After unprecedented fiscal support for the pandemic, investors are understandably concerned about government debt levels. Now, with infrastructure spending on Congress’ agenda, that debt could be moving even higher. Government spending – and the financing of that spending – have complicated impacts on economic growth, inflation, and investment returns. This piece describes those factors, with tactics investors can take to mitigate or even capitalize on those impacts. 

 

What is happening to the deficit?

The federal deficit has risen substantially since the onset of the pandemic. The Congressional Budget Office (CBO) projects a deficit exceeding $3 trillion for 2021, the second consecutive year of $3+ trillion deficits. This compares to a deficit of roughly $1 trillion in 2019. With a large infrastructure package, and an even larger reconciliation bill looming on the horizon, it’s expected to grow even more.

The two infrastructure plans at play will have a large impact. The $1.2 trillion package that recently passed the Senate and the $3.5 trillion reconciliation bill expected this fall together make up the Build Back Better plan.

Both plans still require broader Congressional approval, but together could cost as much as $2.4 trillion over 10 years and set the stage for up to $4.3 trillion of total borrowing over the next decade, outlined in the table below.

 

Total Potential Net Cost of Build Back Better Agenda

*Assumes total cost of reconciliation policies, if made permanent, of $5.25 trillion – halfway between CRFB’s  published range  of $5 trillion to $5.5 trillion.

Sources: New York Life Investments’ Multi-Asset Solutions team, Committee for a Responsible Federal Budget (CRFB) estimates based on CBO and Office of Management and Budget (OMB) data, rounded to the nearest $5 billion. Data as of 8/11/21.  

 

The cost would lift debt to 119% of GDP by 2031, up from the current 98.3%1 and an already-record 106.4% of GDP projected under current law. If lawmakers also extend the 2017 tax cuts (and other expiring provisions) and grow discretionary spending with the economy instead of inflation, the U.S. debt level could reach 129% of GDP by 2031.2

 

Build Back Better's Cost Compared to Other Recent Legislation

Ten-Year Deficit Impact, Billions

Costs do not include debt service and are over the applicable budget windows when they passed. *Borrowing generally makes sense for emergencies and recessions, so COVID-19 relief is noted separately. TCIA = Tax Cuts and Jobs Act; CARES = Coronavirus Aid, Relief, and Economic Security Act; BBA = Bipartisan Budget Act; FFCRA = Families First Coronavirus Response Act. Sources: CBO, Joint Committee on Taxation, and CRFB calculations

 

We expect both packages to eventually pass. First, the Infrastructure Investment and Jobs Act at the bipartisan $1.2 trillion price tag, which invests in traditional infrastructure (i.e. roads, bridges, power grid, etc.). Second, the reconciliation bill that holds a range of social infrastructure components such as the child tax credit, Medicare and Medicaid, and climate change initiatives - albeit with a lower price tag than the currently proposed $3.5 trillion package. More details around infrastructure spending and funding sources can be found in the Market Matters podcast episode: The infrastructure bill’s uncertain future.

 

Concerns around the deficit are not unfounded.

Investors are concerned about rising debt levels – and with good reason. Economic theory tells us that debt can increase economic and market risks: Higher debt levels will increase service costs, or the interest level on the national debt. And if the government plans paydown of debt poorly (i.e. tax increases), investors may lose faith and expect higher taxes to pay for it. The potential higher tax burden can spook the market and cause households and businesses to save more in anticipation of future tax hikes. Consequently, investors may demand a higher compensation for this additional risk, meaning interest rates may rise.

 

However, benchmarked against the potential benefits of spending, we are not yet overly concerned.

Spending on infrastructure should boost long-term growth. While Fed policy has supported good market functioning throughout the pandemic and moments of market panic, its tools cannot independently keep households and businesses afloat when aggregate demand is on the decline. Therefore, at least in terms of economic theory, fiscal spending in programs focused on high government investment return such as infrastructure, job training, and technological updates (such as 5G) could promote stronger economic growth and reduce the reliance on monetary policy. The Build Back Better plan indicates progress on this front, therefore increasing long-term growth potential.

Interest rates are unlikely to rise to punitive levels. Three key factors drive market interest rates higher: the policy rate, inflation expectations, and the risk premium – the amount of compensation investors demand for taking on the risk of holding government debt. 

  • The policy rate is likely to stay “lower for longer”. Fed Chair Jay Powell’s recent Jackson Hole speech suggests that asset purchases will not taper until the end of 2021, with risks to the later side. Policy rate hikes are unlikely to come before tapering ends, a year or more away. When they do, the market expects they won’t be able to rise much higher than 1.75%.
  • Inflation expectations are a pandemic-era wildcard, but so far the markets believe inflationary pressures will be transitory. Our analysis of structural factors impacting inflation confirms that inflationary pressures will rise, but only modestly.
  • The risk premium can rise if investors begin to doubt the “full faith and credit of the United States government.” In our view, this is unlikely to be the case unless persistent political battles shake global investors’ faith that the U.S. government will pay its bills on time – a years-long process. In the meantime, most developed-market government debt boasts even lower interest rates than the U.S., meaning investor demand for U.S. assets remains high – keeping the risk premium low. 

 

Infrastructure spending’s debt impact: Implications for asset allocation

While we believe the risks around increasing the government deficit are manageable, we recognize that higher government spending may impact an investor’s asset allocation decisions. We encourage investors to look for the opportunities just as much as the risks.

1. Source: Federal Reserve Economic Data, 2nd quarter 2021 total federal debt held by the public as a % of 2nd quarter GDP (annualized), 2021.

2. Active management is an investment strategy involving ongoing buying, selling, and holding actions by the investor. Active investors purchase investments and continuously monitor their activity with a goal of outperforming the overall market. 

 

All investments are subject to risk including loss of principal.

The opinions expressed are those of the Multi-Asset Solutions team, an investment team within New York Life Investment Management LLC and not necessarily those of other investment boutiques affiliated with New York Life Investments.

Investing involves risk, including possible loss of principal. Asset allocation and diversification may not protect against market risk, loss of principal, or volatility of returns. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors, and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

“New York Life Investments” is both a service mark, and the common trade name, of certain investment advisors affiliated with New York Life Insurance Company. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302, a wholly owned subsidiary of New York Life Insurance Company.

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