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This is a guest post by Michael Cembalest, Chairman of Market and Investment Strategy for J.P. Morgan Asset Management. You can read the entire report as a PDF here .

In August 2011, the United States lost one of its AAA credit ratings, a designation first bestowed around 100 years ago, which when combined with the debt ceiling debate, created one of the sharpest market corrections in post-war US history. Financial markets remain concerned about the ability and willingness of the US and Europe to tackle their respective fiscal challenges. With US federal debt approaching its highest level since the formation of the federal government in 1789 (other than during WWII and its immediate aftermath), rating agencies are taking a close look at rising US debt and what the legislature does to contain it. The appetite of foreign central banks to accumulate Treasuries has provided the US with a reprieve; these entities, plus Federal Reserve holdings, now account for half of all Treasury bonds. But monetary policy in Asia and the Middle East is subject to change, and we have seen in Europe the suddenness with which sovereign debt can be re-priced by financial markets. Downgrades, government shutdown rumors and political impasse on deficit reduction have not lost their ability to negatively affect equity markets, business activity and confidence. This note details 10 reasons why we believe financial markets will take a close look at what Congress does in the year ahead.

1. Assuming that sequestration takes place as planned, the Budget Control Act reduces the trajectory of the debt from the CBO’s explosive Alternative Case, but does not yet set federal debt on a sustainable path. Even after incorporating all phases of the BCA and assuming expiration of various business and household tax relief provisions, future debt ratios still rise into the mid-80s as a percentage of US GDP. The CBO Baseline shows a decline in federal debt since it assumes the following three policy options: a sunset of all Bush tax cuts, an end to indexation of AMT to inflation, and reductions to Medicare doctor reimbursements which Congress has agreed to but never enacted. These three cuts and associated interest savings would amount to roughly $6 trillion in deficit reduction over a 10 year period. However, it remains unclear what political support there would be to do so.

2. Financial markets are focused on this issue since large deficits and debt levels can affect growth. There are plenty of debates in the economic community these days (e.g. why haven’t monetary or fiscal stimulus multipliers behaved the way their supporters believed they would). One possible explanation is that fiscal stimulus loses its effectiveness when debt ratios rise too high. In the chart below, we summarize Ken Rogoff’s findings that when debt ratios in the US and in other advanced economies have exceeded 90%, economic growth suffered notably. With the US federal debt ceiling now over 100% of GDP (on a gross debt basis) and projections of net debt rising above 80%, financial markets have reason to be concerned.

Supporting Rogoff’s findings is a paper prepared by BIS economists for the Fed’s 2011 Jackson Hole symposium. In a study of sovereign, corporate and household debt over the last 3 decades, the authors find that at around 85% of GDP, government debt exerts a significant negative drag on growth. Their conclusion:

“the immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds.”

3. Hoping for growth might not be the best strategy. The post-Budget Control Act debt ratio of 85% by 2022 includes the CBO growth assumptions shown in the chart below. Growth is assumed to spike to 5% in 2015, and average 2.7% over the decade. Some argue that faster growth may bail out the US from its budget problem, reducing the need for deficit reduction measures. It is true that the US has experienced growth surges before, and it is always possible another one will occur. In the 1950’s, real GDP growth averaged 4.3% for the entire decade [see table in Appendix], which resulted in debt ratios declining from 80% to 46%. However, the unique economic conditions and productivity gains of the 1950’s (e.g. interstate highway, rebuilding of Europe and Japan) may not be repeated. While we are hopeful that the US economy recovers more quickly, if it doesn’t, debt ratios might not decline below the mid 80’s, risking another round of rating agency downgrades.

Other areas of potential budget slippage: projections of military spending declines are not the same as structural deficit reduction. One item in the President’s budget proposal was an assumed $800 billion in savings from troop withdrawals out of Iraq and Afghanistan (so-called “OCO” spending). While progress has been made on this front, uncontrollable geopolitical events could require OCO spending to rise again. In addition, as shown above, the Budget Control Act already projects that non-OCO military spending as a % of GDP will fall to its lowest level since 1940, barely above the levels now spent by Japan and Germany after decades of demilitarization. As a result, financial markets may not ascribe a high likelihood to deficit reduction achieved through lower estimates of future military spending.

4. It’s not just rating agencies that are unnerved by polarization of political parties. Markets are aware of the polarization in Congress, a trend that can be understood by empirical analysis of Congressional voting patterns. As shown below, the polarization in the House and the Senate is as high as it has ever been, even higher than after Reconstruction, one of the most acrimonious periods in the country’s history. A closer look at the Senate in particular (below, right) shows that the number of party non-conformists has plummeted. Without a political middle, there is a greater risk that the ideological divide between the parties cannot be bridged, leading to intermittent government shutdowns (or the threat of them2) and market disruptions.

5. Entitlements: where we are now. Market participants are increasingly focused on entitlements relative to discretionary spending. First, some history. When Medicare was introduced in 1960’s, it was described as “brazen socialism” in the Senate. When Truman proposed a national healthcare program in the 1940’s, the plan was called a Communist plot by a House subcommittee. And when President Roosevelt introduced Social Security in the 1930’s, he was branded as a Communist sympathizer by Republican Senators from Ohio, Pennsylvania and Minnesota, publisher William Randolph Hearst and Alf Landon (Roosevelt’s GOP opponent in the 1936 Presidential election). So in 1969, when the US Census found that one quarter of Americans over the age of 65 lived in poverty, politicians showed courage in creating a larger social safety net.

However, it may take even greater courage to examine and adjust what was created. In the late 1960’s, the government estimated that Medicare expenses would grow by 7 times by 1990 (unadjusted for inflation); they grew by 61 times instead. As shown in the table, healthcare spending has overtaken education spending (a); entitlements have grown sharply compared to growth in population, household income and overall government spending (b); price-sensitive medical spending (paid out-of-pocket) has collapsed (c); and more “productive” forms of government spending have fallen to an all-time low (d). David Walker, the former Comptroller of the US, refers to this as the “crowding out” of productive discretionary programs.

6. Entitlements: where we go from here. Markets generally look at financial statements which are governed by GAAP accounting, which requires accrual of future commitments. Countries and states are not bound by accrual accounting, leaving markets to wonder (and sometimes panic) when they find out what hasn’t been accrued. The existing federal debt, which is already at elevated levels, does not include the present value of unfunded future entitlement payments. Government agencies have estimated this latter number at $36-63 trillion, which is 3-6 times the existing stock of federal debt held by the public. How much would tax rates have to rise to support entitlements growing at 5%-7% per year, if nominal GDP grew at 4%-5%? First, the 2001 tax cuts would have to expire on all brackets, and then tax rates would have to be raised by the same amount on everyone. At that point, federal debt to GDP would still be well above 2007 levels, but at least it would create some borrowing capacity to fund entitlement payments. The question is what such a policy would do to growth and employment.