Morning Note: Market news and our thoughts on the US budget deficit.

Market News

US equity markets moved higher last night – S&P 500 (+0.6%), Nasdaq (+0.8%) – on optimism about US interest-rate cuts after Federal Reserve Chair Jerome Powell said the latest economic data suggest inflation is getting back on a downward path. Treasuries steadied – the 10-year currently yields 4.44% – while gold ticked up to $2,343 an ounce.

This morning in Asia, markets were also firm as the yen weakened to a fresh three-decade low: Nikkei 225 (+1.3%); Hang Seng (+1.1%). The Indian stock market rose 0.7% to hit a record high. China’s Caixin services PMI missed at 51.2 in June, the slowest pace in eight months. Separately, the finance ministry notified underwriters to re-submit demand for Friday’s 30-year government bond auction, people familiar said.

The FTSE 100 is currently trading 0.5% higher at 8,160, while Sterling buys $1.2685 and €1.1807.

The oil price held at $86.50 a barrel on signs of US inventory drawdown. Rystad cut its forecast of oil output growth in the Permian Basin by 30% to 252,000 barrels a day on continued consolidation and a slowdown in drilling.

Source: Bloomberg

Economic View

An update to the Budget and Economic Outlook: 2024 to 2034 – Congressional Budget Office, June 2024

The US Congressional Budget Office recently gave an update for their projections for the US budget deficit for the current fiscal year and over the next 10 years. The CBO estimates that if no new legislation affecting spending and revenues is enacted, the budget deficit for fiscal year 2024 will total $1.9 trillion. That amount is $408 billion (or 27 percent) more than the $1.5 trillion deficit the agency estimated in February 2024, when it last updated its baseline budget projections.  Since then, CBO has increased its projection of outlays in 2024 by $363 billion (or 6 percent) and decreased its estimate of revenues by $45 billion (or 1 percent).

While these headlines have garnered much attention, the assumptions that underpin them are even more eye-opening.  The US deficit is forecast to never go below 6% of GDP between now and 2034, even though it assumes 175-200 bps of Fed rate cuts; no recessions for the next 10 years (note that in the last 3 recessions, deficit/GDP has risen by 600, 800, and 1200 bps of GDP respectively); and unemployment never rising above 4.5%.

Historic and Projected US Budgets 1974-2034

Source: An update to the Budget and Economic Outlook: 2024 to 2034 – Congressional Budget Office, June 2024.

The nominal growth of the economy is not expected to keep pace with these deficits and hence the government debt to GDP ratio is forecast to continue to rise.

US Government Debt to GDP

Source: An update to the Budget and Economic Outlook: 2024 to 2034 – Congressional Budget Office, June 2024

The make-up of the US budget is such that the only categories of spending that are large enough to make a difference are Entitlements, Interest and Defence.  Entitlements are mandatory and politically impossible to address.  Interest is a function of the existing debt burden and its intersection with Federal Reserve policy, which is itself driven by its inflation mandate.  Defence, given the geo-political landscape is also untouchable and although not categorised as such, is effectively mandatory spending.  This leaves taxation as the only lever to try and rein things in.  While there is undoubtedly some room to increase taxes, there is a limit before they become self-defeating.

The solution for the US, and most developed economies, is to have nominal GDP (NGDP) (real growth plus inflation) run higher than the deficit to stop the inexorable rise in the debt to GDP ratio.  Obviously, the more of this that can come from real growth the better.  However, high NGDP regimes have historically been bad news for the holders of nominal bonds in the long run.  That is not to say the bond market cannot have periods where it does well, but over time the returns struggle to keep pace with inflation.  This means that firstly, bonds should be viewed through the lens of a trader rather than an investor and secondly, investors should look elsewhere for diversifying assets for their equity exposure.