The annual report of the Congressional Budget Office typically receives little media fanfare. More likely to be used as a paper weight or coffee table accessory than actually read, the report projects the budget deficit over a ten-year window using various assumptions regarding government revenue and expenses.
This year’s report, however, picked up more press coverage in light of the recent tax bill and large budget passed in March. Entitled “The Budget and Economic Outlook: 2018 to 2028,” the report projected a 10-year cumulative federal deficit of $10.1 trillion, of which $2.7 trillion is due to laws enacted just since June 2017. The IMF now projects the U.S. as the only major developed economy to increase its debt-to-GDP ratio over the next five years.
We have previously written about the U.S. debt and concluded it is a longer-term concern but not an immediate crisis. So why are we concerned about the budget deficit now?
Typically, budget deficits follow the ebb and flow of the U.S. economy — widening during and immediately after downturns and tightening when growth is strong. Mainstream Keynesian economic principles advocate the countercyclical nature of government spending, where the government attempts to boost activity during downturns and repay its bills during boom times. We are now following a different path, with the deficit widening over the last two years and projected to widen significantly in the coming years. This will occur while economic growth is projected to remain strong, with consensus estimates for U.S. GDP growth of 2.8% in 2018 and 2.5% in 2019. The procyclical nature of the budget deficit creates two risks of note:
- A reduction in the government’s latitude to jump-start the economy in a downturn.
- Upward pressure on inflation, which may force the Federal Reserve (Fed) to raise rates more than expected to slow the economy.
Recessions are notoriously difficult to predict. Considering the projected deficit (even with the relatively strong economic outlook), Congress will be reticent to increase deficit spending in the event the U.S. unexpectedly sinks into a recession over the next few years. This potential lack of countercyclical government support could worsen and prolong the next economic downturn. Today’s deficit essentially inhibits the ability of Congress to dig the U.S. economy out of the next recession.
Inflation has remained below the Fed’s target of 2% for almost a decade. However, with unemployment nearing historically low levels and economic growth robust, inflation has become a greater concern. Highly stimulative fiscal policy this late in the economic cycle risks stoking inflationary pressures, which could push inflation above the Fed’s target. The Fed may then need to raise rates faster than the market expects, which would also inhibit economic growth.
Despite the negatives of increased deficits, there are also positives we need to acknowledge. Stimulative policies may add up to 3% to GDP growth over the next two years, which should keep the U.S. economy on a positive course. Outside of the low headline unemployment rate, we are seeing many detached workers re-enter the workforce, which is a positive from a societal and an economic standpoint. Additionally, inflation due to positive developments such as higher wages could help spur consumer spending and accelerate growth further.
We believe the projected deficit widening provides medium-term support for equities, as fiscal stimulus buoys the U.S. economy and supports corporate profits. However, we remain wary of the longer-term implications for risk assets such as stocks. Higher inflation should pressure bonds, as yields continue to rise. This outlook supports our current view to remain overweight equities versus bonds.