The Investor February 2023
ShareFinder’s prediction for Wall Street for the next 3 months (top) and the JSE (bottom).
The Great Experiment begins!
By Richard Cluver
The Investor enjoys an international readership of well over 10 000 people and so I have to confess to being somewhat disappointed that only 66 of you took advantage of our Great Experiment and considerably fewer elected to donate to the charity I nominated.
Happily, however, because many who took advantage of the experiment nominated other charities which in turn confirmed receipt of donations, the overall result was that charities as a whole got an unexpected bonus. A few of the latter, moreover, contacted me to say how welcome the money had been at this very difficult time for everyone working in such organisations because, “…so many traditional sources of funding have been drying up because of the financial hardship in the country at present.”
Probably the greatest beneficiary was ShareFinder International which saw a three-fold increase in the number of new subscribers to their services. Since, however, they had indicated that the half-price offer applied to their entire client list rather than simply those coming up for annual renewal during December and January, their surprise was that the majority who took advantage were new clients. Only a few long-standing regular users of the ShareFinder software and readers of the Prospects newsletter service took advantage.
If you missed reading about The Great Experiment, last November readers of The Investor were offered a half-price entry into ShareFinder products linked to a request that they make a donation to charity. In the process we were seeking to prove the age-old belief that charitable donations get rewarded tenfold…and more.
The belief is best encapsulated in the biblical book of Malachi 3:10 which states: “Bring the whole tithe into the storehouse, that there may be food in my house. Test me in this,” says the Lord Almighty, “and see if I will not throw open the floodgates of heaven and pour out so much blessing that there will not be room enough to store it.”
I have long been numbered among the sceptics. However, throughout my life I have encountered so many folk whose opinions I have respected who have sworn to the truth of it in their own lives. So I have never been able to fully ignore their reality. But is it just a religious touchstone or, as the ancients believed, an esoteric reality that has nothing to do with a belief in celestial deities and is in truth actually a fundamental and inexplicable reality of the human condition?
So, last November, after seeking the advice of a number of priests and theologians lest we in the process tread upon the toes of any religious belief systems and, having received an unanimous blessing, we went ahead and put the belief to the test. Nevertheless I have to admit to being a little nervous about the whole project because religion is one of those taboo areas for business and financial journalists. However, I am happy to relate that, with few exceptions, readers gave us a favourable response. Furthermore most participants faithfully passed on the whole benefit that they received from ShareFinder while one or two gave with exceptional generosity.
So, thus far both ShareFinder and a number of charities have received an unusually large material benefit. Whether the former’s annual cash flow will be diminished by a like amount will require that they carefully monitor their figures throughout 2023. But now the real test begins. With the permission of those donors whose share portfolios are stored upon the ShareFinder International servers, these will be monitored over the coming year in the hope that they will all significantly outperform the ShareFinder Blue Chip Index whose current outlook is traced out in the graph below:
Here, it is interesting to note that ShareFinder projects that the months ahead will see South African Blue Chips gaining in value at a very modest annualised rate of 11.3 percent. But do note that this growth rate is in extreme contrast with a projection that the JSE All Share Index will FALL at an annualised rate of 14.5 percent between now and mid-October as traced out in the following graph:
Thus, in contrast, Blue Chips are expected to do better than twice as well as the All Share Index which is seen to be in steady decline for most of this year. Returning to the first graph above, ShareFinder’s artificial intelligence system demonstrably calculates that a Blue Chip recovery has already begun from the negative trend which began in April 2022 and is traced by the falling-wedge formation marked out by red and mauve trend lines.
After cutting momentarily this month below the mauve support line, ShareFinder projects that Blue Chips will continue gaining until late October before beginning a brief retreat. Since, however, the majority of donor participants in the Great Experiment are already mostly quite close followers of my Prospects portfolio, the acid test will be whether they significantly outperform that portfolio. If they do this will be a true miracle which will conclusively prove that some other force other than scientific data analysis has taken a hand in these donor portfolios.
The following graph traces the performance of the Prospects Portfolio since October which makes it clear that the portfolio has to date been unaffected by the stormy undercurrents of South Africa’s recent economic shock waves. The dark green support line underscores a recent compound annual average growth rate of 13.6 percent. So the test will come in the April to July period when ShareFinder senses trouble for the portfolio.
Electricity and load shedding
By JP Landman
Antonio Gramsci had it right: ‘The crisis consists precisely in the fact that the old is dying and the new cannot be born; in this interregnum a great variety of morbid symptoms appear.’
Gramsci was referring to politics in Italy in the 1930s, but the quote also describes Eskom and load-shedding in South Africa in the 2020’s. Load-shedding brings with it the morbid destruction of many small businesses and the merciless disruption of peoples’ lives. Eskom is dying and cannot be saved in its current condition. Electricity provision, however, is not dying. It is important to distinguish between those two, lest we are overwhelmed by morbid symptoms.
Load-shedding
We have load-shedding because South Africa does not generate enough power. The capacity gap is estimated at between 4 000 MW and 6 000 MW. As recently as November, Eskom put the capacity gap at 4 000 MW. Let’s assume the gap is the higher number of 6 000 MW. That is 6 000 MW of base load (ie energy that is available continuously for 24 hours of the day). To produce that from renewables (solar and wind) we need about 18 000 MW of renewable-energy capacity with a mix of storage and gas. That is the first of the new that must be born.
Currently there is about 12 000 MW of solar and wind power in the pipeline – 9 000 MW is being driven by private companies for their own and clients’ use (embedded power) and about 3 000 MW through the official procurement processes run by government (including local government, but the latter is miniscule).
Add 2 000 MW that is being procured through Eskom’s repurposing of land around coal-fired power stations for renewables. The first 6 000 ha of land has been leased out to producers. Another 30 000 ha are available, and the next parcels to be released are at Kusile, Kendal and Newcastle. These sites are already connected to the grid. This initiative became possible after the president raised the level for which a licence is not needed from 1 MW to 100 MW (June 2021) and then abolished it altogether (July 2022).
A further 1 000 MW can be bought from existing independent producers and the Southern African Power Pool under Eskom’s Standard Offer of Purchase. (Although Bloomberg reports that 2 000 MW can be bought under this scheme, let’s tread cautiously and use only half that number.) The standard offer allows Eskom to buy power from existing producers at a predetermined price, approved by the National Energy Regulator of South Africa (NERSA).
All this adds up to 15 000 MW of the 18 000 MW needed to beat load-shedding. There is enough transmission capacity to connect all 15 000 MW to the grid, but the grid will then be ‘full’. (See ‘Transmission capacity’ below.)
How long?
How long before these 15 000 MW are connected to the grid and produce electricity? The time from when proposal is initiated by a developer to final connection is about three years. But many of the MWs referred to above have already progressed beyond the initial stages. In fact, construction has commenced on three projects and six have reached financial closure. (Bloomberg quotes a presidency report that 2 800 MW is ready for construction.) The construction time for a wind farm is typically eight to 14 months and for a solar farm from six to 12 months. Most of the 15 000 MW should be connected by the end of 2024 or beginning of 2025.
So, to plug the load-shedding gap we still need an additional 3 000 MW renewables, or about 1 000 MW baseload. For that we turn to …
Medupi
Yes, yes … I can hear the howls of protest, snorting of disgust and derisory laughs! But let’s just look coldly at the data we have.
Medupi has six units, of which three are in full operation. For the last year they have run above 85% EAF (electricity availability factor). One in fact ran above 92%. The manager there is a 21-year Eskom veteran, Mr Zweli Witbooi. The notion that Medupi can never produce is simply not correct. Flaws can and are being
corrected – of course at huge costs (R19 billion in the case of Medupi).
Two units at Medupi are being modified to deal with carbon emissions and are currently running at partial capacity only. Eskom was denied an emission exemption for Medupi and the modifications must be made. Medupi unit 4 was damaged in an explosion in 2021. The two employees who were investigated for the incident have been dismissed. The unit will be operational by September 2024 and will add 800 MW of base power to the grid. Then we only need 200 MW baseload to plug load-shedding, or about 600 MW of renewables.
… but not Kusile
Kusile also has six units, four of which had been brought into operation by June 2022. Three months later in September an ‘explosion’ took one of the four out of action. In October an ‘accident’ took two more out. Currently only one unit is running. Unit 5 is scheduled to come into operation by December 2023 and unit 6 by the middle of 2024. Some are sceptical that these dates can be met, so it’s better to tread cautiously and exclude any MW numbers from there. If we exclude Kusile, where are we going to find the 600 renewables MWs we still need?
Homeowners to the rescue
Across the country more and more rooftop installations are appearing, which reduce demand on the grid and generate surplus energy that can be fed into the national or a local grid. Industry insiders reckon there is about 3 600 MW of solar rooftop installed in South Africa, with another 1 000 MW being added every year. We are talking more MWs than Kusile’s current production. No doubt that 1 000 MW extra per year is rising. Homeowners can overtake Medupi in a few years.
On the lovely sunny days here in Johannesburg one can use all the electricity one needs and from about noon the batteries are fully charged (ready for load-shedding!). The power generated when the batteries are fully charged simply goes to waste.
A precondition for using that wasted power is a feed-in tariff at which Eskom and municipalities buy from producers. The current state of play is neatly summarised by Engineering News. ‘Eskom already has net-billing tariffs being used by agriculture, commercial and industrial customers (called Gen-Offset). These tariffs provide a credit for energy exported at the same energy rate that the customer pays for consumption. NERSA still needs to approve the residential tariff Homeflex (my emphasis), which will then allow Eskom to offer net-billing to residential customers as well.’
All this is okay for customers directly linked to Eskom, but similar arrangements would have to be made for customers getting their power from local municipalities. Municipalities are not keen to lose a source of income and have in fact launched a court case to declare that only they can distribute power in a municipal area. Municipalities will have to develop a new business model: use their local grid as a resource that can be rented out to power providers – much like a fibre company rents its fibre line out to internet service providers.
At municipalities too, the old is dying and the new is not yet born. The country needs a dedicated energy champion that can drive these issues and push the birth of the new.
In the context of load-shedding there is clearly considerable capacity available on rooftops to help plug the gap.
It can be done
It is clear from adding the above numbers that, between renewables currently in process, the return of units at Medupi and existing solar power on rooftops, the capacity gap of 6 000 MW base load (or 18 000 MW renewables) can be filled, and load-shedding alleviated, albeit only in two years’ time. Equally clear is that if we do not add the additional capacity, load-shedding will persist beyond the two years.
Is there any short-term solution?
All the above adds up to relief by the end of 2024. But what can be done immediately to alleviate load-shedding? The answer is not much.
One option would be to go the dreaded Karpowership route. Dreaded because it involves 20-year contracts, very little permanent infrastructure, and undesirable environmental impact. Emergency power can provide 2 000 MW, equal to two stages of load-shedding. Word on the street is that NERSA has not approved a fee for the Karpowership deal, so let’s see what comes out of the wash in the next while.
The other alternative is diesel, which is dreadfully expensive. For example, R1.1 billion can prevent two levels of load-shedding for 79 hours.
Under both alternatives there will still be load-shedding. There are no quick fixes.
Last year I wrote that load-shedding would be with us for two years until the end of 2024. This is where we are now. I do not see a quick way out.
The mirage in the desert
There is, however, a school that argues that load-shedding is not about the lack of capacity, and that Eskom has more than 44 000 MW of installed capacity. If only the place is properly maintained and managed, all the country’s needs could be met. This school wilfully ignores the EAF (energy availability factor) history of Eskom.
During the last financial year (to March 2022) Eskom ran at an EAF of 58,6%. For the coal fleet, the EAF was a mere 55,5%. In the current financial year, measured to October 2022, the coal fleet’s EAF fell to 53,9%. Only two of Eskom’s 14 power stations run above a 70% EAF. I will write that again. Only two of 14 stations run above 70%.
To say Eskom can be fixed in six to 12 months is simply wrong.
Eskom’s power stations ran at an EAF level above the global average, as measured by VGB in Germany, until 2011. (VGB is an international association of companies from the electricity and heat supply industry.) Remember, in the early 2000s Eskom was voted the best utility in the world. Since 2011, now eleven years ago, the Eskom EAF decoupled from the global average. The latter is now running at 75% while Eskom is at 53,9%. It is a big gap and speaks to the fact that a lot of the 44 000 installed capacity at Eskom is old and decrepit. Exclude Medupi and Kusile and the average age of the Eskom stations is more than 40 years – past their sell-by date. Add poor maintenance since about 2008 and the result is what we now have: highly unpredictable plant performance; continuous multiple failures; a low EAF and load-shedding. Eskom has been in decline for 11 years; it is not going to be fixed in 11 months. Those proclaiming this are chasing a mirage in the desert.
The new is still to be born
The age of the Eskom plants combined with poor maintenance mean that many will be closed in the near future. Komati was the first to go last year. Hendrina, Camden and Grootvlei will follow over the next four years. Four more stations will follow thereafter. In total, eight of Eskom’s 14 stations will close down over the next decade. Add adherence to minimum emission requirements and more plants may close quicker.
Closing all those plants means many thousands of MWs will be retired. Not only will this be replaced, but a lot more will be added. Some 53 000 MW of renewables is to be built over the next 10 years, together with some gas and probably some nuclear. It will involve many billions in investment, creating an investment boon for South Africa (See Green is the new gold of August last year.) That is the upside to all this mess. The old system of electricity is dying and the new is still to be born. We are caught in the interregnum.
Transmission capacity
In December it became very clear that the current South African grid has reached the end of its tether and cannot accommodate more renewable producers. Only 860 MW of the 4 200 MW in Bid Window 6 could be accepted. (That 860 MW is part of the 15 000 discussed above.) There were 56 bidders in the round (indicating how keen people are to invest) and only six were eventually accepted (indicating the wasted opportunity). It was a big disappointment – in fact a fiasco, which reflects poorly on all the official energy players. The dirigiste nature of our energy system is often justified with the argument that it allows for coordination. So where was the coordination to prevent this mishap?
How did this happen?
Essentially companies in the private sector who built generation plants outside the bid windows snapped up the available grid space before Bid Window 6 was concluded.
Currently South Africa is running two energy procurement systems simultaneously. The one is an official process by the Department of Energy involving bid windows; the other is a private process where companies or investors go ahead and build plants for their own and others’ use. This creates a problem because players under both systems use the same grid. Eskom is bound by its transmission licence to provide non-discriminatory access to the grid. It looks like Eskom used a ‘first come, first served’ basis. Clearly what is needed is a queuing system that can balance bid windows, private developers, shovel-ready and environmentally friendly projects.
In fairness, this is new territory for everybody. The official procurement system is slow, bureaucratic, and very dirigiste. Alongside this, a market in electricity is developing with fleet-footed private players. (Private companies have 9 000 MW in the pipeline and Bid Window 6 had 4 200 MW). These two systems must be integrated and managed as one. It is part of the interregnum we find ourselves in: the old system is dying, the new one has not been fully born yet.
How to get out?
The only way out is to throw money at the problem, i.e. a serious investment in grid capacity. Eskom’s Transmission Development Plan for 2023 to 2032 (released in October) shows that over the next five years 12 100 MW of additional grid capacity can be unlocked from 23 transmission projects in the north-eastern part of the country (Mpumalanga, Limpopo, the Free State, North West and Gauteng). A total of 4 500 MW can be unlocked through 13 projects across the Eastern, Western and Northern Cape provinces. These projects will involve 2 890 km of high-voltage lines and 60 transformers, requiring a capital investment of R72.2 billion by 2027.
In short, R72 billion of transmission investment can unlock 16 600 MW of grid capacity. In the Just Economic Transition Investment Plan (JET IP) R131 billion is budgeted for grid upgrades (see December’s COP 27 and South Africa). President Ramaphosa has emphasised that the first money from the JET IP will indeed go to grid upgrades.
As announced by the President in 2019, Transmission is being set up as a company distinct from Eskom. It has been registered as the National Transmission Company (NTC), and a binding agreement with suspensive conditions has been signed to transfer the assets and liabilities from Eskom to the NTC. Eskom’s creditors must give their consent for this transaction and that is still outstanding. If all the substantive conditions are met, the NTC can start operating independently by April 2023 (the new financial year). Last year Transmission (still a division of Eskom) made a net profit of R1.6 billion. It had assets of R80 billion and liabilities of R19,5 billion. With an injection of climate change funds, it can expand its activities considerably.
Upgrading the grid and building a stronger transmission company is part of the new that must be born.
So what?
- Since April 2018, when the then new Ramaphosa government reinstated the renewables contracts cancelled by Brian Molefe, government has introduced several changes to energy policy and practice, but it never got on the front foot. Load-shedding kept getting worse and government remained on the backfoot. The reality on the ground is running faster than government.
- Load-shedding will be with us for two years (as I wrote last year) and there are no quick fixes however many marches and court applications there are.
- It is imperative that the projects in the pipeline are concluded and not delayed, whether they are under a bid window, from private developers or under the Eskom repurposing and standard offer schemes. A delay in any of these will perpetuate load-shedding beyond two years.
- It is equally imperative that a feed-in tariff be agreed and announced, and that climate change funds are used to expand and upgrade the grid. We cannot take our eye off the ball that 50 000 MW more capacity is needed to position South Africa for the future.
- To drive these changes the country needs the right political leadership regarding energy. We do not have it now.
Inflation? What inflation? Why a soft landing is very possible
Professor Brian Kantor
Investec Wealth & Investment
The evidence shows that there has been no inflation in the US for six months.
There’s an old military adage that generals often end up “fighting the last war”, taking little account of how the battlefield may have changed. A similar observation may be made about central bankers, notably the Fed, who continue to concentrate on a danger that has passed.
Recent US data show that there has been no inflation in the US for six months. The headline inflation rate in the US peaked at 9.1% in June last year. It fell rapidly and was 6.5% in December 2022. Month-on-month increases in the price level slowed down significantly after June. Month to month, the consumer price index (CPI) is now falling.
In short, the index was no higher in December than it was in June. Seasonally adjusted, it was only slightly higher over the six months and both versions of the CPI fell in December (see figures 1 and 2 below).
Figure 1: US headline inflation 1970-2022
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment, 12/01/2023
Figure 2: The US CPI, unadjusted and seasonally adjusted, monthly percentage change from January 2021 to December 2022
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment, 12/01/2023
The convention of measuring inflation as the year-on-year growth in the CPI has not helped to understand the inflation dynamics under the currently unusual and volatile circumstances. Six months can be a long time for an economy. Waiting a year to see what happens may be too long for a business or a central bank to make a judgment and adjust accordingly. If these monthly increases in the CPI remain at these levels for another six months, the headline inflation will recede to close to zero by June.
There is no good reason to expect a reversal of these trends, absent any new supply-side shocks to the economy over which the Fed has no influence. They should be ignored by the Fed because they are temporary and can reverse, just as the post-Covid supply side shocks have now reversed.
The demand side of the US price equation will not pose an inflationary danger if recent subdued trends in spending and the money supply (and bank credit) are maintained. Real private consumption expenditure, which accounts for 70% of all spending in the US, has not increased since the second quarter of 2021. The US money supply is now lower than it was in early 2022. Without any sharp reversal of short-term interest rates, any pick-up in aggregate demand seems unlikely. Any further and likely increase in interest rates will depress demand further.
The Fed has done what it needed to do to control inflation and that was to contain increases in aggregate spending. The absence of further growth in the money supply and bank credit in 2022 has helped, with higher prices themselves, to restrain the growth in real private consumption expenditure (PCE). Other measures of economic activity, for example, the monthly surveys of activity in the manufacturing sector and now also for the service sector, indicate that the US economy is shrinking.
The cause of higher prices is typically the result of too much demand (relative to constrained supplies of goods and services) and will inevitably be the result of excessive money supply growth. The effect of higher prices, as it has in the US, is to restrain volumes of goods and services demanded, reduce real disposable incomes, and will limit further price increases, provided no more money is pumped into an economy, which is the case in the US.
Figure 3: US Real private consumption expenditure and growth
Source: Federal Reserve Bank of St Louis and Investec Wealth & Investment, 12/01/2023
Unfortunately, the Fed greatly underestimated inflation and its persistence on the way up and has almost as egregiously overestimated it on the way down. One hopes for the sake of the US economy and its financial markets that the Fed will recognise that inflation is down, possibly out, for the foreseeable future, and that they will react accordingly.
There seems to be no good reason for the Fed to risk a recession to maintain low rates of inflation in 2023 by raising interest rates further. The Fed should rather be reducing them, given the likely state of the US economy. Nor should the Fed frighten investors and businesses about such possibilities, given the inflation outlook. The fright has been severe enough to remove trillions of dollars off the value of US equities, government and other bonds. There is good reason for the Fed and the market to expect satisfactorily low rates of inflation in 2023. On the current evidence of inflation and its causes, the Fed’s guidance should be on the likely and reassuring prospect of a soft landing.
Deficits Forever
By John Mauldin
“Diamonds are forever,” according to the jewellery industry. That may be a slight exaggeration, yet diamonds will certainly outlive you and whomever you give them to.
Debt isn’t forever but can definitely seem like it. That feeling is a clue you have too much debt. Wisely used, debt helps build income-generating assets that pay for themselves. The payments are manageable because you’re also getting something else of value. On a national level, though, we’re not investing in the future. We use debt to fund routine government services, long-promised benefits like Social Security and interest on all of it at the highest rates in decades.
Anyone who has ever been over their head in debt can testify how paralyzing it is. You become ultra-cautious, unwilling to take risks because even a small mistake can be catastrophic. The same can happen (and has happened) to entire countries when the government gets over its head. Sovereign defaults—or the fear of them—lead to austerity for everyone.
The United States has so far avoided that fate because we have unique advantages: the largest economy, the global reserve currency, military strength. Yet even with those, we face limits. No one is going to foreclose on the US Treasury but at some point, they will become less willing to lend it more cash. Long before then, the debt will suppress economic activity enough to force the changes voters and politicians have been unwilling to make. Today we’ll look at the latest federal budget data and see how much time we have.
In the event you missed the interview with Keith Fitz-Gerald I mentioned last week, you can still click here to watch (transcript version also available at the link).
In this wide-ranging interview with Ed D’Agostino, Keith discussed his 2023 market thesis, inflation, Fed policy, as well as big picture risks and opportunities he sees. It’s a great primer on Keith’s current thinking.
Mandatory Madness
Here is an updated version of the budget chart I’ve been sharing occasionally since 2016. It uses data from CBO’s 10-year spending and revenue projections. As noted in that earlier letter, CBO makes numerous assumptions in projecting these numbers. For one, they don’t try to forecast the fiscal impact of recessions, which is why you see the lines get jagged around 2008 and 2020. CBO also has to assume current laws and tax policies will remain unchanged for the next decade, which certainly won’t be the case.
The new data shows some subtle but important differences. Adding 2033 shows, for the first time, mandatory spending plus defense consuming all tax revenue. It also shows how that mandatory spending drives the train. The other three spending categories (defense, non-defense discretionary, and net interest) show only minor projected growth, except for net interest. (I say “minor” ironically because they’re still vast sums of money.) The mandatory spending accounts for most of the spending growth, and most of that is Social Security and Medicare as the rest of the Boomer Generation reaches retirement age.
Just eyeballing the chart, you might see an appealing solution. If we could just return spending to 2019 levels and keep tax revenue where it is, the budget would balance and we’d have a surplus to begin paying down the debt. But that would require benefit cuts for current retirees, not just future ones. There is no political will to make benefit cuts. Franklin Roosevelt, when offered the opportunity to means test Social Security, flatly rejected it. He wanted everyone to feel they had “skin in the game.”
In reality, each one of those annual deficits (i.e., the amount above the tax revenue line) adds to our already-giant debt load. Here is the latest CBO summary table.
Source: CBO
Not so long ago I was lamenting the idea we would have $30 trillion in debt by 2030. Now that’s officially projected to occur in 2026, reach $40 trillion five years later, and approach $50 trillion in the mid-2030s. The debt is doubling roughly every 10 years.
Watching these 10-year forecasts develop over time, I have learned they understate reality. CBO’s January 2016 report, which we used to make the very first version of the above chart, showed the debt reaching $23.8 trillion 10 years from that point (i.e., the end of 2026). It’s only 2023 and CBO now projects $30.9 trillion for 2026. Their 10-year projection underestimated the debt by 30%.
That’s not a knock on CBO. It doesn’t know the future and certainly didn’t know COVID was coming. It’s bound by inherently uncertain assumptions. The point is these numbers, however bad they look, probably don’t look nearly as bad as reality will.
We aren’t going to get through the next decade without some other kind of fiscal catastrophe, whether recession, war, pandemic, or something else. And whatever it is will aggravate a bunch of already-terrible problems.
Who Holds the Debt?
This brings up a personal pet peeve that I have with the CBO data. It shows debt in terms of debt held by the public. But that is not all the debt the US owes. There is the debt held by the Federal Reserve and various government agencies (like Medicare, Social Security, the highway trust fund, and so on).
If you include this other debt, you get $31.5 trillion. Here is that debt helpfully displayed from US Debt Clock (a very cool site full of data you can drill down on by clicking the numbers). Further, the off-budget debt is really hard to find. That averages about $269 billion a year but can vary wildly.
Source: US Debt Clock
Some argue that debt held in the Social Security trust fund should not count. We owe it to ourselves. I shouldn’t have to restate it, but there is no Social Security trust fund. It is an accounting fiction because that money has already been spent, and part of why we have “off-budget” debt and deficits.
Let’s look at that “we owe it to ourselves” line of thinking. In one sense it is actually true, but we still have to repay it. The accounting fiction that is the Social Security trust fund will slowly dwindle as we are now paying out more in Social Security benefits than we are receiving in Social Security taxes. The same with Medicare and other such pools.
You can make an argument that money held by the Fed should not be counted, but it is rolling off that Treasury debt even as we speak. How much will it reduce the balance sheet? No one, including officials at the Fed, knows. But it is not nothing.
Let’s look at the actual debt owed as of the end of the fiscal year 2022 (ending in September 30) from the US Treasury website. It goes back five years in this table. As above, we now have $31.5 trillion in debt and rising. That means in the last five years we have added $10 trillion to the national debt. Yes, a lot of it was pandemic relief, but a lot was also budgeted deficits which were pushing $1.5 trillion. So we were on course for adding $6 trillion even without the pandemic.
Source: US Treasury Department
We will explore what the debt will really look like in a minute but first let’s look at spending growth.
Spending Growth
You may notice I describe all this in dollar terms, unlike many analysts who measure the debt as a percentage of GDP. I do this on purpose, partly because dollars are what people know. I find using familiar terms helps people see the situation more clearly.
But more important, GDP is itself an artificial construct that doesn’t necessarily measure the economy. There was a large debate in the 1930s on whether or not to include government spending as part of the GDP. More conservative economists noted that counting government spending merely double counted the same dollar that went from private to public sources. Yes, government spending does influence GDP in that it provides salaries and other stimulus. If that money had been left in private hands, it would have been used differently, and maybe more productively when directed by private citizens.
Further, we do not know what GDP will be in the future, so using it in budget projections adds yet another assumption.
That said, expressing debt as a percentage of GDP does simplify historical comparisons to periods when the economy was smaller. It also helps when comparing one country’s debt to another’s. On the debt clock website, you can look at the upper right-hand corner and click on world debt clocks for various countries. You’ll find that Japan has 296% debt to GDP, Italy has 171%, and Russia has the lowest debt in this analysis at 26%. Helpfully, you can also see their external debt (non-government) to GDP, which is a real eye-opener, and maybe a topic for a future letter. But back to the US.
This chart from CRFB (Committee for a Responsible Federal Budget) draws on the same CBO data but expressed in GDP terms. The differences are instructive, so let’s look closer.
Source: CRFB
The lower line shows revenue and the upper one spending; the gap between them is the yearly deficit. The red dashed lines are the CBO’s previous projections as of May 2022. They proved pretty close on revenue but significantly underestimated spending, in part due to the infrastructure legislation Congress passed last summer.
Comparing this to my chart that uses dollars, the spending growth from 2023‒2033 doesn’t look nearly as dramatic. That’s because CBO also assumes GDP is growing at the same time. It also shows revenue growth flattening as a percentage of GDP while spending keeps rising. Hence the growing debt.
CRFB’s latest debt analysis covers the highlights pretty well, so I’ll quote them and then give you my quick reaction.
“Debt [held by the public –JM] is on course to reach a record 118 percent of GDP by 2033. CBO projects debt held by the public will grow $22 trillion over the next decade, breaching $46 trillion by the end of Fiscal Year (FY) 2033. Debt will grow from 97 percent of Gross Domestic Product (GDP) in 2022 to 118 percent by 2033; it could grow to over 130 percent of GDP if policymakers extend various expiring policies.”
As bad as this sounds, it is quite a bit better than Japan, where the public debt is presently 296% of GDP, much of it held by the Bank of Japan. Debt service consumes about half of Japan’s government tax revenue.
But before you think that’s good news, keep in mind Japan runs a large trade surplus, which is one reason it has much higher savings rates. The US has a structural trade deficit because our main “export” is really the US dollar. We don’t have the kind of domestic savings needed to support Japan-like debt levels.
“Deficits will double from $1.4 trillion today to almost $2.9 trillion by 2033. Deficits will total 6.1 percent of GDP ($20.3 trillion) over a decade and reach 7.3 percent of GDP by 2033—the highest ever outside of a national emergency.”
Note that last part. There are times, true emergencies, when governments need to run large deficits. Preserving the capacity to do so means you can’t let large deficits become normal. Yet that’s what we have done, and I fear it will become a giant problem in ways we don’t yet foresee.
“Spending on health, retirement, and interest will grow rapidly while revenue fails to keep up. Spending will grow from 23.7 percent of GDP in 2023 to 25.3 percent by 2033, while revenue will fall to a low of 17.4 percent of GDP in 2025 before rising to 18.1 percent in 2030 and beyond. Interest costs alone will reach a record 3.6 percent of GDP—$1.4 trillion—by 2033.”
All that, of course, assumes that the CBO headline numbers will be what plays out. But if you drill down you find that the confidence level on those numbers is rather shaky. The CBO website has a number of very interesting charts in one convenient place.
“CBO’s projections of economic output and labour market conditions are subject to a high degree of uncertainty. In the short term, the effect of higher interest rates on overall demand, the easing of supply-chain disruptions, and participation in the labour market could be larger or smaller than expected. In the longer term, the growth of potential output in the aftermath of the pandemic could be faster or slower than expected.”
Source: CBO
The CBO estimates an approximately two-thirds chance that the annual rate of real GDP growth will be between -1.5 percent and 1.7 percent in 2023 and between 0.7 percent and 3.6 percent in 2027. Note, they never project a recession in the out years, for reasons that are partly political but mostly because they justdon’t know. While I disagree with some of the CBO’s assumptions (who doesn’t?) its analysts do the best they can in a very difficult job.
Spending growth is a problem, but no one is seriously talking about a solution. Most are more focused on protecting the particular spending they like, whether it be social programs or defence. Nor are many talking about how to close the gap by raising revenue in sensible ways like a VAT tax. As with spending, most view tax policy as a way to reward their friends and/or punish their enemies.
Meanwhile the debt keeps growing and the cost of that debt—interest—keeps rising. From 2008‒2021 we became accustomed to abnormally and artificially low interest rates. That era isn’t coming back, meaning the same amounts of debt are far less feasible now.
Here is a table we made to summarize the CBO’s latest scenario:
Now let’s modify that with some different assumptions. I think the debt is going to contribute mightily to a slowing growth in GDP, which will reduce tax revenues but not do much to spending. Further, history shows that spending growth will just increase, whether from Congress or from inflation. So, what if we have less revenue and more spending?
Let’s assume (and I truly hope this proves to be an exaggeration) that spending will rise 5% more than CBO projects, and revenues will be 5% less than CBO projects. Plus, we’ll add the same off-budget spending number we’ve used before. In that scenario, debt held by the public jumps to $54 trillion in 2033.
And here is a line graph comparing CBO with this alternate scenario. Add in the off-balance sheet debt of about $6.5 trillion and you get to $61 trillion in 2033.
As noted above, the CBO cannot assume, because they don’t know, any negative economic problems in the future. None of us know what’s coming, but experience says we shouldn’t expect a smooth ride over the next 10 years.
Sometimes I wonder what it must feel like not to care about all this. I really don’t enjoy being a budget scold, partly because we are a dying breed. It is getting lonely in my worry closet. Very few people truly care about government debt anymore, and even the number who pretend to care about it is shrinking, especially in Washington, DC, and Congress. And almost no one even talks about the drastic changes it would take to actually balance the budget—much less begin paying down the debt.
I titled this letter “Deficits Forever” because, unfortunately, I think that’s probably what will happen. And that might be okay of we could at least keep the deficits somewhat smaller and more stable. That doesn’t seem to be in the cards, though. We are going to reckon with this debt for a long time.
My friend Neil Howe is working on a new book, “The Fourth Turning Is Here.” I’ve been privileged to read the first draft. As long-time readers know, I’ve been fascinated with Neil’s work, and maybe that influences me when I talk about The Great Reset. But I do see a period of turmoil coming. The good news is the Fourth Turning will give way to another, far more upbeat era. We just have to endure a rather bumpy ride first.
It’s not the end of the world. While I don’t think that period will truly be what I think of as “Muddle Through,” we will in fact get through it. If you pay attention, you can probably do quite well. But we will not be able to rely on past performance to manage our portfolios. Hope is not a strategy.
I have no idea how we should be positioned today for something that will happen in 7 to 10 years. I have no idea who will be in charge of Congress, what the situations will be, etc., but we will have options. Stay tuned.
