Debt woes

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   By Guest Blogger Ryan Lewenza

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It’s time for another update on the US debt situation. I covered this topic a few years and many trillions ago. While things are not good, which I’ll outline today, there is still time to turn the ship around. All is not lost but when will US leaders and politicians step up and finally get their house in order before it is too late?

I have a good friend who is quite ‘left wing,’ and we have some heated discussions around politics, capitalism, and specifically, US government spending and deficits. His view is that deficits don’t matter, and points to fact that there have been no consequences so far for their out-of-control deficits and debt. But this misses the point. It doesn’t matter till it does! This is what we call a ‘Minsky moment.’

A Minsky moment is when an overindebted country or corporation suddenly collapses under the weight of their accumulated debt and interest payments. Everything is going just fine until poof, confidence in said country/corporation evaporates and the market realizes that the company or country cannot pay the interest payments and principal. Think of Argentina, Enron or Lehman Brothers during the financial crisis. This is what I’m afraid of happening with the US and their debt one day if they don’t sort it out.

Let’s start with an update on US government finances.

Last year US government spending clocked in at $6.1 trillion, which is up 30% from the 2020 levels of $4.8 trillion. Under President Biden spending has surged as he introduced several ambitious new programs. This includes things like student loan forgiveness, expanding Obamacare, and the infrastructure bill.

Looking at the other side of the ledger, revenues or taxes were $4.9 trillion last year, resulting in a deficit of $1.6 trillion. Outside of the 2020 covid year, these are the largest deficits seen in US history, as seen in the chart below.

The last time there was yearly surpluses was during the early 2000s under President Clinton. Since then, it has been nothing but deficits. As a result of these yearly deficits – under both Democrat and Republican presidents – the US federal government debt stands at an eye popping $35 trillion.

US federal annual budget deficits/surplus

Source: Bloomberg, Turner Investments

Let’s look at how the US government spent $6.1 trillion. US government spending is broken into three broad categories – mandatory spending ($3.8 trillion and 62% of total), discretionary spending ($1.7 trillion and 28% of total) and interest expense ($700 billion and 11% of total).

Mandatory spending is spending required by law and includes things like Social Security, Medicare, and Medicaid. This spending cannot change unless new laws are passed. Discretionary spending is spending that the US congress controls annually through appropriation acts. This includes things like defense, education, foreign aid, and agriculture.

US government spending breakdown

Source: CBO

To balance the budget the US government will have to either cut spending, raise taxes or make big changes/reform to key programs like Social Security and Medicare.

The Democrats would prefer to raise taxes then make cuts, while the Republicans would prefer to slash spending. Unfortunately, given the size of the problem, they don’t have the luxury of doing just one.

Neither party wants to touch the important social programs like Social Security. That would be an election campaign killer. So that means there will unlikely be any action on the mandatory programs, which represent over 60% of annual spending.

So, that leaves the $1.7 trillion discretionary spending portion. If the deficit last year was $1.6 trillion (projected to be $2 trillion for this year) then it would require cutting all discretionary spending to zero. That means no defense spending ($800 billion last year). No money for schools, transportation, and protection for the environment.

Clearly, they can’t cut their way to a balanced budget. This is why I say that if the US wants to get serious about addressing the deficits, they will need to do all of the above. It will require raising tax rates, cutting spending and reforming Social Security and Medicare.

Will it be easy and without hardship? No, but the alternative could be so much worse. If investors lose confidence in the US and their ability to service the interest payments and principal, US government bond prices will crater, driving yields up and making it even harder to service the debt.

Below is a chart showing US federal government interest payments as a percentage of their yearly budget. Even with the record debt the interest expense as a precent of spending has continued to decline because of interest rates hitting record lows. What this chart shows is that if interest rates spike then then this could blow up their budget as they will have to direct more spending to servicing the debt. This is the risk.

US government debt servicing costs & interest rates

Source: Bloomberg, Turner Investments

To be clear, there is still time to fix this problem. I believe it’s more important to focus on government debt compared to GDP. It’s no different than an individual. If I have a million dollars in debt and earn $1 million per year then I can easily service the payments. But if I only earn $40k/year than it’s going to be a lot harder to meet those payments. A government is no different.

When looking at US government debt to their GDP it currently equates to 123%. Compare that to Italy at 139% or Japan at 254%. These are weaker economies than the US yet have higher debt ratios. This shows that countries can go a long time before the debt starts to be a problem and investors lose confidence.

G7 nations debt to GDP ratios

Source: Bloomberg, Turner Investments

Also, the US has been in this situation before. During WWII, it took on a lot of debt to fund the war with the debt to GDP ratio getting up to 120%, where it stands today. Granted the US went on a big growth spurt following the war, but they were able to address their debt problem and reign it in. So, they’ve done it before and can do it again.

Finally, I think there is still time to fix their fiscal hole and the US economy remains the strongest, most dynamic economy in the world. Given this we still have confidence in US treasury bonds, and in fact have been adding to them in client portfolios. As the Fed continues to cut rates, US government bond prices will rise, so we see the potential for decent returns over the next year.

So, we’re sticking with them for now. But, if the US continues down this long path of fiscal irresponsibility, we’ll be dumping these bonds and looking elsewhere for our safe, low risk government bond allocation.

Let’s just hope the US wises up before it’s too late and Americans avoid the dreaded Minsky moment.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

Source: https://www.greaterfool.ca/2024/11/02/debt-woes/