There is an alternative to the abrupt austerity of a fiscal cliff and the attenuated austerity implied by a Grand Bargain. The Congressional Budget Office has even got a fancy name for it: They call it the "Alternative Fiscal Scenario." For purposes of this article, we will call it the "Can-Kick Scenario."
The CBO analyzes the consequences of a specific version of a can-kick scenario, the details of which you can peruse here. The bottom line is that the CBO's Alternative Fiscal Scenario assumes that the fiscal cliff is avoided and, more specifically, that virtually none of the currently projected budget cuts go into effect and that virtually all of the Bush tax cuts are extended (although payroll tax breaks are allowed to expire). Under this scenario, the CBO projects a 2013 budget deficit of -6.5% of GDP and an average of annual deficit of almost -5.0% of GDP between 2013 and 2022.
According to the CBO, the Can-Kick Scenario would provoke an increase of the Federal Debt Held By the Public as a percent of GDP from 72.6% in 2012 to 89.7% by 2022. Beyond that point, the CBO projects that the US public debt will escalate quickly and surpass Greece-type levels by 2030 and reach 200% of GDP by around 2038.
But, as investors, perhaps we should not get too far ahead of ourselves and start fretting about problems that could arise between 2022 and 2038. After all, what evidence is there that financial markets are so forward-looking? Indeed, if we just focus on the next decade and ignore anything beyond, the Can-Kick Alternative doesn't look so bad. Actually it even looks sort of enticing.
After all, in the past, the US has been able to absorb annual deficits in excess of 5.0% of GDP per annum for extended periods without going to hell in a handbasket. Furthermore, the CBO's projected US public debt level of 89.7% of GDP by 2022 is below the level that currently afflicts most crisis countries in Europe - and way below the magnitudes of public debt that Japan has been able to live with for decades.
So, if one assumes that US leaders will embrace the Can-Kick alternative, and assuming that one's investment time horizon is less than ten years, why worry? The real problems won't really surface until after 2022, right?
Alas, one can sustain such pleasant expectations for the next decade under the Can-Kick Scenario only if one believes the CBO's projections.
The CBO's Wonderful World
Strangely enough, in its report outlining the Alternative Fiscal Scenario (i.e. Can-Kick Alternative), the CBO did not provide a detailed breakdown of the assumptions it employs to arrive at its projections. Fortunately, it is possible, with a little detective work, to mathematically derive the CBO's assumptions from their published data (from the previously referenced report and elsewhere) with a high degree of accuracy. And after performing such an analysis, and reviewing the underlying assumptions for myself, I've wondered whether the failure of the CBO to publish their assumptions might be intentional. Because, quite frankly, the CBO's assumptions are of a sort that might cause any reasonable economic analyst to blush.
Let us examine these underlying assumptions.
In order to assign credence to the CBO's projections regarding the USA's debt trajectory for the next decade under the Can-Kick Scenario (i.e. Alternative Fiscal Scenario), you must believe the following:
1. GDP will surge strongly for most of the next decade. According to the CBO, after growing slowly between 2013 and 2014, US real GDP growth will all of the sudden leap to an average of 4.0% per annum during the five-year period between 2015 and 2019. For the longer 8-year period between 2015 and 2022, the CBO projects US GDP growth to average 3.4%. Such performances would register as some of the strongest economic expansions in US economic history since 1950, over five and eight year time-frames. Evidently, the CBO is not concerned that household debt constraints, or that major demographic headwinds, might significantly restrain economic growth going forward relative to past trends. That's awfully nice of the CBO to think so, isn't it?
2. No recessions for thirteen years. The CBO is essentially projecting thirteen consecutive years of economic growth between 2009 and 2022. The length of this wondrous economic expansion that the CBO is forecasting would be by far the longest in US economic history, smashing the previous record by 30 months. The CBO evidently believes that the US will suffer no major organic adjustments due to internal imbalances for the next decade. Similarly, the CBO essentially assumes a nil probability of wars, oil crises or other exogenous shocks for the next ten years. Now, wouldn't that be swell?
3. Ultra-low and steady inflation. Readers should note that since 1913, US inflation has grown at an average pace of over 3.2%, with considerable volatility along the way. That is important to keep in mind because the CBO projects that overall US inflation (i.e. not just core inflation) will average under 1.6% in the next five years between 2013 and 2017, and only 2.0% in the five years between 2018 and 2022. Such low nominal rates of inflation would be unprecedented in US economic history in the context of the type of GDP growth that is being forecast. Furthermore, the CBO predicts virtually no inflation volatility during this period. Apparently, the CBO assumes that there is no risk that the unprecedented Federal Reserve policies of recent years might result in above-average inflation and/or inflation volatility. It must be wonderful to experience such complacency, no?
4. US interest rates will remain at historically low levels. As part of its assumptions used to project federal interest expense, the CBO assumes that both nominal and real yields on US Treasury securities will remain at extraordinarily low levels by historical standards, thereby enabling the US to finance deficits and debts at bargain basement costs. For example, the CBO projects that real (inflation adjusted) interest rates will remain negative for several years until sometime during 2016 - constituting a stretch of negative real interest rates that would virtually be without precedent in US history. Furthermore, the CBO projects that the real yield on 10Y Treasury notes will remain at historically unprecedented low levels through 2017. Finally, the CBO projects that nominal yields on 10Y Treasury notes will rise gradually until reaching and sustaining a plateau of 5.0% between 2019 and 2022. Never will US interest rates have been so low while GDP growth rates were so high. All of this is awfully convenient, since to assume real and nominal interest rates that were more along the lines of historical norms would raise the CBO's projected interest expenses, and therefore deficits and debts to quite a substantial degree. It's really a wonderful world where deficit/debt levels and default risk rise but nominal and real interest rates fall, isn't it?
I have great respect for the folks that work at the CBO. However, in this particular instance, it is my belief that the CBO as an institution is doing the USA a disservice by publishing and endorsing highly optimistic, and almost certainly unrealistic, assumptions that enable policymakers and the public to operate under the delusion that they can afford to dither and postpone difficult choices for another decade.
If you believe that US policymakers will choose a can-kick alternative such as outlined in the CBO's Alternative Fiscal Scenario, and you also believe in the CBO's macroeconomic assumptions and forecasts associated with this policy route, you should run, not walk, to load up on stocks such as Apple (NASDAQ:AAPL), Oracle (NASDAQ:ORCL) and Amazon (NASDAQ:AMZN) and just about any other stock represented in equity index ETFs such as (NYSEARCA:SPY), (NYSEARCA:DIA) and (NASDAQ:QQQ). For in the CBO's world of the Alternative Fiscal Scenario, there evidently are many free lunches.
However, if you are like me, and believe that the next ten years will not be quite as rosy as the CBO projects - whether the US falls off the fiscal cliff, a Grand Bargain is reached, or the can is kicked further down the road (as is assumed under the Alternative Fiscal Scenario) - you might consider raising some cash. I believe greater bargains are ahead.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.