Gimme Three Steps...on the Path of Deleveraging
- Debt (and Fed policy) continue to be my biggest longer-term concerns; even with the progress made over the past few years by the household sector.
- The budget deficit is plunging; and that's great news, but more is needed to bring overall debt growth down to more reasonable levels.
- The solutions stool is three-legged: spending, revenues … and growth!
One of the most common questions I get from investors and the media is, "What keeps you up at night?" Aside from having two teenagers, and being a chronic insomniac anyway, the two concerns I typically cite are Fed policy and the US debt overhang. As for the former, I will address that topic in a couple of weeks when the Fed next meets; after which I'll pen our usual post-Fed meeting commentary. As for the latter, it's a topic I've addressed many times over the years, but it's been a while since I've provided an update, so this report will be devoted to where we are in the debt deleveraging cycle.
As everyone is acutely aware, the massive debt deleveraging cycle the household sector's undergone was "forced" upon it when the financial crisis hit with a vengeance in 2008; since which time most measures of debt have fallen sharply. The debt binge that preceded the crisis has been followed by a massive hangover, which finally seems to be receding. A primary way to measure household debt is seen below.
Household Debt Way Down
Source: FactSet, Federal Reserve, as of June 30, 2013. Yellow and purple chart lines represent trend lines.
As you can see above, household debt has dropped meaningfully since its pre-financial crisis peak and is now well below the long-term trend line. I also think it's important to look at the pre-bubble trend, which is arguably a healthier benchmark vs. one that includes the debt bubble. Household debt is even getting close to breaking below that trend; and my guess is that we overshoot on the downside. The good news is that we are past the point when deleveraging is a drag on economic growth.
To me, the bigger problem is government debt; but even here, a dent has been made. The solution to a long-term debt problem is a three-legged stool: spending, revenues and growth. The first two can be viewed through both short-term and long-term lenses. Near-term spending cuts have been fairly dramatic "thanks" to the sequestration; but longer-term there really isn't much of a prayer unless entitlement reform is on the menu. Near-term revenue increases have also been fairly dramatic "thanks" to the fiscal-cliff related tax increases; but ideally, longer-term revenue increases can be found via fundamental tax reform. Finally, the economy needs to grow at a healthy clip.
Let's start with the short-term. It's important to remember that long-term debt is the cumulative effect of running short-term deficits and in order to begin tackling the former, the latter needs traction. Here we have some good news. As you can see in the two charts below, the federal budget deficit has improved markedly from over 10% of gross domestic product (GDP) to less than 4% today.
Deficit Improving Dramatically
Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2013 © Ned Davis Research, Inc. All rights reserved.), US Department of Treasury, as of October 31, 2013.
It is rare to see this significant a change in a relatively short period of time. At 3.9% of nominal GDP, the deficit is the smallest share in five years and has been accomplished due to tighter fiscal policy, including the fiscal cliff deal (tax increases) and government sequestration (spending decreases), as you can see in the bottom chart above. But importantly, it has also been a function of fairly steady job growth and the resultant increase in individual tax receipts; stronger corporate profits and the resultant increase in corporate tax receipts; still-low net interest payments by the government; and less dependence on income support from the government.
In dollar terms, the 12-month total deficit shrank to $652 billion as of October 2013. Given political sentiment in DC still focused on deficit reduction, the budget deficit is likely to continue to improve; with the consensus of economists at $620 billion in 2014.
…But, debt is still growing
Again, long-term debt is the cumulative effect of running budget deficits. The efforts underway to improve the deficit have resulted in a much lower growth rate of public debt. But the problem is it's still growing. You can see the plunge in the growth rate below, but also that fact that it's still in positive territory (and as a result, the absolute level of public debt as a percentage of GDP is still extremely elevated).
Debt Growth Down But Level Still High
Source: FactSet, Federal Reserve, Ned Davis Research, Inc.(Further distribution prohibited without prior permission. Copyright 2013 © Ned Davis Research, Inc. All rights reserved.), as of June 30, 2013.
For now, as you can see below, the cost of servicing this debt remains fairly low; but it's worth contemplating what this cost curve will look like as rates begin to go up; especially if debt growth is not reined in further.
Debt Servicing Costs Low … For Now
Source: FactSet, Federal Reserve, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2013 © Ned Davis Research, Inc. All rights reserved.), US Department of Treasury, as of June 30, 2013. Debt Servicing Cost = interest payments made on outstanding federal divided by total government expenditures.
Objective analysis vs. political leanings
Most observant readers and listeners know I lean fiscally conservative; but I'll try to keep my views on spending vs. taxes relatively objective. The reality is, we probably don't continue to make significant dents in our long-term debt problem without movement on both, but as you can see below, relative to the post-World War II averages, government spending remains well above the "norm," even with the recent decline. Conversely, the spike in taxes over the past year has taken them as a percentage of GDP to well above the "norm."
Taxes Up More Than Spending's Down
Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2013 © Ned Davis Research, Inc. All rights reserved.), as of June 30, 2013.
As I mentioned earlier, I think there's room for higher revenues; but ideally it's done through fundamental tax return; not simply by raising taxes further. (As a reminder, I'm passionate about this topic having served on President Bush's nine-member bipartisan tax reform commission in 2005.)
Ignore the debt doesn't matter cries
Finally, there are (surprisingly) many who argue that high and still-rising government debt is not an impediment to growth; some of whom suggest we should be ramping up spending even more to boost growth.
High debt's effect on growth is frankly undeniable; whether as seen through the "This Time is Different" lens of Ken Rogoff and Carmen Reinhart; or via a simple chart like below. It shows the percentage relative to GDP of total credit market debt (the broadest measure of debt across the public and private sectors; excluding unfunded entitlement liabilities).
Just Starting to Make Dent in Debt Problem
Source: FactSet, Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2013 © Ned Davis Research, Inc. All rights reserved.), as of June 30, 2013.
Since the "great recession" ended in June 2009, the overall economy has seen average real GDP growth of only 2.3%. On the other hand, the private sector alone has seen average real GDP growth of 3.2%. Call it the mirror image economy: what it reflects is that the deleveraging that's been underway in the private sector has led to higher growth; and that much more is needed from the government sector.
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