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.
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.
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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.
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