120% of GDP. Without China, the EM’s only carry a 60% debt-GDP ratio. When you account for implicit liabilities (pension, healthcare) the debt level goes up to 204% in Advanced Economies and 122% in Emeriging Markets.
Future Direction of Debt
Out of all the advanced economies, only the US is expected to further increase its budget deficit. For all the Advanced Economies, the IMF expects them to keep expansionary policies into 2018 and 2019, followed by a consolidation, with debt expected to decline to 100% of GDP by 2023. The US is expected to remain expansionary until 2019, when deficits are expected to rise to surpass $1T and hit a 117% debt-GDP ratio by 2023.
The rest of the G7 Countries are working to reduce their debt load at a forecast of (0.24%), but the US is increasing debt substantially at a forecast of 1.6%. Emerging markets are increasing debt at a rate of 2.11%, with China increasing at 2.37%.
Why is Debt Bad?
Some debt is okay. In fact, it might even be preferable, especially from a consumer perspective. Build up the credit, pay interest on bigger items so you can save more cash for other things. Spend more for less, essentially.
It’s a little bit different for governments. It makes countries vulnerable to refinancing their debts at higher rates because of their large gross financing needs. High debt also makes it difficult to conduct countercyclical policies (ie. pulling us out of a recession) – and worsens the depth and duration of recessionary periods. Countries with higher ratios of debt to GDP tend to have a less stable fiscal stabilization coefficient – (how fiscal policy impacts the output of an economy in the good and bad times). And finally, high debt can crowd out growth.
What Impact Will This Have?
The baby boomers are retiring. Social Security, Medicare, and Medicaid cost $2T a year. We used to be able to afford deficit spending because interest rates were low. But we had to raise rates to normalize the economy and neutralize the inflationary impact of fiscal stimulus – which is essentially a catch-22 because now our debt is more expensive to pay off.
Source: Zero Hedge
There is a tightening in financial conditions across the globe. There is also global policy uncertainty, such as the current isolationist tendencies of the US and fears of a trade war. In the US, there are changing demographics and a shrinking labor force that are increasing the cost of retirement and health benefits.
We think we are growing. But we really aren’t. That 4.1% GDP number we posted in Q2 of 2018 is short term. The government can only finance growth with debt for so long, before the interest payments catch up.
Source: Wall Street Journal
Short and Long Term
We benefit from the deficit in the short term. Spending money on various programs and cutting taxes is good, especially for votes. It drives economic growth over that short time frame, and for a little bit, spending money can create more money.
But in the long term?
As debt-GDP increases, debt holders demand larger interest payments because the risk of their debt increases. People might choose to move out of US treasuries because of the potential risk of default (however, it is unlikely that the US will ever default). The US will have a lot of interest to pay back. Social security is already bankrupt. Higher taxes are inevitable and what benefits are left will have to be curtailed to pay off the debt.
We have a lot of debt and are continuing to add to it, and there isn’t an end in sight. US Equities are approaching bubble territory, and with the corporate sector heavily exposed to debt, they are susceptible to continued rate hikes.
There are several ways to play the game here. You could short US Equities (SPY, DJIA, QQQ) or put a neutral strategy (iron condor, strangle) on them, depending on what time frame you think the reversion to the mean will begin.
Emerging markets (per my most recent blog) are a source of diversification against the pitfalls of US debt (although, they too carry their own share of leverage). India is an interesting place of growth right now, posting growth of 8.2% for the most recent quarter. INDA, the iShares MSCI India ETF is trading flat for the year with room to the upside.
Getting exposure outside of the US is a great place to start building organic growth into a portfolio. IEMG is an index that carries a decent amount of exposure and is underexposed to China, relative to its peers. The 30 delta short put at a strike of 52 is trading for $111 with 64% probability of profit, and a daily theta of 1.39.
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.