- US government debt nearing US$25trn, and its WWII debt/GDP peak. Then the US quickly cut debt with higher taxes and GDP growth. This will be much more difficult today.
- Is a recipe for lower-for-longer GDP growth and bond yields, favoring long duration and quality growth equities, such as Staples and Tech.
- Inflation is not impossible, as the economy recovers with large fiscal deficits and high debt/GDP, supply chain disruption, and large cap pricing power. Inflation is off investors' radars with expectations near lows.
- Energy, industrials, healthcare, and real estate sectors have historically been best inflation-era performers.
US debt and what to do about it
We look at the investment implications from the surging US fiscal deficit and debt/GDP levels, on the back of the government's COVID response. We think this ultimately means both lower-for-longer GDP growth and bond yields, which would favor defensive and quality growth equity sectors. We also examine the ‘tail-risk’ scenario of an inflation pick up, as a mechanism to reduce debt/GDP levels. Whilst unlikely, current inflation expectations are very low, implying making hedging against such risks relatively attractive. Healthcare and real estate are our two favored sectors with the best inflation-beating track record.
US deficits and government debt soaring
US government debt approached US$25 trillion in April, and the federal government is forecast to run a US$3.8 trillion deficit this year, equivalent to 19% of GDP, and a $2.1 trillion deficit next year, according to the non-partisan Committee for Responsible Federal Budget (CRFB). Over the last 20 years, US government debt has grown by US$19 trillion, or by 80%.
Debt/GDP almost back to peak levels
The end of World War II is the only time in history with budget and debt figures comparable to today. Then US debt/GDP peaked at 118% in 1946, compared to the 111% projected for 2020. Debt/GDP fell quickly after this peak, returning to the pre-war c40% level by the mid-1960s, and troughing at 30% in the 1980s.
However, looking at the four main economic policy levers available to reduce current debt levels, we do not see a similar debt reduction on the cards in the near future, and think investors need to be prepared for higher-for-longer debt levels.
Three of four levers harder to pull now
1. Higher taxes or lower spending: The pre-WWII level of tax revenue/GDP never exceeded 8%. By the immediate post-war era it had grown to 15%/GDP, as the marginal income tax rate went from a 24% low to over 90% by 1945, the taxpayer base was widened, and social security taxes grew. By contrast, current government revenue/GDP is at similar WWII levels, and pressure has been for it to fall not rise, with the 2017 corporate tax cut, from 35% to 21% rate, and individual income rates cut in the Tax Cuts and Jobs Act. Additionally, there are significant constraints on the spending side of the budget. 70% of the Federal budget is accounted for by mandated (and increasing) spending on social security, Medicaid, and Medicare. This makes any near-term budget adjustments focused on very draconian cuts to discretionary spending.
2. Higher Inflation: This would boost nominal GDP relative to debt, and shrink the debt/GDP ratio. Wars have generally been inflationary, but pandemics may not be. The Fed 2% inflation target is a further constraint to inflation rising significantly, as is Japan's experience of how difficult raising inflation can be, especially facing deflationary demographic headwinds. Also, any success in significantly raising inflation would likely also drive-up long-term bond yields (financing costs), absent WWII-style yield curve control measures.
3. Real GDP growth: A combination of inflation and real GDP growth, driven by robust demographics and labor productivity, saw US GDP outpace debt growth by an average of 4% annually between 1946-1980. Since then the opposite has been the case, as labor productivity growth has halved, to only 0.9% annually the last decade. An aging population - and now stricter immigration controls - have also hurt demographic trends.
4. Debt service costs. Of the main economic levers, this is the most realistic currently. Government borrowing costs are at a historic low, with 10yr Treasury yields well below 1%. This has kept the government’s debt interest burden below 2% of expenses, in line with the 60-year average, despite the significant nominal debt increase. Similarly, low financing costs have allowed Japan to sustain debt/GDP at more than twice US levels for decades.
What this base case means for equities
We think this is an economic recipe for lower-longer US GDP growth and bond yields, with the economy not able to generate higher GDP growth or support higher bond yields. This would broadly continue to support US equity (SPY) valuation multiples at above long-term average levels. It would also favor ‘long duration’ equity sectors, such as consumer staples - proxied by Consumer Staples Select Sector SPDR ETF (XLP) - and real estate (VNQ), that have the majority of their value in the long term (terminal value), and hence benefit the most from low bond yields. Also, quality growth sectors, such as IT (XLK) and healthcare (XLV), which can consistently deliver earnings growth, will be favored in a world with little growth.
What is the risk? Inflation
We also examine the ‘tail-risk’ scenario of an inflation pick-up, as a mechanism to reduce debt/GDP levels. Whilst unlikely, current inflation expectations are very low, making hedging against such risks relatively attractive. Healthcare and real estate are our two favored sectors with the best inflation-beating track record.
Inflation expectations have collapsed
Long-term market inflation expectations are below 1%, the lowest in recent history, and near-term pressures falling fast with March US consumer prices falling 0.4% month over month. These expectations are less than half the Fed target 2% level.
The case for inflation
On the face of it, resurgent inflation is implausible with US GDP to fall c6% this year, c20% of the workforce jobless, and commodity prices plunging. But we believe it is not impossible, and current low expectations give a potential opportunity to put on cost-effective equity hedges. The case for inflation is of surging fiscal deficits and government debt to GDP heading to WWII peak levels, alongside a ballooning central bank balance sheet. Government sending money directly to citizens and companies without QE era building of excess reserves. Supply chains are fragmenting and re-shoring. Large company pricing power is also being boosted by the crisis. Any of these could at least boost inflation expectations from current depressed levels in the medium term.
Hedging the tail risk
We look beyond traditional non-equity hedges such as TIPS and commodities, which have been weak, and gold, which is at a 7-year price high, on risk-aversion rather than inflation expectations. We looked at correlations between inflation and equity sectors over the past 10 years. Since these correlations can shift significantly over time, we also looked at the average returns for these assets during inflationary periods over the past 50 years, when inflation was above the US 36-month average in the US and G7 (as a proxy for the world).
Energy, Industrials, Healthcare, Real Estate stand out as strongest performers. Healthcare and Industrials also have among the highest 10-yr correlations. Healthcare - proxied by Health Care Select Sect SPDR ETF (XLV) - demand is inelastic, with strong corporate pricing power. Many industrials (XLI) have commodity-price linked pricing policies, allowing significant inflation pass-through. Historic inflationary periods have often been associated with higher energy (XLE) prices, whilst REITs (VNQ) are a tax-efficient reflection of underlying real estate values, with inflation-linked rents/leases, and high dividend payouts.
Conclusion: What higher debt means for equities
US government debt is nearing US$25 trillion, and WWII era peak debt/GDP. Back then the US quickly cut debt with both higher taxes and GDP growth. This is tougher today, with only ultra-low debt servicing costs of the realistic available levers. We believe this is a recipe for lower-for-longer GDP growth and bond yields, which would favor long duration and quality growth equities. The main risks is that inflation returns as the economy recovers from the recession, with surging fiscal deficits and debt/GDP, supply chain disruption, and large cap pricing power. Energy (XLE), industrials (XLI), healthcare (XLV), real estate (VNQ) sectors have historically been the best inflation-era performers.
This article was written by
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