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'3D' Hurricane Force Headwind

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Too often in investing we concentrate on the little decisions—the “trees”—that may impact the portfolio for the next quarter, year, or even three years. The “trees” of security and manager selection receive the bulk of our investment management resources, while the “forests”—the big issues that will affect our portfolios for potentially decades—receive scant attention. Such long-term thinking is difficult amidst the barrage of daily economic news and the steady flow of quarterly peer group rankings. We are a short term lot, us homo sapiens, reacting on instinct while seeking comfort and safety. We didn’t survive the lions of the African Veldt by planning ahead five or ten years!

But the forests will inevitably have the greatest impact on our future, on the returns we can expect from endowment and retirement assets, and ultimately on the way we should allocate assets. In this issue we examine three critical long-horizon issues—the deficit, the national debt, and demographics—and find a disturbing structural headwind that will impede the real returns we can expect from financial assets in the years ahead. The coming quarter century will be very, very different from the past quarter century; the lessons we’ve learned in the past generation may lead us astray in the coming generation.

The Deficit

It’s common knowledge that the United States has been running a fairly consistent deficit for the past quarter century. Figure 1 shows the rolling 12-month deficit or surplus, as a percentage of GDP (blue line), going back to the early 1980s. The annual average deficit for the past 25 years is about 2.4% of GDP—not a big deal when real GDP growth hovered around 3%. The latest year shows a deficit of 10% of GDP, but even this isn’t a problem as long as it’s a one-off deficit incurred to help avert a major financial and economic crisis. Right? Right… if the past average really was 2.4% and the current deficit really is temporary.

 

Figure 1. The Fiscal Budget Deficit —Official and Unofficial1953–2008

Source: Research Affiliates

 

The gold line shows the 12-month change in the national debt. Hmmm… isn’t the deficit supposed to match the change in our national debt? The big difference between the two lines is the off-balance-sheet spending, of which the largest component is the prefunding of entitlements such as Medicare and Social Security, which bumps the 25-year average deficit up to 4.5%. On this metric, the much-vaunted budget surpluses of the late 1990s disappear.

The green line adds in the incremental net indebtedness of government-sponsored enterprises (GSEs), which are now officially backed by the full faith and credit of the federal government. If we add the incremental net debt of the GSEs, year by year our average annual deficit spikes to 7.9% of GDP. And, the dotted line shows the impact of adding the unfunded portion of Social Security and Medicare. The average increase in our national debt, including unfunded obligations and GSEs, soars to 9.8% of GDP for the past 25 years. The latest 12 months saw our public debt and unfunded obligations grow by 18% of GDP! No wonder the debt seems to have grown crushingly large.

It’s noteworthy that, if a company computes its debt by ignoring off-balance-sheet and unfunded obligations, the management team wins an all-expense-paid extended holiday at Club Fed. Enron, anyone? But, if you write the laws, you can allow yourself these games. In emerging markets debt investments, managers are wary of sovereign credits when their deficits approach 5% of GDP. Yet here we are, after measuring on a more economically accurate level, running at twice this worrisome warning level… for over 25 years.

 

 

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