August 04, 2011 11:22 AM
By Tobias Levkovich, Chief US Equity Strategist
Athough Americans have heard a lot about the debt ceiling negotiations in Washington over the past few weeks, many do not fully understand the problem of the U.S. debt load itself, which is likely to generate severe challenges in the years ahead. Indeed, the U.S. debt to gross domestic product (GDP) ratio is back up to levels last seen after World War II. Given current budget deficits, the ratio likely will climb further. Economists will contend that faster economic growth would be very helpful in addressing this uncomfortable situation but there will be major hurdles to climb.
Periphery Europe's rising sovereign cost of money represents a critical threat since it seems investors do worry about an economy's debt burden at some point in time. In this context, $14.4 trillion of national debt and growing in the U.S. can be very worrisome in a rising interest rate environment since more money would be required to simply service debt versus the priorities of the country's citizenry such as a social safety net, security, etc. Some might argue that Japan has a much higher debt to GDP ratio alongside lower rates, but 20 years of economic malaise is arguably not the preferred trajectory and Japan is not reliant on foreigners buying its debt given very high national savings.
Looming tax increases could also restrain economic activity. The debate over spending cuts has replaced the discussion about targeted investments in areas such as education and infrastructure. In this context, investors have focused on the impact of any budgetary restraint on areas such as health care and national defense, but this does not fully encompass the near 5% of GDP in cumulative tax increases that may occur over the next three years. The combination of the expiring Bush tax cuts at the end of next year (accounting for roughly 1.7% of GDP), the termination of accelerated depreciation by the end of 2012 (0.7%), the Alternative Minimum Tax's (AMT) expiration this year (0.6%) and the roll off of the temporary payroll tax cut by year-end 2011 (0.6%), to name a few, will be a drag. Accordingly, one may need to adjust downward his or her equity market return expectations.
NOTE: This post is adapted from a CIRA North America Equity Strategy note entitled "August Chart of the Month: Debt Difficulties," published on August 3, 2011.