Doug Kass posted a wonderful diatribe from The Great Strategist around the debt ceiling talks on his Real Money Pro Daily Diary on Thursday. The first paragraph went like this:
The debt-ceiling negotiations exposed the grim fiscal future facing America. They demonstrated that our political system is locked and loaded - with weapons of mass financial destruction aimed at our own heads. When the deal expires on January 1, 2025, the federal deficit will be ~$35 trillion, annual deficits will be between $1.5 and $2.0 trillion, and the annual cost to service this debt will be ~$1.0 trillion. The modest spending limitations in the debt-ceiling extension barely make a dent in these forbidding numbers. Goldman Sachs estimates the bill will cut spending by -0.2% of GDP in nominal terms. That's a joke but the joke's on us. The only thing the deal accomplished was avoiding a near-term default and giving financial markets more excuses to rally into even more overvalued territory. We are witnessing a slow-motion train wreck except Americans are the ones lying down on the tracks being run over by the very legislators they elected to drive the trains."
Doug's conclusion was the country either was heading toward a financial debacle or political upheaval, possibly both. I would postulate that neither event would be good for equities or the markets. While I think Doug's advocacy of term limits as a way to end this madness is little more than a panacea, I do agree the nation is heading toward a financial reckoning in the foreseeable future.
I am not taking any political side in this matter as my view is along the timeless bit of wisdom from Joseph Heller's "Catch 22" -- "The enemy is anybody who's going to get you killed, no matter which side he is on" -- as leadership in both parties lacks the sense of urgency and will to right the financial direction of the country.
While the markets may have breathed a sigh of relief as Congress kicked the debt can down the road to the beginning of the next presidential term, I think investors are being too complacent here. What this deal assures if the government will spend $1.5 trillion to $2 trillion more than it takes in annually over the next two fiscal years. This will be a continued tailwind for inflationary pressures and probably ensures that the so-called "sticky inflation" we have seen over the past couple quarters will remain with us for some time.
In addition, the Federal Reserve will need to keep fed funds rates higher and for longer than it would like as inflation levels remain stubbornly hard to bring down. One reason is that the central bank's favorite measure of inflation, the core Personal Consumption Expenditures Price Index, or core PCE, hasn't budged so far in 2023.
This persistent inflation will have myriad ramifications, from the interest that will need to be paid on the $31 trillion in national debt to the ability of commercial real estate funds to roll over the hundreds of billions of dollars of debt on their office and retail properties that is starting to come due just as asset prices are declining. This will not be a harbinger of good times for regional banks that make the majority of these loans.
High rates will increasingly slow economic activity while continued high levels of inflation will pressure consumers, who have lost buying power to higher prices for 24 straight months and counting. The latter is one key reason that guidance from well-known retailers such as Macy's (M) and Best Buy (BBY) has been so dismal this quarter.
In short, the debt ceiling agreement increases the chances of a prolong bout of stagflation, something the market at roughly 18x earnings is clearly not pricing in right now.
