All kinds of factors are coming together beautifully.

by Leonard Hyman and Bill Tilles:

The US, like many other countries, has a large demographic cohort (baby boomers) entering retirement. This new class of retirees, like those before them, will request and presumably receive their social security benefits. And, as this cohort ages its medical bills will likely increase, thus increasing outlays for federal programs like Medicare and Medicaid. Elementary, as Holmes might have said.

The US Congress recently approved a dramatic reduction in the corporate tax rate from 35% to 20%. The consensus view is that this and other provisions in the new tax law will reduce federal revenues and add about $1.5 trillion to future federal budget deficits over the next decade. (A budget compromise proposed shortly afterwards would add several hundred billion more to the deficit.)

Out of curiosity, we wanted to see what the Congress’s own internal forecaster was saying. The Congressional Budget Office, in a June 2017 report underscores the obvious: “boomers” social insurance benefits will lead to increasing federal deficits.

An old technician we knew had a simple response to the question whether a trend is long-term and meaningful. He would say, “Look at a long-term chart without your reading glasses. If you can still see the trend, it’s meaningful.” The trend line that describes the growing increase in federal deficits requires no visual aids to discern clearly.

The recently enacted corporate tax cut is now expected to add to an already growing deficit due to “demography.” Something on the order of 5-5.5% of GDP.  Bond rating agency Fitch, in analyzing the tax bill, stated plainly that it would exacerbate existing budget deficit trends despite proponents’ claims to the contrary.

We remain skeptical of the so-called “crowding out” thesis. Supposedly, the federal government’s relatively large and  growing need to sell debt has the potential to “crowd out” and distort normal credit channels and that leads to higher interest rates. Yet Germany and Japan, both nations with a large percentage of retiring boomers and more generous social insurance than the US, both experience far lower interest rates.

If we put on our bond analyst’s hat, from a simple credit quality perspective the US federal government’s credit quality is headed south. Tax collections will fall due to recent cuts in corporate tax rates. Over the same periods, expenditures will increase due to the demographic imperative.

As we’ve seen this week with a certain unfortunate class of financial products, things aren’t a problem — until they are. Reminding us of Buffett’s old line about not knowing who’s skinny-dipping (i.e. cutting it way too close financially) until the tide goes out.

If we had to guess, we’d say things proceed swimmingly for the bulk of this year. Corporate profits should be solid with a boost from lower taxes.

But at some point in the not-too-distant future the narrative may quickly change. We’ve all seen moves in the dollar, oil, and gold suggesting an end to inflation’s long slumber. Whether this results in a more hawkish Fed remains to be seen.

One further budgetary imbalance we expect the CBO to address next June is higher interest expense on a rapidly growing federal debt. The question for us is not if, but when will credit markets see this as a problem.

In the US Treasury market, the 10-year yield has already begun to move up over the past two months, a first move, and just the beginning. But corporate bonds have not broadly reacted to the factors coming together – but will likely do so soon. We think the third and fourth quarters of this year will be “interesting.” By Leonard Hyman and Bill Tilles.

When all is said and sold off, GE’s debt burden – much of it attributable to GE Capital – looks enormous versus the size of remaining assets and cash flow. Read… What’s the Chance of Iconic GE Going Bankrupt?

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