September Outlook: The Quiet Return of Big Government
September 14, 2023
Markets have been pleasantly surprised by the economic strength this year.
The reasons are many and vary across countries. However, one that has gone largely unnoticed is the return of supportive fiscal policy. In 2022, the US fiscal deficit contracted by the most on record after posting the largest expansion on record through 2020 and 2021. This year, even as the economic expansion has matured, bringing down the unemployment rate to its lowest level in a generation and pushing interest rates materially higher, the federal deficit has stealthily – and significantly – grown. In fact, the deficit doubled over the first 10 months of the fiscal year, from an already large US$726 billion in 2022 to US$1.61 trillion this year.
The surprises have come on both the revenue and spending sides of the ledger (see Chart 1). Tax refunds, normally peaking in the spring, actually rose over the summer, particularly to small businesses that have been filing backdated Employee Retention Tax Credits for meaningful sums. This plan has been increasingly utilized and recent reports suggest claims are now being denied in an effort to reduce excess use. Another reason for the lower tax revenue is depressed capital gains taxes amidst last year’s market returns.
Chart 1: Major fiscal items contributing to the $800bn deficit increase
June 2022 – June 2023
Source: US Department of Treasury, Strategas
On the other side of the ledger, spending has crept upward in the usual areas, such as social security, Medicare and defense. New investment and construction projects from the Inflation Reduction Act and Infrastructure and Clean Energy bill have not yet started, but should pick up in 2024 and carry forward for years, further deepening deficits.
However, the biggest increase in spending has been from interest payments on public debt, which have been impacted by the combination of growing financing needs and rising interest rates. Up until last year, even though the total debt outstanding grew materially, interest costs as a proportion of federal spending held in below prior highs.
Looking ahead, this is set to change even more significantly because around 70% of all US Treasuries held by private investors are maturing and will need to be rolled over in the next five years. In other words, most US debt is short term, and unfortunately, where interest rates are the highest. This is a sharp contrast to household mortgage debt and corporate debt that tends to be longer term and thus cushioned to some extent from the immediate effects of rate hikes.
Today, payments on federal debt take up about 14% of all revenues the government brings in. The Congressional Budget Office projects that interest costs will triple over the next decade, growing from 1.9% of GDP to 3.7% in 2033 (see Chart 2). Given the size of the deficit, the cost of servicing the debt and that there is no plan to materially reduce the deficit, it’s little surprise that Fitch downgraded US debt from AAA to AA+ in early August.
Chart 2: Interest costs will exceed previous high by 2029
Source: CBO, Macrobond
Deficits are useful and important policy tools. Government spending using borrowed funds can support growth and productivity if funds are earmarked for infrastructure or investments. Importantly, running a deficit can soften the impact of a recession and also mitigate crises, like an economic shutdown, or help rebuild after a natural disaster. That said, large deficits should not occur at a time when the economy is already pushing up against full employment. In this situation, the government artificially creates demand, making inputs more expensive, and crowds out private investment by competing for financing that would otherwise invest in new ideas or business expansion. Cyclically, during downturns, government support is critical to many, and indeed, if this is the deficit during good times, what will it be in a recession?
Shorter-term implications are equally important. The size of the debt is now roughly the same as annual GDP and threatens to surpass the short-lived surge during World War II (see Chart 3), and, at this size, may force a reprioritization of servicing the federal debt above the fight against inflation.
Chart 3: US government debt to exceed previous high by 2028
Source: CBO, Macrobond
In other words, monetary policy – already balancing the competing priorities of price stability, full employment and financial stability – may also need to temper high interest rates to prevent a fiscal crisis. From a historical policy perspective, monetary policy tools may not be the best suited to combat deficit-fueled inflation; instead, fiscal austerity may ultimately be the required policy tool. The New York Fed’s recently published research supports this argument, concluding that extensive government support was responsible for about a third of the inflation between December 2019 and June 2022.
We believe that the Fed’s primary focus will remain on the inflation risk and Chair Powell has said as much in asserting the Fed’s independence and leaving debt and servicing costs for Congress to address. The problems are nonetheless intertwined – too much fiscal support is being noted by bond investors, who were attuned to similar fiscal risks in the UK a year ago.
This problem is more widespread than just the US. The EU has struggled with rising interest costs, as has Japan, which has stopped projecting a balanced budget. Canada is in better shape comparatively, maintaining an overall AAA rating (Fitch downgraded Canada to AA+ during the pandemic). Provincial governments are also on solid ground. While spending has meaningfully expanded deficits compared to the past two decades, Canada’s deficit is anticipated to be at a comparably modest 1.4% of GDP in 2023-24 and is projected to decline to just 0.4% in four years. Debt levels are a different story, as pandemic support costs were absorbed largely by the federal government and caused a surge in total debt outstanding from 32.8% of GDP pre-pandemic to 44.5% of GDP this year.
Even compared to other countries, the US’s fiscal problems stand out and remain a key risk by virtue of the importance of the bond market and yields. These deficits are unhealthy for the economy longer term and a reversal in the trend would help the Fed’s cause, but it’s not clear that will be forthcoming. Spending is set to rise next year and interest costs are headed higher.
The fiscal picture is one suggested reason for longer-term interest rates rising in August, with the Fitch downgrade a catalyst for the move. The US 10-year Treasury yield reached a peak of 4.36% mid-August before easing back to close the month up about 20 basis points (bps) at 4.11%. This intra-month high has not been seen since 2007. Canadian 10-year yields rose about 6 bps, lagging the move in the US. Two-year yields fell in both countries and the FTSE Universe Bond Index declined marginally, by -0.2%. The higher long-term rates did weigh on risk assets, with credit spreads widening somewhat, but also equity markets, which, on a monthly basis, fell for only the second time this year and the first time in five months. Equities did recover off their lows for the month, as softer inflation data tamed fears of interest rates staying higher for longer. The S&P 500 Index fell 1.6% in August, while the S&P/TSX Composite Index fell 1.4%. Most sectors saw declines in the month, with only energy, consumer staples and the health care groups posting meaningful gains. Despite weakness in China and Europe, energy prices rose for the third straight month, while metals prices weakened alongside industrial production.
Equity markets this year have so far been optimistic about a soft-landing scenario for the economy, due in part to the unanticipated fiscal support, though we continue to view a soft landing as a lower probability scenario. Despite the move higher in interest rates through the summer, valuations this year have actually expanded. If the soft-landing scenario does come to pass, then it’s likely the market and the Fed would need to reassess the neutral policy rate, as the economy would appear able to handle these levels of rates. Thus, long-term interest rates could stay higher for longer compared to prior cycles, which would ultimately disappoint risk assets. This upside risk to yields is particularly true if the concern over fiscal mismanagement continues to grow.
Balanced portfolios remain overweight cash, while both equities and bonds are underweight relative to benchmarks. Equity markets continue to reward companies with resilient earnings. We are adding to some cyclical stocks with attractive valuations that reflect the potential to benefit from extended economic strength. We believe the generative artificial intelligence theme will continue to support multiple expansion in the technology sector and look for companies that will benefit from the forthcoming capex cycle driven by increased fiscal investments in the coming years.
Fixed income portfolios continue to position for higher longer-term yields against short-term rates, and the positioning should perform well across different economic scenarios. We continue to monitor the evolving landscape, assess the longevity of the various factors that have helped support growth to date and adjust portfolios accordingly.