Last week, interest rates moved higher, stocks moved higher and earnings moved higher.

The headline this past week read, “Budget Deficit Declines from Prior Year.” However, the real story is more sobering. After a record budget deficit in 2020 of $3.2 trillion, we incurred the second highest budget deficit of $2.8 trillion this past fiscal year, which ended September 30th. In other words, we spent a lot more money than we took in through taxes.

The cumulative deficits are funded through issuance of U.S. Treasury securities, and our public debt now totals $28.4 trillion according to the U.S. Treasury. The speed at which the debt was accumulated has been startling. It took roughly 230 years for our country to accumulate $9.9 trillion in public debt but only 13 years to accumulate another $18 trillion. Since 2017, we have added an astounding $8.3 trillion to the national debt.

What does this mean?

1. Interest expense on the federal debt has been relatively stable at $300 billion over the past several years; however, with higher debt, there is a higher burden to pay the interest on the debt outstanding. The Congressional Budget Office is projecting that the annual interest expense will grow from the current level of $331 billion to $910 billion by 2031. Higher interest expense reduces budget dollars that can be allocated to other parts of the budget, such as social security, Medicare, Medicaid, or defense.
2. The higher debt burden and interest burden reduces the nation’s flexibility to respond to national emergencies. At the current level of net public debt and an economy that is roughly $22.7 trillion in volume, the United States is roughly at 103% debt to GDP ratio. The cost to keep the economy moving through the pandemic was nearly $5 trillion.
3. To the extent that the deficit spending produced a surge in demand, a surge in the rate of inflation is a risk if there are supply imbalances. The current supply chain disruptions are contributing to a surge in inflation, which we expect will persist through next year. This, in turn, erodes the purchasing power of the dollar and investment returns. With the yield on the 10-year U.S. Treasury at 1.65% and inflation running near 4%, the real rate of return on the Treasury note investment is -2.35%.
4. Congress is looking to produce a $3 trillion stimulus bill that will allow for additional spending. In order to balance the cost, we expect higher taxes. In addition to higher income taxes and a minimum corporate tax, for the first time, there is discussion around a “wealth tax” in which unrealized capital gains would be taxed.

Equity

The S&P rose 1.6% to 4,545 as the index hit all-time highs on continued strong earnings reports. The financials and health care sectors both rose over 3% for the week, as big banks and pharmaceutical companies highlighted strong quarters and guidance. These sectors pushed the index to a year-to-date performance of 21%. Last week, JP Morgan, Goldman Sachs, Morgan Stanley, and Wells Fargo all had big beats over expectations. This week, we got insight into the health care sector through Johnson & Johnson.

Johnson & Johnson [JNJ]
JNJ reported earnings of $2.60 per share vs. $2.35 expected on revenue of $23.34 billion, which slightly missed estimates. The company did increase full year guidance to $9.80 per share from previous estimates of $9.65. JNJ also maintained their Covid vaccines sales outlook of $2.5 billion. The consumer unit reported sales of $3.7 billion, up 5% year-over-year. The pharma business rose 14% to $12.9 billion, and the company’s medical device unit rose 8% to $6.6 billion. The miss on revenue was mostly due to the Covid vaccine and its medical devices unit, with a lot of unknowns in elective procedures due to the delta variant. Shares rose over 2% on the day.

Netflix [NFLX]
Netflix reported earnings of $3.19 a share vs. $2.56 expected. Revenue was in line with estimates at $7.48 billion. Global paid net subscriber additions were 4.4 million, which beat estimates by 500k. The subscriber beat was expected, with a large amount of recent new content releases that were originally delayed due to the pandemic. Netflix expects to add 8.5 million subscribers in the fourth quarter. Top shows of the quarter include Squid Game, which was the streaming platform’s biggest TV show ever. Over 142 million households globally watched the show in its first 4 weeks. Shares fell about 1%, although much of its recent success has already been priced in as the stock surged 25% in the last 2 months to all-time highs of $640.

Intel [INTC]
Intel reported earnings of $1.71 versus $1.11 expected. However, revenue of $18.1 billion missed expectations. Intel operates in two segments, client computing and data center. Client computing, the larger segment, was down 2% year-over-year to $9.7 billion, due to lower laptop volumes because of the chip shortage. The Data Center Group reported $6.5 billion in sales, which was up 10% from last year, but still fell short of expectations. The company fell 11% on its revenue miss and continues its struggle as it is underperforming the S&P by 20% for the year.

The upcoming week for earnings is busy, as 30% of the S&P is scheduled to report, including tech giants Apple, Amazon, Microsoft, Alphabet, and Facebook. Earnings have been strong thus far, with 84% of companies beating expectations. Earnings growth is expected at 35% year-over-year. However, we have also seen big misses with companies like Intel and Snapchat. Intel fell 11% and Snapchat tanked 25% on their earnings reports, which could foreshadow trouble for advertising heavy companies such as Facebook and Twitter this week.

Fixed Income

The levered loan market grew beyond $1 trillion in 2019, surpassing the size of the publicly traded high yield bond market. We have continued to see the lending market move further away from bank and towards private markets. 2021 has been a record issuance year for Collateralized Loan Obligation (CLO), the largest buyer of levered loans. CLO issuance is expected to reach $200 billion in 2021, almost doubling the issuance in 2020. The strong demand for CLO’s have come on the heels of investment grade and high yield bond spreads collapsing to record tight levels. CLO’s receive high credit ratings due to their pooled structure. We believe investors should be careful investing into CLO’s. While the ratings seem high, the underlying loans that are bundled together are typically riskier and possess correlated risk. Correlated risk is precisely what caused the mortgage backed crisis in 2008. However, default rates across the levered loan market proved resilient through the Covid-19 pandemic. The asset class also benefits from a generally floating rate structure, meaning it would weather a rising interest rate environment much better than traditional bonds. While we generally think the asset class has value, CLO’s should only be invested in by investors willing to do the extra work to understand the structure and underlying credit of what they are investing in.

This report is published solely for informational purposes and is not to be construed as specific tax, legal or investment advice. Views should not be considered a recommendation to buy or sell nor should they be relied upon as investment advice. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Information contained in this report is current as of the date of publication and has been obtained from third party sources believed to be reliable. WCM does not warrant or make any representation regarding the use or results of the information contained herein in terms of its correctness, accuracy, timeliness, reliability, or otherwise, and does not accept any responsibility for any loss or damage that results from its use. You should assume that Winthrop Capital Management has a financial interest in one or more of the positions discussed. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Winthrop Capital Management has no obligation to provide recipients hereof with updates or changes to such data.
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