When will it matter

By Guest Blogger Ryan Lewenza

We live in a world of debt! Individuals, corporations and governments have all been gorging on cheap and free flowing debt, leaving many to believe that we’re closing in on a major debt crisis that will have untold consequences for the global economy. Of course these types of dire and apocalyptic predictions almost never come to full fruition, but one would be foolish to believe that we can get through this historic debt binge completely unscathed. This week I examine the boring, yet critically important topic of rising debt levels, and what it could portend for the economy in coming years.

Let’s focus on US government debt since it’s absurdly high and receives the most attention. US government debt has been rising steadily for decades under both Democratic and Republican parties – both parties suck at reining in spending and balancing budgets.

In 2000, under President Clinton, US government debt stood at $5.5 trillion. Then under Bush II, it doubled to $10.6 trillion in part due to increased government spending and the costly Afghanistan and Iraq wars. US debt then exploded under President Obama, due in large part to the effects of the Financial Crisis and the half-speed recovery that followed. US debt doubled again under his two-term presidency to $20 trillion, with the last $2 trillion coming under Trump’s presidency. So neither party can claim moral high ground on the persistent US deficits and high debt levels since both parties have done a terrible job in reining in spending and addressing the out of control debt, which currently stands at an almost incomprehensible $22 trillion or $67,000 per woman, man and child in the US.

Total US Government Debt Outstanding

Source: Bloomberg, Turner Investments

Where did it all come from?

The US government spends more than it takes in in tax revenue, resulting in huge annual deficits. For example, last year President Trump and Congress spent a record $4.75 trillion, which is broken into 3 categories – mandatory spending (e.g., Social Security) at $2.84 trillion, discretionary spending (e.g., military) at $1.43 trillion and interest on the debt of $479 billion. Now, the government only took in $3.65 trillion in revenues, resulting in a deficit of over $1 trillion last year. As seen below, the US government has posted 18 consecutive years of deficits with no end in sight. Basically, the US government (and our own government) is spending like a drunken sailor on leave, which is what got them here today.

US Government Annual Budget Deficit/Surplus

Source: Bloomberg, Turner Investments

How can the US get back to surpluses and start addressing the debt?

The problem is there are not many levers that the government has at its disposal to address the deficits so if politicians are serious about addressing this problem they are going to have to make some really tough choices.

First, they could look at the revenue side by increasing taxes on individuals and business. Clearly this is not an option under the current administration given that Trump and the Republican-controlled Senate just implemented historic tax cuts last year. The Democrats would have to take back the Senate and the Whitehouse to have any chance of raising taxes. So don’t expect any progress on this front for a while.

Second, is on the spending side and again there are few available options. Either discretionary spending, particularly military spending would have to be slashed, and/or they would have to reform the mandatory programs like Social Security payments to make any real dent in the deficits.

If I were the President I would take a measured, all of the above approach, given the severity of the problem, by increasing taxes on individuals (I also think they cut the corporate tax rate too far last year), cutting discretionary spending (US military spending is completely out of control at $716 billion for this year, up $82 billion since 2017), and reforming social programs like Social Security and Medicare. Of course these spending cuts would have huge negative consequences on so many people, but if the US wants to actually address the debt they will have to put their big boy/girl pants on and make some tough decisions. The alternative down the road could be so much worse!

Now it’s important to emphasize that when analyzing debt levels and the potential implications you have to look at the debt relative to the size of the economy, as the tax revenue that supports the spending and debt flows from the state of the overall economy. Currently, the US government debt-to-GDP ratio sits at 109%, which was just 60% prior to the Financial Crisis. This is unstainable over the long-run and absolutely needs to be the focus.

The other important point to stress is that it’s not just the US that has high debt levels. Below are the debt-to-GDP ratios of the G7 nations and you can see Japan is the worst at 234%, then Italy at 127%, followed by the US. Germany looks pretty solid at 61%, and Canada is ok at 84%. The point being, a lot of countries have racked up debt so the problem is global.

G7 Nations Debt to GDP Ratio

Source: Bloomberg, Turner Investments

So when will it matter and what’s the end game?

From a timing perspective I think we’re still some years away from when this risk could metastasize and really start to have an impact on people’s lives and the broader economy. As a society we have an uncanny ability to kick the can down the road and delay making the hard sacrifices. One reason I think we’re still a ways off from this risk manifesting is that I believe it will require a large spike in government bond yields to set off alarm bells as this would lead to a significant increase in servicing the debt.

I believe we’re in a low-growth, low interest rate environment for years to come, in part due to the high debt levels and declining population growth rates and productivity gains – the two key drivers of long-term economic growth. If correct, this could push out the day of reckoning.

The second way this debt time bomb could go off is if we see a material decline in investor confidence over the debt levels. In this scenario, investors would rush to the exits driving up yields quickly, which could really set things off and have a very negative impact on the economy and financial markets. This is the worst case scenario.

Finally, the third potential outcome is that somehow we just deal with this high debt in a somewhat orderly way. Governments finally wake up and start cutting back on spending, bringing deficits back in line, interest rates remain low, and economic growth remains overall supportive. This is the goldilocks scenario and while unlikely, is possible.

In closing, I fully acknowledge how boring this blog topic is but I can’t stress how critical this debt problem could be if left unaddressed. I hope that in the not too distant future our political leaders will man or woman up, and start making the tough decisions to finally rein in the excessive spending and debt levels. I’m an optimist and think there is still time, but the hourglass is slowly emptying.

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