July 2009 - Investment Implications of Sustained Fiscal Debt & Deficits

Investors are right to be concerned about the longer term implications of fiscal deficits and debt on their portfolios. Further, the trend towards foreign ownership of US sovereign debt presents a new set of potential risks to US economic sovereignty. Debate on this issue has moved beyond whether or not the US fiscal deficit will expand greatly in 2009 and whether or not outstanding US borrowings will be the highest since WWII as a percentage of GDP. Both are now accepted facts. What this means for investors is a matter that is up for considerable debate.

US Federal Deficit As Percent Of GDP
Government Spending in US from FY 1900 to FY 2010

Due to the twin effects of declining tax revenues and increased government spending, the United States is expected to run a fiscal deficit in 2009 that exceeds $1.9 trillion dollars. The government estimates its receipts to be $2.1 trillion and its spending to be $4 trillion. The deficit represents an astonishing 13.5% of GDP. Putting aside the moral argument for purposes of this article, we generally do not believe the aggregate fiscal deficit represents clear and present danger to investors. However, this situation could become serious if deficits are not contained in future years through spending discipline and economic growth.

Federal debt outstanding as a percent of GDP may limit the government’s ability to use fiscal policy as a stimulus tool. Growing debt loads and potential increases in inflationary pressures could drive interest rates up. This could present a major problem to the US government, which has financed most of its debt with shorter maturity borrowings.

As a result of its tremendous economic growth and its balance of trade surplus, China finds itself an increasingly large holder of US Treasury securities. While the market for US Treasuries is highly liquid, this concentration of securities in the hands of a foreign nation may give investors concern. We do not believe there is an imminent threat of attack on the US dollar; however, it is a situation that warrants vigilance. Large scale selling of greenbacks would drive down the price of our currency and raise the prices of some systemically important commodities in dollar terms - most notably oil. A sudden and sustained drop in the value of the US dollar would be inflationary in the purely monetary sense and would likely dampen economic growth in the United States. Currency fluctuations can be self correcting however, as any decline in the value of the US dollar would make US exports significantly more attractive to a growing international demand.

Major foreign Holders of US Treasury Securities

While we believe the US fiscal situation is serious, we are not as fatalistic as some. It would not be in the self interest of China or other nations to attempt to drive the US further into recession by devaluing its currency. We also question the theoretical assumptions that it would be possible. The expansion of free markets and the real rise in the standard of living of many nations is at least partly responsible for their increased ownership of US assets. Investors may interpret the holdings of foreigners as a sign of confidence in our economic system and the safety of the US dollar as the world’s reserve currency.

This information has been developed internally and/or obtained from sources which Sand Hill Global Advisors, LLC ("SHGA" ), believes to be reliable; however, SHGA does not guarantee the accuracy, adequacy or completeness of such information nor do we guarantee the appropriateness of any investment approach or security referred to for any particular investor. This material is provided for informational purposes only and is not advice or a recommendation for the purchase or sale of any security. This information reflects subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. This material reflects the opinion of SHGA on the date made and is subject to change at any time without notice. SHGA has no obligation to update this material. We do not suggest that any strategy described herein is applicable to every client of or portfolio managed by SHGA. In preparing this material, SHGA has not taken into account the investment objectives, financial situation or particular needs of any particular person. Before making an investment decision, you should consider, with or without the assistance of a professional advisor, whether the information provided in this material is appropriate in light of your particular investment needs, objectives and financial circumstances. Transactions in securities give rise to substantial risk and are not suitable for all investors. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of SHGA.