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The deficit and your portfolio
No investor can afford to shrug off interest rates. As the government competes for capital, you'll have to factor the effects into your planning. Here's how.
By Jim Jubak
Do deficits matter? The question is too important to be left to economists and politicians. Theres nothing more important to investors and workers than the size and direction of interest rates over the next 10 years. Nothing has more power to turn an intelligent decision on what assets to own in a portfolio into a disaster. And nothing else makes putting together a portfolio right now so uncertain and so risky.
Unfortunately, the answer to the question is, "It depends." It depends on the size, duration, and cause of the deficit. Looking at these three factors, I believe, will tell investors whether they should breathe a sigh of relief or head for the hills.
How big is the deficit?
This exercise would be a lot simpler if everyone agreed on the size of the deficit, but they dont. Accounting tricks and political games make the number elusive at best. But we have to start with somewhere, and I suggest with the budget President Bush submitted to Congress for the 2004 fiscal year that begins in October 2003.
- Deficit for fiscal 2004: $307 billion
- Deficit for fiscal 2005: $208 billion
- Deficit for fiscal 2006: $201 billion
- Deficit for fiscal 2007: $178 billion
- Deficit for fiscal 2008: $190 billion
Total deficit for 2004-2008: $1.1 trillion
But those numbers actually measure whats called the off-budget deficit. It includes the surpluses that are currently being piled up by the Social Security trust fund as baby boomers at the height of their earning power put more into the fund through taxes than they take out in benefits.
Take those surpluses out of the budget figures and the deficit numbers are almost twice as high:- Deficit for fiscal 2004: $482 billion
- Deficit for fiscal 2005: $407 billion
- Deficit for fiscal 2006: $412 billion
- Deficit for fiscal 2007: $406 billion
- Deficit for fiscal 2008: $433 billion
Total deficit for 2004-2008: $2.1 trillion
Now these numbers are all forecasts, of course, and are subject to the usual problems with forecasts. For instance, the White House budget assumes that the U.S. economy will grow by 3.6% in fiscal 2004 (remember thats the 12 months starting in October 2003) and by an average of 3.3% a year for the fiscal 2004-2008 years. Inflation will stay at a low 2.1% in fiscal 2004 and average 2.2% for the period. Interest rates for the 10-year Treasury note will hit 5% in fiscal 2004 and average 5.2% for the period.
Shift any of these assumptions and the end result bears little resemblance to the current projections.
Change the time period and the budget forecast looks totally different as well. The budget produced by the White House this year has a serious case of back-loading costs. For example, the Bush administration has proposed creating vast new categories of savings and retirement accounts that would have the effect of exempting gains from taxation when theyre withdrawn at some point in the future. According to the budget, these proposals have no net cost because taxes paid in the early years by investors converting from current IRAs and the like to the new plans would offset any revenue losses from forgone taxes on distributions. And since the projections in this years budget stop after five years with fiscal 2008, the heavy losses of tax revenue produced after 2008 dont count.
This kind of back-loading of costs produces especially large distortions because the Bush budget team released budget estimates for just the next five fiscal years instead of the 10-year projections in use beginning in 1996. The White House is perfectly correct in saying that the country got along with five-year budget projections from 1971-1995, but the change comes at an awkward moment in the fiscal life of the federal budget because it is the period after 2010 that will see the big explosion in costs for health care and retirement as the "boomer" cohort shows its age.
For example, the Treasury Department, which still produces 10-year projections, estimates that the cost of the tax reductions that President Bush has proposed as part of his economic growth package will be $1.5 trillion over 10 years. That's more than double the $700 million price tag for five years. The Center on Budget and Policy Priorities figures that the 10-year figure is closer to $1.9 trillion.
How long does the deficit last?
Most of the argument about the effect of the deficit concentrates on its size. One side claims that the deficit is so big that it will force borrowers to pay higher interest rates as they compete with the federal government for cash. The other sides retort basically boils down to: Will not. And the experts on either side are off and yelling.
The truth is the U.S. deficit as a percentage of gross domestic product (GDP) is still very modest. Theres a lot of leeway in a $10.5 trillion economy, and the Bush administration is absolutely right to point out that the proposed 2004 deficit is smaller, as a percentage of GDP, than in 12 of the last 20 years. The projected fiscal 2004 deficit of $307 billion is only 2.8% of projected U.S. GDP. Japan would kill for that low a deficit, and France, which recently became the third country in the European Union to face fines for running a deficit above 3% of GDP, can only look on with envy.
But the U.S. role in the global monetary system isnt like that of France or Japan. The U.S. depends on the rest of the world to buy U.S. dollar-denominated financial assets to fund our massive consumption of imports. And the worlds economy depends on the continued ability of U.S. consumers to buy those imports. That makes foreign central banks, very, very reluctant to dump dollars and dollar-denominated assets onto world financial markets.
For example, youd expect that Asian central banks would have been selling dollar assets recently. After all, the euro has picked up better than 20% against the dollar since the start of 2002, and investors who switched currencies have seen a sizable profit. But instead, Asian central banks, which have about 75% of their reserves invested in dollar-denominated assets, mostly U.S. Treasury notes, have actually been buying more dollar-denominated assets. According to CrossBorder Capital, an investment research company, foreign central banks have increased their holdings of U.S. Treasurys by about 10% in the last six months of 2002. Much of that buying has come from Japan, China and South Korea.
Its all part of a global economic deal -- these countries buy our Treasury notes, which keeps the dollar relatively strong versus their own currencies, and U.S. consumers buy their products.
But this isnt a deal that can withstand all pressures. Foreign holders of dollar-denominated assets do see the value of those assets erode if the value of a dollar sinks versus the value of their local currency. At some point, the losses from a falling dollar become large enough so that U.S. Treasurys become a harder and harder sell . . . unless they pay a higher rate of interest.
Different groups of overseas investors and institutions reach that switching point at different moments. Individual investors, who arent charged with protecting their countrys trade surplus, have already started to re-evaluate their willingness to hold dollar-denominated assets. Foreign central banks are still on board since taking currency losses is less important -- as long as the losses are reasonable -- than making sure that a rising yen or yuan or won doesnt price Japanese, Chinese or Korean goods out of U.S. markets.
But even central banks dont have endless patience. The disquieting thing about the White House budget numbers, to an overseas investor or banker, is that the deficit doesnt come down very fast over the next five years or very far. The fiscal 2004 shortfall of $307 billion does indeed sink to just $208 billion in 2005. But then it sticks there, falling to $201 billion in 2006 and finishing the period at $190 billion. Five years is a long time if youre a banker watching the value of your reserves slowly decline because the U.S. government cant get its deficit down.
What are the causes of the deficit?
In his budget message, President Bush said that a recession and a war that we did not choose have lead to a return of deficits. Call this the cyclical view. A major cause of the surplus that the budget ran during the Clinton administration, according to this view, was the revenue bubble that went along with the stock market bubble. Soaring stock prices produced soaring tax revenues. And when the bubble burst, tax revenues went into a steep decline. Tax revenue fell in 2001 and 2002, the first back-to-back decline in 40 years. The 7% revenue decline in 2002 was the steepest drop since 1946.
The good news in this bad news is that, if the deficit is a result of a cyclical decline in tax revenue, then an economic recovery that produces a cyclical increase in tax revenue should rapidly eat into the deficit.
But what if the deficit isnt cyclical but structural? According to this view, the Clinton-era surpluses were temporary and misleading. The surplus was an accounting fiction caused by baby boomer revenue that was arriving before the costs of benefits and retirement for that generation came due. If you looked at the surplus in a longer time frame than an annual budget, it disappeared -- eaten up by increases in health-care costs, for example. If you agree with the structural viewpoint, then the temporary surplus should have been saved to meet the bills that were rapidly coming due.
The Bush administration and its allies among supply-side believers have an answer for the structural deficit camp. The Bush tax cuts will create enough extra growth and generate enough extra revenue to meet these future bills.
The structural deficit believers argue the tax cuts just make the structural problem worse. They guarantee that when the economy does come out of its cyclical trough, the tax rates in effect wont generate enough revenue to get us back to even a Clinton-era surplus, let alone the kind of surpluses necessary to fund the bills coming due.
I dont think theres any way to settle this argument in the abstract now, and Im not even sure that the data when theyre available will be clear enough to declare a winner. After all, none of the parties to the great supply-side experiments of the Reagan administration is willing to admit defeat 20 years after the numbers are in.
What investors can take away
But using my three-part framework, investors should be able to calculate how much play there is in the system and how much (or little) time there is before truly negative consequences start to appear.
Interest rates go up under all of these scenarios. Even the Bush budget sees rates on the 10-year Treasury note climbing to 5.6% in 2008 from less than 4% now. If the deficit turns out to be worse than currently projected, or if it comes to be seen as structural rather than cyclical, investors can expect interest rates that are higher than that projection.
We're likely to know the answer to the cyclical/structural debate sometime in calendar 2004 or so. If the economy does indeed start to pick up -- which in itself will put some upward pressure on interest rates -- but the actual and projected deficit stubbornly wont fall significantly, then investors here and abroad will start to rethink their bets on the U.S. dollar and the assets denominated in dollars.
And that, too, could easily push interest rates above the 5.6% projected by the White House for fiscal 2008.
Exactly how high rates could climb and how fast depend on far more than just the size of the federal budget deficit. But reading the numbers from Washington, investors should be planning on an end to 20 years of falling interest rates and building portfolios with climbing rates, even if they are just gently climbing rates, in mind.
Picking the right asset classes for the new investing environment is the topic of my next column. In that piece, Ill take a look at asset classes that most investors dont own but that now should be part of every investors portfolio planning.
New developments on past columns
Spot the winners, cut the whiners
On Feb. 27, Comcast (CMCSK, news, msgs) reported quarterly numbers that show the company beginning to turn around the troubled cable assets it acquired when it purchased AT&T Broadband. Pro forma revenue for the company as a whole grew by nearly 12% in the quarter and EBITDA (earnings before interest payments, taxes, depreciation, and amortization) grew 18%. On the balance sheet side, things looked equally solid: Comcast management cut its estimate for 2003 capital spending to $3.3 billion, a sum that just about equals Comcasts current holdings in cash and shares of AOL TimeWarner (AOL, news, msgs). In the quarter, the former AT&T Broadband systems showed a loss of almost 50,000 basic subscribers, continuing a pattern that resulted in a loss of almost 500,000 basic subscribers by these systems in 2002. Comcast has pledged to reverse those losses by concentrating on cable services, and especially high-speed and digital cable services, instead of the phone-over-cable products that AT&T pushed while it owned the systems. The new figures show progress on that front with the old AT&T systems added 180,000 high-speed and 257,000 digital subscribers in the quarter. The company confirmed its goal of hitting cash-flow break-even in 2003, and that continues to look like a conservative estimate. As of March 4, Im keeping my target price of $34 by December 2003. (Full disclosure: I own shares of Comcast.)
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: AOL Time Warner and Comcast. He does not own short positions in any stock mentioned in this column.
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