Deficits Don't Matter to Stocks — Until They Do

(Bloomberg View) -- The outlook for U.S. debt and deficits isn't pretty. The latest projections from the Congressional Budget Office are for $1 trillion annual budget shortfalls. On top of that, Treasury debt held by the public will almost double to $27.1 trillion over the next 10 years as the U.S. steps up its borrowing to finance the deficits. Perhaps the worst part is that there are no recessions built into these numbers, which would have surely shown debt eventually exceeding 100 percent of gross domestic product.

Here's the important point when it comes to markets: The literacy rate among investors is 100 percent. Everyone knows these numbers are essentially gamed, but no one seems particularly bothered. It's not as if there's widespread belief that the U.S. government will cut spending and/or dramatically increase taxes to reduce deficits. So we are left with the conclusion that investors believe there is no day of reckoning.

And perhaps that is so. After all, recent history speaks volumes. Adding 200 percent to the U.S. national debt over the last decade hasn't hurt stocks, with the S&P 500 Index gaining some 88 percent even when including the big losses during the financial crisis. But what if that complacency is misplaced? And if it is, what would cause investors to start to worry? There are three scenarios to consider.

The first is that rising U.S. sovereign debt levels will begin to hurt stock valuations in the next two to three years as inflation picks up dramatically and the economy cools, likely due to an energy price shock. There is plenty of precedent for that: 1973, 1979 and 1990. The result would be reduced tax revenues and increased long-term interest rates. Also, any military expenses needed to address a geopolitical challenge would add to the deficit. Lower tax receipts from a recession would have the same effect. Deficits would rise, as would Treasury issuance, possibly resetting longer-term bond risk premiums to higher levels. Higher long-term interest rates would ding equities by increasing the discount rate used to value cash flows.

The second scenario is that rising debt levels will matter, but not for five to 10 years. The idea here is that aging demographics across the U.S. and Western Europe will keep a lid on rates, even as deficits climb. Any recession is mild and can be addressed by Federal Reserve rate reductions rather than requiring fiscal stimulus. Eventually, however, the U.S. will have to offer higher interest interest rates to attract a trillion dollars of capital annually. That's when the "Who is going to buy our debt then?" question comes into play. The answer: "Everyone, but only at the right price." Those higher rates will push equity valuations down, as in the prior point.

The third scenario is that rising levels of U.S. sovereign debt will simply never matter to stocks. Since this is the current environment, it is easy to sketch out a base case. The fact that 10-year U.S. Treasuries still yield just 3 percent is testament to the fact that the world remains awash in liquidity in spite of central banks either tightening (the Fed), moving to neutral (the European Central Bank) or running out of assets to buy (the Bank of Japan). Aging demographics everywhere in the developed world, even China, keep a lid on rates for decades. This cohort is a natural buyer of fixed-income assets and, they don't spend as much as during their working life so economic growth is slower and inflation calmer. It's not like the U.S. is alone in its debt problems. The euro zone, U.K. and Canadian governments have similar levels of debt to GDP. Even China's debt sits at 48 percent of GDP at the moment, more than double the levels back in 2000.

It's easy to understand why scenario No. 3 is the crowd favorite. It is hard to even consider factoring risk into a nominally risk-free asset like U.S. Treasuries. Once you start down that rabbit hole the recursive elements are dizzyingly complex. Perhaps most importantly, the demand for Treasuries is inexorably linked to the dollar's global reserve currency status. To see that go by the wayside means something very unexpected has occurred. In that event, we doubt most people's first thought will be "I wonder where the S&P 500 will close today?"

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nicholas Colas is the cofounder of DataTrek Research. He is the former chief market strategist at Convergex Group LLC.

For more columns from Bloomberg View, visit http://www.bloomberg.com/view.

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