Tick, Tick, Tick…
Quarterly Commentary | Q2, 2024
Author: Jason Kirchhoff
Picture this - the year is 1989, I am a freshman in high school listening to the latest from pop sensation Milli Vanilli, enjoying an innovative Crystal Pepsi, and patiently waiting for the evening news to end so I can watch the debut episode of The Simpsons. One of the last stories on the news that evening was about a gentleman in New York who put up a “debt clock”, an electronic billboard that showed the current amount of the U.S. Federal debt. His goal was to make people aware of the dangers of the rising debt level.
At the time the national debt had grown to around $2.7 trillion which represented about 53% of the U.S. economy as measured by the Gross Domestic Product (GDP). Throughout the 90s and into the 2000’s many pundits were predicting that the rising debt level would create all sorts of problems for the U.S. including rising interest rates, runaway inflation, credit downgrades and a crashing US dollar. However, these warnings were for naught as inflation stayed benign and interest rates dropped to zero for an extended period of time while the Federal debt continued to rise.
Why didn’t the debt matter as much as predicted?
While there were many factors helping to mitigate the impact of the increasing Federal debt, there were two key structural changes that had a large impact. The first was the trend towards globalization which was kicked off by the fall of the Soviet Union and the addition of China to the World Trade Organization. Increased global economic integration was a large deflationary force that allowed for cheap labor and cheap imported goods. The second big factor was the Shale revolution. The combination of hydraulic fracking and lateral drilling unleashed a tsunami of cheap, abundant energy in the U.S. These two massive deflationary forces helped keep interest rates low and therefore the high debt level appeared manageable.
What about now?
The federal debt today is over $34 trillion (about 120% of GDP) and is growing quickly. The U.S. is running an annual budget deficit of close to $2 trillion (approximately 7% of GDP), a level we haven’t seen since World War II. In addition, as interest rates have risen the interest charges on our outstanding debt will be about the same as the U.S. spends on defense. Is this time different? Will the rising debt levels impact markets unlike the past 30+ years? I can answer these questions with a high level of conviction… maybe. There has been a partial reversal of a few of the trends that helped mitigate the risk in the past. For example, the pandemic has tentatively reversed the push for continued globalization into a move toward reshoring or nearshoring our supply chains and manufacturing. Also, the “shale revolution” has shown signs of peaking as many of the oil/gas fields have seen their production stop growing and even start to decline. There also seems to be no appetite from either political party to seriously address the debt problem. The recent presidential debate included a longer discussion about golf handicaps than how to handle the ever-increasing debt. The risks have increased since the late 80s but that doesn’t necessarily mean the pain that has been predicted for 30+ years is imminent. We could grow our way out of the problem, perhaps through a large leap in productivity from artificial intelligence. Also, while the U.S. debt situation seems perilous it is still better than some other countries which could make the dollar and sovereign debt relatively more attractive than the other options investors have.
What does this mean for your portfolio?
We build portfolios to be resilient to many different outcomes rather than relying on our ability to predict the future. Looking back at past predictions, such as the “panic” around the rising debt in the late 80s, is a helpful exercise because it reinforces how uncertain and unpredictable the future is, but at the same time we must contemplate that maybe this time is different. Over the past year we have added diversifying strategies apart from traditional stocks and bonds, and we continue to review investments that may provide additional exposures to buffer portfolios against a broad range of outcomes. It would have been hard to predict that both Milli Vanilli and Crystal Pepsi disappeared in just a few years while The Simpsons is still on the air three and a half decades later.
The opinions expressed are those of Jason Kirchhoff as of the date stated on this article and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.
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