The Deficit, the Election and Interest Rates

Subscribe to the Notes on the Week Ahead newsletter to receive it directly in your inbox. Listen to the podcast on Apple Podcasts and Spotify.

Growing up in Dublin, I had a well-earned reputation as a child of very healthy appetite. At birthday parties, I’d always make sure, at the outset, to get my share of any cocktail sausages, cucumber sandwiches or Rice Krispie treats going around. When it came time for cake and ice cream, I made sure my plate was amply stocked. And I know my mother was filled with pride, (and the other young mothers equally filled with envy), as her little man waddled back up to the table in search of seconds.

But even I had my limits. I vaguely recall a rather distressing incident on the car ride home from one of these parties. I won’t go into the sordid details – suffice to say that the upholstery in the back of the car neither looked nor smelt quite the same thereafter.

I have a similar foreboding about federal deficits. For decades, I have tended to downplay the risks from a rising tide of red ink, reasoning that the world has always shown a very healthy appetite for U.S. Treasuries. However, adding the extraordinary promises being made on the campaign trail today to the already alarming trajectory of future deficits, puts the federal debt on a path that may prove too much, even for global capital markets. The risk is already there – and the results of next month’s federal elections could increase that risk.

For investors, it is important to keep an eye on this issue, since, if fiscal recklessness finally causes a meaningful spike in Treasury yields, all financial assets could take a hit.

The Deficit – Where it Stands and Where it is Headed

Within the next week or two, the Treasury Department will release official figures for the federal budget deficit for fiscal 2024, which ended on September 30th. However, thanks to the bean counters over at the Congressional Budget Office (or CBO for short), we have a very good idea of what those numbers will be. In their monthly budget review for September[1], released last Wednesday, they estimated a total deficit of $1.834 trillion for fiscal 2024, up from $1.695 trillion in fiscal 2023. We won’t get official data on third-quarter GDP until October 30th. However, based on our own estimates, we believe that the deficit equaled 6.4% of GDP in fiscal 2024, with the federal debt in the hands of the public climbing to 98.2% of GDP.

These numbers are, of course, extraordinarily high. However, even under current law, which assumes the expiration of many of the tax cuts from the 2017 Tax Cut and Jobs Act (or TCJA) at the end of next year, the CBO estimates[2] that deficits will average more than 6% of GDP over the next decade and that the federal debt will climb to over $50 trillion, or 122.4% of GDP, by fiscal 2034. And all of this could be impacted by the elections.

Election Probabilities

Before going any further, it is useful to consider the potential configuration of the government after November 5th. Technically, with the presidency, the Senate and the House all in play, there are eight possible configurations, ranging from a Republican Sweep to a Democratic one. This could even be extended to 10 configurations since, as practical matter, a landside sweep could have very different implications from a narrow one. As both Donald Trump and Joe Biden found out, a narrow majority in the Senate provides no guarantee that you can achieve your domestic agenda.

Having said this, a number of scenarios are more likely than others. The presidency itself is currently an absolute tossup. However, even if Vice-President Harris becomes president, the Democrats would likely have to hold a seat in Montana to retain control of the Senate – something current polling suggests is unlikely. If former President Trump were to win, the Democrats would have to hold that seat and pick up another one to retain control of the Senate, since J.D. Vance, as the vice-president, would have a tie-breaking vote in the Senate.

Conversely, if Harris wins the popular vote for president, it would be difficult for Republicans to retain control of the House. In the 2022 House elections, Republicans won 50.0% of the vote compared to 47.3% for the Democrats and ended up with 222 seats to the Democrats 213. However, most of the narrow races were won by Republicans. If Republicans had uniformly polled 1% less and Democrats 1% more – i.e. a Republican victory in the popular vote of 49.0% to 48.3%, the House results would have been exactly flipped – 222 Democrats to 213 Republicans. Unless Democratic House candidates significantly underperform Harris, a popular vote victory for Harris, even if she loses the presidential race, should mean the House goes Democratic.

All of this being said, while divided government looks like the most likely scenario today, there are serious doubts about the quality of polling. In addition, with three weeks to go before election day, there is every possibility of some event occurring that could nudge the race in one direction or another. One party rule in 2025 remains quite possible.

Deficit Scenarios

So what would different election outcomes mean for the deficit? The Committee for a Responsible Federal Budget[3] (or CRFB for short) published some estimates on just this question last week, as they examined the policy proposals of the Harris and Trump campaigns.

The Harris Plan, as they assessed it, included:

• Extending the Tax Cut and Jobs Act tax cuts for households earning less than $400,000
• Expanding child and earned income tax credits
• Enhancing the Affordable Care Act
• Establishing a $25,000 first-time homebuyer tax credit
• Exempting tips from income tax
• Raising the minimum wage
• Increasing spending on Pre-K and child care
• Increasing the corporate income tax rate from 21% to 28%
• Increasing taxes on capital gains and dividends for households earning over $1 million a year and taxing unrealized capital gains for households with more than $100 million in wealth

All told, as a middle estimate, the CRFB estimates that the Harris plan would boost the debt by $3.5 trillion over a decade, relative to the CBO baseline, taking the debt to 133% of GDP by 2035.

The Trump Plan, as they assessed it, included

• Extending all the Tax Cut and Jobs Act tax cuts
• Removing the $10,000 state and local taxes (SALT) deduction cap
• Exempting overtime income from taxes
• Exempting tips from taxes
• Exempting social security benefits from taxes
• Cutting the corporate income tax to 15% for domestic manufacturers
• Providing tax credits for first-time homebuyers
• Securing the border and deporting unauthorized immigrants.
• Eliminating the Department of Education, and,
• Imposing a universal 10% tariff on all imported goods and a 60% tariff on goods from China

All told, as a middle estimate, the CRFB estimates that the Trump plan would boost the federal debt by $7.5 trillion over a decade relative to the CBO baseline, taking the debt to 142% of GDP. This estimate dose not include the cost of making auto loans tax deductible as this proposal was made after they had conducted their analysis. As a rough estimate, this could add another $400 billion to federal debt over a decade taking the total cost of the Trump plan to $7.9 trillion.

Impacts on Growth, Inflation and Interest Rates

It should be emphasized that many of the proposals from both candidates would likely not be implemented with divided government. That being said, tariff proposals, in particular, could likely be implemented without Congressional approval. In addition, in all potential post-election scenarios, most of the 2017 Tax Cut and Jobs Act tax cuts would likely be extended and even a divided Congress might find it hard to resist politically popular measures such as eliminating taxes on social security and tips. Finally, it should be noted that these estimates make no provision for the impact of any recession or any new war.

And then there is the question of how all of this could impact the economy.

First, it should go without saying that the economy does not need fiscal stimulus. The unemployment rate has been close to 4% for almost three years, indicating an economy at full employment. An extension of the tax cuts in the TCJA wouldn’t really amount to fiscal stimulus since these tax rates are already in place. However, any additional tax cuts or spending increases would. In a full employment economy, this extra demand wouldn’t add to output – it would add to inflation.

Second, any attempt to partially fund tax cuts through tariff increases would also fuel inflation through higher import costs, while the recessionary impact of retaliation for tariffs could slow the economy, eroding the tax base.

Third, the Federal Reserve would likely respond to higher inflation by raising short-term interest rates, further slowing the economy and raising net interest costs for the government. A president could, with the approval of the Senate, gradually replace Fed governors with ones more willing to maintain low interest rates. However, this could help undermine the confidence of global financial markets in U.S. Treasuries and the value of the U.S. dollar.

Finally, the sheer size of the annual shortfall in revenue relative to spending could hurt investor confidence. In fiscal 2024, the federal government raised 73 cents in revenues for every dollar it spent. By fiscal 2035, under the CFRB’s middle estimate of the Harris plan, that would fall to roughly 67 cents – under the Trump plan it would fall to roughly 61 cents. Global investors might well worry that a government that was so incapable of funding its own operations might not be trusted to pay interest on its debt.

All of this could mean a significantly higher level of interest rates than the 3.9% average 10-year Treasury yield assumed over the next decade in the CBO baseline estimates.

Investment Implications

On Friday, the S&P500 closed at an all time high, continuing an exceptionally positive year for U.S. investors. However, in the midst of great returns, many investors have become more and more concentrated in U.S. large-cap equities, underweighting all other asset classes.

I’m often asked why, given the long-term outperformance of large-cap U.S. stocks, investors should bother with any other assets at all. The trajectory of our debt and our cake-and-ice-cream politics constitute a very good reason. If soaring debt leads to higher inflation, investors could benefit from having more real assets in their portfolios. If deficits eventually lead to higher taxation, particularly on wealthier individuals, tax smart strategies will be more important. And if fiscal recklessness finally leads to spiking U.S. interest rates and a falling dollar, international investments could help balance portfolios.

In short, the November elections could well result in a further sharp deterioration in the outlook for the federal finances, with the potential to inflict serious long-term damage on bonds, stocks and the dollar. That being the case, investors may want to focus on achieving greater balance in their portfolios, in case global financial markets can finally no longer stomach America’s lack of fiscal discipline.

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.”).

[1] Monthly Budget Review, September 2024, Congressional Budget Office

[2] An Update to the Budget and Economic Outlook, 2024 to 2034, June 2024, Congressional Budget Office

[3] The Fiscal Impact of the Harris and Trump Campaign Plans, October 7th, 2024, Committee for a Responsible Federal Budget