Ratings firm Moody’s lowered its assessment of US credit outlook from “stable” to “negative” last week underscoring America’s worsening fiscal outlook. But Standard & Poor’s and Fitch have already downgraded the US to one notch below AAA. It means very little for your portfolio today, but it speaks to the longer-term decay of fiscal balances that is visibly starting to matter. While I’ve been concerned about the fiscal outlook since the spike in deficits following the 2008/09 great financial crisis, the interim solution has been a partial monetization by increasing the size of the Fed’s balance sheet (known as quantitative easing). This will likely be part of the “easy” government solution, but not the good one.

We are now feeling the impact of trying to shrink the balance sheet and fight the inflation triggered by covid related policy responses. The trend is alarming and has little hope in curtailing with the increasing political gridlock and polarization. Senator Joe Manchin appears to be looking for a by-partisan third party solution and a run at the White House, but unless Congress comes to the middle with him, there is little hope in fiscal prudence from our lens. Most of the opinions on a longer-term solution needs to come to the middle in terms of policy choices.

In the chart below, the Congressional Budget Office forecast shows 8-10% deficits in the coming years with about 40% of the deficit (over $1 trillion next year) just to cover the interest payments. In their downgraded outlook assessment, Moody’s projects the debt-to-GDP ratio (120% today) to be 170% by 2042. The fiscal outlook is catastrophic, and Washington is so dysfunctional, there is little hope of near-term change. There is an increasing call from independent sources to make something happen on a bi-partisan basis.

Aspen Economic Strategy Group, a group of former policymakers, top executives, and others led by former Treasury secretaries Hank Paulson and Tim Geithner put out a paper titled “Building a More Resilient US Economy.” A few weeks ago, we recommended reading a new book called Permacrisis for some insight into what might be needed to get us through this challenging economic period. Speaking at a Bloomberg investment forum last week, Citadel head Ken Griffen warned of higher inflation lasting decades with de-globalization. When we put all this in the blender, we see stagflationary headwinds brewing.

“Policymakers will need to make difficult spending and tax policy decisions to bring the US fiscal situation into better balance and to maintain our ability to invest in key priorities like national security, health care, and addressing climate change,” write Paulson and Geithner.

The bulk of the increase in the structural deficit has come from higher spending on Social Security and Medicare benefits as the Baby Boom generation retires. In order to reduce deficits to the point where the public debt levels off as a share of the economy — a more plausible goal than balancing the budget outright — Congress would have to enact some mix of spending cuts and tax increases equivalent to 2.8% of GDP, or nearly $800 billion per year. Yes, but: There is no political momentum for deficit reduction at that scale. Complicating it is a sticky inflation and higher for longer yields, which is making the cost of financing the debt even higher.

While the US economy is still the most robust in the world and it hosts most of the best performing companies in the world, the average company globally is performing poorly this year. A stagflationary outlook seems most probable and we can expect economic growth rates to continue to slow. This should mean lower multiples and higher risk premiums for asset markets. So what does it mean for your portfolio? An increasing need to look to alternative ways to grow and protect your portfolio relative to inflation and the period of below average performance for traditional stock and bond markets looking forward. We love ETFs that use options to add yield and help protect during volatile periods.

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