THE MARKETS
In prior commentaries, I’ve discussed the “Fed watch” game. When would the Fed cut interest rates? By how much? With every consensus “guess” in one direction or the other, the markets bounced pretty much in lockstep. The Fed answered the questions in late September with a larger than expected rate cut of 50 basis points (one half of one percent). The markets reacted favorably with strong returns in every asset class.
In the past I’ve also devoted a lot of ink to the “Magnificent 7” big tech stocks that have dominated the market, accounting for most of the major index returns. The third quarter saw a reversal as the big tech Nasdaq composite index returned 2.1%, while the S&P index gained 5.9%. Nonetheless, the Mag 7 still accounted for 45% of the S&P 500’s return year to date. The rate cut has led to a welcome broadening of the market as small company growth stocks out-performed large company stocks and value stocks outdid growth stocks. Bottom line: more stocks are participating in the market rally.
The U.S. equity market rally has continued through the first three weeks of October. International stocks and bonds have not fared as well. The yield on the 10-year Treasury has increased to 4.2%, driving prices down.
The Fed’s rate cut reflected its confidence that inflation has been tamed, even though it’s not at its 2% target. The unexpected size of the rate cut raised concerns that the Fed foresaw a weakening economy and sought to engineer a “soft landing” thereby forestalling a recession. Economic reports have been generally positive over the last few weeks, now leading to speculation that the Fed may now make fewer than expected rate cuts this year. Inflation is not gone, just accelerating at a slower pace, after having reached a painfully high 9%. Unfortunately, many of the inflated prices we see every day are likely to be permanent.
THE NATIONAL DEBT, THE ELECTION and MORE
The “Fed watch” is over, only to be replaced by the “election watch.” Fiscal policies offered by both candidates have been judged by economists as potentially increasing the deficit, which has swelled to approximately $1.9 trillion for 2024. That is 6.4% of Gross Domestic Product (GDP), the highest since 1947, following the end of WW II. The U.S. fiscal year (FY) ended on September 30th with the federal debt just above $35 trillion. ($35.8 trillion today.) Increases in the national debt at an annual rate of almost $2 trillion do not seem like a viable economic policy. Federal government spending amounted to $23.4 trillion of GDP for FY 2004. We haven’t seen a balanced budget since the end of the Clinton administration.
Over less than four years, from March 2021 to September 2024, the interest on the national debt has grown from $315 billion to $872 billion, an increase of 177%. That’s roughly 3% of GDP, the highest since 1996. And interest rates are now rising along with the debt. Likely not a sustainable formula. And spending is the problem, not a reduction in tax revenue. Over the last five years, tax revenue has increased from 16.3% to 17.2% of GDP—from $3.5 trillion to $4.9 trillion. The deficit increased from 4.6% of GDP, to 6.4%, a 1.8% increase, over the same period.
Some may say, “What’s the big deal, it seems to be working?” Well, is it, really?
- Interest payments on the debt were 8% of the 2024 budget. Mandatory entitlement benefits – Social Security, Medicare and Medicaid – made up another 66% of the budget. Combined, they left only 24% for discretionary spending, 45% of which went to defense, leaving only 13.2% of the federal budget for everything else. And the interest portion will be greater next year.
- Initially, the Fed’s artificially low interest rates made excess spending at least appear to be affordable. That illusion has been put to rest with rising rates and the swift increase in the debt.
- At the end of 2023, the national debt was $34 trillion dollars. Public debt made up $27 trillion, or 79% of that. Public debt is debt owed to foreign and domestic investors, who buy U.S. Treasury bonds, T-bills, and notes. The Fed owns 27% of the debt held by domestic investors.
- This monetizing of the debt by the Fed has increased the money supply – the root cause of recent inflation. In effect, devaluing the dollar. The devaluation of the dollar makes our bonds less attractive domestically and, more importantly, internationally – especially for longer-term bonds which may be repaid with 70 cents, 60 cents, or even 50 cents on the dollar. The world is aware of the implications of our soaring national debt for our economy and place in the world. See below.
- If the public debt made up $27 trillion of the total debt at the end of 2023, what made up the other $7 trillion? That’s intragovernmental debt, an accounting of the transactions between one part of the federal government and another. This writer is inclined to think of it as “Robbing Peter to Pay Paul.” Why? Taking money from pools of earmarked, collected tax revenue, or “Peter,” and giving it to “Paul,” who or whatever that is. Let’s see who our government borrowed the $7 trillion from: (Source: U.S. Department of the Treasury)
- Social Security Old Age and Survivors Trust Fund—$2.642 trillion
- Federal Employees Retirement Fund—$1.053 trillion
- Medicare Hospital Insurance Trust Fund—$209 billion
- Medicare Supplemental Medical Insurance Trust Fund—$187 billion
- Social Security Disability Trust Fund—$147 billion
- Highway Trust Fund—$113 billion
- Federal Housing Authority—$78 billion
- Other—$2.892 trillion (Wouldn’t you like to know what this is?)
The intragovernmental debt is rather like a family spending more than it earns for years even as its earnings went up, then resorting to borrowing from its 401(k) plans, even though it has no capacity to repay them without getting its spending under control. Before or after consuming the 401(k) reserves, the family likely maxed out its credit cards. Then what happens? What happens should investors cut back on the U.S. government’s “credit limit”— refusing to own as much U.S. debt in the future?
What is to be done? Increasing taxes seems to be an undesirable solution. For one thing, how much faith should we have that Congress use the added tax revenue to reduce the deficit rather than find new ways to spend it? For perspective, 2023 GDP was $27.36 trillion. The IRS took in 16.34% of that or $4.47 trillion in taxes. It was 17.1% of GDP in 2024. How much more of the total U.S. economic output should be consumed by the federal government? The interest alone takes 8%. The debt is now 131% greater than the total output of the 2023 economy.
Increased business taxes would likely reaccelerate inflation as the tax cost would be passed on. Corporate investment and innovation would go down, reducing economic growth and increasing unemployment as the economy slows. U.S. companies will be disadvantaged in world markets and will be incented to move operations to lower tax rate countries, as has been done in the past.
Increasing individual taxes reduces consumer spending which makes up roughly 65% of GDP. Individuals paid roughly one half of the $4.7 trillion collected by the IRS last year. They also paid into Medicare and Social Security through payroll taxes and paid local and state taxes. Some are also burdened by large credit card payments, having borrowed to cope with a 20% cost of living increase, at a time when credit card interest rates have increased 11 times since March of 2022.
Well, why not “tax the rich, because they don’t pay their fair share.” Maybe they do and maybe they don’t. What do you think? The following data is provided by the IRS for 2021, the last year for which IRS data is available. Overall, the top 50% of earners paid 97.7% of total income taxes. Here’s a breakdown:
- The top 1% of income earners paid 45.6% of the total
- The top 5% of income earners with incomes of $252,840 and above, paid 66% of the total.
- The top 10%, everyone who earned at least $169,800, paid 76% of the total.
Also, small business profits are taxed at the owner’s top tax bracket, not at the corporate tax rate.
Let’s hope that politicians on both sides stop buying votes with money they (we) don’t have and magically become fiscally responsible citizens. Yes, there is a debt ceiling, but most of the Congress treats it more as a nuisance to be raised each year, rather than a deterrent to spending. Entitlement programs are maxed out, there is no money to expand them. Tax cuts are also not feasible without increasing the deficit, at least in the short term. Serious entitlement reform is necessary. Creative solutions must be found. The growing debt burden puts the country at risk. This is not an indictment of either political party, they both spend, but rather a plea for fiscal sanity and responsibility. See below.
It’s worth noting that the stock market generally does equally well in the year following a presidential election, irrespective of which party wins the White House.
Are we nearing a tipping point where foreign buyers become reluctant to hold U.S. bonds? China and Brazil have agreed to conduct international trade in their own currencies rather than the U.S. dollar. Russia and China have agreed to abandon the U.S. dollar in their bilateral transactions. China’s long-term objective is to have the yuan replace the dollar as the world’s currency for international trade. Creating the BRICS coalition was one of its initial efforts. BRICS is holding its annual Summit as this is being written (October 22 to 24, 2024). Russia is the host country. In his opening remarks, Vladimir Putin said that “Deepening financial cooperation [among attendees] and creating a new world order that challenges the West is the priority.” Thirty-six countries are in attendance, including Russia, China, Brazil, Iran, India, South Africa, Egypt, Saudi Arabia and the UAE. These are but a few examples of the movement toward de-dollarisation spurred primarily by China. This de-dollarisation movement is worthy of a detailed discussion on its own. The long-term repercussions are significant.
Five countries, Japan, China, the United Kingdom, Luxembourg and Canada hold approximately 40% of all foreign-owned bonds. Reliance on foreign investors to keep our government afloat carries risk. If foreign bond holders become concerned about the U.S. dollar they could demand higher interest rates. Japan and China, the largest foreign holders of U.S. debt, have decreased their holdings of U.S. bonds in the last few years. Many of the other 28 countries that hold our bonds have as well.
Reliance on external financing to pay for U.S. deficits creates a dependency that may not be sustainable. It also increases vulnerability, as a change in global conditions or investor sentiments could trigger a sell-off of U.S. bonds, thereby increasing interest rates or affecting U.S. financial stability.
Finally, we come to the issue of U.S. trade deficits, which result from importing more goods and services than we export. To balance the books for international accounting purposes, these deficits are offset by borrowing cash from foreign investors through the sale of Treasury bonds. Alternatively, or in addition, we can allow foreign investors to buy U.S. assets. In short, some portion of U.S fiscal deficits are indirectly funded by the requirement to balance the trade deficit books.
The debt has weakened our United States economically and on the world stage. A price will be paid. It may become impossible to support the cost of the debt as lenders demand higher interest rates, just as credit card companies do to borrowers with poor credit.
This author thinks that it’s time we stop feeding the monster. Our bloated government should begin by looking inward. It might even encourage efficiency, then focus on eliminating waste and fraud.
