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Nothing but a Congressional comb-over

July 29, 2011: 11:14 AM ET

Even when a compromise is reached, the current bills proposed to lower the deficit are merely covering up long-term budget deficit issues that will need to be addressed again in the next 12 to 18 months.

By Daryl G. Jones, Hedgeye

Discussion of the debt ceiling debate has become the one of the most overhyped factors in global markets and it is a little depressing to analyze the political shenanigans going on in Washington. Nonetheless, I feel compelled to comment.

Speaker Boehner is having serious issues garnering votes for his debt and deficit plan. The vote was scheduled yesterday and is now postponed. It seems the Tea Party is not on his political side, despite fear mongering from the White House that Christmas will be ruined if a long term debt deal is not passed in short order.  I can't say I agree with the Tea Party on everything, but I will give them credit for a conviction of their beliefs.

The debt limit deadline is August 2nd, which is now four days away. Between now and then, how this plays out is really anyone's guess. It seems likely the Tea Party will acquiesce and a deal gets passed in the House, although as we saw yesterday evening, even that is uncertain. If that does occur, Senate Majority Leader Reid and President Obama have been adamant that they will not support any bill that has a two-step process and that doesn't extend the debt ceiling past the 2012 election.

Regardless of the two-step process in the Boehner bill, the Boehner and Reid bills have dramatic differences regardless. At face value they are talking about similar numbers -- the Boehner plan, in total, is looking for more than $2.7 trillion in cuts, while the Reid plan is proposing almost $2.2 trillion in deficit cuts. While those numbers are in the same area code, the methodology for getting to the cuts is dramatically different.

The Reid plan only has $710 billion in real budget cuts -- the remainder of the deficit reduction plan comes from the winding down of the wars in Iraq and Afghanistan. Setting aside the differences in process, that leaves us with a $2 trillion difference in the nature of deficit cuts between the parties. That's one mother of a compromise for four days.

Stepping back to the longer term, we need to keep in mind that both of the current bills proposed are really nothing more than Congressional comb-overs. As a refresher, Merriam Webster describes a comb-over as follows:

"An arrangement of hair on a balding man in which hair from the side of the head is combed over the bald spot."

As a man who sports a comb-over, I can vouch that is an apt description.  The sneaky thing about a comb-over is that while you can comb your hair over, the rest of the world can usually tell that there is a bald spot lingering beneath.

In the chart of the day, I've shown what I mean graphically by comparing proposed Reid plan discretionary spending cuts as a percentage of the estimated deficit. Similar to many a bad business plan, the Reid plan is very back-end loaded (by the way, so is the Boehner plan). In fiscal 2012, the discretionary spending cuts as proposed by Reid ramp from 2.2% of the CBO's projected deficit to 14.0% of the CBO's projected deficit by 2020.

The other key assumption to keep in context when considering the currently proposed Congressional comb-overs are the GDP growth assumptions proposed by CBO. In the projection period used in my analysis in the attached chart, the federal government budget years from 2012 to 2020 at an average real GDP growth rate of 2.9% per year. This compares to the actual real GDP growth rate over the last ten years of 1.7%. Obviously, future deficits will be much higher if growth in the next decades tracks similar to the last decade.

While the political drama in Washington has been entertaining over the last few months, we need to keep in mind that even when the compromise is reached, the current bills proposed are merely covering up long term budget deficit issues that will again need to be addressed in the next 12 – 18 months.  Therefore any short term positive stock market reaction should be taken with a grain of salt in the context of continued long term issues.

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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