Yesterday bond guru Jeff Gundlach gave a scary lecture, warning about the danger of rising federal deficits which in turn could trigger a decline in the value of the dollar and a significant rise in interest rates. I disagree. I lived through the scary inflationary 1970’s when some yields hit 21% in 1981 and inflation hit 14%. Many frightening things happened in the 1970’s where it was common for people to worry that we were doomed, but eventually inflation was brought under control and the economy grew out of its problems.
First, the recent contribution to the rising deficit is the Trump tax cut signed on 12-22-2017. But this is a temporary law constrained by the ten year time limit of the Byrd amendment; the law expires and the tax code reverts to the previous law in 10 years. Additionally it is not properly inflation indexed and thus the expected present value of the tax cuts is smaller than they look, meaning the impact on the deficit is less worrisome.
Secondly the reason for the significant increases in the deficit over the past 20 years were the war on terrorism since 9-11, which hopefully is a one-off expense instead of an external ongoing expense, and the other big reason for the rising deficit was the mortgage and real estate bubble fraud of 1997-2008 which resulted in a deep crash and bailout in 2008. Had there been no 9-11 incident in 2001 and no 2008 gigantic real estate bubble crash then the cumulative balance of the deficit would be much more slowly growing and thus less scary. Let’s have faith that systems put in place to prevent a repeat of these tragedies will work and are working.
Since the Reagan era changes in the 1980’s the U.S. has moved far ahead of other countries, developing sophisticated Intellectual Property that is less available elsewhere, along with more flexible job-creating tax policy that has made our per capita income grow faster than other developed countries. Thus the U.S. economy is on track to earn the income which allows the tax system to have something to tax and thus make progress on paying the debt. By contrast, debts in other developed countries such as Japan, China, and the EU are growing at a faster pace while their GDP’s ability to earn money to pay their debt is growing at a slower pace than in the U.S. There was even an article last month claiming that China’s true GDP growth is only 1.7%, which if true, means we are growing faster than they are, since the U.S. GDP has been around 2.5% in recent years. Currently the only big source of honest economic growth in the world are U.S. West Coast tech industries, since the China and Australia real estate bubbles are a bogus source of growth. The true growth and debt service capacity of the U.S. is higher than it appears since some of the GDP is “stored” offshore in subsidiary companies for tax purposes, if this was classified as being done in the U.S. and taxes were paid on it to the U.S. then the debt load would look better and the EU would look weaker. (The recent tax law now requires a minimum payment to the U.S. of 12.5% tax rate for these companies or else they must pay more to local authorities).
It has been said rhetorically that the U.S. federal debt is so great the Federal Reserve is forced to make interest rates artificially low. But actually if U.S. interest rates go up, the dollar will go up in value making EM countries have a more difficult time to repay their dollar based debt, triggering a global recession. If Congress repeals the tax cuts in 2021, which I expect, and solves the Federal Deficit then the result will be a decline in private sector consumption and thus the economy will experience lower inflation, lower growth, higher unemployment, lower interest rates, etc.
The two big economic trends are (1) globalization, that started in the 1980’s, cutting wages and cutting inflation in Developed countries, leading to low interest rates, and (2) a new mega-era of tech growth in the U.S., that started in 1991, that enables legitimate economic growth to occur which in turn enables more high income taxable income to be generated, thus resulting in management and professional type of people paying more taxes. Currently the top 10% of the population pay a huge proportion of taxes and the have skills that are very much in demand, so this tax paying segment of the population is able to grow faster than the rest of the economy and thus get to work on making progress on paying the federal deficit.
I maybe bearish on stocks because the PE ratio is too high, and thus I believe stocks are likely to drop significantly, but I’m not bearish on the growth of the U.S. economy. It is possible that GDP growth can occur even if we have a slight degradation of profit margins while workers are getting bigger pay increases. A reduction in corporate profit margins and stock prices would act to cool down interest rates, so I don’t see how the U.S. economy can move to a high interest rate regime associated with an over-indebted Banana republic.
The topic to worry about is the global economy falling into a debt/deflation trap where oversupply results in ruthless cost cutting at the same time people struggle to pay excessive debt. In such an environment people would flee into the safety of U.S. Treasuries and our rates would converge with the low negative or near zero rates of Japan and the EU. The U.S. will end up being the last man standing as the other Developed countries get sicker with more debt to GDP and slower growth for other countries.
Investors need independent financial advice about the risks of misunderstanding federal debt problems.