On the Radar

City National Rochdale, | Feb. 17, 2021

FAQs on the Markets and Economy

Are record U.S. federal debt levels a concern?

U.S. fiscal policy response to the pandemic has been enormous, and likely necessary, but it also has accelerated the build-up of Federal government debt. According to the CBO, federal debt, which reached 100% of GDP in the last fiscal year, is expected to rise to a record 107% of economic output by 2031.

However, it’s not just a question of how much debt is outstanding, but rather what it costs to service that debt. Even as the amount of debt issued by the U.S. Treasury has hit record levels, interest costs on the national debt, relative to the size of the economy, are expected to fall over the next few years to levels lower than at any time since the early 1970s.

This suggests that the government will be able to issue more debt in response to the COVID-19 crisis, should policymakers see the need to do so.

Still, in the long term, fiscal prudence is necessary. Borrowing rates will not always be as cheap as they are today, and rising interest costs will have to be addressed in the future either through reduced spending, higher taxes, or both.

Federal borrowing also isn’t without other costs. Deficits reduce national savings, shrinking the pool of funds available for private-sector investment. Over time, less investment leads to lower productivity and slower wage growth, reducing living standards and economic output. Inflows of foreign capital can make up for this, but also lead to increases in payments to foreign investors and reductions in domestic income.

To make sure the U.S. can meet future challenges when deficit spending is called for, putting the national debt on a downward trajectory should be a top priority once the crisis has passed.

The year is not starting off on a strong step forward. Although the January labor report showed a gain of 49,000 workers, reversing the decline that occurred in December (chart), but the previous two months were revised down by 159,000. What was viewed as the “December lull” seemed to get extended into the “winter lull.”

It is important to remember this is old news. The virus played an important role in the lull, but the news is getting better. In early January, infections hit a one-day total of over 300,000 with a 7-day average of about 250,000. Since then, the 7-day average has been on a steep decline to about half that level. Furthermore, vaccinations have been administered to 35 million people, and there are another 22 million doses that have been delivered. The outlook is looking good.

After several years of positive rating trends, the pandemic’s initial fiscal shock and the lingering effects from social and business restrictions continue to impact municipal issuers’ finances, albeit unevenly. Over the near-to-medium-term, rating transitions will likely evolve, changing the ordinal ranking of credit quality within some areas of the municipal bond market.

Rating agency data suggests a degree of restraint and latitude that the issuers can manage and respond to the pandemic to preserve their credit quality. To date, monthly rating changes, particularly downgrades, from the major agencies are not as significant as investors initially projected. However, rating actions tend to lag experience. For example, downgrades did not peak during the last cycle until three years after the financial crisis. While this cycle is different, it is likely an uptick in negative outlook revisions, and downgrades will occur, but most issuers should exhibit stability.

Moody’s recently published their 2020 rating revisions, which showed issuer downgrades surpassed upgrades for the first time since 2014, but barely. The agency also stated just 5% of its public finance ratings were affected, and the total number of actions reached a five-year low. The market is carefully monitoring issuer credit quality and their capacity to absorb the impact on their budgets and operations. Policy actions, such as congressional relief and the speed of vaccine distribution, should improve the economic trajectory and, therefore, prospects for issuer credit quality. Notably, the market has not experienced a material rise in distress, with Municipal Market Analytics reporting the cumulative default rate is less than 0.5% (excluding Puerto Rico).

Fed chair Jay Powell continued to set a very dovish tone at his recent speech to the Economic Club of New York.

The Fed plans to continue to bolster the economy by keeping short-term interest rates low and continuing asset purchases (they buy $120 billion of Treasuries and mortgages each month). The Fed has no plans to change those policies.

Although there is much optimism about the economy, the job market has a long way to go until it reaches full recovery. The Fed cannot do it alone, it needs help from Congress by adding more to fiscal policy. He noted that, “Workers and households who struggle to find their place in the post-pandemic economy are likely to need continued support.” The same is true about small businesses.

The resilience of corporate America continues to exceed expectations and goes a long way toward explaining record levels in U.S. stock markets.

Since bottoming in July, forward earnings estimates have been climbing steadily, with expectations suggesting S&P 500 companies will surpass their 2019 pre-pandemic earnings peak before the end of this year – a remarkable achievement considering the challenges.

Q4 earnings season has been especially strong. With 74% of companies reporting, analysts now expect fourth-quarter earnings for S&P 500 companies to turn positive for the first time since the crisis broke, growing 2.9% year over year versus a forecast of 10.3% decline at the beginning of January. Positive growth in earnings would be especially impressive given that the year-ago quarter took place before the pandemic.

While Tech companies continue to pace the market in terms of percentage of companies beating estimates, the breadth of earnings surprises has been encouragingly broad based. Overall, nine of 11 sectors have either matched or exceeded their prior 20-quarter average.

Given better than expected earnings and more fiscal stimulus likely, CNR now expects earnings growth to be near the top end of our forecast ranges for both 2021 and 2022. With valuations high, a continuation of the improved outlook for earnings is important to keep the near-term momentum in stocks moving high, especially as interest rates are rising.

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Index Definitions

S&P 500 Index (S&P500) is a stock market index that tracks the 500 most widely held stocks on the New York Stock Exchange or NASDAQ. It seeks to represent the entire stock market by reflecting the risk and return of all large-cap companies.

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