Weekly Market Update

The recent kerfuffle in Washington over the extension of the debt ceiling presented investors with many competing arguments and seemingly contradictory information. On the one hand, we hear that debt is bad for growth. On the other hand, we are told that government spending is key to supporting the economy. And why is it that stocks tanked after an agreement was reached to avoid default and extend the debt limit? In this Weekly Market Update, we will try to provide some context for understanding these competing positions, as well as the recent market reaction to these events.

Defining Terms: Debt, Deficit, Debt Limit, and GDP

The budget deficit is the shortfall between IRS tax receipts and government outlays as budgeted by Congress and approved by the president each year. For the current 2011 fiscal year, the federal deficit is approximately $1.4 trillion, according to the Congressional Budget Office.

The U.S. national debt represents the total amount borrowed by the United States government over time to fund its annual deficits. The national debt comes in two forms, debt held by the public and debt held by the government. The portion of the national debt held by investors, corporations, and foreign governments in the form of Treasury bonds is publicly held debt. In addition to debt held by the public, there is debt held in various government “trust funds”—such as those for Social Security and Medicare, among many others—which the federal government exchanged for surpluses in those accounts. According to the U.S. Treasury, the national debt currently stands at $14.6 trillion, or about $47,000 for every U.S. citizen.

The debt limit applies to essentially all federal borrowing, and sets a specific limit, or ceiling, beyond which the Treasury cannot issue debt without Congressional approval. Following the recent agreement to raise the federal debt limit, the ceiling currently stands at $14.7 trillion, with a well-publicized framework established to decide the size and timing of debt ceiling hikes into 2013.

The U.S. gross domestic product, or GDP, is a measure of the value of the country’s total economic output in a given year. According to the Congressional Budget Office, U.S. GDP is around $14.8 trillion.

Historical Perspective on the Debt and Deficit

Congress has virtually always placed restrictions on U.S. borrowing. The current aggregate limit on federal borrowing has been in place since 1939. Prior to that time, Congress typically set separate limits for bond issues, savings certificates, etc., that were typically designed to meet specific funding needs, such as financing the construction of the Panama Canal, for example.

The annual budget deficit has varied widely over the course of U.S. history. Indeed, the government ran a budget surplus for much of the 1800s, with the notable exception of the Civil War, when the deficit approached 10% of GDP. Significantly, only three times in U.S. history has the deficit actually breached the 10% level—during World Wars I and II, and in the wake of the 2008 financial crisis.

With respect to the total national debt, we are rapidly approaching a debt level equal to 100% of GDP. This has happened only once before in U.S. history, near the end of World War II.

Government’s Contribution to GDP Growth

Government spending accounts for about 20% of GDP in a given year, so curtailing government spending will detract from GDP growth, other things being equal. This is one reason why financial markets are nervous—much of the developed world is experiencing at best modest economic growth. And yet, the U.S. and many European countries are launching into spending cuts and austerity programs aimed at reining in their debts. While this is desirable from the point of view of long-term economic health, austerity measures that curtail government spending will, by definition, detract from short-term GDP growth. Investors worry that this hit to growth is occurring at a time when the global economy is already weak and could tip us back into recession.

Indeed, University of California Berkeley economist Christina Romer, who was the Chair of the Council of Economic Advisors and a co-author of the Obama stimulus plan, once famously listed six lessons of the Great Depression for policymakers. One of these was “Beware cutting back stimulus too soon.” It is this dictum that the markets fear the government is violating with its newfound focus on austerity measures and fiscal discipline. 

The Relationship Between Debt and Economic Growth

The relationship between government debt and economic growth is a complex one, involving interest rates, tax rates, and the level of inflation, among other factors. This subject has been the focus of much academic analysis, including two seminal works by Carmen Reinhart and Kenneth Rogoff, Growth in a Time of Debt and This Time is Different: Eight Centuries of Financial Folly.

Rogoff summarized his findings in a recent Bloomberg editorial*: “At what point does indebtedness become a problem? In our study “Growth in a Time of Debt,” we found relatively little association between public liabilities and growth for debt levels of less than 90 percent of GDP. But burdens above 90 percent are associated with 1 percent lower median growth.  . . . We aren’t suggesting there is a bright red line at 90 percent; our results don’t imply that 89 percent is a safe debt level, or that 91 percent is necessarily catastrophic. Anyone familiar with doing empirical research understands that vulnerability to crises and anemic growth seldom depends on a single factor such as public debt.”

He goes on to highlight additional complicating factors such as demographics, unaccounted for debts (such as liabilities of states or government agencies that may require federal bailouts), and the very reason the debt was accumulated in the first place. For example, debts racked up in periods of slow growth and financial crises can signal larger problems that may persist for years or even decades. Japan in the last two decades may be a good example here. Contrast this with the massive debt levels accumulated by the U.S. during World War II, which were worked off relatively quickly because an end to the war meant a sharp break in government spending, and allowed for the rapid reallocation of people and productive resources back into the peacetime economy.

Reducing Debt Requires Growth

It follows then that the best way to reduce public debt-to-GDP ratios is through economic growth, as happened during the two most recent periods in which the U.S. ran sustained budget surpluses—basically the 10 or so years following World War II and the late 1990s. Indeed, toward the end of the 1990s, government deficits switched to surpluses with essentially no change in tax rates or spending cuts. But it should be clear that the opposite is also true—there is a vicious debt cycle in which poor economic growth means worse deficits, other things equal.

Amid the Uncertainty, Market Volatility Seems Likely

It seems safe to assume that improvement on U.S. debt and economic growth is likely to be drawn out and fraught with challenges. Uncertainty around debt, growth, inflation, currency valuations, credit ratings, and so much else have contributed to sharp volatility in global financial markets, with no clear resolution in sight.

In this sort of environment, we believe investors would do well to focus on things they can control—their financial plan. Market volatility can be unnerving, but it can be easier to tolerate in the context of a diversified portfolio that spreads risk across a number of different asset classes and markets. Of course, diversification cannot ensure against a loss, but it may improve risk-adjusted performance of your overall portfolio.  It may also provide a framework for capitalizing on market volatility in your portfolio by means of rebalancing—that is, selling assets that have done well to buy assets that may be underperforming.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: U.S Investment Professionals

* “Too Much Debt Means the Economy Can’t Grow,” Bloomberg.com, July 13, 2011.

You should consider a fund’s investment objectives, risks, and charges and expenses carefully before you invest. The fund’s prospectus or summary prospectus contains this and other information about the fund, and should be read carefully before investing. Investments are subject to market risk.

Rebalancing allows you to keep your asset allocation in line with your goals. It does not guarantee investment returns and does not eliminate risk.

Diversification does not assure a profit nor does it protect against loss of principal.

The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

 

 

(c) American Century Investments

wwwamericancentury.com

 

Remember, if you have a question or comment, send it to .