What Happens to Stocks if Washington Addresses the Budget in 2011

The Republican and Democratic positions on the long-term budget woes are clear: The GOP has pushed strongly for sharp spending cuts to help bring down the national debt, while the Democrats believe current spending efforts to get the economy on track now will boost government revenue and close the budget gap.

Yet both sides agree that sooner rather than later, the annual gap must shrink. Many hope to see the budget go back into balance within the next five years. But that’s not good enough. Even as we hope to eliminate annual deficits, we’ll still be sitting on a whopping pile of unpaid bills that has been run up for the past decade. By the latest tally, we’re talking about almost $14 trillion. To pay off those bills, we’ll eventually need to run budget surpluses.

Some would argue that manageably-sized government debt levels are tolerable. One politician has even famously quipped that “deficits don’t matter.” They do. Even if the United States chooses to carry some level of persistent debt, it’s still too large at current levels and will need to come down by at least half. This means the government needs to bring in $7 trillion more in revenue than it doles out in spending in the next few years.

Hard choices
New Congressional leadership means a fresh start for potential progress in 2011. Both parties will need to meet halfway and make “compromises,” a word that John Boehner (R-OH) was loathe to use in a recent 60 Minutes interview. But neither party can tackle entitlement spending, defense spending, tax code changes or other contentious issues alone — they need each other. Washington has shown little courage in recent years. Here’s hoping 2011 will be different.

The impact

For equity investors, a serious plan to take down the deficits (and eventually the debt) could provide a major boost. As the markets grow more confident that the United States is getting back on a sound fiscal track, fewer investors are likely to stick by defensive assets such as gold, commodities and debt instruments. [See my article, “What to Expect From Gold Prices in 2011”] Considering the currently low level of inflation and interest rates, stocks should be sporting higher valuations. After all, sky-high interest rates in the 1970s led to very low price-to-earnings (P/E) ratios. Why shouldn’t the converse be true now?

There are a range of reasons behind the economic boom of the late 1990s. But perhaps it’s no coincidence that stocks moved into favor as national budget deficits turned into budget surpluses.

But there’s a downside to tackling the debt. The government, which accounts for roughly one-fifth of economic activity, serves as an economic stimulator when it runs deficits because it puts more cash into the economy than it takes out. If Washington ever got serious about bringing down the deficit, it would create a drag on the economy. If we’re talking about $1 trillion in cuts a year for seven years (which would cut the current national debt in half), then we’re talking about layoffs in the public sector as well as in industries such as defense, healthcare, education, etc. In an ideal world, gross domestic product (GDP) growth would be sufficiently robust so that the private sector takes up all the slack (as happened in the late 1990s). But that’s no sure thing.

Action to Take –>There are certain actions the government can take to minimize the negative effects of debt reduction efforts. For example, means testing for social security recipients would likely limit the amount of money sent to retirees who don’t really need it. It can also change federal retirement programs from defined benefit (pension) to defined contribution (401K). Or it could cut some of the bloat out of the Department of Homeland Security, for example. And it’s not just cuts. Tax rates remain at historically low levels, and a return to more typical tax rates appear essential.

I know that just reading these suggestions will make some of you quiver with anger. But hard choices are all we have. If not these, then other equally difficult sacrifices will need to be made.

Make no mistake. Serious moves to finally tackle the budget deficit and debt would be applauded by stock markets. Stocks could conceivably rise by 40% in a few years as P/E ratios expand to truly reflect the benefits of a low interest rate environment. But such a rally would be a good reason to book profits, as the actual process of deficit cuts (and presumed eventual surpluses) will create real headwinds for GDP growth.