For the first quarter of 2023, the Dow Jones Industrial Average, Standard & Poor’s 500 Index, and the Nasdaq Composite gained 0.4%, 7.0% and 16.8%, respectively. After a weak February, equity markets rallied in March. The S&P 500 gained 3.7% in March, while the Dow Jones Industrial Average (DJIA) rose 2.1%. The Nasdaq outperformed the other two indices, with the technology-heavy index gaining 6.8%. U.S. bond markets were up in the same range, with the U.S. 10-year yield falling to 3.5% from 3.8% at year-end, the largest decline in yield since March of 2020. International equity markets also showed modest gains, with developed markets advancing at about the same rate as the U.S., and emerging markets doing slightly better.
The first quarter of 2023 saw an incipient global banking crisis and heightened financial market volatility. Three U.S. banks failed (Silvergate Capital Corp., Silicon Valley Bank, and Signature Bank), Credit Suisse Group was rescued (or ‘taken-under’) by UBS Group, and a consortium of large U.S. banks temporarily shored up First Republic Bank by adding $30.0 billion of deposits. Global interest rates declined dramatically, adding fuel to the growth stock rally that had already been underway since the start the year. Financials came under significant pressure during the quarter, while mega-technology stocks advanced strongly, but narrowly. In fact, 88% of the S&P 500’s first quarter gains were generated by just seven mega-tech stocks. Ignoring the outsized gains for mega-capitalization growth stocks, the S&P 500 rose just 1.4% in the first three months of 2023. That is not very healthy. Growth stocks significantly outperformed value stocks across most market capitalizations and geographies. Marginally lower interest rates increased multiples on long-duration holdings (like growth stocks) and gave wounded banks a moment of relief, as fixed income instruments traded higher. After the close of the first quarter, investor and depositor concerns about regional banks shifted from underwater securities to concentrated exposure to commercial real estate loans. Our guess is that we will see more failures in weaker banks, but that depositors will be indemnified. Investors in weak bank securities are at risk, depositors will likely be safe.
The United States surpassed its $31.4 trillion debt ceiling in mid-January. That means it is time again for budget ceiling theater, as we last witnessed in 2011 and 2013. House Speaker Kevin McCarthy led Republican representatives to narrowly pass a stop-gap proposal to deal with the coming fiscal cliff. A little background on the debt ceiling is in order. Before 1917, there was no debt ceiling as Congress was required to authorize each debt issuance by legislative act, approving the issue and the amount. World War I spending tied up Congress which increased both the amount of spending and the time it took Congress to legislate spending approvals. In 1917 Congress passed a law allowing the Treasury to issue debt instruments, as long as the total issuance fell below a Congressionally-defined debt ceiling. The current debt limit apparatus has been in place essentially unchanged since then. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit - 49 times under Republican presidents and 29 times under Democratic presidents. Amazingly, since 1960, the debt ceiling has actually been reduced three times (once under President Eisenhower and twice under President Kennedy).
Under the current Republican proposal, the new law would raise the debt ceiling by $1.5 trillion or until March 31, 2024, whichever comes first. In return, it would set discretionary spending levels for the coming year at fiscal 2022 levels and limit spending growth to no more than 1% a year. According to the Congressional Budget Office, that means that in FY 2024, discretionary spending - which represents only 28 percent of the budget—would fall to about $1.7 trillion from the currently projected $1.9 trillion. Mandatory spending due to entitlements, however, would continue to rise - from $3.8 trillion in FY 2023 to $5.9 trillion in FY 2033. The “Limit, Save, Grow” Act would leave Pentagon spending unchanged, while eliminating unspent Covid-19 relief money (amounting to about $30.0 billion), impose new work requirements for government benefits ($120.1 billion), and stop the administration’s plan to forgive some student loans ($460.0 billion). The Congressional Budget Office (CBO) estimates that the bill would reduce the projected budget deficit by $4.8 trillion over ten years, with $3.2 trillion of that related to reductions in discretionary outlays, $0.5 trillion coming from reduced interest costs and the rest coming from increased revenues and small reductions in mandatory spending.
A few caveats are in order. Firstly, the Republican proposal, as written, will never be passed by the Democrat-controlled Senate. Secondly, President Biden has promised to veto any House proposal that does not present a “clean” debt ceiling increase, devoid of spending cuts or tax reductions. Thirdly, the Biden administration has already proposed a budget that promises tax increases for the wealthy and corporations (a revenue increase of $5.5 trillion over ten years) in order to pay for $2.8 trillion of increased spending for education, health and social spending. The Administration’s budget projects a $3.0 trillion reduction to the 10-year deficit, but leans heavily on a $3.0 trillion increase in corporate taxes over the period, a 59% increase over baseline projections. Historically, it has been very difficult to realize projected revenue increases from corporate tax rate increases. This is because of three reasons: 1) lawyers; 2) accountants; 3) politicians who create tax loopholes utilized by lawyers and accountants that they later complain about in committee hearings.
The Republican and Administration proposals are so far apart both financially and philosophically, it is difficult to imagine a mid-range compromise. However, both Congress and the Biden administration recognize that failure to reach a new debt ceiling is not an option. While there might be a 1-2% chance of a technical and temporary default, we foresee a 100% chance of posturing and pontificating by both sides until June. The final caveat is the most important. Whether we are contemplating a $3.0 or a $4.8 trillion hypothetical reduction in the ten-year deficit, neither amount is meaningful to the hole in which we have put ourselves. Over the next decade, the federal government will spend over $80.0 trillion while only taking in $60.0 trillion. During that period, cumulative interest on federal debt will grow to $10.5 trillion, about half of the level of projected cumulative discretionary spending. Annual debt costs are projected to triple between 2022 and 2033. Over the same period, Federal debt held by the public is projected to grow from $25.7 trillion to $46.4 trillion. That means that Federal debt per American household will grow from $198,000 to $338,000. To us, this is a shocking number.
The imbalance in spending commitments and revenues is getting worse. The drivers of this mismatch are rising healthcare costs per capita, the aging of the American population and increasing interest costs on Federal debt. They are all related, and they are all intertwined. On March 31st, the Social Security and Medicare Trustees released their annual reports on the state of the trust funds. The Trustees project that Medicare’s Hospital Insurance trust fund will be insolvent by 2031, Social Security’s Old-Age and Survivors Insurance trust fund will run out of reserves by 2033, and the theoretically combined Social Security trust funds (the Disability Insurance fund plus the Old-Age and Survivors Insurance fund) will be insolvent by 2034. Upon insolvency, Social Security benefits will be reduced across the board by 20 percent under current law, while Medicare Hospital Insurance payments will be cut by 11 percent. Those reductions will grow to 27 percent and 19 percent, respectively, as costs and benefits outpace revenues. Again, under current law, both Social Security and Medicare will be insolvent by the time today’s 56-year-olds reach the full retirement age. There is no triage mechanism under the current law that will soften the blow to the sickest and neediest. The chart below (which was created by the CBO before the Trustees released their latest report) illustrates the mismatch between revenues and benefits. (The CBO projections are more pessimistic than the Trustee projections.)
Social Security has always been a pay-as-you-go plan, and it benefitted greatly in its early years as workers were paying more into the plan than retirees were taking out. Demographics caught up with Social Security in 2021, and the Trustees had to start paying benefits from its accumulated surplus. But that is misleading: the Trustees never had a tangible surplus, only an IOU from the government. The Social Security Trust holds non-marketable Treasury debt, and the actual surplus contributions were spent long ago. Our government will be forced to raise debt and/or increase taxes to honor the Trustees funding requests that exceed current Social Security revenues. The Committee for a Responsible Federal Budget, a think tank, estimates that to restore 75-year solvency to the Social Security trust funds, the law would have to change to require a 28 percent (3.4 percentage points) payroll tax increase, a 21 percent across-the-board benefit cut for all beneficiaries, a 25 percent benefit cut for new beneficiaries, or some combination of these. Delaying action until 2034 would increase the necessary payroll tax increase to 33 percent (4.2 percentage points) and the necessary benefit cut for all beneficiaries to 25 percent. Social Security has always been the “third rail” to American politicians, and, true to form, they are either ignoring the problem or denying it. And so with the presumptive presidential frontrunners: Mr. Trump has said: “I will do everything within my power not to touch Social Security, to leave it the way it is.” Mr. Biden was quoted in March, “I guarantee you I will protect Social Security and Medicare without any change. Guaranteed.” Newspaper editor and pundit M. Stanton Evans once said, “We have two parties here, and only two. One is the evil party, and the other is the stupid party. ... I'm very proud to be a member of the stupid party. ... Occasionally, the two parties get together to do something that's both evil and stupid. That's called bipartisanship.”
The debt ceiling debates are likely to cause volatility in the next few months: partisanship. The long-term fiscal stability of our economy is a far greater cause of concern, and it is largely being ignored by our representatives: bipartisanship. The best defense for conservative investors is a disciplined and age-appropriate asset allocation strategy that limits risk without precluding potential upside rewards. Please let us know if your cash needs or investment objectives have changed recently.
Your Team at Baxter Investment Management
Addendum: A few charts that might be interesting or elucidating:
Federal Government Revenue sources:
Federal Revenues: Despite many different tax regimes, government receipts consistently fall in a narrow range of between 15 and 20 percent of GDP.
In 1945, the highest marginal tax rate on individuals was 94%. From 1950 until 1986, it was between 84% and 50%. It is now 37%. The corporate tax rate reached a high of 53% in 1969, and generally was between 40-50% since 1945. The corporate rate has been 21% since 2018. If history serves as a guide, 20% of GDP seems to be a durable ceiling for what the Federal government can expect to collect from America.