Volatility is the name of the game, and we don’t know when it is going to end. The Dow dropped more than 1,000 points two days within the same week: Feb. 5 and Feb. 8. Concerns over the bond market and inflation are capturing headlines, too.
There is an inverse relationship between interest rates and the value of bonds. In other words, the price of the bond falls when the interest rate rises. Thanks to quantitative easing after the 2008 market decline — a program by which the Federal Reserve sought to stimulate the economy by buying Treasury bonds and mortgage-backed securities — interest rates have remained artificially low for about 10 years. Until now. The Federal Reserve is committed to slowly unwinding the 2008 stimulus program. Former Fed chairwoman Janet Yellen started small interest rate hikes during her term, and her newly sworn-in successor, Jerome Powell, plans to follow suit.
The Deficit
My economic concerns about the prospect for stock market volatility extend far beyond interest rates. The U.S. federal deficit is out of control. In fact, current estimates indicate a $1 trillion deficit by 2020.
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I recently published two articles on 2017 tax reform, showcasing the benefits to individuals and businesses. But I failed to articulate how this historic tax package would be funded.
If you’re ever short on money, you have four possible solutions:
- Increase your income
- Cut expenses
- Sell an asset, or
- Borrow more
Let’s take a look at each in the context of funding the Tax Cuts and Jobs Act of 2017.
Raise More Revenue
President Trump is optimistic that the deemed repatriation of accumulated foreign earnings — triggered by the lowering of corporate tax rates to 21% from 35% — will raise a sizable amount of revenue in the short-term. However, it is anyone’s guess if that tax revenue will actually offset lucrative tax breaks.
Slash Funding
If you are a retiree taking Social Security, or on the cusp of it, you may be concerned about benefits being cut. And rightfully so. The outlook is bleak for the federally funded program, which is already in trouble.
According to the Committee for a Responsible Federal Budget, Trump’s second 2019 budget proposal has a total of $3.1 trillion in budget savings relative to current law. Fortunately, there do not appear to be any direct cuts to Social Security in the recently proposed budget. Also, Medicare policies in the 2019 budget improve efficiency and value of care rather than cutting benefits to beneficiaries.
Even with these changes, deficits would rise to over 4% of gross domestic product (GDP) for the next couple of years, up from 3.5% currently. Additionally, the budget calls for a 42% reduction in non-defense discretionary spending over the next 10 years that many experts view as unrealistic.
Balance Sheet Items
The last two solutions in my list above, sell an asset or borrow more, relate to the balance sheet. Income and expenses, the first two solutions, are apparent on an income statement.
Have you ever looked at the Fed’s Balance Sheet? Section 5 outlines the Consolidated Statement of Condition of All Federal Reserve Banks. The Fed is reporting over $4.4 trillion of assets as of Feb. 7, 2018. Most of these assets are U.S. Treasury notes and bonds, plus mortgage-backed securities.
U.S. currency represents $1.6 trillion of Fed liabilities, and deposits held by depository institutions (i.e., banks and savings associations) constitute an even larger portion of the Federal Reserve’s liabilities.
The Federal Reserve system is the U.S. central bank. Its employees promote the effective operation of our economy. So, unless you or I go to work for the Fed, we don’t have much say in which assets to sell or how much to borrow.
Some Final Thoughts: What Investors Can Do
I did not write this article to scare you or say we’re headed towards another bear market. I don’t have a crystal ball, and neither do the economists.
Instead, focus on the things that you can control. Re-evaluate your time horizon. See if the level of risk you’re taking in your investment portfolio matches the volatility you can actually stomach. Also, focus on long-term goals, such as charitable giving, education funding or financial independence.
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