Ask The Expert: Is A Shrinking Deficit Good For Stocks And Bonds?

By David Sterman
September 19, 2013

Question: How does the deficit impact stocks and bonds

-- Tim, Gainesville, Fla.

The Investing Answer: Great question, Tim. Deficits are a major hot-button topic these days. However, there's actually some good news to report... It’s the feel good story of 2013 that nobody is talking about. 

Our nation’s budget deficit, which had been spiraling out of control, is finally coming down to manageable levels. Thanks to a combination of higher government revenues and lower government spending, this year’s shortfall (for the fiscal year ended September 30) will likely be around 40% lower than a year ago.

In fact, the Congressional Budget Office (CBO) predicts the budget deficit will fall below $400 billion by fiscal 2015. 

Good news indeed. 

Or is it? 

Should we be pleased that the budget deficit will still be larger than the entire economy of many mid-sized countries? And for investors, does that falling budget portend good news for stocks and bonds

Before we answer those questions, let’s take a closer look at the road ahead for our government’s finances…


Source: Congressional Budget Office (CBO)

Despite the current good news, demographic forces threaten to push the deficit higher later this decade. Until and unless policy makers adopt additional measures to raise revenues (likely through tax increases) and cut government spending, the CBO forecasts a $650 billion deficit by fiscal 2019 and an $800 billion deficit by 2022 as a growing pool of retirees absorb a higher amount of retirement and health care benefits. 
 
What kind of numbers are we talking about? The CBO notes that we are currently spending around $2 trillion every year on mandatory spending such as Social Security and Medicare, though that figure is expected to swell 75% to $3.5 trillion by 2022. 
 
Yet a deficit is still troublesome, no matter how large or small. It means that our national debt, which now stands at $16.7 trillion, keeps rising. And all that debt means the government doles out more than $300 billion a year in interest payments on that debt, which plays a role in keeping the budget from coming into balance.  
 
Erskine Bowles, who has been leading a government council that seeks to tackle the persistent deficits, paints matters in starker terms: "We'll be spending over $1 trillion a year on interest by 2020. That's $1 trillion we can't spend to educate our kids or to replace our badly worn-out infrastructure," said Bowles at a November 2012 forum hosted by IHS Global Insight. "What makes it doubly bad is that trillion will be spent principally in Asia, because that's where our debt is," he added. 
 
No matter how you look at it, it remains hard to see how our national debt will stop growing and start shrinking. Even with current low interest rates, the annual interest payments consume more of the federal budget than the U.S. Department of Agriculture, Department of Education and State Department -- combined. By next year, interest payments will exceed what we annually spend on Medicaid
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To be sure, the current interest payments actually benefit from the current era of low interest rates. When interest rates start to rise, the government will likely pay much higher sums. 
 
Bad for bonds?

Thus far, the huge tide of deficits and debt has not had much of an impact on bond markets. The global economy has been so weak that investors have gladly bought relatively safe government bonds. But as the global economy strengthens, massive sums of money will pull out of bond funds in pursuit of higher returns, such as stocks. 
 
The drop in demand for bonds means that bond issuers (such as the government, states, municipalities and corporations) will have to offer higher yields. And rising bond yields mean falling bond prices, which will lead to a drop in value for that bond fund you may own. Net/net, bonds are vulnerable to our ongoing budget deficit, no matter whether it's $1 trillion or $400 billion.
 
Good for stocks?

So if investors can be expected to pull money out of bonds and into stocks as the global economy firms, should we read that to mean that budget deficits are good for stocks? 
 
Not at all. 
 
In fact, we're already seeing real headwinds in our economy as government spending shrinks. Uncle Sam provides a lot of juice to the U.S. economy, through defense spending, technology investments, infrastructure spending and the like. Economists suggest the smaller level of government spending is already shaving a full percentage point of growth from our economy.
 
And with the massive debt and deficit pressures still in place, government spending is bound to fall yet further. This means Uncle Sam will be providing an ever-smaller boost to the economy. Net/net, stocks have rallied in recent years, despite still-large deficits, but the road ahead will become bumpier as the government shrinks in size. (Speaking of the road ahead, my colleague Elliott Gue -- editor of StreetAuthority's Top 10 Stocks newsletter, has just released his picks for the Top 10 Stocks Of 2014. Click here to learn more.) 
 
Can we ever eliminate our nation’s budget deficit? When there’s a will, there’s a way, but Washington thus far has lacked the will to do so. In 2012, I suggested ways that the government could balance its books but thus far, only defense spending has been tackled. The other five suggestions have thus far gone unheeded. 
 
Yet until you see Washington finally come to agreements that both cut spending and raise revenue, you need to be concerned about bonds and stocks. The recent drop in the annual deficit is indeed great news, but the fact that the national debt is fast-approaching $17 trillion means that a debt-triggered crisis can’t be ruled out.
 

P.S. -- Don't forget to check out Elliott Gue's Top 10 Stocks for 2014. It's our most popular research of all time, and for good reason. During the past decade, this annual list has beaten the market time and time again, including individual gains of up to 159.9%. Click here to learn more.

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