This article was first published on Lyn Alden Investment Strategy
This issue examines what’s causing the structurally high fiscal deficits in the U.S. economy, why the probability of meaningfully reducing them anytime soon is vanishingly low, and what investment implications this may have.
For an initial visual, the Congressional Budget Office projects structurally high deficits forever unless meaningfully addressed, despite the fact that they assume no recessions will ever occur, and deficits tend to be even larger when recessions do occur:
So that’s the conservative baseline, which calls for over $20 trillion in net new public debt additions over the next 10 years.
The Background
One of the primary themes that I’ve frequently written about going back to 2020 and that has guided a lot of my investment decisions, is the concept that the United States is in the process of entering fiscal dominance.
This means that fiscal deficits are larger and more impactful for the economy and for financial markets than they used to be, and at inflection points they can even impair the effectiveness of the central bank’s monetary policy or outright constrain the central bank’s ability to make certain monetary policy decisions independently.
-In summer 2019, I wrote about the bubble in bond markets that was occurring at the time, and examined how an uncommon MMT-style combination of aggressive monetary policy and fiscal policy in the next economic downturn could trigger a big reversal of the 2010s disinflation trend and bring us back toward a period of higher inflation.
-Throughout 2020 as the early stage of that scenario began to play out even more dramatically than I had expected, I wrote a flurry of articles about it. My two most comprehensive ones, from autumn 2020 were “A Century of Fiscal and Monetary Policy” and “Banks, QE, and Money-Printing” which explained why the blend of big monetized fiscal injections were likely to be inflationary down the line if they were continued. I contrasted what was happening in this scenario with the QE and bank recapitalization that happened back in 2008, with the main difference being that the large fiscal component of these recent events had a much bigger impact on broad money supply, and eventually on consumer prices, than any of the activities of 2008.
-In spring 2021, as this monetary inflation began to show up in price inflation in its early stages, I wrote a newsletter called “Fiscal-Driven Inflation” which continued to argue that this was not at all like the deflationary 1930s, but rather was more like the inflationary 1940s, in terms of the deficit-driven inflation that we were now seeing. The inflation rate went on to double from there into the next year.
-Throughout 2022, I began starting to forecast a top in this particular wave of inflation as the fiscal stimulus wore off and monetary tightness kicked in. My analysis revolved around the question of whether the central bank’s tightening stance would lead us into a recession, or whether we would avoid one. In spring 2022, I viewed us as likely to enter a recession. For a while this was partially right; indeed we ended up seeing the manufacturing sector go into a large contraction, commercial real estate go into a large contraction, and that year in general was bad for most asset prices. The first half of 2022 had two consecutive negative quarters of real GDP growth, the misery index spiked to recession levels, and consumer sentiment fell to recession levels, but ultimately there was no NBER-defined recession.
-However, by late 2022 and early 2023, I began to see signs of a re-emergence. And by summer 2023, I saw fiscal dominance take hold again, and pushed away the idea of a recession for a while. Specifically, the large interest expense was showing early signs of being stimulative for the economy at a faster rate than the central bank’s interest rates were weighing down the private sector. This is because the government’s debt was so large and was consisting of so much short-duration securities, while the majority of private debt was long-duration and fixed-rate, and so the central bank’s higher rates were ironically affecting the federal government faster and more thoroughly than the private sector. Interest expense poured out from the federal government into the private sector, which stimulated some parts of the economy since it’s part of the widening deficit. The economy indeed went on to hold up better than most expected, and inflation proved stickier to get back down to the 2% target than most expected.
-More recently, I’ve been focused on the topic of the U.S. economy slowing down again, but in ways that are somewhat counterintuitive and rather sector-specific. Some aspects of the economy look like they’re at risk of going into recession, whereas other aspects of the economy look as if they’ve already been through a recession and are emerging back into growth. I’ll touch on this in more detail at the end of this newsletter.
One of the investment implications from all of this in this cycle is that, despite being quite concerned with the outcomes of a lot of these actions at times, I’ve been heavy on equities and other scarce assets, and light on bonds. Since we’re in fiscal dominance, we can’t bet too much on the value of the denominator (the dollar) other than as a temporary trade. The defensive side of my portfolio has mostly consisted of T-bills and gold, which both held up better than T-bonds since 2019.
Why the Deficits Are So Sticky
The fiscal deficits are harder to fix than most people realize, and to understand why, we have to see how we got here.
It’s easy to blame the deficits on any one politician, but really it’s a blend of many factors going back decades.
Item #1: Unbalanced Social Security
Social Security was structured in such a way that the math breaks down if population growth slows down, which wasn’t conceivable to most people decades ago. Wealthier, more urban, and/or more socially disconnected people produce fewer children than the more rural and fast-growing environment that some of these original models were more geared to.
As the nation grows older and more top-heavy, there are fewer workers supporting each retiree. The social security fund that was built up for decades is now shrinking, and is expected to be depleted by 2035, from which point it’ll have an inability to make the full payouts if left unfixed.
Item #2: Inefficient Healthcare Spending
The United States government subsidizes the raw ingredients that go into inexpensive carbohydrate-based ultra-processed foods. For example, the high-fructose corn syrup industry gets more federal funds (via subsidies for types of corn that are bred for that purpose and inedible for corn-on-the-cob consumption) than grass-fed beef, fruits and vegetables, or seafood.
For a variety of reasons, obesity and metabolic disorders are on a structural growth trajectory, resulting in ballooning healthcare costs. And with our complex public/private hybrid health system with high administrative overhead, we pay more for healthcare than every other country, despite having higher infant mortality and lower life expectancy outcomes than many of them, in addition to a lower number of physicians and hospital beds per capita than many of them. For wealthy people the American healthcare system is great, but in terms of its impact on deficits and in terms of its quality for the median person, it is a major drag.
The Commonwealth Fund published a report last year comparing the healthcare spending and concluded:
-Health care spending, both per person and as a share of GDP, continues to be far higher in the United States than in other high-income countries. Yet the U.S. is the only country that doesn’t have universal health coverage.
-The U.S. has the lowest life expectancy at birth, the highest death rates for avoidable or treatable conditions, the highest maternal and infant mortality, and among the highest suicide rates.
-The U.S. has the highest rate of people with multiple chronic conditions and an obesity rate nearly twice the OECD average.
-Americans see physicians less often than people in most other countries and have among the lowest rate of practicing physicians and hospital beds per 1,000 population.
The American Journal of Managed Care further summarized the report:
The report evaluated US health spending, outcomes, status, and service use compared with Australia, Canada, France, Germany, Japan, the Netherlands, New Zealand, Norway, South Korea, Sweden, Switzerland, and the United Kingdom. In addition, US health system efficiency was compared with the Organisation for Economic Co-operation and Development (OECD) average of the 38 high-income countries that had available data from December 2022.
Of all (of these listed) countries in 2020, the United States possessed the highest infant mortality rate at 5.4 deaths per 1000 live births, which is markedly higher than the 1.6 deaths per 1000 live births in Norway, which has the the lowest mortality rate.
US maternal mortality in 2020 was over 3 times the rate in most of the other high-income countries, with almost 24 (23.8) maternal deaths for every 100,000 live births.
The authors cited a few reasons behind the danger of giving birth in the United States, including:
- Inadequate prenatal care
- High rate of cesarean section
- Poverty, which contributes to chronic illnesses like obesity, diabetes, and heart disease
The United States has lower life expectancy and much worse health outcomes than other countries, although the country spends 2-4 times as much on health care as most other high-income nations.
Item #3: Foreign Adventurism
The post-9/11 War on Terror is estimated to have cost around $8 trillion with all things considered. And going forward from here, our baseline military spending is $800+ billion per year, plus various contingency spending that brings the full figure in a typical year higher than that.
These activities have accumulated a lot of debt onto our public ledger, contributing to our rapidly growing interest expense.
Item #4: Accumulated Debt Interest
For the past four decades, the United States had a rising debt/GDP ratio, but falling interest rates. This kept interest expense manageable in absolute terms and especially as a percentage of GDP.
But now that interest rates hit zero and are bounding in a more sideways pattern, it means that the rising debt/GDP ratio no longer has an offset of structurally falling interest rates. That’s a big change.
A country with well over 100% debt-to-GDP has two main choices in this scenario. The first choice is that they can keep interest rates very low despite periods of price inflation that occurs, and debase all of the currency holders and bond holders. Japan is far enough into fiscal dominance that they’ve chosen that route. The second choice is that they can try to meaningfully raise interest rates when needed, and contribute to a fiscal spiral of ever-higher interest expense.
What politicians are hoping for as they string this out, is for productivity growth to offset price inflation. Aggregate price inflation is normally lower than the rate of money supply growth, because there is a gradual increase in productivity. We become more efficient at providing goods and services, due to gradually improving technology and organization. In other words, the price inflation that we do get, is measured from a negative baseline, rather than from zero.
From a politicians’ standpoint, the best realistic scenario for them is that money supply growth will be high to support the deficits as needed, but that there will be enough productivity growth from AI and other areas to offset it and prevent aggregate prices from increasing too rapidly.
The problem, however, is that even if that were to happen for the official CPI metric, it wouldn’t occur evenly. Things that are truly scarce will increase more in line with money supply growth, widening the gap between the haves and the have nots, likely contributing to ongoing wealth concentration and populism.
Item #5: Political Polarization, Except for Deficits
Republicans and Democrats are now very polarized politically; far more than in the 1990s when they could still come to large compromises on fiscal topics. The probability of getting through meaningful tax hikes and/or meaningful spending cuts is minimal now.
And yet, the one thing they do agree on, is to not dramatically cut any of the major spending areas. They have plenty of differences, but the biggest areas of spending are not really among those differences anymore.
The Republican party, which used to push for cuts to Social Security, now has incorporated protecting entitlements into their 2024 platform.
Before and during the Paul Ryan era (2011-2015 as the chair of the House Ways and Means Committee, and 2015-2019 as the Speaker of the House), the Republican party generally advocated for cuts to major entitlement programs. But the voter base is largely among those receiving those benefits, cutting them is very unpopular, and by 2018 it was clear that these plans were not going to happen. As the Washington Post reported in April 2018:
WASHINGTON—When House Speaker Paul Ryan leaves Congress, the Republican Party will lose its most influential advocate for changes to Social Security, Medicare and Medicaid.
As Budget committee chairman, a vice-presidential running mate to Mitt Romney in 2012, Ways and Means chairman and finally House speaker, Mr. Ryan had pressed for curbs on federal spending on the three programs. These retirement and health care programs are popular with voters, but their costs are rising faster than the current funding to pay for them.
Mr. Ryan will leave Congress in January with no substantial progress on any of them, few lawmakers interested in picking up the torch, and a clear signal that prospects are dim for any big overhaul in the foreseeable future.
The Trump era of the Republican party, starting from his presidential win in 2016 and strengthening from there, has been a more populist version of the Republican party. The focus has been on social policies, immigration policies, and other matters, and not fiscal conservativism and its associated focus on deficit reduction. Trump himself had backed both Democrat and Republican politicians prior to his own run at politics, and his populist MAGA contingent is similar to the populist movements we see in Europe: nationalist and socially conservative, but not necessarily fiscally conservative.
The Republican party began this year’s platform with a series of promises, and this was promise 14, which used to be a position we’d find primarily within the Democratic party:
14. FIGHT FOR AND PROTECT SOCIAL SECURITY AND MEDICARE WITH NO CUTS, INCLUDING NO CHANGES TO THE RETIREMENT AGE
The Democratic party, meanwhile, is less in favor of cutting military spending than they used to be. In their 2024 platform, they directly discussed the rising competition from China on all fronts including militarily, as well as the deepening ties between China and several other countries. They continue to be support of social programs, and in general want to extend them to cover more people.
So now in practice, the spending differences between the parties are around the margins, and instead the main differences are 1) tax policy and 2) social and geopolitical stances.
The handful of things that the majority of Republicans and Democrats agree on now is that it’s a third rail to touch any of the major spending areas, ranging from Social Security, to Medicare, to Defense, to Veterans’ Benefits. And then there’s Interest Expense, which is also untouchable.
And to be clear I’m just analyzing this for investment purposes, rather than passing judgement on any particular view. I have my preferences on any given topic like anyone else, but they’re irrelevant for investment analysis purposes.
Item #6: Financialization of Tax Receipts
If we suppose, somehow that the prior item about polarization were to change substantially, and politicians were to come to a grand bargain on spending cuts and/or tax increases and managed to shrink the deficit considerably, then we would still have another impediment between us and a sustained reduction in fiscal deficits.
The United States’ tax receipts are more correlated to asset prices than most other countries, with tax receipts lagging the performance of the stock market. This can be seen in both absolute terms and year-over-year terms:
We might wonder if this is an example of correlation but not causation. We could propose, for example, that a declining stock market predicts a rising unemployment rate, and that the rising unemployment rate is what really causes weaker tax receipts.
However, the recent period invalidates that idea. The stock market peaked in 2021, troughed in 2022, and then soared again in 2023 all while the unemployment rate remained low. Tax receipts, with a lag, did the same thing. The strong market performance in 2021 led to strong tax receipts in 2022. The weak market performance in 2022 led to weak tax receipts in 2023. The rebounding market in 2023 led to rebounding tax receipts in 2024.
Of course, the unemployment rate and other variables do matter, but the point is that the stock market going sideways or down tends to be a key problematic variable for the following year’s tax receipts even on its own. This is partially because the United States has more wealth concentration than most other developed countries, and with a higher ratio of that wealth tied to the stock market. And it’s also partially because a very large portion of U.S. executive compensation is tied to equity value.
What this means is that many attempts at fiscal austerity are likely to reduce the deficit less than we might imagine, because if those austerity measures negatively impact the stock market and other types of asset prices, it’s likely to weaken the tax receipt side even as certain other spending and revenue items are adjusted.
So in order to meaningfully fix the deficit, not only would a highly polarized Congress have to agree on some sort of grand bargain which has been entirely impossible in the post-GFC environment and is unpopular with the voter base, it would also have to include a rather deep and skillful overhaul of the tax system itself to successfully untangle the Gordian knot that ties asset price performance and tax receipts together.
I’d assign an extremely low probability to that combined outcome for the next five years or ten years, which is roughly what a long-term investment timeframe is.
On social media, I’ve been repeatedly using the analogy of Walter White from the 2008-2013 show Breaking Bad regarding the nigh-unstoppable momentum of these fiscal deficits.
In the well-known show, the chemistry teacher Walter White originally starts making drugs in order to make ends meet, as he is diagnosed with cancer and wants to make sure his family is financially safe. However, as the show progresses, he gets addicted to the power of his work as he rises through the criminal underworld, and it ceases being about the money and his family, and starts becoming something he cannot bring himself to stop.
By the fifth season of the show, some of his criminal colleagues debate what to do as things get rough, and suggest they should stop for a while and lay low until things get safer. Walter White, however, slowly says:
The methylamine keeps flowing no matter what.
We are not ramping down.
We are just getting started.
Nothing stops this train.
Nothing.
Quantifying the Deficits
These next few charts are from my prior newsletter issue, but repeating the importance of fiscal dominance is something I intend to maintain to some degree, since it’s such a powerful variable that many investors and economists haven’t adjusted to yet and that continues to be an important variable in my analysis.
The first set of charts emphasizes periods of time where annual fiscal deficits exceed the sum of annual net bank lending and annual net corporate bond issuance, especially without having been caused by a recession (with recessions shaded in gray). This began occurring by 2019, prior to the pandemic, outlined with the first green box. And even if I exclude 2020 and 2021 as post-recession allowances, the resumption of this trend in 2023 brought it back, indicated by the second green box:
The second chart highlights the decoupling of fiscal deficits from unemployment levels, which is partially due to top-heavy entitlement demographics and partially due to interest expense on the accumulated debt becoming very material:
The decoupling of deficits from unemployment levels across two presidential administrations of differing political parties, outside of the pandemic spike, helps to illustrate Walter White’s “unstoppability” of this deficit train. The deficits are tied to a combination of entitlement demographics, healthcare inefficiencies, decades of foreign adventurism, accumulated debts and their associated interest expense, political polarization, and the financialization of tax receipts.
Investing Implications
There are two primary investment implications or data sets from this observation of encroaching fiscal dominance that we can turn to for analysis.
The first place we can look is to see how developed markets have fared under a state of fiscal dominance in the past. The problem is that we have to go look back at the 1940s for that, which is a long time ago with a lot of different variables.
Developed countries reached their peak of centralization back then. Franklin D. Roosevelt, at the height of his power, had over 70% of Congress in his party. Roosevelt and his party had a supermajority, and could pass almost anything they wanted, could stack the Supreme Court if they contested him, and had plenty of political power to suppress aspects of the private press. They removed 120,000 Japanese Americans from their homes and put them in camps, and banned Americans from owning gold for the next four decades, among many other things. The U.S. Treasury as part of the Executive Branch outright captured the Federal Reserve and had them perform yield curve control on their government debt until it was no longer needed. The Fed held short term rates barely above zero, and long-term rates at 2.5%, as price inflation hit 19%. The current political environment is more polarized compared to back then. The stock market, coming out of the Great Depression and entering World War II, was very cheaply priced, which differs from our currently more expensive market environment.
The second place we can look is at how emerging markets deal with large monetized fiscal deficits in more recent decades.
And what we see in general is that they tend to be more inflationary on average, and their recessions tend to be somewhat stagflationary rather than deflationary. During crises their asset prices often do well in local currency terms, even as they do poorly when denominated in dollars or gold, because the denominator of the local currency weakens so quickly. When money supply grows persistently at a double-digit annual rate, it’s hard for most assets to go down in nominal terms on a sustained basis, even as they can easily go down in global purchasing power terms. And much like how the U.S. behaved in the 1940s with all sorts of controls on movements of capital, emerging markets with currency crises frequently turn to various levels of capital controls.
When looking at U.S. markets, I think there’s a little bit from both of those areas that can be helpful. During periods of fiscal dominance, the general trends are that 1) governments often try to restrict the flow of capital in subtle or overt ways, 2) asset prices are often not as nominally bearish as you might expect since the denominator is weak, and 3) inflation is more likely to be an issue, either persistently in waves.
My Tentative 5-Year Outlook
-For U.S. stocks, I have a neutral-to-negative view on the major U.S. stock indices in inflation-adjusted terms. They’re starting from an expensive baseline, and with a high ratio of household investable assets already stuffed into them. However, I do think that among the universe of more cyclical and/or mid-sized stocks that make up smaller portions of the U.S. indices, there are plenty of reasonably-priced ones with better forward prospects.
-For international stocks, I think the upcoming 2024 Fed interest rate cutting cycle is one of the first true windows for them to have a period of outperformance relative to U.S. stocks for a change. It doesn’t mean that they certainly will follow through with that, but my base case is for a meaningful asset rotation cycle to occur, with some of the underperforming international equity markets having a period of outperformance. At the very least, I would want some exposure to them in an overall portfolio, to account for that possibility.
-For developed market government bonds, like the U.S. and elsewhere, I don’t have a positive long-term outlook in terms of maintaining purchasing power. A ten-year U.S. Treasury note currently yields about 3.7%, while money supply historically grows by an average of 7% per year, and $20 trillion in net Treasury debt is expected to hit the market over the next decade. So I think the long end of the curve is a useful trading sardine, but not something I want to have passive long exposure to.
-A five-year inflation-protected Treasury note, however, pays about 1.7% above CPI, and I view that as a reasonable position for the defensive portion of a portfolio. T-bills are also useful for the defensive portion of a portfolio. They’re not my favorite assets, but there are worse assets out there than these.
-Gold remains interesting for this five-year period, although it might be tactically overbought in the near-term. It has had a nice breakout in 2024, but is still relatively under-owned by most metrics, and should benefit from the U.S. rate cutting cycle. So I’m bullish as a base case.
-Bitcoin has been highly correlated with global liquidity, and I expect that to continue. My five-year outlook on the asset is very bullish, but the volatility must be accounted for in position sizes for a given portfolio and its requirements.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- Added ULTA to the growth stock pie.
Bitcoin Note:
I use allocations to bitcoin price proxies such as MSTR and spot bitcoin ETFs in some of my brokerage portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine through Swan.com.
I don’t have a firm view on the bitcoin price over the next few months, but I am bullish with a 2-year view and beyond.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Note that the annual price for this subscription has remained unchanged for the past five years at $199/year, which is purposely set low relative to most investment research subscriptions to keep it widely accessible.
By the end of this calendar year, the price will increase to $249/year for new subscribers to keep up with five years of inflation, and I plan to leave that price in place for a while. This price change will not affect those with existing active subscriptions, or those that buy between now and the end of the year. It will be the new rate for those that join in 2025.
Final Thoughts: Recession or No?
Economists continue to debate about the likelihood of a recession in 2025. Various economic metrics are slowing down, and the unemployment rate has risen from 3.4% to 4.2%, and that sort of move almost always presages a recession. The yield curve has been inverted for quite a while, and is now flirting with un-inverting, which has also been a classic recession indicator.
However, jobless claims remain low, and the rising unemployment rate is still low in absolute terms.
But what I find most interesting is that the credit cycle has not been the primary driver of the economy during this period so far. Banks went through a major credit tightening cycle in 2022, and without an NBER-defined recession occurring. If anything, the banking sector currently looks similar to how it normally looks when it is coming out of a recession:
And in 2022, both consumer sentiment and the misery index (the sum of inflation and unemployment levels) reached recessionary levels, but again without an NBER-defined recession:
This, I would argue, is a hallmark of fiscal dominance. The credit cycle on its own over the past couple years was typical for a recession, but the credit cycle is now smaller than what’s happening fiscally.
Will we have a recession in 2025? The short answer is I don’t know yet. But the more important answer is that even if we do have a recession, it’ll likely look different than we’re used to, given that the country is running 7%-of-GDP deficits as a pre-stimulus.
The true benchmark comparison is to look for periods of weak economies amid fiscal dominance, which is not what the pre-pandemic U.S. economy has experienced for the past several decades, and instead is found in either emerging markets or history books.
This article was first published on Lyn Alden Investment Strategy
September 2024 Newsletter: Why Nothing Stops This Fiscal Train
This article was first published on Lyn Alden Investment Strategy
This issue examines what’s causing the structurally high fiscal deficits in the U.S. economy, why the probability of meaningfully reducing them anytime soon is vanishingly low, and what investment implications this may have.
For an initial visual, the Congressional Budget Office projects structurally high deficits forever unless meaningfully addressed, despite the fact that they assume no recessions will ever occur, and deficits tend to be even larger when recessions do occur:
So that’s the conservative baseline, which calls for over $20 trillion in net new public debt additions over the next 10 years.
The Background
One of the primary themes that I’ve frequently written about going back to 2020 and that has guided a lot of my investment decisions, is the concept that the United States is in the process of entering fiscal dominance.
This means that fiscal deficits are larger and more impactful for the economy and for financial markets than they used to be, and at inflection points they can even impair the effectiveness of the central bank’s monetary policy or outright constrain the central bank’s ability to make certain monetary policy decisions independently.
-In summer 2019, I wrote about the bubble in bond markets that was occurring at the time, and examined how an uncommon MMT-style combination of aggressive monetary policy and fiscal policy in the next economic downturn could trigger a big reversal of the 2010s disinflation trend and bring us back toward a period of higher inflation.
-Throughout 2020 as the early stage of that scenario began to play out even more dramatically than I had expected, I wrote a flurry of articles about it. My two most comprehensive ones, from autumn 2020 were “A Century of Fiscal and Monetary Policy” and “Banks, QE, and Money-Printing” which explained why the blend of big monetized fiscal injections were likely to be inflationary down the line if they were continued. I contrasted what was happening in this scenario with the QE and bank recapitalization that happened back in 2008, with the main difference being that the large fiscal component of these recent events had a much bigger impact on broad money supply, and eventually on consumer prices, than any of the activities of 2008.
-In spring 2021, as this monetary inflation began to show up in price inflation in its early stages, I wrote a newsletter called “Fiscal-Driven Inflation” which continued to argue that this was not at all like the deflationary 1930s, but rather was more like the inflationary 1940s, in terms of the deficit-driven inflation that we were now seeing. The inflation rate went on to double from there into the next year.
-Throughout 2022, I began starting to forecast a top in this particular wave of inflation as the fiscal stimulus wore off and monetary tightness kicked in. My analysis revolved around the question of whether the central bank’s tightening stance would lead us into a recession, or whether we would avoid one. In spring 2022, I viewed us as likely to enter a recession. For a while this was partially right; indeed we ended up seeing the manufacturing sector go into a large contraction, commercial real estate go into a large contraction, and that year in general was bad for most asset prices. The first half of 2022 had two consecutive negative quarters of real GDP growth, the misery index spiked to recession levels, and consumer sentiment fell to recession levels, but ultimately there was no NBER-defined recession.
-However, by late 2022 and early 2023, I began to see signs of a re-emergence. And by summer 2023, I saw fiscal dominance take hold again, and pushed away the idea of a recession for a while. Specifically, the large interest expense was showing early signs of being stimulative for the economy at a faster rate than the central bank’s interest rates were weighing down the private sector. This is because the government’s debt was so large and was consisting of so much short-duration securities, while the majority of private debt was long-duration and fixed-rate, and so the central bank’s higher rates were ironically affecting the federal government faster and more thoroughly than the private sector. Interest expense poured out from the federal government into the private sector, which stimulated some parts of the economy since it’s part of the widening deficit. The economy indeed went on to hold up better than most expected, and inflation proved stickier to get back down to the 2% target than most expected.
-More recently, I’ve been focused on the topic of the U.S. economy slowing down again, but in ways that are somewhat counterintuitive and rather sector-specific. Some aspects of the economy look like they’re at risk of going into recession, whereas other aspects of the economy look as if they’ve already been through a recession and are emerging back into growth. I’ll touch on this in more detail at the end of this newsletter.
One of the investment implications from all of this in this cycle is that, despite being quite concerned with the outcomes of a lot of these actions at times, I’ve been heavy on equities and other scarce assets, and light on bonds. Since we’re in fiscal dominance, we can’t bet too much on the value of the denominator (the dollar) other than as a temporary trade. The defensive side of my portfolio has mostly consisted of T-bills and gold, which both held up better than T-bonds since 2019.
Why the Deficits Are So Sticky
The fiscal deficits are harder to fix than most people realize, and to understand why, we have to see how we got here.
It’s easy to blame the deficits on any one politician, but really it’s a blend of many factors going back decades.
Item #1: Unbalanced Social Security
Social Security was structured in such a way that the math breaks down if population growth slows down, which wasn’t conceivable to most people decades ago. Wealthier, more urban, and/or more socially disconnected people produce fewer children than the more rural and fast-growing environment that some of these original models were more geared to.
As the nation grows older and more top-heavy, there are fewer workers supporting each retiree. The social security fund that was built up for decades is now shrinking, and is expected to be depleted by 2035, from which point it’ll have an inability to make the full payouts if left unfixed.
Item #2: Inefficient Healthcare Spending
The United States government subsidizes the raw ingredients that go into inexpensive carbohydrate-based ultra-processed foods. For example, the high-fructose corn syrup industry gets more federal funds (via subsidies for types of corn that are bred for that purpose and inedible for corn-on-the-cob consumption) than grass-fed beef, fruits and vegetables, or seafood.
For a variety of reasons, obesity and metabolic disorders are on a structural growth trajectory, resulting in ballooning healthcare costs. And with our complex public/private hybrid health system with high administrative overhead, we pay more for healthcare than every other country, despite having higher infant mortality and lower life expectancy outcomes than many of them, in addition to a lower number of physicians and hospital beds per capita than many of them. For wealthy people the American healthcare system is great, but in terms of its impact on deficits and in terms of its quality for the median person, it is a major drag.
The Commonwealth Fund published a report last year comparing the healthcare spending and concluded:
The American Journal of Managed Care further summarized the report:
Item #3: Foreign Adventurism
The post-9/11 War on Terror is estimated to have cost around $8 trillion with all things considered. And going forward from here, our baseline military spending is $800+ billion per year, plus various contingency spending that brings the full figure in a typical year higher than that.
These activities have accumulated a lot of debt onto our public ledger, contributing to our rapidly growing interest expense.
Item #4: Accumulated Debt Interest
For the past four decades, the United States had a rising debt/GDP ratio, but falling interest rates. This kept interest expense manageable in absolute terms and especially as a percentage of GDP.
But now that interest rates hit zero and are bounding in a more sideways pattern, it means that the rising debt/GDP ratio no longer has an offset of structurally falling interest rates. That’s a big change.
A country with well over 100% debt-to-GDP has two main choices in this scenario. The first choice is that they can keep interest rates very low despite periods of price inflation that occurs, and debase all of the currency holders and bond holders. Japan is far enough into fiscal dominance that they’ve chosen that route. The second choice is that they can try to meaningfully raise interest rates when needed, and contribute to a fiscal spiral of ever-higher interest expense.
What politicians are hoping for as they string this out, is for productivity growth to offset price inflation. Aggregate price inflation is normally lower than the rate of money supply growth, because there is a gradual increase in productivity. We become more efficient at providing goods and services, due to gradually improving technology and organization. In other words, the price inflation that we do get, is measured from a negative baseline, rather than from zero.
From a politicians’ standpoint, the best realistic scenario for them is that money supply growth will be high to support the deficits as needed, but that there will be enough productivity growth from AI and other areas to offset it and prevent aggregate prices from increasing too rapidly.
The problem, however, is that even if that were to happen for the official CPI metric, it wouldn’t occur evenly. Things that are truly scarce will increase more in line with money supply growth, widening the gap between the haves and the have nots, likely contributing to ongoing wealth concentration and populism.
Item #5: Political Polarization, Except for Deficits
Republicans and Democrats are now very polarized politically; far more than in the 1990s when they could still come to large compromises on fiscal topics. The probability of getting through meaningful tax hikes and/or meaningful spending cuts is minimal now.
And yet, the one thing they do agree on, is to not dramatically cut any of the major spending areas. They have plenty of differences, but the biggest areas of spending are not really among those differences anymore.
The Republican party, which used to push for cuts to Social Security, now has incorporated protecting entitlements into their 2024 platform.
Before and during the Paul Ryan era (2011-2015 as the chair of the House Ways and Means Committee, and 2015-2019 as the Speaker of the House), the Republican party generally advocated for cuts to major entitlement programs. But the voter base is largely among those receiving those benefits, cutting them is very unpopular, and by 2018 it was clear that these plans were not going to happen. As the Washington Post reported in April 2018:
The Trump era of the Republican party, starting from his presidential win in 2016 and strengthening from there, has been a more populist version of the Republican party. The focus has been on social policies, immigration policies, and other matters, and not fiscal conservativism and its associated focus on deficit reduction. Trump himself had backed both Democrat and Republican politicians prior to his own run at politics, and his populist MAGA contingent is similar to the populist movements we see in Europe: nationalist and socially conservative, but not necessarily fiscally conservative.
The Republican party began this year’s platform with a series of promises, and this was promise 14, which used to be a position we’d find primarily within the Democratic party:
The Democratic party, meanwhile, is less in favor of cutting military spending than they used to be. In their 2024 platform, they directly discussed the rising competition from China on all fronts including militarily, as well as the deepening ties between China and several other countries. They continue to be support of social programs, and in general want to extend them to cover more people.
So now in practice, the spending differences between the parties are around the margins, and instead the main differences are 1) tax policy and 2) social and geopolitical stances.
The handful of things that the majority of Republicans and Democrats agree on now is that it’s a third rail to touch any of the major spending areas, ranging from Social Security, to Medicare, to Defense, to Veterans’ Benefits. And then there’s Interest Expense, which is also untouchable.
And to be clear I’m just analyzing this for investment purposes, rather than passing judgement on any particular view. I have my preferences on any given topic like anyone else, but they’re irrelevant for investment analysis purposes.
Item #6: Financialization of Tax Receipts
If we suppose, somehow that the prior item about polarization were to change substantially, and politicians were to come to a grand bargain on spending cuts and/or tax increases and managed to shrink the deficit considerably, then we would still have another impediment between us and a sustained reduction in fiscal deficits.
The United States’ tax receipts are more correlated to asset prices than most other countries, with tax receipts lagging the performance of the stock market. This can be seen in both absolute terms and year-over-year terms:
We might wonder if this is an example of correlation but not causation. We could propose, for example, that a declining stock market predicts a rising unemployment rate, and that the rising unemployment rate is what really causes weaker tax receipts.
However, the recent period invalidates that idea. The stock market peaked in 2021, troughed in 2022, and then soared again in 2023 all while the unemployment rate remained low. Tax receipts, with a lag, did the same thing. The strong market performance in 2021 led to strong tax receipts in 2022. The weak market performance in 2022 led to weak tax receipts in 2023. The rebounding market in 2023 led to rebounding tax receipts in 2024.
Of course, the unemployment rate and other variables do matter, but the point is that the stock market going sideways or down tends to be a key problematic variable for the following year’s tax receipts even on its own. This is partially because the United States has more wealth concentration than most other developed countries, and with a higher ratio of that wealth tied to the stock market. And it’s also partially because a very large portion of U.S. executive compensation is tied to equity value.
What this means is that many attempts at fiscal austerity are likely to reduce the deficit less than we might imagine, because if those austerity measures negatively impact the stock market and other types of asset prices, it’s likely to weaken the tax receipt side even as certain other spending and revenue items are adjusted.
So in order to meaningfully fix the deficit, not only would a highly polarized Congress have to agree on some sort of grand bargain which has been entirely impossible in the post-GFC environment and is unpopular with the voter base, it would also have to include a rather deep and skillful overhaul of the tax system itself to successfully untangle the Gordian knot that ties asset price performance and tax receipts together.
I’d assign an extremely low probability to that combined outcome for the next five years or ten years, which is roughly what a long-term investment timeframe is.
On social media, I’ve been repeatedly using the analogy of Walter White from the 2008-2013 show Breaking Bad regarding the nigh-unstoppable momentum of these fiscal deficits.
In the well-known show, the chemistry teacher Walter White originally starts making drugs in order to make ends meet, as he is diagnosed with cancer and wants to make sure his family is financially safe. However, as the show progresses, he gets addicted to the power of his work as he rises through the criminal underworld, and it ceases being about the money and his family, and starts becoming something he cannot bring himself to stop.
By the fifth season of the show, some of his criminal colleagues debate what to do as things get rough, and suggest they should stop for a while and lay low until things get safer. Walter White, however, slowly says:
Quantifying the Deficits
These next few charts are from my prior newsletter issue, but repeating the importance of fiscal dominance is something I intend to maintain to some degree, since it’s such a powerful variable that many investors and economists haven’t adjusted to yet and that continues to be an important variable in my analysis.
The first set of charts emphasizes periods of time where annual fiscal deficits exceed the sum of annual net bank lending and annual net corporate bond issuance, especially without having been caused by a recession (with recessions shaded in gray). This began occurring by 2019, prior to the pandemic, outlined with the first green box. And even if I exclude 2020 and 2021 as post-recession allowances, the resumption of this trend in 2023 brought it back, indicated by the second green box:
The second chart highlights the decoupling of fiscal deficits from unemployment levels, which is partially due to top-heavy entitlement demographics and partially due to interest expense on the accumulated debt becoming very material:
The decoupling of deficits from unemployment levels across two presidential administrations of differing political parties, outside of the pandemic spike, helps to illustrate Walter White’s “unstoppability” of this deficit train. The deficits are tied to a combination of entitlement demographics, healthcare inefficiencies, decades of foreign adventurism, accumulated debts and their associated interest expense, political polarization, and the financialization of tax receipts.
Investing Implications
There are two primary investment implications or data sets from this observation of encroaching fiscal dominance that we can turn to for analysis.
The first place we can look is to see how developed markets have fared under a state of fiscal dominance in the past. The problem is that we have to go look back at the 1940s for that, which is a long time ago with a lot of different variables.
Developed countries reached their peak of centralization back then. Franklin D. Roosevelt, at the height of his power, had over 70% of Congress in his party. Roosevelt and his party had a supermajority, and could pass almost anything they wanted, could stack the Supreme Court if they contested him, and had plenty of political power to suppress aspects of the private press. They removed 120,000 Japanese Americans from their homes and put them in camps, and banned Americans from owning gold for the next four decades, among many other things. The U.S. Treasury as part of the Executive Branch outright captured the Federal Reserve and had them perform yield curve control on their government debt until it was no longer needed. The Fed held short term rates barely above zero, and long-term rates at 2.5%, as price inflation hit 19%. The current political environment is more polarized compared to back then. The stock market, coming out of the Great Depression and entering World War II, was very cheaply priced, which differs from our currently more expensive market environment.
The second place we can look is at how emerging markets deal with large monetized fiscal deficits in more recent decades.
And what we see in general is that they tend to be more inflationary on average, and their recessions tend to be somewhat stagflationary rather than deflationary. During crises their asset prices often do well in local currency terms, even as they do poorly when denominated in dollars or gold, because the denominator of the local currency weakens so quickly. When money supply grows persistently at a double-digit annual rate, it’s hard for most assets to go down in nominal terms on a sustained basis, even as they can easily go down in global purchasing power terms. And much like how the U.S. behaved in the 1940s with all sorts of controls on movements of capital, emerging markets with currency crises frequently turn to various levels of capital controls.
When looking at U.S. markets, I think there’s a little bit from both of those areas that can be helpful. During periods of fiscal dominance, the general trends are that 1) governments often try to restrict the flow of capital in subtle or overt ways, 2) asset prices are often not as nominally bearish as you might expect since the denominator is weak, and 3) inflation is more likely to be an issue, either persistently in waves.
My Tentative 5-Year Outlook
-For U.S. stocks, I have a neutral-to-negative view on the major U.S. stock indices in inflation-adjusted terms. They’re starting from an expensive baseline, and with a high ratio of household investable assets already stuffed into them. However, I do think that among the universe of more cyclical and/or mid-sized stocks that make up smaller portions of the U.S. indices, there are plenty of reasonably-priced ones with better forward prospects.
-For international stocks, I think the upcoming 2024 Fed interest rate cutting cycle is one of the first true windows for them to have a period of outperformance relative to U.S. stocks for a change. It doesn’t mean that they certainly will follow through with that, but my base case is for a meaningful asset rotation cycle to occur, with some of the underperforming international equity markets having a period of outperformance. At the very least, I would want some exposure to them in an overall portfolio, to account for that possibility.
-For developed market government bonds, like the U.S. and elsewhere, I don’t have a positive long-term outlook in terms of maintaining purchasing power. A ten-year U.S. Treasury note currently yields about 3.7%, while money supply historically grows by an average of 7% per year, and $20 trillion in net Treasury debt is expected to hit the market over the next decade. So I think the long end of the curve is a useful trading sardine, but not something I want to have passive long exposure to.
-A five-year inflation-protected Treasury note, however, pays about 1.7% above CPI, and I view that as a reasonable position for the defensive portion of a portfolio. T-bills are also useful for the defensive portion of a portfolio. They’re not my favorite assets, but there are worse assets out there than these.
-Gold remains interesting for this five-year period, although it might be tactically overbought in the near-term. It has had a nice breakout in 2024, but is still relatively under-owned by most metrics, and should benefit from the U.S. rate cutting cycle. So I’m bullish as a base case.
-Bitcoin has been highly correlated with global liquidity, and I expect that to continue. My five-year outlook on the asset is very bullish, but the volatility must be accounted for in position sizes for a given portfolio and its requirements.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
Bitcoin Note:
I use allocations to bitcoin price proxies such as MSTR and spot bitcoin ETFs in some of my brokerage portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine through Swan.com.
I don’t have a firm view on the bitcoin price over the next few months, but I am bullish with a 2-year view and beyond.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Note that the annual price for this subscription has remained unchanged for the past five years at $199/year, which is purposely set low relative to most investment research subscriptions to keep it widely accessible.
By the end of this calendar year, the price will increase to $249/year for new subscribers to keep up with five years of inflation, and I plan to leave that price in place for a while. This price change will not affect those with existing active subscriptions, or those that buy between now and the end of the year. It will be the new rate for those that join in 2025.
Final Thoughts: Recession or No?
Economists continue to debate about the likelihood of a recession in 2025. Various economic metrics are slowing down, and the unemployment rate has risen from 3.4% to 4.2%, and that sort of move almost always presages a recession. The yield curve has been inverted for quite a while, and is now flirting with un-inverting, which has also been a classic recession indicator.
However, jobless claims remain low, and the rising unemployment rate is still low in absolute terms.
But what I find most interesting is that the credit cycle has not been the primary driver of the economy during this period so far. Banks went through a major credit tightening cycle in 2022, and without an NBER-defined recession occurring. If anything, the banking sector currently looks similar to how it normally looks when it is coming out of a recession:
And in 2022, both consumer sentiment and the misery index (the sum of inflation and unemployment levels) reached recessionary levels, but again without an NBER-defined recession:
This, I would argue, is a hallmark of fiscal dominance. The credit cycle on its own over the past couple years was typical for a recession, but the credit cycle is now smaller than what’s happening fiscally.
Will we have a recession in 2025? The short answer is I don’t know yet. But the more important answer is that even if we do have a recession, it’ll likely look different than we’re used to, given that the country is running 7%-of-GDP deficits as a pre-stimulus.
The true benchmark comparison is to look for periods of weak economies amid fiscal dominance, which is not what the pre-pandemic U.S. economy has experienced for the past several decades, and instead is found in either emerging markets or history books.
This article was first published on Lyn Alden Investment Strategy