At the end of 2018, after one year of Trump's tax cuts, federal gross debt to gross domestic product (GDP) was 105%. Gross debt includes the Social Security Trust Fund, which is an interest-bearing but intra-government non-marketable liability. This plus 16 trillion U.S. dollar (USD) of outstanding Treasury bills and bonds, puts U.S. debt at 22 trillion USD vs. 21 trillion USD GDP. Despite debt to GDP being 180% of the 50-year average of 58%, the interest expense/GDP is among the lowest levels in 40 years. And when the real interest rate on debt is considered, the interest burden on debt is similar to that of the 1960s when debt to GDP was about 40%.
Debt to GDP climbs when the deficit as a % of GDP, including interest expense, exceeds GDP growth. The 2018 deficit was 4.4% of the year-start nominal GDP, GDP grew 5.2%, but yearend debt to GDP climbed to 105% from 103% due to other debt issuance. The last 12-month 1 trillion USD deficit was caused by 4.4 trillion USD of spending and 3.4 trillion USD of tax revenue, 20.5% and 16% of GDP, respectively. Spending remains a bit above the nearly 20% norm since 1975 and revenue was at the lower end of the 16 to 18% norm that has persisted with remarkable consistency despite wide variation in tax rates.
Provided the deficit does not materially exceed nominal GDP growth, assuming stable and low inflation near 2%, debt and deficits are unlikely to trouble Treasury investors. Some argue that with 100% plus debt to GDP that a 1% point increase in interest rates would raise the deficit by 1% point of GDP. But the real interest rate must climb 1% point to affect the real interest burden or cause the debt-to-GDP ratio to rise. This is unlikely, but it is comforting that the average time to maturity of U.S. debt is six years.
While a 5% deficit 10 years into an expansion is unusual, so are longer than 10-year expansions. We think it is never too late, nor worth waiting for the next downturn, to try to optimize tax rates to best incentivize the economy's supply side and meet the government's demands. If economic growth and productivity trends benefit from lower corporate and top marginal tax rates, the deficit relative to GDP will shrink. Though top marginal income tax rates were lowered, Federal revenue could be more progressive in nature owing to sizable rate cuts at lower income brackets. There is risk that tax revenue could be more cyclical in nature the more progressive federal income tax becomes.
We often argue that corporate or household debt-to-GDP metrics are misleading, because they fail to account for corporate or household assets to GDP. We consider debt to GDP appropriate for government debt, but even the government has some assets. In addition to gold and oil reserves, loans, defense assets and vast land holdings, a "resource" is the U.S. Federal Reserve (Fed). The Fed's balance sheet has assets and liabilities, yet currency in circulation, which is 1.7 trillion USD or 8% of GDP, is a non-interest bearing liability. Thus, cash in circulation can ostensibly be thought of as a government asset. It cannot be used to extinguish debt; because the economy needs the liquidity it provides to operate. But it can fund some of the Fed's holdings of interest-bearing Treasuries conceivably indefinitely. This notion has given rise to Modern Monetary Theory (MMT). But there is nothing new or modern here. It is an old idea that can be very dangerous. The power to coin or print money without backing, or seigniorage, is ancient. This power can be abused as unlegislated taxation through confiscatory inflation. The power to print should only be used as a tool to achieve monetary, not fiscal, policy goals. Monetizing debt is clearly taboo; and attempts to monetize deflation or a shortfall from inflation targets raise many worries.
The new federal fiscal year begins October 1 and will require a budget or at least short-term authorization to avoid another partial government shutdown. Moreover, the debt ceiling at 22 trillion USD should have Treasury asking for it to be raised by then. Finding the mix in lifting sequester spending caps on defense and discretionary spending from the Budget Control Act of 2011 will cause much partisan wrangling.
First quarter 2019 earnings season begins next week. We expect S&P 500 earnings per share (EPS) to be flat for the current constituents, but up mid-single-digit excluding Energy, Materials and Apple. Results on a broad basis and guidance should relieve profit-recession concerns. But earnings season is unlikely to be a positive near-term catalyst of S&P 500 gains from current levels.