When asked about growing deficit in the U.S., Ronald Reagan famously quipped, “I am not worried about the deficit. It is big enough to take care of itself.”
Investors are having a less sanguine response to the growing government deficit today, though. The impact of a tax cut passed in 2017 with new spending bills passed in 2018 create the potential for a growing budget deficit. That is stoking worries about the sustainability of government debt and what today’s decisions might mean for the future.
So, what is the risk in growing deficits and is there any benefit to them?
Deficits pose a risk because they limit the government’s flexibility in the future. One response that the government can make to a weak economy is to increase spending and give economic activity a shot in the arm. That’s exactly what the Federal government did in 2008 and 2009. Federal spending picked up while other parts of the economy cooled off. The Federal Government’s ability to dip into deficit spending helped avert an even deeper recession. As the debt increases, the government may find that is has less leeway to do this in the future.
Deficits also pose a risk because high government spending in stronger economy can stoke inflation. High rates of inflation create winners and losers in the economy and can be disruptive. Winners are borrowers, including the Federal government, who may have had the ability to lock in interest rates that were too low. The losers are savers, especially those financing long term debt.
Any discussion of deficits should acknowledge the potential benefits. What good is debt financed spending today? The recession of 2008 and 2009 was so deep and the subsequent recovery so slow, that by some definitions the U.S. economy is still operating below its capacity. Deficit spending today can help to close that gap.
We believe that investors should focus on the potential risks of deficit spending in the current environment, especially the risk of rising inflation, and respond to it with their bond portfolio. Some of the best ways to avoid inflationary risks include investing in shorter term bonds, whose interest rates reset quickly in a rising inflation/interest environment. Another approach is to include inflation protected bonds, whose values rise with rising rates of inflation. Lastly, a well diversified portfolio of bond managers with open mandates, what we call Opportunistic Bond Managers, may have the ability to shine in a rising rate and rising inflation environment.
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