Are you prepared for the future?

By Tom Anderson/Consulting

In my previous writings in the Corridor Business Journal, I proposed that my goal is to fundamentally change the way you look at the world.

If I have yet to grab your attention, the lessons from the fiscal cliff and the sensitivity of our economy to shocks will surely shift your thinking. Let’s consider the following: Why was the fiscal cliff a big deal? And what does it really mean?

The fiscal cliff is the sharp decline in the budget deficit that could have occurred due to increased taxes and reduced spending as required by previously enacted laws. The fiscal cliff triggers changes in Gross Domestic Product (GDP), which is a common measure of how our economy is growing. GDP is calculated with this simple equation: GDP = Consumption (C) + Investment (I) + Government (G) + (Exports –Imports). We need to remember that our economy is very sensitive to even small changes in GDP.

The fiscal cliff was a big deal because most economists felt that the mandatory sequestration would lead to a decrease in Government spending (G) and the increase in taxes would lead to a decrease in Consumption (C). Although estimates varied, the concern was that the fiscal cliff could potentially cause a significant recession during an already weak recovery.

In my last column, I suggested that the United States may face an alternative economic history in the next 30 years that more closely resembles Japan’s catastrophic deflation, Argentina’s hyperinflation, or the European (Spain, Greece, and Italy) economic crisis characterized by weak equities, higher interest rates and weak currencies.

You may think, “At least the United States doesn’t look like them.” But we have more in common with Europe’s economic crisis than many investors think. Our perspective must shift.

Spain’s economic environment in the last few years closely mirrors our own, with increasing taxes causing Consumption (C) to plummet, a decrease in Government (G) spending, and Investments (I) falling due to a lack of consumer confidence. All of these indicators mean that GDP is contracting.

What has happened to the United States’ debt and deficits over the past decade is not insignificant. What is worse is that we didn’t see it coming. In fact, the Congressional Budget Office (CBO) predicted the opposite, projecting a cumulative surplus of $5.6 trillion between 2002 and 2011. In actuality, the U.S. ran a $6.1 trillion cumulative deficit – or debt increase – of $11.7 trillion. This was a stunning miss.

In 2000, the U.S. had about $5.7 trillion of debt and was running a budget surplus of about $236 billion. In 2013, the U.S. has more than $16.5 trillion of debt and deficits of $600-$900 billion per year for as far as we can see. After such a dramatic increase in debt and deficits, one might intuitively think that rates would move higher, because we are lending to an inherently riskier entity. It turns out, however, that rates have actually moved lower.

This understanding of the economic reality in the United States should help us frame several key questions, including:

· Why were investors demanding an average rate of roughly 6 percent in 2000 but are now willing to accept rates under 2 percent?

· Were rates too high in 2000 and were investors being massively over compensated for their risk? Or, are rates too low today and investors are being massively undercompensated for their risk?

Somebody is wrong.

So, let’s employ a stress test to evaluate the sensitivity of the U.S. economy to shocks. A good place to start is by reviewing key assumptions made by the CBO, including that our economy has stable interest rates, decreasing unemployment, and consistent GDP growth. These assumptions led the CBO to declare that the U.S. will “only” have $20 trillion of debt in 2013 and will be running annual deficits of $1 trillion.

But what if the CBO is wrong? What if interest rates go up? If we assume that the Government’s average cost of borrowing moves from 2 percent to 6 percent on the $11.5 trillion of debt held by the public, then the resulting increase in interest expense would be 4 percent multiplied by 11.5 trillion, resulting in $460 billion per year. With all else equal, this would lead to three economic possibilities: revenue must go up (tax increases), Government spending would decrease, and the deficit would increase.

So what would happen to GDP in this scenario? As I said before, increasing taxes leads to a decrease in GDP and a decrease in Government spending results in a decrease in GDP. Other people may balk at this stress test, believing that interest rates can’t go up because the Federal Reserve doesn’t want them to. Oddly, with interest rates near generational lows, one might think that the U.S. is borrowing money long term, locking in low rates. It turns out, however, that of the marketable securities held by the public according the US Treasury as of Sept. 30, 2012, $6.255 trillion (or 58 percent) will mature within the next four years. In addition to this $6.255

trillion, we will also have to sell enough debt to finance our ongoing deficit.

So who is going to buy all this debt?

Roughly $5.6 trillion of U.S. debt is held by foreigners. Other nations hold more of our debt today than the total level of outstanding debt in 2000. An event that is quite significant occurred in 2012: China reduced its outstanding holdings of treasury securities. If we know that the U.S. must continue to finance debt and that some of the biggest buyers are becoming sellers, we must ask ourselves if it is not at least possible that interest rates could rise.

Next time, I will address how investors should position their portfolios for the different potential environments we could face as a result of this knowledge.

Tom Anderson is an executive director – Wealth Management, senior portfolio management director, family wealth director and financial advisor with Morgan Stanley.

The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.

Excerpted and adapted with permission from The Value of Debt: How to Optimally Manage Both Sides of a Balance Sheet to Maximize Wealth by Tom Anderson. Copyright 2013 by Tom Anderson. To be published by Wiley in September 2013.