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WashingtonWise Investor: Episode 2

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The federal debt and yearly budget deficits continue to climb with no letup in sight. What’s the impact on the economy and investors?

In this episode of WashingtonWise Investor, Mike Townsend considers the small but promising improvements in the trade war with China, the likelihood that we have averted a government shutdown, Treasury’s progress toward issuing 50-year bonds, and what’s happening in the 2020 presidential election.

Mike is joined by Liz Ann Sonders, Schwab’s chief investment strategist, for a deeper dive into what is driving mounting U.S budget deficits and government debt, the impact on the economy, and what investors should be watching for.

WashingtonWise Investor is an original podcast from Charles Schwab.

If you enjoy the show, please leave a rating or review on Apple Podcasts.

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MIKE TOWNSEND: Welcome, everyone, to WashingtonWise Investor, an original podcast from Charles Schwab. I’m your host, Mike Townsend. We’ve got a great show for you, featuring an interview coming up in just a few minutes that I know you will want to stick around for. I talk with Schwab’s chief investment strategist Liz Ann Sonders about the federal debt and budget deficits.

But let’s begin with a look at what’s making news right now in Washington—a couple of updates on issues I discussed in the last episode.

First off, in the trade war with China, there has been some positive momentum.

The president recently delayed a planned increase for tariffs on about $250 billion in Chinese imports from October 1 to October 15.

And in response, China dropped tariffs on a few U.S. imports and lifted its ban on purchasing U.S. agricultural products. In fact, they just made their biggest purchases of soybeans and pork in many months.

The market reaction to these developments was positive.

And I think they are small but significant steps. And a sign that both countries are getting more serious about jump-starting face-to-face negotiations.

Now no dates have been set for those meetings, but it’s looking more and more like Chinese negotiators will visit the United States for a new round of talks in mid-October. We’re still a long way from a major agreement, but a little positive momentum is better than no momentum at all.

Second, it looks like we won’t have a government shutdown next week.

As discussed last time, Congress is facing a September 30 deadline to pass the 12 appropriations bills that fund each federal agency and federal program for the fiscal year that begins October 1.

Now, the House passed a temporary bill to fund government operations through November 21 at the same rate as currently. And the Senate is expected to approve that this week, though it’s not across the finish line yet.

The deal gives Congress eight more weeks to work on those appropriations bills, but it’s not clear just how lawmakers—in the Senate in particular—are going to resolve the stand-off, even with the extra eight weeks. There are deep divisions over issues like funding for the southern border wall, and they won’t be resolved easily.

So we could be right back here talking about the risk of a government shutdown come mid-November.

Well that brings me to my “Why It Matters” segment of the show, where I look at some recent news that you may not have focused on and share with you why I think it’s important.

This week, let’s talk ultra-long bonds.

The Treasury Department is considering issuing a 50-year bond, perhaps as soon as next year, and is even weighing the idea of a 100-year bond.

Now, this is an idea that has been kicking around Washington for a couple of years—Treasury reportedly explored it back in 2017—but it sounds like there is more momentum towards it this time around.

Now, why is the government thinking about this? Well, they want to lock in low interest rates for years to come, which is important when the government is running a trillion-dollar budget deficit and is expected to have big deficits for years to come.

Advocates say locking in those low rates now would mean the government would not have to refinance shorter-term debt at higher rates in the future, and that, potentially, would save taxpayers money.

For investors, longer-term bonds typically pay better interest than shorter-term bonds. But the yield curve recently inverted, meaning that some short-term bonds are actually paying better rates right now than longer-term ones. And that’s contributing to real concerns about the demand for these ultra-long bonds.

There’s also concern that issuing these bonds would sap demand for the 30-year Treasury, which has become an important staple of our economy—particularly in the mortgage market.

Now, a few companies, universities, and other organizations have issued ultra-long bonds in recent years, and at least 14 other countries have tried it as well. But here in the United States, no final decision has been made. I do think it bears watching in the months ahead.

For this week’s deeper dive, I want to look more closely at two things that we hear a lot about, the federal deficit and the national debt. Earlier this month, the Treasury Department announced that the federal budget deficit had exceeded a trillion dollars this year, the first time that has happened since 2012. Deficits of greater than a trillion dollars could persist for years to come.

And at the same time, the national debt has risen to approximately $22½  trillion, a number that’s hard to even wrap your brain around. We hear these numbers in the news all the time, but I think a lot of people just kind of shrug their shoulders, and that’s probably because it’s hard to understand “Just what does all of this mean for me?”

So today, I’m going to spend a few minutes talking about how investors should think about deficits and debt with one of my favorite colleagues, Liz Ann Sonders. Liz Ann is the chief investment strategist here at Schwab and a regular presence on financial news shows. Liz Ann, thanks so much for joining me.

LIZ ANN SONDERS: Mike, thanks for having me. And congratulations on the new podcast. We’re very excited.

MIKE: Thanks very much. Well, Liz Ann, you and I have been speaking around the country for many years, and I’m guessing that you get questions on the deficit and the debt as often as I do. And it makes sense, right? I mean, these are big numbers, they’re in the headlines a lot—but I think they’re easy to confuse. So what is the difference between the deficit and the debt?

LIZ ANN: Yeah, you know, a lot of times you think sometimes the simplest concepts should be just that simple, but it’s incredible to me how much conflating there is of these terms, the deficit and debt.

So in very simple terms, the deficit, we’re talking about the budget deficit, of course, is the difference between what the federal government spends and what takes in through tax revenues. So that’s the annual mismatch; that’s the budget deficit.

Now, the debt, or public debt, is the result of the government borrowing money to cover the budget deficit. So it’s really the cumulative effect of running budget deficits.

Now, until recently, the budget deficit had been improving as a percentage of GDP. In other words, it had been coming down as a share of GDP from, I think, over 10% of GDP during the worst part of the financial crisis to actually less than 3% of GDP at the best point following the financial crisis. The problem, though, is it’s still … it was still a deficit. And as long as you still have a deficit, even if it’s improving, you’re still adding to that cumulative effect, which is debt. So that’s the difference between the two.

MIKE: So that’s pretty straightforward. Every time the government spends more than it takes in, that’s the deficit, and the accumulation of deficits means more borrowing—and that’s the national debt. So let’s talk more about the deficit—as I said earlier, now over a trillion dollars for this year. It seems like it got to that level even faster than experts had predicted. So what happened? How did the deficit grow so fast?

LIZ ANN: Well, again, it’s the mismatch between what’s coming in and what’s going out. So you had tax cuts both for individuals and corporations, but you also had increased government spending in the most recent budget, and then you add a trade war and tariffs dragging down overall economic growth. So here are the numbers: As of August of this year, you had the year-over-year growth rate of federal receipts of 2.9%. Now, the good news is that actually improved a little bit relative to where it was the month before when it was a 2.4% year-over-year growth rate. In turn, though, we’ve got federal outlays. That has year-over-year growth of 3.7%. So the growth in spending is higher than the growth in what’s coming in.

MIKE: Given all that, how should investors be thinking about this? Does history give us any guide about how deficits affect economic performance?

LIZ ANN: You know, it’s hard to really come up with some particular investment strategy that is consistent with being in a high and rising deficit environment. It’s more of a macro thought process that you have to bring into the mix. We know that, a high and deteriorating budget deficit places a burden on the next generation. That’s sort of the simplest way to think about it.

And a lot of the data that you can get that have hard numbers ironically started the year I was born, in 1964. And there’s some Ned Davis data that I dug up that when the six-month change of the annualized budget deficit was improving over that period of time, that 55 years, and that was 53% of the time, the six-month change was improving, the economy grew by 2.7%. Now, when the six-month change was worsening, which has been 47% of the time, the economy only grew by 1.6%.

So improving budget deficit, 2.7% growth historically. Deteriorating budget deficit, 1.6% growth. So history shows that a worsening budget deficit has had a negative impact on growth.

Now, it wasn’t just felt in overall economic growth, GDP. It was also felt on job growth, as well, payroll growth. Those same relative numbers, when the deficit was improving, payroll growth was running historically at 2.3% growth on an annual basis. When the budget deficit was worsening, it was only 1.1% growth.

So what we really can infer based on history is that this has had an actual economic impact, measured in GDP, measured in payrolls, and unless the world is entirely different, that’s one of the things that we have to think about looking forward, is the impact it has and likely will continue to have on growth.

MIKE: So as an investor, our takeaway is that a shrinking deficit equals stronger growth; a rising deficit equals weaker growth.

Well, let’s switch gears for a second to the national debt. When I started my career in Washington more than 25 years ago, the debt was $4.6 trillion. And at that time, everyone in Washington said, “Well, you know, it will never get to 10 trillion because Congress will have to do something about it before then.” And then that number was 12 trillion, and then it was 15 trillion, and 20 trillion, and in a couple more years, we’ll be at about $25 trillion.

But here’s what I think is interesting. As that number has gone up, it feels like the pressure for Washington to do something about it has actually gone down, and there are even some economists who have been debating the degree to which the national debt really even matters. So my question is, does it matter? Is there a point at which it truly becomes unsustainable?

LIZ ANN: So I think … number one, I think, yes, it matters. Number two, probably, there is a point at which it becomes unsustainable. I think the problem is trying to pinpoint what value that will represent or what point in time that will represent, and I think that’s what we’re all grappling with.

But to your point about Washington, what’s amazing to me is that the lack of concern about debt has become somewhat bipartisan, when the reality is that both sides should care. They might care for different reasons, but both sides should care.           

So it’s also … federal government debt, of course, is just one portion of debt. You’ve also got state and local debt, corporate debt, household debt, financial sector debt. In fact, you know, we’re talking about numbers that get upwards of 100% of GDP, that’s just for federal government debt. If you look at total credit market debt, which includes all those other portions of debt, you’re talking about 350% of GDP. And we know those other forms of debt have had an economic impact.

But back to just federal government debt, the latest statistics are that it’s growing at about a 6.3% annual rate. Now, that is below the post–World War II average of 6.8%, but of course, it’s well above the growth rate in the economy. So that’s the key, is that the growth in debt is exceeding the growth rate in the economy.

MIKE: Well, Liz Ann, I want to pick up on something you were just talking about with regard to the lack of concern in Congress about the debt. One of the reasons I think that there’s not a ton of pressure on lawmakers in Washington is because there really isn’t a big public outcry on the national debt. You know, there aren’t people protesting on the streets here in Washington or on the steps of the Capitol. I think one of the reasons for that is because $20 or $25 trillion is a meaningless number to the average person. It’s hard to understand what that means to our daily life. So the question is, what does it mean to our daily life, and what does it mean for investors?

LIZ ANN: Yeah, I agree with you, there really isn’t much of a public outcry, although, Mike, as you suggested when you started this podcast today, you and I hear about this all the time when we are out speaking with investors, doing client events. It is, by far, the number one theme of questions I get. It hasn’t turned into this crescendo of concern, but at least on the part of our investors at Schwab, for whatever reason, this is top of mind.

But the way to think about it is that, longer term, if there’s just no checks on debt growth, it does become detrimental to economic growth because servicing the debt, even if you don’t have rapidly rising interest rates, starts to take a growing share of government resources that would have otherwise gone to more productive uses.

So to put some numbers on it, last year, 2018, the government paid 1.6% of GDP for debt service. That’s expected to almost double to 3% by 2029, and then double again, actually more than double again, to 6.3% by 2050, and that’s based on Congressional Budget Office numbers. If you assume current law, current sort of budget law, interest payments will exceed the cost of Medicaid by next year, and spending on defense by 2025, and will be the single largest government expenditure after 2050.

Framed a different way, interest payments, right now, already, consume every dollar raised by the corporate income tax, the estate tax, gift taxes, and federal excise taxes. And by the late 2040s, again, under current law, interest costs will consume all payroll tax revenue.

That is, the more that is paid on interest, the less it is available for investment. So let’s translate that. The less you have to spend on long-term productive investments means less machinery, fewer buildings, less equipment and software, etc., etc., fewer new ventures or technologies. And, as a result, you have lower productivity growth, ultimately, lower income and wage growth.

Now, I think what is more likely to happen here, and frankly, has been happening, I would call this more of a subtle crisis, where you have these high and rising debt burdens actually lead to a slow erosion of U.S. growth and prosperity. And that, I would argue, has already been happening. This is the longest economic expansion in history, but it’s also the weakest by far, and I think debt is a big part of that. Just before the Great Recession, debt-to-GDP, just, you know, held by the public, federal debt, was 35%. That was about its historical average. But by 2012, because of what the government had to do to combat the financial crisis, that had doubled. And under the current trajectory, if we continue to grow at this pace, you have to question whether we would have the fiscal space to repeat that magnitude of intervention in the event of another serious crisis.

MIKE: Well, thank you so much, Liz Ann. You’ve given us a lot to think about, fascinating insights, as always. That’s Liz Ann Sonders, chief investment strategist at Schwab.

Well now let’s talk Election 2020. We had the third debate among Democratic presidential candidates earlier this month. There were tighter qualifying standards this time, and that limited participants to just 10 candidates, even though there’s still 19 running. So it was the first time that all of the top candidates had shared the same stage. Let me share three observations about the state of the race coming out of that debate.

First, not much has really changed. In the debate, no one landed a big punch and no one made a big, game-changing mistake.

And in fact, the race has been surprisingly steady over most of the year. Debates just have not proven to be a springboard for lower-tier candidates to have that kind of viral moment that propels them toward the front of the pack.

California Senator Kamala Harris got a nice bounce in the polls after a strong performance in the first debate back in June. But that turned out to be a temporary blip, and she’s slipped back a bit since then. 

Second, I think the issues are starting to crystallize.

One of the challenges for lower-tier candidates trying to break through the crowded field is that it can often seem like there are just not that many substantive differences between the candidates.

Three issues—health care, gun control, and climate change—are starting to become the dominant issues in the campaign, because these are three issues where there are significant differences among the candidates.

All three are consistently among the issues that Democratic voters identify as the most important to them in polls. So look for those issues to continue to be a focus in the weeks ahead, because those are the issues where candidates can draw distinctions with other candidates.

Finally, I think having one debate with all the top candidates—well, that probably won’t last. And that’s because already 11 candidates have qualified for the next debate on October 15, and it’s possible that one or two more candidates could qualify between now and then.

So that means it’s likely that the field will be split into two debates. The Democratic National Committee has not yet announced that, but that’s been their practice in the past.

My own view: Having 10 or 11 candidates on the stage at the same time is just too many. It’s better to have two smaller debates, with perhaps six candidates each night. I think that would give all candidates more air time and more chances to make their case.

Well, that’s it for now.

I’ll be back on October 8 with another episode of WashingtonWise Investor. I’ll be talking then with our international expert, Jeffrey Kleintop, and he’ll help me explore some of the developments around the world that have investors anxious, from China to Iran to Brexit.

Until then, thanks for listening. Please consider leaving us a review or a rating on Apple Podcasts or your favorite listening app, and make sure you subscribe so you don’t miss an episode. For important disclosures, see the show notes or Schwab.com/Washingtonwise, where you’ll also find transcripts of every episode.

I’m Mike Townsend, and this has been WashingtonWise Investor. See you next time—and keep investing wisely.

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