The US Deficit: How and when does the US get out of this mess?

The US Deficit was greater than $1,000,000,000,000 in each of the last 4 years.  I have written the number in its numerical form, and not in its abbreviated form ($1 Trillion) to highlight how large a number that is.  The US government debt has increased from $9 Trillion to over $14 trillion in 4 short years, currently representing 70% of US GDP.   Without a change to taxation or spending, the debt will continue to rise.  When the debt/GDP ratio gets to unsustainable levels, interest rates will begin to rise.

The question that needs answering is how did we get here? The first side of the deficit equation is about taxes. Historically, US spending have averaged 20% of GDP while taxes have run at the 18% level.  This 2% annual deficit was considered sustainable by a majority of economists.  During President Obama's term, US tax revenues have averaged 16% of GDP.  This is related to a combination of the recession and a gradual decline in the number of US citizens paying taxes.  Current figures estimate only 50% of the US population pays taxes as compared to 66% 10 years ago. (See Chart below).                                                                                                                                                           

Source: IRS, Heritage Foundation

The other side of the deficit equation is about spending, which has averaged 25% of GDP over the last 4 years.  This is related to the combination of a weak economy and an increase in social programs and regulations. The latter suggests that a portion of the spending increase is structural rather than cyclical.

From a simplistic perspective, we need to see a decrease in spending and an increase in tax revenues, in order to drop from the current 9% gap to the historical 2% gap. Republicans and Democrats have not come to terms on how to achieve a more balanced budget.  The philosophical questions that the 2 political parties are debating is not should we reduce the deficit, but how should we close the gap between spending and revenues?  The democrats on the far left would like to close the gap entirely through increased taxes while the right wing republicans would like it to do it entirely through spending cuts.  The most practical method of bridging the gap is via a combination of spending cuts and increased revenues so that they move closer to their long term averages.

While both parties recognize what is necessary to reach a negotiated agreement, neither side wants to overtly yield in an election year.  Until we have one party firmly in control of the White , the Senate and the Congress or increased willingness to compromise between the parties, the risk remains of continued inaction.

Implications of the US Election

During the second quarter, Mitt Romney won enough delegates to lock up the Republican nomination for the US presidency, effectively signalling the start of the US presidential race. As we write this commentary, President Obama has a slight lead, but the election is still too close to call.  We do not profess to be smart enough to pick the winner, but we can discuss the implications of a democrat or republican victory.

If President Obama wins another four years in the White House, we can expect more of the same; a continued push for higher taxes, increased spending for social programs and increased regulatory oversight.  The success of his agenda becoming law will depend on the makeup of both the house and the senate.  We presume that if President Obama retains the Senate, he would still have to deal with a Republican majority in the House of Representatives.  This would lead to continued gridlock with little progress being made on deficit reduction.  Corporate spending would also be constrained due to the uncertainty related to future tax levels and regulations.  Which party controls the Senate remains a tossup, but it is unlikely significantly impact the balance of power in Washington.  If current spending patterns continue apace, further rating downgrades of US debt should be expected. The first rating cut last summer had minimal impact, but a second or third rating cut has the potential to damage the US economy.

On the other hand, a victory for Mr. Romney and his platform would be looked on more favourably by US investors.  Mr. Romney is talking about scaling back US government spending to levels that are closer to the historical norm of the last 50 years (see box on page 3).  While we are not certain that there would be a significant reduction in taxes, we are confident that there would be more certainty related to the level of taxation and regulations faced by companies.  Mr. Romney understands that US spending is pushing the cumulative debt load of the country to a level that is ultimately unsustainable.   Hard decisions need to be made now or the country will be faced with even more difficult choices in the future, akin to what Europe is currently facing.  If Mr. Romney is leading in the polls heading into the fall, stock markets are anticipated to react favourably to the perception of a changing of the guard.  If Mr. Romney wins the fall presidential election, supported by Republican majorities in the House and the Senate, he would be able to fulfill his promises.

Second Quarter Market Commentary

After six months of uninterrupted gains, the global stock markets declined during the last quarter.  The US stock market as measured by the S&P 500 lost 3.3%, which translates into a 1.3% decline in Canadian dollars. The resource heavy Canadian stock market was further impacted by declining energy and metal prices resulting in a decline of 6.4%.

The European debt crisis is dampening global economic growth.  The US Economy has slowed to 2% GDP growth during the last quarter.  Emerging market growth has also been negatively affected by the European debt crisis.  Global economic growth forecasts for 2012 have recently been lowered to 3.0% - 3.5% from a forecast of 4.0% six months ago.  For the moment, 2013 global economic growth is projected to reach 4%.

It is not surprising with all this negative news related to the European debt crisis and global growth, bonds returned 2.3% during the last quarter.  The yields for 10 year US government bonds declined to a generational low of 1.5%.  These historically low bond yields reinforce our belief that stocks will outperform bonds in the long term.

Conditions are ripe for the commencement of a long multiyear bull market in stocks.  Widespread negative investor sentiment, anxiety about the future and low valuations provide seeds for the next bull market. Potential catalysts to ignite investor enthusiasm include sustained global growth and evidence of firm plans to deal with European and American deficits. While we continue to favor stock over bonds, we recognize that growth and debt uncertainties are unlikely to disappear overnight.  The foundation for the next bull market remains in place, but fears related to these concerns will cap the near term upside, at least until we get clarity on the US presidential election.

European and American politicians understand the need for fiscal restraint and debt reduction. The European countries remain hampered by their inability to sell austerity measures to the voters.  US politicians are fighting a philosophical battle on the measures needed to reduce the deficit.  Both political parties understand the necessity of moving towards a more balanced budget, but differ on the timeframe and the mechanisms required (increased taxes vs. reduced spending) to achieve deficit reduction.

Typically when credit ratings decline, bond yields will increase as bond prices decline. In a world where sovereign debt ratings are under pressure, the continued decline in long term US government bond yields stands out as an anomaly.   On the surface this appears illogical but with the persisting European debt crisis, the US is currently perceived as the “best house in a bad neighborhood”.  The US government has continued to rack up record deficits resulting in increased risk of a credit rating downgrade. US cumulative debt as a percentage of GDP is approaching levels where bond prices decline due to the need for higher yields.  The US needs to get its fiscal house in order to prevent a fiscal crisis similar to that in Europe.

The US Government is collecting taxes at the relatively low rate of 15% of US GDP.  This compares to around 35% in Canada and Japan and 40-45% for most European countries.  This leaves some room to raise American taxes whereas the European economies have minimal flexibility in their ability to further raise taxes. 

Despite recent “doom and gloom” there are some positive signs.  There is no immediate recession call (except in select European countries). Stocks remain attractively valued.  Recent evidence  further supports our thesis that the US housing market is in a bottoming phase.  As we have previously discussed, any growth in housing activity would be positive for the economy and for employment.

We continue to recommend a balanced portfolio, weighted toward conservative stocks. Within our stocks we have taken a more defensive posture to compensate for the current lacklustre global growth environment.  Our preference is for high quality, dividend paying companies that have the ability to grow earnings in the current sluggish economic environment.