MACRO 6 minutes to read

Why we need to talk about the US budget deficit?

Mahesh Sethuraman

Singapore Sales Trader

Summary:  We may not have reached the inflection point where the marginal risk-reward favours bears more than bulls just yet, but we are getting ever so close to that moment of truth.


We are at a critical stage of the market cycle with multiple headline risks opening up a wide array of possibilities from here. Will US-China trade war escalate further or end in a sooner-than-anticipated truce? Will the Federal Reserve march ahead with its projected dot plot hikes into 2019 or pause after the December hike? How long will the likely EU-Italy collision on the Italian budget issue last? Will there be a Brexit deal before the close of the year or will both parties borrow more time for negotiation by extending the transition period by another year? Will Theresa May survive as PM through all these uncertainties? What is going on with Saudi Arabia? Is Trump going to penalise Riyadh for an extraordinary overreach of power or use it as a bargaining chip to get the Saudis to increase crude production and drive oil prices down? All these questions have massive implications depending which way the tide turns.

But underneath the headline agendas, there is a substantial risk floating slightly under the market’s radar which is following a structural trend with little hope of any dramatic correction – the big, booming US budget deficit.

  • The budget deficit published last week for the preceding 12 months widened to alarming levels of $779 billion -a whopping increase of $113bn (a 6-year high) that constitutes 3.9% of GDP
  • This is a not merely the result of Trump’s tax cuts from last year but a more structural problem of unsustainable debt building over many years that was nonetheless exacerbated sharply by the tax cuts
  • Although the official Treasury estimates differ from more independent estimates for 2019 and 2020, the trend is likely to continue. The Congressional budget office forecasts a budget deficit of 973bn for 2019 and more than €1 trillion for 2020 – which would mark the first time the deficit breaches the $1tn mark since 2012 when the US economy was at a nascent stage of recovery from the great financial crisis.
  • The interest payments alone have crossed $500bn for the year ($523bn).
Enlarge
Source: Bloomberg, Saxo

The chart above tracks the sharp rise in total US debt against the falling trade deficits (both absolute and as a % of GDP), the Fed funds rate, and the S&P 500 index.

  • There is a particularly acute trend of increasing budget deficits – both in absolute terms and as a percentage of GDP – since the end of 2015 alongside the still-spiralling total debt well past $21tn.
  • The S&P 500 has been resilient to the widening budget deficits, along with ballooning total debt and a raising Fed funds rate, from end-2015 until the beginning of 2018, but has since run into some sharp corrections and heightened volatility in two phases within eight months of each other this year.
  • There is also an eerie technical resistance seen in the S&P 500 every time it touches the US total debt line; both times it has touched this level it has sharply sold off. Is this an optical illusion brought about by mixing up two different scales, or is there a real relationship?
  • Irrespective of the technical relationship, the scenario of an exploding budget deficit with little room to increase receipts or contain expenditure fundamentally means that the debt will keep rising and the cost of debt will escalate particularly acutely as the Fed’s interest rate hike cycle marches on.
  • With most of the tax stimulus’ impact on GDP already showing up and likely to scale down over time, the US is likely to face the double whammy of rising deficit and sagging growth at some stage through 2019. Imagine if inflation shoots up in the midst of all this…
  • While a case of unsustainable equities strength could have legitimately been made since the end of 2015 and the opportunity cost of sitting out the rally from end- 2015 to now could have proved to be expensive for any portfolio manager chasing benchmark returns, the reality of riding on that premise is running thinner than at any stage of this bull run.
  • While a Fed pause in 2019 could keep equities supported for a while, there are way too many factors coming together in favour of a decisive, healthy (but painful nevertheless) correction in US equities over the next two quarters.
  • We may not have reached the inflection point where the marginal risk-reward favours the bears more than the bulls just yet, but we are getting ever so close to that moment of truth.

You can access both of our platforms from a single Saxo account.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.