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Conclusion:  It seems that the politicians in Washington have their victory on the debt ceiling debate, a victory for whom remains the question.  Assuming this deal is passed, it will do very little to alleviate the bleak fiscal outlook of the United States.

 

Subject to passage by the Senate, the politicians in Washington have reached a compromise on the debt ceiling.  Despite the best fear mongering by both parties and many of the talking heads on TV, the credit markets, both Treasury yields and credit defaults swaps, have been consistently signaling that a U.S. debt default was highly unlikely.  The derivative impact of the fear mongering is that a deal is being pushed through, but the deal will not truly address deficit issues and continues to leave the door wide open for a potential ratings downgrade.

Based on the details we can discern from various sources, the Republicans will effectively get most of their deal, while President Obama will get the debt ceiling extended past the 2012 election.  The key points of the bill that were passed by the House 269 – 161 last night include: 

  • The debt ceiling can be increased by up to $2.4 trillion.  This increase will come in two tranches of $900 billion and a second tranche of up to $1.5 trillion.  The second tranche could be halted if Congress approves a joint resolution of disapproval;
  • The bill implements the $917 billion in discretionary spending cuts that were in the bill passed by the House last week, but these cuts are now split between “security” and “non-security”;
  • The top leaders in both chambers will appoint three members each to a twelve person committee (six Democrats and six Republicans) who will be charged with coming up with $1.2 trillion in additional cuts.  The committee will report by November 23rdand a Congressional vote on their proposed cuts will be implemented by December 23rd; and
  • New cuts will automatically go into effect if Congress doesn’t act on the super committee recommendations to ensure that the cuts reach $1.2 trillion. 

Keynesian economist and Nobel laureate Paul Krugman voiced his concern about this bill in the New York Times on Sunday with his emphasis that “there will be big spending cuts”.  We are not sure whether Dr. Krugman has a calculator in either his Upper West Side apartment or hallowed Ivy League office, but nothing could be further from the truth.

In the short term, according to the most recent scoring by the Congressional Budget Office, the impact of this bill is minimal with a mere $21 billion in cuts in fiscal 2012 and $42 billion in cuts in 2013. In the Early Look last Friday, we called this the Congressional Comb-over.  That is, while the amount of cuts to the deficit and the amount that the debt ceiling will be extended are roughly equal, they are on two very different time frames.  As noted, in the short term, the bill literally does nothing to alleviate the deficit and if the ratings agencies are being intellectually honest, this bill should not meaningfully change the creditworthiness of U.S. government debt.

Moreover, it is important to understand that the proposed spending cuts come off of the Congressional Budget Office baseline.  Based on the current CBO baseline, as represented in “An Analysis of the President’s Budget Proposal For Fiscal Year 2012”, total debt held by the public will increase from ~ $10.4 trillion in 2011 to ~ $20.8 trillion in  2021.  Therefore, the baseline projections will still add over $8 trillion in debt to the U.S. balance sheet over the next decade AFTER the proposed cuts.   As Senator Rand Paul wrote in an open letter stating why he won’t vote for this deal:

“This deal, even if all targets are met and the Super Committee wields its mandate - results in a BEST case scenario of still adding more than $7 trillion more in debt over the next 10 years. That is sickening.”

 

In the intermediate term, the more critical issue impacting the U.S. deficit is the domestic outlook for economic growth. Hedgeye has been on the low end of U.S. GDP estimates for the majority of the year, and consensus growth forecasts for 2H are still nearly twice that of ours.  The actual reported numbers have supported our contrarian stance, coming in at 0.4% on a quarter-over-quarter SA basis in Q1 2011 and 1.3% in Q2 2011 (advance estimate – which may also wind up being ~80% too high after future revisions!).  There are many issues with slow growth, but the key one that is not currently being contemplated is its impact on the federal deficit.

From a bigger picture perspective, the deficit projections provided by the CBO, which are the basis on which the spending cuts are predicated, are highly questionable based on a number of the imbedded economic assumptions, in particular GDP growth.  According to the CBO’s January 2011 publication, “The Budget and Economic Outlook: Fiscal Years 2011 to 2021”:

“All told, if growth of real GDP each year was 0.1 percentage point lower than is assumed in CBO’s baseline, annual deficits would be larger by amounts that would climb to $68 billion in 2021. The cumulative deficit for 2011 through 2021 would rise by $310 billion.”

 

In its economic projections, the CBO assumes 2.9% real annualized GDP growth from 2011 to 2021.  Interestingly, that is a noted acceleration from the last ten years, which produced an average annual rate of 1.7% real GDP growth.  If the next ten years produce comparable growth to the prior ten years, which is reasonable for an economy that is at 90%+ debt-to-GDP, the incremental deficit in that period over the CBO baseline would be $3.7 trillion, upping Rand Paul’s $7 trillion figure to a whopping $10.7 trillion in additional deficits added to the U.S. balance sheet through 2021.  And that, my friends, is a lot of billions.

Daryl G. Jones

Director of Research