A New Record
The U.S. Federal Public Debt just set a new record high of $26.95 trillion for FY20 (9/30/20). This is a sharp increase from $23.2 trillion on 9/30/19, and is approximately 23.9% higher than U.S. GDP for the period ending 12/31/19.1,2 This year-over-year increase was driven by the passage of the $2.2 trillion CARES Act3, along with the budget deficit. The public debt looks to rise meaningfully again in FY21, as the pandemic driven decline in GDP negatively impacts government receipts and a with second round of stimulus in the range of $1.8 to $2.2 trillion currently under debate.
A Long Term Concern
With bi-partisan agreement that a second stimulus is needed to combat the effects of the Covid pandemic, we expect the passage of at least one, if not a series of stimulus actions in the near term. Even Treasury secretary Mnuchin stated this week that while “the deficit is a long-term concern…now is not the time to worry about bringing it down”.4 Amazingly, due to the fall in treasury yields, there is little short-term fiscal pressure from the absolute size of the U.S. debt. The cost to service the Federal Debt fell in FY20 to $522.8 million, the lowest level since 2017.5
3 Ways to Address the Debt
In our view, the rising federal debt and the Fed’s intention to let inflation build over its prior 2% target will drive interest rates up.6 There are essentially three ways to address skyrocketing government debt:
1) Devaluation – which is highly unlikely.
2) Growth in GDP which would raise Fed receipts and narrow the deficit.
3) Inflation growth that is over the fixed rate paid on treasury securities.
Over the next few years, we see the dual combination of 2 and 3, i.e. GDP growth driven by eased pandemic restrictions and stimulus actions, as well as inflation allowed to run ‘hot’ by the Fed.
It Matters When It Matters
We have seen long periods where stocks moved in contrast to what we believed were sensible valuation and economic paradigms. We think the current environment where the yield on the 10-year U.S. Treasury note is at 75 basis points7, despite the sky-rocketing U.S. debt, is another instance of the market ignoring long-term developments. We think that when investors in general decide to focus on interest rates and inflation, the resulting market moves will be quick and sharp.
The Time to Prepare is Now
The implication for equities is fairly clear. For smaller companies, the first couple hundred points of interest rate hikes and inflation should be a positive, as the financial sector benefits from higher rates, spreads and credit quality, while cyclicals and services stand to benefit from strong demand and pricing power. This is in strong contrast to the risk we see in larger cap growth names that in our opinion have been propelled too far by momentum and quantitative models that likely have erroneously assumed lower interest rates for all periods of their long-term discounted cash flow (DCF) models.
While we cannot definitively say when a rotation might take-hold in earnest, we think investors should start to reposition portfolios now, before they are forced to chase the investing herd.
1 U.S Federal Public Debt Outstanding, as reported by the U.S. Treasury, https://www.treasurydirect.gov/govt/reports/pd/mspd/2020/opds092020.pdf
2 U.S. Current Dollar GDP for 2019 as of 4Q19 from U.S. Bureau of Economic Analysis, source from Bloomberg.
3 CARES act signed into law 3/27/20, Source U.S. Treasury. https://home.treasury.gov/policy-issues/cares
4 Secretary Mnuchin quoted in the New York Times 10/16/20 https://www.nytimes.com/2020/10/16/us/politics/federal-deficit-31-trillion.html.
5 Service cost reported by CNBC 10/16/20. https://www.cnbc.com/2020/10/16/us-government-budget-ends-fiscal-year-with-a-more-than-3-trillion-deficit.html
6 U.S. Federal Reserve 9/16/20 statement https://www.federalreserve.gov/newsevents/pressreleases/monetary20200916a.htm
7 U.S. 10-year treasury closing yield of 74.56 basis points on 10/16/20 as reported by Bloomberg.
All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results.