Must-know: Why the peace dividend can fund Obamacare

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Must-know 2014 US macro outlook: The crack in the debt ceiling (Part 7 of 10)

(Continued from Part 6)

U.S. discretionary spending

The below graph tells an interesting (and factual) story lost in the current media hype: believe it or not, defense spending as a percentage of gross domestic product, or GDP, is nearly half of what it was under Reagan. It’s true! It’s important to note that actual defense spending (the blue line) is likely to decline in future years—barring unforeseen events—as future budget requests going out the next few years remain modest. As a result, it’s reasonable to expect fairly flat to declining defense-related spending, and as the economy grows, the level of defense spending relative to the entire U.S. economy begins to shrink. Should future defense spending as a percentage of GDP shrink from 4% of GDP to 3% of GDP, that would represent an annual budgetary “savings” of roughly $150 billion—which would be more than enough to cover the Congressional Budget Office (CBO) worst-case scenario of $126.5 billion a year of Obamacare-related over runs. This article considers the decline in discretionary spending in the context of the larger budget debate concerning entitlements and considers the implications for investors.

Bad news for Republicans: Obamacare is exceeding expectations

The CBO estimates that Obamacare, otherwise known as the Affordable Care Act (or the ACA) is working out much better than anyone initially expected (they didn’t comment on the Obamacare website):

  • “CBO estimates that the ACA will substantially reduce long-term deficits. In large part because of the ACA’s role in slowing the growth of health care spending, CBO estimates that the ACA will reduce deficits by about $100 billion over the coming decade and by an average of 0.5 percent of GDP ($83 billion per year in today’s economy) over the following decade. These deficit savings are likely to grow over time and are separate from the revisions in CBO’s Medicare and Medicaid spending projections that were discussed on the last page (which are not directly attributable to the ACA).”

Do the math

With modest savings in defense and modest savings due to Obamacare, it might be reasonable to presume that the U.S. could improve its budgetary balance by 0.50% of GDP, or roughly $75 billion per year. Over 20 years, that would mean roughly 10% of GDP in budgetary excess, or $8 trillion dollars. That would pay down the majority of the $12 trillion in gross publicly held debt. Crisis solved.

Near-term considerations: Should the debt ceiling be lifted?

As Paul Krugman notes:

  • “It’s not that we as a Nation have overspent and need to spend less; it’s that some people are being forced to spend less, and we have a depression because other people won’t (NOT can’t) spend more. This is how you need to think about debt; it’s not a burden on the Nation’s resources, because its mainly money we owe to ourselves, and it’s a problem not because we have to tighten our belt, but because debt is currently leading to spending that’s less than we need to maintain full employment.”

Krugman’s analysis suggests that the debt ceiling isn’t as critical as the media might have you believe. While the current debt level is high by historical standards, at least the interest rates remain low, suggesting that the U.S. economy is suffering from a lack of demand, which needs to be addressed by growth in investment rather than simply further declines in spending. Perhaps a compromise can be reached that optimizes the balance between fiscal prudence and social objectives. For further comments by Paul Krugman related to the apparent initial success of Obamacare, please see, “Obamacare’s Secret Success.”

Conclusion

Given the above noted progress in declining defense spending in relation to the apparent muted expectations of costs surrounding Obamacare, it might seem that the U.S. economy isn’t as bad off as you might have thought, and that the U.S. Federal Budget is certainly on the mend. Should this trend continue and should political agendas remain subordinate to prudent economic and social policy, it would seem that taxpayers need not fear large-scale tax hikes if the tax reform debate comes to the fore after mid-terms elections. Overall, the current trend with regard to the Federal Budget and the associated debt may be well be the investor’s friend.

To see how much U.S. corporate profits have been rising while overall investments have been declining, please see the next article in this series.

Equity outlook: Cautious

Should the debt ceiling debate re-emerge and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So, investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the sequester issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment or individual companies such as Wal-Mart Stores (WMT).

Equity outlook: Constructive

However, if investors are confident in the ability of the USA to sustain the current economic recovery as a result of the improving macroeconomic data noted in this series, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the Schiller S&P 500 price-to-earnings ratio standing at 25.39 versus the historical average of around 15.50, the S&P is slightly rich in price—though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that’s “on strike,” including corporate profits, into long-term fixed investments could lead to greater economic growth rates in the future and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).

 

Continue to Part 8

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