With potential policy changes on the horizon, many investors are focused on what this may mean for the deficit and federal debt, but we do not expect this concern to weigh on U.S. growth.
With Donald Trump elected as the next president of the United States, attention has turned to his pro-growth priorities and what they will mean for the economy. While the short-term impact of tax reform, less regulation and increased infrastructure can be positive for economic activity, many investors are beginning to focus on how these potential policies will weigh on the federal deficit and national debt.
When considering the federal debt/deficit, there are two distinct issues related to the different time frames: long term over the next several decades and medium term over the next several years. Our view is that the increasing federal debt presents long-term challenges that will need to be addressed eventually, but politicians are not likely to deal with those issues anytime soon. In the near term, however, we do not expect concern about the deficits or debt to weigh on U.S. growth. In fact, the potential for substantial fiscal stimulus is positive for our cyclical outlook.
Favorable Cyclical Outlook Despite Long-Term Concerns
Long-term debt concerns focus on the growing spending on Social Security, Medicare and Medicaid over the coming decades as the baby boomers retire, exacerbated by the expected rising cost of financing as inflation and real interest rates normalize. There is widespread focus on the federal debt — and the federal deficits that increase that debt — for several reasons. Many in the public are concerned about what high deficits and debt may imply about future tax hikes or spending restraints that might affect them personally. In addition, federal spending and taxes are among the few economic indicators that politicians decide on, making them the focus of both public comments and fundraising. Forecasts of rising federal debt are also linked to general apprehension about whether the U.S. is on the “right track" or the “wrong track."
The Congressional Budget Office (CBO) released a report of its outlook for the next decade, “An Update to the Budget and Economic Outlook: 2016 to 2026" (August 2016, cbo.gov).* This report indicated that annual budget deficits as a share of GDP would trend higher from 2.5% in 2015, to 3.2% (3.0% adjusting for timing shifts) in 2016, to 4.6% in 2026. The CBO lowered its estimate of potential economic growth and real GDP growth, as well as its expected path for interest rates. This was before the victory of Donald Trump, who advocates policies which are likely to increase the deficit over the next few years and quite likely well beyond.
In a separate report, “The 2016 Long-Term Budget Outlook" (July 2016),* the CBO forecast that the debt-to-GDP ratio for debt held by the public would rise from 39% recorded in 2008 to 75% in 2016, to 86% in 2026, to 141% in 2046, as the baby boomers age. If the proposals for a large fiscal stimulus program are enacted, the debt and deficit problems are likely to increase over the next few years. Eventually, tax hikes and spending cuts will be needed to deal with these issues, but those are likely many years in the future.
We do not think that these long-term unresolved problems are likely to have much impact on the U.S. cyclical outcome over the next several years. Deficit hawks, focused on reducing the deficit, tend to be upset with this view. They are correct that it will be easier to deal with this problem if we take corrective action soon. However, we believe that they are wrong to think that the prospect of a high debt-to-GDP ratio in coming decades will have much impact on the U.S. cyclical outlook over the next several years.
Fiscal Policies Should Be Stimulative in the Near Term
President-elect Trump proposed huge fiscal stimulus during the election campaign. Given political realities, however, we expect a smaller degree of fiscal stimulus — perhaps close to 1.5% of GDP, with the greatest economic impact in 2018. Such a policy is also likely to stimulate somewhat faster real GDP growth and inflation.
We believe that the fiscal multiplier — a ratio of how much aggregate GDP will increase for a unit increase of fiscal spending — is cyclical. Easier fiscal policy has its greatest impact near a recession trough at a time of continuing financial stresses. We expect it to have less of an impact when the economy is already near full employment, as it is today. The net effect of the new fiscal stimulus may be limited by both the strength of the U.S. dollar and higher interest rates. A key uncertainty is the likely effect on the supply potential and trend growth rate of the U.S. economy from the new administration's policy changes for corporate and individual taxes, deregulation, trade, immigration and healthcare. Overall, we believe that the Trump administration policies are likely to be somewhat stimulating for both parts of nominal GDP growth (real growth and inflation) — at least for the next year or two.
The situation with repatriation of foreign corporate cash has some special characteristics. In nearly all other cases, when the federal government receives tax revenue from the private sector, those funds drain financial liquidity from the private sector. Under corporate repatriation, however, the federal government would get about 10% of the repatriated cash but the remaining 90% would shift from trapped foreign corporate cash to immediately available corporate cash. It would be an unusual federal tax in that it would increase private sector financial liquidity. In the short run, repatriation would be a tax hike with an impact on the economy closer to what would be expected from a tax cut. The tax revenue from repatriation will help the calculated budget deficit.
Even before the election of Donald Trump, we believed that interest rates were destined to move persistently higher over the next several years for two reasons. First, the Federal Reserve would normalize short-term interest rates as it achieved its dual mandate of full employment and 2% inflation (as measured by the Personal Consumption Expenditure, or PCE). Second, government bond yields of the largest developed countries should be pushed up by the “QE hangover" over the next several years. We view quantitative easing (QE) in the U.S., Japan, Europe and the U.K. in the last several years as the greatest market manipulation in the history of the world. The resulting scarcity of sovereign bonds of the major developed countries is destined to gradually be phased out in the coming years, with sovereign interest rates likely to be higher in response to more normal net supply/demand dynamics in the sovereign bond markets.
The new Trump administration policies are likely to add to those pressures for higher interest rates. We believe that U.S. bond yields made a double bottom in July 2012 and July 2016 and have begun a multi-year uptrend. In the initial stages, we expect little damage to U.S. financial liquidity in that process. The Fed is likely to remain a “tentative tightener" for a year or more, allowing market forces to move rates higher rather than leading them higher with aggressive tightening. The Trump administration is also likely to halt the tightening trend in financial regulation, permitting a better transmission of credit to the real economy.
We have long forecast an eight-year economic expansion after the recession low in June 2009. With new fiscal stimulus now likely, the odds are favorable for at least a nine-year economic expansion. Unlike advocates of perpetual disinflation, we believe that the next recession will be triggered the old fashioned way: after many years of expansion, an overheated economy will drive inflation above the central bank's tolerance limits. We don't expect that soon, but the risks should be higher by late 2018 or early 2019, in a potential context of rising wage inflation and a rebound in oil prices. At the end, the new cycle may be just like the old cycle — just longer. With substantial fiscal stimulus coming, the cyclical outlook for the long economic expansion is favorable. But don't expect anyone to deal with the long-term debt challenges any time soon. We believe that it is still a “pay me later world."
*Numbers are for fiscal years (ended September 30)
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