We are extremely concerned about spending and debt at all levels of government. We know many of you share that unease as well.
Considering US federal government alone, its debt held by the public grew by 50% in just the last two years (2008 and 2009). It’s projected by the Congressional Budget Office (CBO) to grow another 17% in 2010 as this year’s federal spending is slated to be about $3.5 trillion - nearly 60% greater than the $2.2 trillion in expected tax receipts. Under their most optimistic scenario, the CBO projects significant federal deficits every year for many decades, and that outstanding federal debt in 2020 will have tripled from 2007.
Much of this problem is the result of current choices about spending. But a significant amount is just the impact of demographics on prior spending choices about Social Security and Medicare: today there is about one American of retirement age for every five of working age, but that shifts to a ratio of one to three in a little more than 20 years.
The debt and demographic situation appears unsustainable. Absent a change in spending policy, we can’t see how negative implications to long term economic growth and investment returns can be avoided (more on the distinction between long and short term later).
It’s a fact that federal government debt as a percentage of GDP is higher today than it has been since just after WWII. The future is conjecture, but the prospect of ever increasing debt levels does not bode well. Ultimately, an unsustainable government debt problem can only have some combination of the following outcomes: default, spending cuts, additional borrowing, additional taxation (with attendant lower economic growth), or greater money supply growth (with attendant inflation). State and local governments face similar problems, but have one fewer option – they can’t print money. We believe the best option is spending cuts, and that is likely at state and local levels, but it may be less likely at the federal level. The most likely eventual result may be some combination of: 1) as much ongoing additional borrowing as markets will allow (especially, near term); 2) much higher taxes eventually; and 3) somewhat higher structural inflation ultimately. Lower economic growth and higher inflation have very different investment implications. Some assets clearly benefit from inflation while others are clearly harmed. But lower growth is essentially a universal negative.
We also think it’s important to distinguish between near term and long term. For now, interest rates are low, so budget problems can be addressed by more borrowing, and cyclical influences dominate the question of near term economic growth. In particular, economic recovery continues, but the removal of fiscal and monetary stimulus adds uncertainty to a naturally uncertain arena. Corporations are operating very efficiently, and while that does not help the unemployment problem, it has resulted in strong earnings growth. As to inflation, many are convinced that much higher inflation is imminent, but there are also strong influences that could easily result in near term deflation. The near term outlook for both inflation and economic growth is unusually uncertain.
In that uncertainty, we think a couple of points should be emphasized. The first is that while stocks are an important hedge against inflation in the long run, that’s not always true in the short run. Specifically, stocks can perform well in the face of high and steady inflation, but stocks (other than specific sectors like energy or materials) almost uniformly respond negatively during periods of increasing inflation. The other point is that stock market returns are not highly dependent on economic growth in the near term (contrary to popular belief). Stock returns are, however, very influenced by interest rates and liquidity (both currently positive), and by initial market valuations (which are, depending how measured, currently neutral at best).
What can be done to protect portfolios from the risks associated with unsustainable government spending and debt? Greater uncertainty obviously calls for maximum emphasis on diversification. Beyond that, we anticipate emphasizing municipal bonds more for some, while applying even more attention to municipal bond credit risk given the deteriorating financial condition of most state and local governments. We expect over time to increase relative exposure to international equities (especially emerging markets). Contrary to the impression you may have from the media, money supply growth has recently been low (perhaps even too low). We’ll continue to monitor that, and would expect to respond to potential higher money growth rates by addressing bond portfolios’ durations and relative allocations to TIPs and other inflation protected bonds, and by increasing relative exposure to commodity related investments. We may at some point recommend increased exposure to alternative investments generally. And we continue to explore the option of incorporating a small amount of dynamic asset allocation into our portfolio management.
We don’t know the future, but each of those steps might be slightly helpful. None individually nor all collectively should be thought of as a magic bullet that should allow portfolios to sail through a potentially challenging economic environment unscathed. The more important message is that should our concerns prove well founded, there will be little we can do to insulate portfolios, in spite of our most thoughtful and energetic efforts.
Any increased prospect for lower growth and potentially higher inflation also begs the question: Why not reduce equity exposure? Two reasons. One is that the only certainty in all this is that higher levels of government debt increase uncertainty. And broad diversification – including into equities – is the best response to that. The other is that lower long term economic growth would likely translate into lower long term equity returns, but lower returns would not necessarily be negative returns, or even lower than bond returns. Current bond yields are so low that it is certainly possible (and perhaps likely) for long term stock returns from this point to be both better than bond returns and worse than long term historical stock returns.
The most important and prudent response to increased uncertainty, to increased potential risk, and to potentially more modest returns is to make sure we are each careful with our personal financial planning (especially our spending and debt), and to be cautious about return projections.
This is an unpleasant message on a worrisome topic. But it’s also tempered by important good news: all the concerns detailed above are very long term in nature. None appears to be an important immediate threat. In fact, we’re currently in a period of low interest rates which defers the real consequences of government debt until interest rates should rise significantly. We have no idea how long that may last - it could be days or it could be years. In the meantime, it offers a window of opportunity for spending adjustments by both governments and families that could make a real difference. In the meantime, the potential time bomb of government debt keeps ticking.