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Yesterday, I was reading over economist Brian Westbury's analysis for First Trust. It's a very interesting (and quick) read that is worthwhile to check out. Westbury was critical of the 'politicization of the economy' by both political parties, criticizing some in right-wing circles for seeing a 'recession behind every corner' and criticizing the left for an obsession with constantly increasing spending and expanding the size of government.

While Westbury is critical of the political environment, he says he is made optimistic by the fact that corporate profits have grown rapidly, GDP growth has held up OK, and that we've had 41 consecutive months of gains in private sector payrolls. He views this as particularly astounding given the tax increases this year, Obamacare, Dodd-Frank, and the sequestration. Westbury also points out that the Federal budget deficit has been declining as a share of GDP, which is also good news.

I'm in agreement with a good chunk of Westbury's analysis, but I find myself a bit in disagreement on the broader theme of economic growth. For this article, I want to take a look specifically at the budget deficit and why the recent optimism I'm seeing from many economists is very misplaced. The budget deficit is still a major issue and still a very critical figure to watch for investors.

The Disappearing Deficit?

Over the past year, there's been this shift with many economists proclaiming that our budgetary problems are over or near-over. These proclamations have come as the budget deficit clocks in lower than expected as a percentage of GDP, with the CBO estimating that the deficit could fall all the way down to 4% of GDP by the end of the Federal fiscal year.

Paul Krugman has naturally led the charge. In his article, "Dwindling Deficit Disorder," Krugman argues that, if anything, the budget deficit is too low.

"People still talk as if the deficit were exploding, as if the United States budget were on an unsustainable path; in fact, the deficit is falling more rapidly than it has for generations, it is already down to sustainable levels, and it is too small given the state of the economy."

Unfortunately, Krugman is wrong here, as is so often the case. The budget deficit is a HUGE problem! Indeed, it's one that is now flying a bit under the radar, but that could manifest itself in ugly ways in the real economy and have significant investment implications in the upcoming years.

The Myths

First off, let's dispel the myths. The United States is a sovereign issuer of its own currency, and thus faces no risk of default. The only way the US could default is if our government voluntarily made a 'political decision' to do so.

In many ways, US government debt is not "debt" at all. Rather, it more closely resembles corporate equity with a fixed dividend. If you own shares in a corporation, your returns ultimately depend on: (1) profits / cash flows, and (2) share dilution.

For instance, let's say a company earns $100 and there are 100 shares outstanding. That means every shareholder made $1 per share. The next year, profits increase to $105. If shares stay at 100, then profits per share increase to $1.05. On the other hand, if the corporation issues 10 new shares, overall profit still increases 5%, but profits per share fall to 95.5 cents. In other words, even though the company improved its earnings, it did so by harming its shareholders.

When the United States government runs large deficits, it does the exact same thing. It is essentially issuing new equity and 'diluting' the value of its shares. In more traditional economic terms, running deficits results in dilution of the US Dollar, which creates inflation. Inflation harms the 'shareholders' of the United States, which is everyone who holds US Dollars.

That's where I'd have to pick another fight with the economic establishment. There's another big economic myth floating around right now. We keep hearing about low inflation and money growth. Yet, M2 money supply growth is actually high relative to nominal GDP on a historical basis.

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In fact, M2 money growth is about on par with late 1990s levels. You remember the late 90s, right? It was that era marked by one of the biggest economic booms in US history.

(click to enlarge)

The only difference this time is that we lack the GDP growth of that era. In other words, we're creating money at a more rapid pace than we are increasing economic output.

Of course, inflation hasn't quite yet followed. Or has it? That's brings us to myth #3. CPI inflation is still low, but the problem with CPI is that, since 1983, it has excluded housing. The result is that CPI understates the true volatility of inflation, and CPI numbers can be misleading for several years.

My housing-adjusted "Alternative CPI" below shows about 4% inflation right now. Note that in this model, inflation was significantly understated from around 2000 - 2005, and significantly overstated from 2006 - 2009. From about 2010 - 2012, it shifted around a bit, but now we are clearly back in 'understated' territory and the BLS's official sub-2% reading looks flawed.

(click to enlarge)

So it turns out we do have inflation right now. It's not sky-high, but when you consider that the housing-adjusted CPI inflation figures shows 4% inflation and nominal GDP growth is around 3%, it suddenly looks as if things may be a bit worse than they appear. We may very well be entering a stagflationary environment.

That leads me back to the budget deficit.

Why The Budget Deficit Will Get Worse

Now that I've laid out some of my base criticism, I want to cut to the bigger problem. Economists in Krugman's camp have been arguing budget deficits aren't a problem at current levels. Unfortunately, they are ignoring a very large looming issue. Of course, we all know the problems with Medicare / Medicaid, as well as Social Security, but I'm talking about something flying further under the radar.

Over the past three years, government tax revenues from income and corporate taxes have increased 39.6%. Why is that? It's likely because the stock market has been rapidly pushing upwards since March of 2009, with only minor pauses.

Let me introduce you to my S&P 500 (NYSEARCA:SPY) Total Return Index. This tracks the S&P 500, including dividends, since 1979.

(click to enlarge) Since the end of 2008, my S&P total return index has increased by about 106%, or roughly 17.1% annually. Now, take a look at the 5-yr trailing annualized returns on that index.

(click to enlarge)

What this chart tells us is that in only 6 years since 1984, have the 5-year trailing S&P returns exceeded the current 4.5 year trailing return of 17.1%. Those six years are 1986 at 19.3%, 1989 at 20.0%, and 1997 - 2000 at 20.0%, 23.7%, 28.2%, and 18.1% respectively.

In essence, we have had a great run over the past 4 ½ years and that's why the budget deficit as a % of GDP is falling. Add in capital gains, dividend, and income tax increases to a booming stock market and it shouldn't be a shock that the budget deficit is falling. The bigger question is whether that fall is sustainable. Given that we've had almost five years of upward-moving markets, I suspect we're not that far away from a correction, and I wouldn't be shocked if we see one in either 2014 or 2015.

Budget Deficits During Stock Market Corrections

The next thing to look at is how a falling stock market impacts the budget deficit. The chart below shows income plus corporate tax receipts on one y-axis, with the S&P total return index positioned on the second y-axis.

(click to enlarge)

You can clearly see that any time the S&P total return index has taken a big fall, tax receipts have followed (albeit, with a bit of a lag as you might expect). In 2002 and 2003, income and corporate ("I+C") taxes fell 12.8% and 8.0% respectively. In fact, from the end of 2000 through the end of 2003, I+C tax receipts fell 21% overall.

I+C tax receipts then fell 27.3% in FY 2009, which includes a 50% drop in corporate taxes. From 2007 to 2009, overall I+C tax receipts fell 31%. So while we seem to be on the path to a 4% budget deficit for FY 2013, there are lurking dangers.

To put things in perspective, I+C tax receipts are estimated at $1.52 trillion for FY 2013. A 10% drop in I+C tax receipts would equate to about 1% of GDP. That's not even looking at other forms of taxes (payroll, excise, etc). When you account for everything, another economic correction similar to 2000 - 2003 bear market could result in the budget deficit increasing somewhere from around 2.0% to 2.5% of GDP. That doesn't even factor spending into the equation, which would likely push upwards in a downturn.

One final chart that I want to share examines the US budget deficit as a % of GDP since 1979. On that chart, I have created a series of lines. The green lines indicate a year that the S&P 500 total return index falls 0% - 10%. The purple lines indicate a year that the index falls 10% or more.

(click to enlarge)

You can see that with the budget deficit always moves up when the market declines during this time frame. The first three green lines represent 1981, 1990, and 2000, when the S&P total return index drop 5.0%, 3.2%, and 9.0% respectively. The first two purple lines represent 2001 and 2002, where the index fell 11.8% and 22.0% respectively. Finally, the last purple line represents 2008, with a drop in the index of 36.6%.

Based on this, we can see that even small drops in the S&P (such as the one in 1981) tend to lead to larger budget deficits, with the deficit increasing from 2.6% in 1981 to 6.0% in 1983. The last two larger declines have triggered much larger increases in the deficit with a 2.4% surplus in 2000 turning into a 3.4% deficit by 2003.

Obviously, there are also political considerations here, with Washington's spending priorities changing during each of these declines, but this seems to be a constant theme. Every recession triggers some reaction by Washington, and it often comes in the form of increased spending.

Other Considerations

There are some other considerations here, as well. I'd be wary of the impact of the Affordable Care Act on the budget deficit. One of the big questions to ask is "how much will Obamacare's subsidies add to the deficit?" It's not necessarily clear, but it is almost inevitable, that Obamacare will result in a more rapid increase in spending than usual.

It's also worthwhile to question whether the tax increases (not to mention Obamacare) will result in slower economic growth. I suspect that both issues increase the odds of a recession (or at least sluggish growth). So it's possible that legislative policies could result in both a hit to revenues, as well as increased spending.

Overall, there are some significant risks here moving forward and the currently projected 4% budget deficit may simply be the result of a 'peaking market'.

Conclusions and Investment Implications

After a 4 ½ bull run in the stock market, one has to wonder whether the ship is about to run out of steam. In spite of a great run, the budget deficit is still projected at 4%, above the historic norm. If the market were to take another dive, it's likely that the budget deficit will once again spike, and it's completely possible that we could find ourselves with deficits at around 7% to 8% of GDP.

If the deficit jumps, politicians will be faced with two choices: (1) allow inflation to increase, or (2) cut spending. Both will have a significant impact on the markets.

If inflation continues to push upward, I suspect that housing (NYSEARCA:ITB) (NYSEARCA:XHB), real estate (NYSEARCA:REZ)(NYSEARCA:VNQ), banks (NYSEARCA:KBE)(NYSEARCA:KRE)(NYSEARCA:XLF), insurers (NYSEARCA:KIE), and oil (NYSEARCA:USO) will be winners. If we cut spending significantly, that could result in another correction, and make the stock market much less attractive.

While no one should expect hyperinflation, don't be shocked if housing prices continue to rise double-digits, and housing-adjusted inflation numbers veer towards the 4% - 6% range, while economic growth lags.

Large budget deficits also tend to result in a more volatile stock market, making things more difficult to predict and increasing risk. All this is to say, that while I'm not bearish, I would proceed with caution. The budget deficit is still a big issue that can impact the markets in the next few years.

Source: The Budget Deficit Is Still A Huge Problem