Ahead of the holiday weekend, US investors focused on earnings given a lack of broader economic data. Earnings season is getting close to wrapping up and Q1 reports suggest the corporate sector remains healthy. With over 95% of S&P companies now reported, earnings have come in 4% above expectations to show nearly 8% year-over-year growth, while revenues have come in mostly in line with expectations, showing 4% YoY growth. Light revenue growth has not impacted sentiment and has been largely overlooked as company executives give solid guidance for the quarters ahead. Buoying investor risk appetite, Nvidia, which has become a critical bellwether of the digital economy, reported quarterly results on Wednesday showing better-than-expected earnings and revenue growth while providing an upbeat forecast on future demand. The results and subsequent guidance justified the dizzying rise in its shares and gave investors confidence to push the broader NASDAQ higher for the week. Markets have posted solid returns so far in May and traded slightly higher again last week—the S&P 500 Index traded higher 0.1%, while the US Aggregate Bond Index fell 0.3% with rates pushing modestly higher, particularly in one-to-five-year maturities.
Given a lack of new macro data last week, several market commentators, economists, and even corporate executives picked up on recent Congressional Budget Office (CBO) reports on the national debt and deficits. Even Chair Jerome Powell said the US is “running big structural deficits, and we’re going to have to deal with this sooner or later, and sooner is a lot more attractive than later” when faced with questions on recent travels abroad. US Government debt has swelled nearly 50% since pre-COVID levels to over $34.5 Trillion, or $11 Trillion more than March 2020, driven by huge fiscal deficits to support economic growth during and after the pandemic.
Total Public Debt
$ Trillions
Source: Congressional Budget Office.
The problem is not so much the response to the pandemic as the policy overhang and lingering spending programs that continue to drive elevated deficits. In fact, the CBO projects the national deficit will continue at 5%-7% per year with no policy changes. For historical reference, deficits have exceeded these levels only during and shortly after World War II, the 2007–2009 financial crisis, and the COVID pandemic. Notice that these are all extreme environments, not the economic expansion the US is currently enjoying.
Driving a large portion of the projected deficit is likely to be net interest charges associated with running up the national debt. As the US needs to refinance maturing Treasuries at higher projected rates, the interest expense is expected to grow into a larger portion of the fiscal budget. This will likely leave the government with less ability to increase spending on other programs, diluting the stimulative impact in future years. While not expected to roll off completely, government consumption will moderate going forward. The knock-on effects for investors remain unclear, but if the US can sustain higher nominal growth rates and reasonable inflation levels, the national debt should be sustainable with smart policy decisions.
Total Deficient, Net Interest Outlays, Primary Deficient
% of GDP
Source: Congressional Budget Office.
Now in an election year, new programs are proposed, and cuts are rarely suggested as politicians appeal to their voting constituents. Both parties have proven to be spenders in their own ways too – debt has soared under President Joe Biden and had also risen significantly under former President Donald Trump. We’ll see how the rhetoric evolves over the election campaign, but investors are beginning to take notice. Capital markets will likely react very differently if investors force the government to enact fiscal restraint (return of the “bond vigilantes”) or if Washington proactively addresses the national debt head on.
– Written by Eric Schmitz, CFA