Sizing Up the Growing U.S. Debt Problem

Jeff Buchbinder:

Hello everyone, and welcome to the latest LPL Market Signals Podcast, Jeff Buchbinder here, your host for today with my friend and colleague Lawrence Gillum, here to talk about the bond market. Bond market's been more exciting, Lawrence, than maybe it has been in the past. How are you today? How was your holiday weekend?

Lawrence Gillum:

I'm doing well. The holiday weekend was good. It's always nice to get those three-day weekends on occasion, but for my Labor Day, I think I was doing more laboring than I was expected to. My wife had a to-do list for me, so no days off in the Gillum household.

Jeff Buchbinder:

The honey-do list. Yes. Yes. We have one of those in the Buchbinder household too. Got through a few of the things, but still more to go. So, maybe it's Labor Week for me, <laugh>. Anyway, well, thanks everybody for joining. It is September 3, 2024 as we're recording this Tuesday morning. Stocks are down a little bit this morning. It's a seasonally weak September, potentially to blame. So we'll talk about that. You'll see that on our agenda here. We're going to recap the markets for last week, as we always do, next talk bonds, as I mentioned with Lawrence. And then we'll end it with the week ahead and a preview of the jobs report. So here we go. Strong week for value. Actually, value outperformed in August as well. But just looking at last week, strong week for value helped to offset the weakness in tech, and we ended up with a, you know, decent week.

Jeff Buchbinder:

Positive week. Although, actually we got a positive week because we rally late into the close on Friday. So maybe this morning's weakness is just giving back those late Friday gains, potentially around rebalancing. We're really close to an all-time high, even with the losses this morning, we're about a percent away from the all-time high in the S&P, and the breadth has been decent, not great, but decent and improving. So we'll see if we can get through that 5,667 number, which is the all-time closing high from July 16. Here you see the weekly returns. We'll do stocks first, Lawrence, then we'll get to bonds. The weekly gain for the S&P, just 0.3%, but again, needed that furious rally at the end of the day, just to get into the positive column. That S&P gain contrasts with the NASDAQ loss.

Jeff Buchbinder:

If you look at the sectors, you'll see why, because tech was down right, tech down 1.5% for the week. Certainly, NVIDIA was a big part of that. NVIDIA shares down sharply this morning as well. Maybe we'll just call that a sell the news after the chip maker reported earnings last week. You also had defensive leadership. In fact, that was something we saw throughout the whole month of August. In fact, the top four sectors were all defensives, if you call real estate, defensive, real estate, utility, staples, healthcare, the leaders. So amidst all of the call for rotation, we got some rotation, no doubt. So I think those are really the highlights. We also saw, by the way, the European markets were really strong in August and you know, had a decent week last week, so that was a bit of a change in trend. You could say. Value leadership is a bit of a change in trend, as well as the strength in Europe that led the MSCI EAFE to a good August, up over 3%. Turning to bonds that's your neck of the woods, Lawrence. I saw bonds are rallying here this morning, but not a very good week last week.

Lawrence Gillum:

It was mixed, right? So, for core markets, core sectors were lower on the week. But we did have some positive returns out of more of those plus sectors. So it looked like there was a rotation between safe into kind of the riskier segments of the fixed income markets last week. A lot of the move happened after that benign inflation report that we got. As the narrative has shifted to this week's growth report, which, or, I'm sorry, labor market report, which we'll talk about in just a second. But for the week, the aggregate bond index down about 50 basis points, up about 3% for the year. So still positive on the year. Mortgages down about 50 basis points as well. They've done really well over the last three months, outperforming the other kind of core sectors, if you will, within our asset allocation portfolios.

Lawrence Gillum:

We have had a bias towards mortgage-backed securities. So it is good to see these higher quality segments of the core bond universe outperforming these other sectors. So that has done well. Looking at munis, munis have struggled over the last couple months, not kept up with taxable alternatives. I still think that the muni market is in really good shape from a fundamentals perspective. Valuations have improved but these next couple months are going to be challenging ones for the muni market, given the supply expected to come towards the end of this month and into next month. So there could be some additional pressures, but at the same time, I do think that valuations are compelling enough to attract investors back into the muni bond market. So despite the relative under performance here, I think that the setup for munis is a positive one on a go forward basis. Last thing I'll point out, preferred securities, that's another area that we've had exposure to within our discretionary asset allocation models. A positive on the week of the month, the year to date period, and over the last one year period. So preferred securities has been a good place to take risk within our models. Valuations are still relatively attractive, not as attractive as they were about a year ago. But nonetheless, it has been a good area for our investors.

Jeff Buchbinder:

Yeah, let's turn to commodities, Lawrence. Thanks for that. The oil market continues to struggle. The latest reason is OPEC+ expected to continue their planned production increases that offset the reduced production out of Libya. So oil just continues to struggle to gain traction down about 4% for the week. Precious metals, you know, that looks like a good place to be, generally, with what's going on geopolitically and with the weak dollar, but didn't really get much help last week anyway, down almost 1%. The precious metals index more broadly down over 1%. So that's an area we continue to watch. Here, you see the well, the dollar was down one and a half percent in August, but up a little bit last week. So that was certainly part of why gold struggled last week, but it was a winner in August, up over 2%.

Jeff Buchbinder:

I think that's it for that. Let's just recap quickly our asset allocation views, though, as we, you know, folks return from vacation, and we probably haven't talked about this for several weeks. We continue to like bonds more than stocks. So we're overweight fixed income relative to equities. And then within equities, our highest conviction idea is to favor the U.S. We are neutral, developed international and underweight emerging markets. Across cap and style, we're really close to the benchmark, call it neutral. And then Lawrence, you highlighted one of the areas in fixed income that we do like, which is preferreds. Any other positioning recommendations that you want to add?

Lawrence Gillum:

Yeah, we remain up in quality in the fixed income side of things. The plus sectors to high yield bonds, bank loans, non-U.S. markets. The, the additional compensation for owning those markets really isn't that attractive. So we've stayed pretty high quality local in the U.S. We've maintained a neutral duration, meaning that we have interest rate sensitivity of our portfolio is in line with our index because we think interest rates are biased, in either direction. Probably equally probability for a move higher or lower in yields. So we've maintained this neutral duration. But yeah, outside of that, we've really kept it high quality. And then our only plus sector exposure is, or has been preferreds.

Jeff Buchbinder:

Very good. So, and that the view that stocks need to pull back in our view has not changed. So still looking for a pullback, maybe September, is it. We'll talk about seasonality here in a minute. So we're going to start with bond market perspectives, implications of the massive U.S. debt pile. I know, Lawrence, you have an investment recommendation to come after that high level discussion about the U.S. debt problem, which we're all aware of. In fact, I'd say I get more questions about this topic than any other from our clients. And so I'm sure you know, many of you're interested to hear our take. A big problem, an important problem that's really not going away soon, unfortunately. So, Lawrence, over to you.

Lawrence Gillum:

Yeah, before we get to that, before we start to talk politics, which we're not going to do, but we'll talk debt within the, which is always fun government. But real quick this was the chart of the week. I presented this to our Morning Call listeners this morning to our advisors. I think this chart is going to get additional play over the next couple months and quarters as the U.S. Treasury yield curve un-inverts. So what we're showing here is the difference between two-year Treasury yields and 10-year Treasury yields. As avid listeners know, the yield curve has been inverted since July of 2022, meaning the two-year Treasury yield has been higher than the 10-year Treasury yield. That is not normal in a normal economic environment. You have an upward sloping curve, meaning the 10-year Treasury yield should be higher than the two-year Treasury yield. As of last Friday,

Lawrence Gillum:

we're close, we're close to normal. We're about a basis point away from having a two-year and 10-year Treasury yield at the same levels. It's actually changed a little bit this morning but as of Friday, we were getting really close to that zero number. I think the message over the next couple quarters is going to be an important one. I've included recessionary. The red shaded part there is actual recessions. The narrative, I think, is going to be about dis-inverting and the chance of recession, because historically, as the yield curve has un-inverted, a recession has occurred on average three to six months after that yield curve has un-inverted. You never want to say this time is different, especially not in this industry. I do think the aggressive rate cut pricing that's priced into markets, I think is potentially overdone.

Lawrence Gillum:

Meaning that the two-year Treasury yield is probably going to be higher than what it is currently, which is going to keep that yield curve inverted for a little bit longer over the next three to six months. We really haven't seen the data soften enough to present as a recessionary outcome. We don't see the macro data as contracting over the next three to six months. So, you know, even though we do get this un-inversion, historically, there's been a signal there. Perhaps this time is a little bit different because of what's priced in the markets. And we'll get this maybe a premature un-inverting that may not come with the same sort of recessionary signal that we've seen in the past.

Jeff Buchbinder:

Yeah, soft landings are not common, but at this point, looks like we're lining up to get one.

Lawrence Gillum:

Yes, regardless of what may be the yield curve is suggesting at this point. But you know, our view is that we don't see a recession over the next three to six months, which historically has been the signal that come out of this un-inverting. So we're a little bit more constructive on the economy than what this one indicator would suggest.

Jeff Buchbinder:

And if we get a recession two or three years from now, people will say, see, told you the yield curve said it was going to happen, and right. And there it is. The amount of lag is very important when evaluating these signals. So, yes we're a little bit skeptical of that signal, I guess, bottom line. Yeah. So thanks for that, Lawrence. Now, we're going to get into the more fun topic which is, yeah,

Lawrence Gillum:

So the fun topic, meaning the.

Jeff Buchbinder:

Debt pile.

Lawrence Gillum:

The amount of government debt coming to the market over the next couple years. We are in the, you know, election cycle. So there's a lot of election noise out there, concerns potentially about Kamala Harris or a Donald Trump President administration. I think the takeaway though is regardless of who wins the White House in November, the federal deficit is likely going to continue to be the big loser, right? So this is data from the Congressional Budget Office. The expectation is that budget deficits are going to be in that five to 7% of GDP range expanding out to about close to 10% over the next 30 years. And this assumes no additional spending, no additional tax cuts. So this is probably on the low end. So essentially the federal budget is going to be in deficit for the foreseeable future.

Lawrence Gillum:

And one of the big reasons why the deficit or the budget's going to be in deficit over the next, call it 30 years, is the amount of interest payments that are going to be required to pay down that existing and growing debt load that we're about to experience. The according, again, to the CBO the net interest outlays. So, net interest payments are going to equal around, call it, you know, six to 7% of GDP, which is a very large number, and will only continue to grow despite the fact that we're likely going to see lower rates over the next few years. Just the amount of debt necessary to plug the hole between spending and revenues is massive, and unfortunately not going away anytime soon.

Lawrence Gillum:

The next slide is looking at just the mountain of debt out there. And again, this is from the CBO, the Congressional Budget Office. So this is kind of an independent analysis, if you will. The amount of Treasury debt held by the public is expected to continue to increase. Currently, our debt to GDP is around that 99 percentile, so probably still manageable. But as you can see on this chart, the amount of debt owned relative to the economic growth of the U.S. is expected to get closer to 160, 170%. So the highest we've ever experienced. 2029 really represents that tipping point in terms of the expectation of additional growth relative to economic growth. So after 2029, we're going to continue to hit all new highs in terms of debt to GDP levels. So it's one of those things where, unfortunately, until there's a market reaction, you know, if you think about what happened in 2022 with the Liz Truss budget over there in the U.K., and we saw markets kind of push back government bond yields in the U.K. gilts, they spiked higher because of a buyer strike.

Lawrence Gillum:

Unless, or until we get something like that here in the U.S., unfortunately, I don't know that we're going to have any sort of pushback from politicians on continuing to grow the debt. If there's no consequences, no market consequences, then likely the deficit and debt outstanding will continue to grow. Now, there is a silver lining here as it relates to the amount of interest payments. There's been three times in history in the U.S. history where politicians did do the right thing and either cut spending or increase taxes when interest payments. So, interest payments are currently around 14% of the total operating budget for the U.S. At these levels, historically, has represented a period of time where Congress has made a change, again, cut spending and or increased taxes and has brought down those interest payments. So if you think about after World War II, with Ronald Reagan in the 80s, and then Bill Clinton in the 90s there were periods where we did see interest payments move lower because of the fiscal restraint within those three time periods. So we'll have to see if current Congress has the intestinal fortitude to make those tough decisions. But right now, it doesn't look like there's a lot of concern coming from Washington with regard to debts and or debt deficit and or debt.

Jeff Buchbinder:

Yeah, I hate to be a downer, but I think we're going to have to wait until 2028 before we have a serious discussion. Hope I'm wrong. But right now, certainly there does not appear to be much appetite really, on either side of the aisle Yeah. To make these tough decisions. So, yeah,

Lawrence Gillum:

No party can really claim fiscal responsibility anymore. But I do want to leave kind of the maybe the main takeaway is that despite this mountain of debt, despite the deficits, the U.S. government is not at risk of a financial collapse, nor is there any concern of such a thing happening. The U.S. government can and will pay its bills. The U.S. government has the risk-free rate associated with its debts, right? Those are Treasury securities, and the U.S. dollar is still the reserve currency, meaning most of the transactions internationally are done through the dollar. So as long as those two things hold the U.S. government will absolutely be able to pay its bills. So there's no reason to avoid Treasury securities or anything like that because of the amount of debt coming due, the government will pay its debts.

Jeff Buchbinder:

Yeah. That gets into MMT, right? If you can print your way out of any problem, then maybe it's really not a problem. Certainly some that's not my view, but certainly that's seems to be the market's view that it just doesn't matter. Yeah. Right now, we'll print money, we'll pay off our debt, and as long as rates stay in the threes or fours, we probably don't have to worry too much about it here. At least in this current election cycle. If you get rates five, 6% or higher on the 10-year, then you got a tougher problem.

Lawrence Gillum:

Yeah. The risk though is that as this debt comes to market as the Treasury Department continues to issue Treasury securities, there could be a bit of a buyer, I don't want to call it a buyer strike, but there could be some pushback with buyers requiring higher yields to own this debt so it could keep yields a bit higher than they would be otherwise. But to your point, I mean, there's zero concern about the government paying, its, its bills back. I shouldn't say zero because there's always, you know, that slight concern. But it's very little, very, very low in terms of the U.S. not paying its bills when they come due.

Jeff Buchbinder:

Yeah. I guess we came off of that zero probability in 2011, you might say, with all of that the U.S. debt downgrade and the market correction in August of that year. So sure, it's a downbeat kind of a message, but eventually we'll have to do the right thing. And our, I mean, it's hard, so hard to have confidence in our politicians, but when push comes to shove the House and Senate, will get something done. It's probably going to be a combination of higher taxes and less spending, but there's really not a lot of spending to cut. Yeah. Because so much of it is interest expense and military expense and entitlements. You are not cutting Medicare and Social Security. There'll be tweaks that you can make to make the problem a little easier, like adjusting the eligibility age for social security, that'll probably happen. Means testing, right? Reducing eligibility so Warren Buffet doesn't get Social Security, things like that. Those things will help. There's still tough decisions and no politician can get elected making that part of their platform. At least not now. But someday those things are going to happen. And we'll get through this, yes. But

Lawrence Gillum:

Only 28% of federal outlays are potential areas to cut because you have Medicare, Social Security, defense, veterans, all these different of expenses that are almost called the third rails because they're untouchable. So it does leave a very low amount of federal outlays that can be cut. So, to your point, this is going to be a problem for a while but hopefully there is a bipartisan solution in the near future.

Jeff Buchbinder:

Right. So from that rosy outlook, <laugh>, it makes sense to think about investment implications. So you've got one here for our listeners, Lawrence.

Lawrence Gillum:

Yeah. So with all the deficit spending you know, there's the potential that economic growth would be higher than it would be otherwise, absent that deficit spending, which means that inflation may run hotter than it has been over the past, call it decade. One of the perhaps solutions to inflationary pressures being higher than they were over the past decade is to own things that are adjusted for inflation expectations. So we have in the fixed income markets, we have these things called TIPS, Treasury Inflation-Protected Securities. These are Treasury securities issued by the U.S. government. They differ from the traditional Treasury securities, in that there's an inflation adjustment based upon realized inflation. So if you buy a nominal Treasury, for example, that's yielding 4%, you're going to get 4% regardless of the inflationary environments that you live through.

Lawrence Gillum:

If you buy TIPS and call it 2% on a real inflation adjusted basis, you're going to get that 2%. But if inflation is higher than what's priced in the market, you're going to get a bit more than what you bought originally. So there is that inflation adjustment based upon what markets are pricing in. And the good thing about TIPS right now is inflation expectations remain relatively low. So it's not going to take a lot or a big inflation adjustment to outperform nominal Treasury securities. So if you own nominal Treasury securities again, there's still zero credit risk associated with those securities. But if we are in a slightly higher inflationary environment than what we've lived through over the past decade, nominal Treasury securities will likely underperform these TIPS securities. So if you're doing things like ladder portfolios and your portfolio is primarily nominal Treasuries, maybe it makes sense to add some TIPS to those securities as well, or those portfolios as well, or even these short to intermediate type TIPS, funds, or ETFs, something that provides some inflation protection given the amount of deficit spending that we're likely going to experience over the next 30 years.

Lawrence Gillum:

So it's not all doom and gloom. There are some there's a problem and here's a potential solution. So we are you know, we do have some you know, investment recommendations that could help offset some of that inflationary spending over the next couple decades.

Jeff Buchbinder:

A ray of sunshine from the doom and gloom bond guy. How about that? That's right. <Laugh>. I love it. Good stuff, Lawrence. So let's keep going here. Talk a little September seasonality before we wrap up with a week ahead preview. As I'm sure many of you know by now, September tends to be a weak month for stocks. So here you see the average performance from by the S&P 500 by month, historically, this goes back all the way to World War II, thanks to Bespoke Investment Group for this data. And that September negative 0.78% stands out quite a bit in red, one of only three months that on average has the stock market down, follows in August, that typically is down. However, as we know now, the S&P 500 actually rose in August. So we bucked that seasonal trend.

Jeff Buchbinder:

Maybe we'll buck this one too. Here's another ray of sunshine. The good news with seasonality in September is that when you're up more than 15% year to date coming into the month, it's actually on average slightly higher, and you're up a little more than 50% of the time. So there's a scenario where potentially we buck this trend. We're also probably going to get a rate cut by the Fed on September 18, that may help. The odds of a soft landing have improved in general, and yields have come down a bit. In general, this is a pretty good environment for stocks. You just have a pretty tense geopolitical environment to put it mildly. And you have an election coming up, of course, in November, and policy uncertainty typically creates a little more volatility in September and October during election years. So those are some things to watch or to consider.

Jeff Buchbinder:

Here's the FOMC meeting on September 18, that I mentioned. This is the average path of the S&P 500 during the month of September. And you see it's pretty choppy for the first two plus weeks. And then you really see a the weakness in the back half of the month. So, of course, this doesn't always hold, but this seems like a reasonable scenario where the Fed is potentially a sell the news event, and then you, you know, sell off after that into the end of the month as you get closer to the election. So expect choppiness the next few weeks. The bias we think for the market is down. We believe that this test of the July all-time highs is likely to fail. And now we're not talking about a massive decline, but, you know, maybe something similar to what we just experienced in early August, that was a little less than 10, maybe this next one's around that level.

Jeff Buchbinder:

Because as long as the economy holds up and earnings are growing, we think that the magnitude of potential declines is limited. But something hopefully not as violent as August 5, but hopefully less than maybe a 10% correction is all that we need. And then we set up for a rally post-election. So that's certainly getting a lot of attention in the media. Wanted to just review the numbers there briefly. So let's preview the jobs report, Lawrence, I think that's really the biggest report. I don't want to say it's the only report that matters this week, but it's certainly the most important report. We did just get the ISM manufacturing index. It was pretty close to expectations. Still below 50. It's been below 50 for frankly much of the last couple of years. The services index from the ISM has been better. So we get that midweek. That's really, I think all that the market's going to care about in terms of the economic calendar until we get to the Friday's jobs report. So the consensus is around 150,000. What do you think, Lawrence? Any sense for whether the over or the under is more likely there?

Lawrence Gillum:

Oh, I've seen both. I've seen analysis from some sell side shops saying 180. I've seen some say 120. So I think the takeaway is that it's uncertain. There's not a lot of conviction in terms of the directionality of payroll growth right now. Last month's report that came in significantly below expectations, I think was it maybe it was concerning to a lot of folks that that pivots in terms of payroll growth has shifted. And now we're looking at much lower payroll growth than what we've seen previously. So, I will say that what's priced into the fixed income markets right now is a number that's call it lower than that 165 number that markets are expecting. I do think that if we get 165 or greater yields are likely going to move higher given what's priced into markets in terms of rate cuts.

Lawrence Gillum:

I think the big takeaway though is if we get 125,000 or something around that number maybe that green lights the Fed to cut 50 basis points in September and not 25. So there's a lot of pricing that's already taken place that a lot of this stuff is priced in. But there is this, there is still a risk that the Fed will change its behavior based upon this one data point, which you never want to see. But it is a risk and probably a volatility inducing data point on Friday, September 6. So, our chief economist Dr. Jeffrey Roach is going to be busy for sure on Friday.

Jeff Buchbinder:

Yeah, no doubt. You know, a lot of folks are calling for 1% worth of cuts this year. So that would imply you get a 50 and two 25s. I know Lawrence, you're more on the three cut camp. We'll see. You know, you could argue that a 50 basis point cut is bad because then the market's going to be worried that the Fed knows something we don't, so not necessarily something we're rooting for. But you bring up a great point, if this is a soft number when some people are expecting the hurricane reversal, right? Because some, at least believe that the hurricane in Texas Beryl dragged the numbers down the previous month. And so maybe we'll get some of that back. That suggests that if it is a hundred thousand or 125, that maybe the market will see that bad news as bad news, whether we get 50 basis points or not. So we'll see. I guess I have a thesis that suggests that we'll get that kind of 160 range or higher based on that hurricane reversal. But I'll leave that to the economists who are focused more on the economic data than I am. So at least we've got some thesis to consider there one thing. So that's really it.

Lawrence Gillum:

One thing real quick, one thing that's interesting though is that we do get the New York Fed President John Williams, right after the payroll data reports. So we could see kind of live current thinking on what the Fed may do with this new payroll data. So, that's something that we we'll certainly be paying attention to on Friday.

Jeff Buchbinder:

Yeah, good point. And maybe the ADP report on Thursday, will cause some folks to shift their expectations around on Friday. We'll see. And then I guess the average hourly earnings is important too, but based on consensus, it's expected to, you know, essentially be where it was the prior month, 3.7% versus 3.6 the prior month. So, that will get attention because the Fed watches of course, wages very closely. It's not just about job gains, but they've said themselves that they're more focused on job growth or the health of the labor market than inflation at this point because they're generally seeing the inflation battle as mostly won. So, thanks for that last piece there, Lawrence, we'll certainly be listening very carefully to the Fed after the jobs report and then before they go into their blackout period. So with that we'll go ahead and end. But thanks everybody for listening to another edition of LPL Market Signals. Thanks Lawrence for tackling some really important topics, especially the debt situation. Sorry to be so downbeat, but hey, you get a bond guy on, that's what happens. So hope everybody had a great holiday weekend. Have a wonderful short week this week and we'll be back with you next week for another edition of LPL Market Signals. Take care, everybody.