President Obama, after coming to power in a relatively ugly economic scenario, has run trillion-dollar-plus deficits in each of his first four years in office. Government spending in critical moments during these four years has provided some stability to the economy and financial system. Therefore, it can be argued that deficit spending was necessary amidst the worst financial and economic crisis after the great depression.
Despite the current stability (relatively) in the economy and the financial system, I am of the opinion that government deficits will be over USD1 trillion annually over the next four years. This article discusses the major reasons for this conclusion.
Before talking about my opinion, I would like to first focus on CBO's deficit estimates under the baseline and the alternative fiscal scenario.
According to the latest CBO estimates, budget deficits will drop sharply to USD641 billion under the baseline scenario and will remain over a trillion (USD1,037 million) under the alternative fiscal scenario for 2013.
The baseline scenario assumes that lawmakers will allow tax increases and spending cuts scheduled under the current law to occur. On the other hand, the alternative scenario assumes that tax cuts and other forms of relief will be extended.
The chart below gives the estimated budget deficits under both scenarios for the next ten years.
I am of the opinion that the alternative fiscal scenario will play out over the next four years. This forms the basis of the assumption that budget deficits will remain over a trillion annually in the coming four years. I will also explain why I assume much higher deficits than the ones projected for the alternative fiscal scenario.
Before that, there are several reasons to believe that an alternative fiscal scenario will play out over the next four years:
Mr. Bernanke has expressed grave concern on the current US employment scenario in a speech to central bankers and economists at an annual forum in Jackson Hole.
The U6 rate currently stands at 15% and is reflective of the real job scenario in the US. A record high duration of unemployment (38.8 weeks) also remains a concern as it makes consumers more cautious and skeptical.
To top the concerns, the civilian employment -population ratio is at a 20 year low at 58.4%. This effectively means that there is a higher pressure on the working population to support an increasing non-working population.
Amidst all this, it is very unlikely that policymakers will increase taxation for individuals. Any such move can result in a very sharp drop in consumer spending and a subsequent recession. Therefore, in all probability, there will be no tax increases for individuals over the next 4 years.
Coming back to the point on deficits remaining higher than projected in the alternative fiscal scenario, the projected GDP growth by CBO looks relatively aggressive and improbable.
The CBO expects recession in 2013 (negative 0.3% growth) followed by growths of 3.1%, 4.8% and 4.5% in 2014, 2015 and 2016 respectively.
I am of the opinion that the US will witness very sluggish growth over the next four years. On an average, the US might grow at 2% in 2013-16 compared to CBO's expected average growth of 3% for the period. Depressed consumer spending arising from high unemployment levels forms the primary rationale for lower growth followed by consumer deleveraging.
Therefore, lower than projected growth would translate into higher than projected deficits.
Of course, the objective of the article was not to talk only about the deficits. It is equally important to understand the implications of the deficits for one's portfolio. Considering the alternative fiscal scenario, the deficits over the next ten years will total USD9.9 trillion. These deficits would be funded by more external debt and debt monetization. In the past, excess global liquidity has come from the US running high annual deficits. This trend should not change in the next decade as mandatory spending such as social security, healthcare and income security continues to increase.
Therefore, my broad investment suggestion would be:
Avoid long-term exposure to the dollar as the currency would trend lower compared to all hard assets.
Consider long-term exposure to gold. The current phase of consolidation in gold prices might be a good time to consider fresh exposure to the precious metal. Investing through the SPDR Gold Shares (GLD) ETF is a good option.
Consider long-term exposure to equities. The corporate sector will continue to do well as a result of global diversification. I had discussed on corporate sector profit expectation in one of my earlier articles. I would personally prefer index investing besides investing in high dividend yield stocks. Investors can consider investing in the S&P 500 index through the SPDR S&P 500 (SPY) ETF.
Consider long-term exposure to emerging market equities. Over the long-term, emerging markets will outperform the advanced economies with respect to economic growth and stock market appreciation. I had discussed this in details in one of my earlier articles. The iShare MSCI Emerging Markets Index Fund (EEM), which provides investment results that correspond generally to the price and yield performance of the MSCI Emerging Markets Index, is a good investment option.