Our Top Market Takeaways for the week ending October 25, 2019.

Markets in a minute

We’ll keep this short and sweet

In a busy week of politics, earnings and economic data, markets have fared well. Japan’s TOPIX (+1.6%) and China’s onshore CSI 300 (+0.7%) rounded out the week with gains, and heading into Friday, both the Stoxx Europe 600 (+1.4%) and the S&P 500 (+0.8%) were feelin’ good. Here are our top three reasons why:

  • Better than feared. In case you missed it: We’re in the thick of earnings season! While there have been both good and not-so-good reports, the overall trend has been better than estimates initially implied. Almost 40% of S&P 500 companies have reported so far, and those companies have beat on sales by about +1.4% and on earnings by about +4.4%. This leads us to think Q3 2019 earnings growth could end up more like flat to slightly positive. We’ll take it.
  • Good vibes on trade. After the United States and China reportedly reached a “partial,” “phase one” deal a couple weeks ago (P.S. it’s expected to be signed next month), a handful of positive comments delighted markets this week. President Trump said a trade deal is “coming along great,” VP Pence said the United States could be ready for a new future with China, and China said it’ll buy $20 billion of U.S. agricultural goods. For now, feels pretty good.
  • Hello, goodbye. At its latest policy meeting, the European Central Bank (ECB) held off on making any big changes. A couple reasons: The ECB unveiled a pretty big stimulus package last month, and after eight years at the helm, ECB President Mario Draghi held his final press conference. His parting words emphasized the need for fiscal stimulus in Europe, a message his successor, IMF alum Christine Lagarde, is expected to continue. Ciao!

We can see where Draghi is coming from. In our recent macroeconomic update, we argued that more government borrowing and spending would help spur demand and could allow bond yields (which are near historic lows) to rise. The counter-argument we often hear is simple: Don’t developed world governments have too much debt already? While you may think that the amount of government debt is unsustainable, we aren’t so worried. Read on for our thoughts.

You ask, we answer

Should we worry about government debt?

At first glance, it seems perplexing that U.S. government bond yields are trading near their lowest levels ever. After all, the U.S. federal deficit is projected to surpass $1 trillion this year, roughly double where it was a few years ago. And, projections abound that the deficit will continue to widen to scary levels in the coming years and decades if the United States doesn’t rein in its entitlement spending (i.e., on programs that are mandatory). Simply, the U.S. government continues to borrow more and more money. Usually, a more highly levered borrower shouldn’t be able to borrow with a lower interest rate. So why can the U.S. government?

The chart shows the U.S. federal deficit from 1990 through 2019. In recent years, the deficit has increased and is projected to surpass $1 trillion in 2019.

The chart shows U.S. debt as a percent of GDP starting in 1990 and projected through 2030, and which is expected to continue to increase through 2030.

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It’s all about supply and demand.

The key things to keep in mind when we talk about U.S. debt and deficits are that 1) the forces of supply and demand hold, just like for any other financial asset, and 2) it’s global supply and demand that matters, not just domestic. When thinking about debt and deficits in this way, it’s not that surprising government bond yields are historically low. Allow us to explain…

On the global growth front, forecasts have been consistently revised downward since the middle of last year due to lackluster global manufacturing demand and trade policy uncertainty (which is holding back corporate capital expenditures). In a relative sense, U.S. growth has held up (as the below chart shows); nevertheless, the global picture is more important for how the U.S. government bond market behaves.

The chart shows the U.S. and global growth forecast index from 2014 to 2019. The U.S. growth forecast has been generally increasing since 2017, while the global growth forecast index has been generally decreasing since the latter half of 2017.

What about supply? Yes, $1 trillion is a lot of money. But what if I told you that in a global context, supply growth has actually been quite weak? This is a product of many years of budget austerity (i.e., trying to reduce government budget deficits), which was pursued most notably in Europe but also in Japan. We can see this trend in the chart below, which shows government bond supply growth for the United States, Europe and Japan (net of central bank purchases and maturing debt, scaled as a percent of global GDP). So, even though the U.S. deficit could reach $1 trillion this year, the global supply of bonds hasn’t grown all that much.

 

The chart shows the global bond supply from 2000 to 2018. In recent years, the global bond supply has remained relatively flat.

OK, but what about entitlement spending and the longer-term projections?

True, they look scary. But the dirty little secret is that, while we don’t know where exactly the breaking point is for U.S. debt, all available evidence from history and from other countries suggests the United States is not close to the point where debt and deficits are a problem. And by a problem, we mean in the economic sense that they breach a point where they start to crowd out private sector economic activity.

First, it’s not actually the debt or the deficit that is the constraint. Rather, it’s the interest burden relative to how much cash is coming in, just like it’s a constraint for any company. And here the irony is that, as U.S. debt levels have risen, the federal government’s interest burden (relative to GDP) has fallen (chart below)! In the 1990s, the interest burden was twice as high, but paradoxically, hardly anybody was worried back then about debt and deficits.

The chart shows the U.S. debt held by the public and the interest burden from 1965 through 2019. The chart shows that as U.S. debt levels have risen, the federal government’s interest burden relative to GDP has fallen.
To take this logic further, the simplest way to assess whether a country’s debt is sustainable is to compare market interest rates to trend nominal GDP growth. Countries that get into trouble typically see a scenario where interest rates are rising and exceeding their cash flows. In other words, their interest costs are higher than their growth rates.

Available evidence…suggests the United States is not close to the point where debt and deficits are a problem.

In the United States, longer-term interest rates are well below trend nominal GDP growth (to the tune of two percentage points). Even in Japan, where the debt-to-GDP ratio is north of 230%, longer-term interest rates are healthily below trend nominal GDP growth (by roughly one percentage point). Put simply, growth is higher than interest costs. Even with Japan's high debt levels, its interest burden seems sustainable. According to the CBO’s “alternative fiscal scenario,” which makes rather pessimistic assumptions about revenue growth and entitlement spending, debt-to-GDP in the United States won’t exceed Japan’s level, even extending the forecast horizon out to 2050.

The chart shows the U.S. debt-to-GDP ratio from 1980 projected through 2050. There are two projections for the U.S. ratio: the Congressional Budget Office (CBO) long-term projection and the CBO’s alternative scenario projection, which is more pessimistic. Additionally, the chart shows Japan’s debt-to-GDP ratio from 1980 projected through 2024. The chart shows that the U.S. ratio will not exceed Japan’s ratio even when projected out to 2050.

The secret sauce: Reserve currency status.

The scenario described so far should not be considered a universal economic truth. The United States and even Japan still have room for more fiscal stimulus in large part because their currencies have “reserve” status. This essentially means that the global investor base sees U.S. dollar- and yen-denominated assets as safe and stable, especially during bouts of global market volatility and geopolitical uncertainty. This reserve status has been built up over many decades and is attributable to the hard-to-quantify things that make countries function well: the rule of law, a court system with robust checks and balances, legally defined property rights, etc.

Countries like Argentina and Turkey, which in recent years have run into problems regarding government debt and deficits, fall substantially behind the United States and Japan on these “soft power” characteristics. While it is impossible to perfectly quantify soft power, a useful ranking comes from the Global Competitiveness Index published by the World Economic Forum. The below chart shows how far ahead the United States and Japan are compared to Turkey and Argentina when it comes to soft power and, thereby, reserve currency status. 

The chart shows the WEF Global Competitiveness Ranking as of 2019 for the United States, Japan, Turkey and Argentina. The United States is ranked at 2, Japan at 6, Turkey at 61 and Argentina at 83; a lower ranking is more competitive.
As investors have grown accustomed to a low interest rate environment, it’s easy to see why the amount of government debt might be worrisome. But given global supply/demand dynamics, structural growth rates and debt service costs, bond yields look more or less appropriate—even alongside seemingly high debt levels. So no, we don’t think you should worry about government debt. In fact, we believe the United States and other developed countries actually have some capacity to borrow even more to stimulate economic growth.

 

All market and economic data as of October 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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