Stock Market Volatility vs. U.S. Budget Deficits and Debt at a Tipping Point?

by Victor Sperandeo with The Curmudgeon

This is the first of a two-part article on the recent stock market turbulence and what might’ve caused it-- fears of increasing budget deficits, debt and potentially higher inflation. It is one of the most well researched and comprehensive articles we’ve ever written.

Part II will be published later this week.

Stock Market Review:

After hitting an all-time high on January 26^th, the S&P 500 then experienced its first sell-off of any consequence since the last 3% decline ended just before the 2016 U.S. Presidential election. Before we look at why stocks declined, let’s review the background that led to the rally.

After its last 10+% correction low February 16, 2016, the S&P rallied to make an intermediate high on August 15, 2016. The index then experienced a minor correction until bottoming on November 4, 2016 (the aforementioned 3% decline). After Donald Trump’s surprise election victory on November 8, 2016 stock index futures had a big spike down overnight but recovered the next trading day. The S&P 500 and all other major U.S. equity indices moved “straight up” until January 26, 2018.

How do we define “straight up?” In this case a rally without a 3% decline on a closing basis. In fact, this was the longest such rally in market history! The previous record in the last 133 years was 370 days long in 1994 and 1995. The post-election rally beat that by 23%, lasting 455 days without a 3% decline. It was like a “runaway train” that wouldn’t stop!

The Intermediate Cause of the Rally’s End:

On February 2^nd, the latest employment report was released by the Bureau of Labor Statistics. The number that received the most attention was the 2.9% gain in year over year wages. That gain was far greater than anything seen in the entire Obama administration and raised fears of accelerating inflation along with higher interest rates. As reported by MarketWatch:

“Average hourly wages jumped 9 cents, or 0.3%, to $26.74, according to the Bureau of Labor Statistics. That means wages have increased 2.9% over the last year - the biggest gain since the end of the Great Recession in June 2009. The federal minimum wage is $7.25 an hour and hasn't increased since 2009. But many states and municipalities enacted laws to raise the wage this year.”

Investors and speculators feared the Federal Reserve would expedite it’s 25bps Fed Fund rate hikes due to increased wage inflation. To the Fed, wage inflation may be perceived as a precursor of accelerating overall inflation. Of course, like all government numbers it was made to look as positive as possible; adjusted for total hours worked the gain was 2.6% year over year instead of 2.9%. But the headline number is the only perception the markets care about and therefore trade on.

Curmudgeon Note:

Average hourly wages are only a single data point, but when combined with a rock-bottom unemployment rate (which is forecast to be below 4% this year) and signs of acceleration in economic growth, it suggests that inflation is a meaningful risk for the United States economy in 2018. Yet inflation, as measured by the Personal Consumption Expenditures excluding food and energy (the gauge the Fed most focuses on), has been below the Fed’s 2% target for years.

The Primary Cause - Debt and Congress:

The apprehension over the wage inflation was compounded by increased risk in the U.S. Treasury markets due to higher budget deficits and national debt spiraling ever higher. The latest two-year spending bill on February 7^thcame just a few weeks after the GOP tax bill which could add $1.5 trillion to budget deficits in coming years. The “compromise” budget bill, signed into law by President Trump on Friday, adds $300 billion of U.S. government spending to the $700 billion per year that had already been legislated.

Curmudgeon Note:

The budget “deal” suspends a 2011 budget law championed by conservatives that set hard caps on discretionary spending and included an automatic trigger known as "sequester" cuts if Congress attempted to bust those spending caps. The combined $1 trillion of additional fiscal stimulus raises the risk of the U.S. economy overheating, which would result in higher inflation. It will also greatly increase the budget deficit as there were no off-setting spending cuts. Budget deficits (and national debt) are financed by the U.S. government issuing more Treasury bonds, bills, and notes. The higher the U.S. budget deficit and national debt, the greater the supply of new Treasury securities that must be sold. Where will the demand for those securities come from if inflation also rises due to a stronger economy?
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The new $300 billion spending increase is split between military and discretionary spending (slightly more than half is to be allocated to the military). Specifics remain to be seen, but three things are now certain:

1. The government debt limit has been extended through March 2019, without restriction of how large the debt can grow.

2. The “sequester caps” are gone.

3. Since there is no actual budget, there can be no reconciliation on proposed new laws. Therefore, new laws will require 60 votes in the Senate to pass. This means President Trump cannot expect to successfully pass new laws unless the GOP picks up nine seats in the mid-term elections (which is highly unlikely) or nine Democrats vote with the GOP (assuming all the Republicans vote together in the first place). Not likely, in my opinion.

This latest increase in U.S. spending just agreed on by Congress (and which the markets were aware of) will result in much greater budget deficits. Expect a $1 trillion deficit in fiscal 2018 and $1.25 trillion deficit in fiscal 2019. This means $23 trillion in total debt by September 2019!

Curmudgeon Note:

Deficits as a share of economic output normally get smaller during an economic expansion when the unemployment rate is falling, and tax receipts are rising due to economic growth. Yet U.S. budget deficits have been INCREASING for the past two years- both in actual dollars and as a percent of GDP! The budget deficit fell to 2.4% of gross domestic product in 2015 before rising to 3.4% last year. Economists at J.P. Morgan expect the tax cuts and spending deal will boost the deficit to 5.4% of GDP next year, or $1.2 trillion. See Addendum below for more on exponentially increasing U.S. budget deficits and national debt.

This is highly unusual, ominous and deeply troubling when one thinks about what will happen to U.S. budget deficits and national debt during the next recession

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The June 2017 CBO Semi-Annual Report had deficits growing $10 trillion in 10 years without any recessions, without any additional spending, and without the tax cuts that recently passed. If the CBO is correct, after July 2019 this would become the longest recovery in U.S. history – 121 months. The current $20.6 trillion in U.S. debt will increase to over $33 trillion, again assuming no recession. It must also be kept in mind that the deficit is usually three times larger than the average of the previous three years during a recession. With a recession, I estimate by 2028 the U.S. debt will surpass $40 trillion!

Let me stress that past tax rate cuts didn’t add to the budget deficits. But this latest tax bill (December 2017) was a major tax cut for corporations, but minimal or nonexistent for individuals and some small businesses. That is not at all typical. Major tax cuts for individuals and small business like those under Presidents Coolidge, Kennedy, and Reagan produced greater revenue and did not add to the deficits.

Increased spending is what adds to deficits. So why does Congress continue to increase spending year after year? Kindly consider Alexis de Tocqueville’s brilliant observation:

“The American Republic will endure until the day Congress discovers that it can bribe the public with the public's money.”

Going back to 1991 when Ross Perot ran for President as an Independent, government debt has been a political issue to varying degrees. Whichever party is out of power bemoans the increase under the party in power, but somehow agreements are always reached and the debt (and spending) continues to grow. In 1991 the U.S. debt was $3.6 trillion, and the debt-to-GDP ratio was 0.58; it is now projected to grow to a 1.10 ratio by September 2018. However, to the markets the debt has never truly been an issue (because we have a central bank monetizing the debt). That is, it has never been an issue to the markets until now. Investors, and every American citizen, now has to ask:

Have we reached the tipping point for debt? Will it matter?

The undisputable fact is that the debt is exploding, while interest rates and inflation projections are moving higher. As a Wall Street Journal editorial recently put it: “Asset prices are adjusting as financial repression ends.” That means the end of the free money party!

Since the last quarter of 2008, Fed Funds and T-Bills have a lower yield than the CPI (i.e. that’s a negative real yield). The average yield on U.S. Government debt is 1.88% with an average maturity of 5.67 years. And rates are rising. Most importantly, the Federal Reserve has stated that it is selling part of its $4.5 trillion Quantitative Easing (QE) debt portfolio to the tune of $475 billion this year, and $600 billion in 2019.

Additionally, the U.S. Dollar is declining. Between late December 2016 to its intermediate low on February 2, 2018 the U.S. Dollar Index has declined over 14%. Who is going to buy $1.4 trillion in Fiscal 2018 of additional U.S. Government debt when the Dollar is set to decline as well?

Secretary of Treasury Steven Mnuchin recently stated: “Obviously, a weaker dollar is good for us as it relates to trade opportunities, and the currency's short-term value is not a concern of ours at all. An excessively strong dollar could have a negative effect on the economy, though longer term, the strength of the dollar is a reflection of the strength of the U.S. economy and the fact that it is and will continue to be the primary currency in terms of the reserve currency.”

Did you hear the big bell sound for the U.S. Dollar decline?

Curmudgeon Addendum:

On February 12, 2018, President Trump delivered his fiscal year (FY) 2019 budget request to Congress. The $4.4 Trillion budget proposal would add $984 billion to the federal deficit next year, despite proposed cuts to programs like Medicare and food stamps and despite leaner budgets across federal agencies, including the Environmental Protection Agency (EPA). Trump’s budget statement calls deficits the harbingers of a “desolate” future, but the White House plan would add $7 trillion to the deficit over the next 10 years. And it never comes close to balancing the budget during that time!

At the end of FY 2018, the gross U.S. federal government debt is estimated to be $21.48 trillion, according to the FY 2019 Federal Budget. Of this gross amount, debt “Held by the Public: Other” is estimated by usgovernmentspending.com at $13.32 trillion, debt “Held by the Public: Federal Reserve System” (i.e. monetized debt) is estimated by usgovernmentspending.com at $2.47 trillion and debt “Held by Federal Government Accounts” is estimated at $5.69 trillion.

U.S. Congressman Ro Khanna recently stated that the U.S. spends more on military/defense than eight of the next large defense spending countries combined. Evidently, that’s not nearly enough, because the Trump budget proposal provides more than $700 billion for defense in 2019 and over the next 10 years it would invest a total of nearly $7.5 trillion.

In light of last week’s budget-busting deal in Congress and the GOP deficit exploding tax bill, now more than ever it is crucial for Congress to pass a budget resolution that is fiscally responsible.

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Victor’s Closing Comment:

U.S. government spending in fiscal 2016 was $3.853 trillion. Trump’s fiscal 2019 budget of $4.4 Trillion is increasing the total budget at a 6.9% rate! To explain this in context, consider the CBO June 2017 report, which projects spending at $6.6 trillion or a 5.15% increase in 10 years. It’s made up of $5.1 trillion “on budget” and $1.5 trillion off budget items. This becomes the new “base line “and is in reality impossible to achieve.

As the Curmudgeon noted in the Addendum above, Trump’s budget proposal would add $7 trillion to the deficit over the next 10 years. That guarantees a $40 trillion deficit without any recession during that time period.

If interest rates are normalized and go to 6% - the average of all maturities compounded from 1961 – 2008 - it would necessitate 2.4 Trillion in interest payments on taxes/ revenues of $5.2 trillion (estimate as per June 2017 CBO report). If you include a recession, the deficit would be ~50 trillion.

Do you think that can work? Will foreign countries come to the rescue and buy up all our debt and continue to hold U.S. dollar financial assets? Think again!

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Stay tuned for part II of this piece to be published later this week.

Good luck and till next time...

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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