Policy, Politics & Portfolios

Topics in this report:

• Social Security cost-of-living increase — Is it enough?
• Financing federal deficits and debt
• Potential timeline for delisting Chinese stocks

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The 5.9% Social Security cost-of-living adjustment this year was the largest increase since 1982. A 5.9% rise may sound large, but with inflation rising faster, can it offset price hikes for items that generally matter most to consumers, like food or gas?

• The cost-of-living adjustment (COLA) for Social Security recipients increased 5.9% in 2022.
• Current projections show the Social Security trust can cover full benefits through 2034 before facing a shortfall.
• Investors looking to supplement their income might consider adding fixed-income assets or high-quality, large-cap stocks that pay dividends.

Social Security and Supplemental Security Income benefits for roughly 70 million Americans increased 5.9% in 2022. Today, Social Security is a primary income source for roughly 65 million U.S. retirees.¹ Yet, rising inflation is eroding consumers’ spending power, particularly for those who are living on a fixed income. The more one’s income depends on a Social Security check to meet monthly expenses, the greater today’s elevated inflation rates erode household budgets.

Presumably, higher inflation rates today could lead to larger Social Security cost-of-living adjustment (COLA) increases tomorrow. A 5.9% increase may sound large, but with inflation rising at a faster clip, can it realistically offset price hikes for items that affect most U.S. consumers — food, gasoline, housing, and health care? More broadly, as some market observers call the solvency of Social Security into question, what are the financial implications of potentially heftier COLA adjustments for the federal budget deficit and the long-term viability of the program?

The 5.9% COLA increase this year was the largest annual increase since 1982. A COLA adjustment is determined by the percentage increase in the Consumer Price Index (CPI) for urban wage earners and clerical workers (CPI-W) from the third quarter of the previous year to the third quarter of the current year. If there is no increase in CPI, there is no COLA adjustment. COLA increases aim to prevent inflation from eroding the purchasing power of Social Security benefits.

The May CPI data showed that prices overall rose 8.6% year over year. Yet, goods that generally matter most for consumers have seen even greater price increases. Since May 2021, gas prices have risen 50.3% and food prices have soared 11.9%, a rate not seen since the 1970s.² Further, the cost of the standard Medicare Part B premium increased 14.5% for 2022. Persistently high inflation this year could lead to a larger COLA increase next year, prompting concerns about the sustainability of Social Security.

Social Security program benefits are primarily funded by payroll taxes collected from current workers. During the past three decades, the Social Security trust has accumulated $2.8 trillion in reserves.³ Over that period, income exceeded costs, and the surplus was invested in interest-bearing Treasury bonds. Looking ahead, as outlays increase, the reserves will cover gaps between revenue and costs for about another decade.⁴

Despite the economic upheaval caused by the COVID-19 pandemic, the long-term outlook for Social Security deteriorated only modestly from last year, pushing the potential date of insolvency up from 2035 to 2034. The loss of payroll tax revenue was partially offset by the reduction in beneficiaries who succumbed to COVID-19. Current projections show that the trust can cover full benefits through 2034 before facing a shortfall. The gap as it stands now would amount to 1.2% of U.S. gross domestic product (GDP) over the subsequent 75 years.⁵

Chart 1. Cost-of-living adjustments (1975 – 2021)Sources: Social Security Administration and Wells Fargo Investment Institute, June 10, 2022

Come 2034, Social Security seems likely to continue to be available. Although 2034 is the projected date for depletion of excess contributions in the Social Security trust, barring no action the program could still pay 78% of scheduled benefits for 75 years beyond that, mainly from workers’ ongoing contributions.⁶ Nevertheless, even if inflation peaks in the coming months, as we expect, high prices are likely to remain sticky well into 2023. With costs of household staples (food, gas, and housing) rising, many households are likely to feel further squeezed.

Investors looking to supplement Social Security checks might consider adjusting portfolios in an effort to increase income. This may include adding fixed-income assets. We currently favor U.S. taxable investment-grade short-term fixed income, U.S. taxable investment-grade intermediate-term fixed income, and municipal bonds. For income-seeking investors, we also suggest higher-quality, large-cap stocks that pay dividends. Additionally, we favor using alternative investments as a way to generate non-correlated (in other words, not correlated to the broad equity markets) returns with stable yields.

Alternative investments are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

Federal deficits and debt grab the headlines, but it’s the cost of paying interest on them that typically determines the impact of government finances on the financial market. The burden of servicing the government’s debt, suppressed in the past decade by ultralow interest rates, eventually could return to the spotlight as higher interest rates are applied to the government’s sizable debt load.

• The financing cost of government debt, not its size or budget shortfalls, ultimately has determined the market’s reaction to budget deficits and debt.
• The U.S. Treasury’s ability to manage long-term increases in financing costs will likely affect Treasury interest rates and, as a risk-free benchmark for valuing other securities, conditions throughout the financial market.

The federal budget, along with housing and the bond market, are touchpoints of the economy’s heightened interest sensitivity as rates rise from ultralow levels in the past 15 years. Deficits and debt get much of the attention, but it’s their impact on government interest expense ultimately determining the market’s reaction to budget shortfalls. The last time the budget deficit was front-page news was in the early 1990s, when net interest expenses peaked at nearly 18.5% of revenues in fiscal 1991 (ending in September of that year) and debt amounted to less than 45% of GDP. Flash forward to fiscal 2021. The chart below shows that debt soared to nearly 103% of GDP. Investors have responded with little more than a wink and a nod, probably because the interest burden still is historically low at less than 9% of federal revenues.

Chart 2. Comparing federal debt and the financing burden to the early 1990s (fiscal years)Sources: U.S. Treasury Department, Congressional Budget Office forecast, and Wells Fargo Investment Institute calculations. FY = fiscal year. GDP = gross domestic product. Forecasts are not guaranteed and based on certain assumptions and on views of market and economic conditions which are subject to change.

Credit the decades-long decline in interest rates with suppressing the rise in debt-financing expenses since the early 1990s. Since 2000, the average interest rate on federal debt has fallen by 5 percentage points, to about 1.5%. More recently, tax revenues propelled by strong economic growth and accelerating inflation have combined with an increase in the average maturity of Treasury debt to a record of just over six years to hold the financing burden to its pre-pandemic level, as shown in Chart 2.

The Congressional Budget Office (CBO), in its May 2022 projections of federal deficits and debt, expected the government’s financing burden to remain low by historical standards in the next several years, and we shared this view in a report last year.⁷ However, the debt’s size can become an issue by exposing financing costs to unexpectedly large increases in interest rates.⁸

The CBO shows in its forecast that even a moderate rise in interest rates could lift the financing burden near its peak level in the early 1990s by the end of the decade if current economic policies remain unchanged. Projected increases in government debt-servicing costs include refinancing of the 70% of privately held Treasury securities coming due in the next five years into higher-yielding debt and CBO estimates of widening budget deficits based on current economic policies.

We believe forecasted increases in the federal debt’s financing burden should be viewed less as inevitable than as a warning flag of the risk from persistent, outsized budget deficits. Interest expenses, once incurred, are the most uncontrollable expense in the federal budget. Atop rapidly growing and less controllable entitlements, that 80% share of total spending reduces fiscal flexibility and makes deficits more difficult to contain.

We believe that the federal debt’s vulnerability will have more to do with the cost of borrowing than with default risk, which is more a political issue. For investors, the importance of Treasury financing costs extends beyond pricing in the market for government debt to its role as a risk-free asset used as a benchmark for valuing other debt securities and, ultimately, for equity valuations. For now, a low debt-servicing burden means that Treasury interest rates should be shaped largely by economic conditions. We believe those conditions, pointing toward moderate interest rate increases through 2023, support our favorable view toward U.S. Short Term Taxable Fixed Income and U.S. Intermediate Term Taxable Fixed Income and a neutral positioning on U.S. Long Term Taxable Fixed Income.

How big a longer-term role has for government finances in shaping Treasury interest rates will depend on the government’s ability to manage any future pressure on borrowing expenses effectively. Our report Paying America’s Bills, republished in October 2021, notes the risk of inaction on deficits and of financing costs but also outlines several different approaches the U.S. government can use to manage debt levels and their financing costs.⁹

China is resisting a U.S. law requiring U.S.-listed Chinese companies to undergo a full audit by U.S. regulators. The risk that the U.S. may delist Chinese companies is an additional headwind for emerging market equities, but ultimately we believe potential opportunities in emerging markets — and China specifically — will offset the regulatory and political hurdles.

• The U.S. and China are working to reach an agreement in which China would fully facilitate audit inspections.¹⁰
• A possible work-around might be for China to voluntarily delist a subset of companies that it considers sensitive while bringing the remainder of firms into compliance with U.S. standards.
• Regardless of how the HFCAA progresses, we continue to believe that its contribution to U.S.-China tensions will accelerate the transformation of globalization, not end it.

The 2002 Sarbanes-Oxley Act after the collapse of Enron required all public companies be audited by the Public Companies Accounting Oversight Board (PCAOB). In late 2020, then-President Donald Trump signed the Holding Foreign Companies Accountable Act (HFCAA), a law that bans the trading of securities in foreign companies whose audit working papers can’t be inspected by U.S. regulators for three years in a row. The HFCAA took effect in 2021 and thus gives Beijing until spring 2024 to comply.

The core issue is whether China will allow the PCAOB to routinely inspect the auditors of U.S.-listed Chinese companies. China has long argued that unfettered access to the audit papers could threaten its national security.

U.S. regulators counter that Chinese companies enjoy the trading privileges of a market economy — including access to U.S. stock exchanges — while receiving Chinese government support and operating in an opaque system. Indeed, Chinese companies are attracted by the liquidity and deep investor base of U.S. capital markets, which offer access to a much bigger and less volatile pool of capital. China’s own markets, while giant, remain relatively underdeveloped.

Additional idiosyncratic factors will likely also have a significant impact on how the HFCAA unfolds:

1. Proposed acceleration of HFCAA — Bills passed by both the U.S. House and Senate would shorten the deadline by a year. And there is a good chance that the accelerated timeline could be included in a more comprehensive China bill by the end of the year that aims to boost America’s competiveness against China.
2. China regulations — Beijing regulators have cracked down on Chinese companies issuing securities overseas by enhancing data security protection and oversight of cross-border data flows. The Chinese government’s focus on data security for overseas-listed firms is underlined in rules from the Cyberspace Administration of China, which took effect February 2022 and require mandatory review for any company collecting personal information of more than 1 million users prior to listing abroad.
3. Variable interest entities — The Securities and Exchange Commission (SEC) has been advocating that investors receive more information about the structure and risks associated with shell companies, known as variable interest entities, that Chinese companies use to list shares in New York.

Since March, the SEC has “identified” more than 135 companies that relied on auditors headquartered in mainland China and Hong Kong, which the SEC deems “non-compliant” by the PCAOB, for their fiscal year 2021 annual report filings. Under the HFCAA, companies so-identified by the SEC in 2022 are on track to become subject to a securities trading ban and probable delisting from U.S. exchanges by 2024.

The PCAOB and Chinese regulators appear to be actively negotiating an agreement on the PCAOB’s access to audit firms based in mainland China and Hong Kong.¹¹ A possible work-around might be for China to voluntarily delist a subset of companies that it considers sensitive while bringing the remainder of firms into compliance with U.S. standards.¹² In the meantime, some Chinese companies are repositioning themselves with dual listings or take-private deals and others are seeking out U.S.-based auditors.

In response to uncertainties surrounding HFCAA, some shareholders have opted to exchange their American depositary receipts (ADRs) in Chinese companies for shares that trade on Hong Kong’s stock exchange. Capital flows have already started to move into Hong Kong. For example, the MSCI China Index swapped out of the ADRs of Alibaba Group Holding Ltd., JD.com Inc., and NetEase Inc. last year for these companies’ Hong Kong listings.

The potential for certain China companies to be delisted from U.S. exchanges also adds risk to their shares and the emerging market asset class overall, which has already been plagued by China’s regulatory crackdowns and pandemic-related shutdowns in major cities such as Shanghai. Case and point, a move by the SEC in March toward forcing companies from China off American exchanges helped trigger the worst decline in U.S.-listed Chinese stocks since the global financial crisis and sparked a sell-off in Hong Kong.

We see HFCAA contributing to U.S.-China economic and political tensions, along with issues such as trade tariffs and disagreements over the Russia-Ukraine war. Looking ahead, however, we continue to expect new investment opportunities over the coming decade as China develops a private sector to serve its 1.4 billion consumers. As with these other issues, HFCAA is likely to contribute to the ongoing development (not the end) of globalization.

Ultimately, we believe potential opportunities in emerging markets — and China specifically — will offset the regulatory and political hurdles. For investors interested in potential opportunities in China, or in the emerging economies of South Asia that trade with China, we suggest considering passive global funds, active managers, and U.S. or European multinationals. We describe these investment vehicles and the potential opportunities we expect during the next decade in our September 2021 report “The Future of Globalization: Investing in an Interconnected World.”

¹ The Senior Citizens League, May 2022

² U.S. Bureau of Labor Statistics, June 10, 2022

³ Congressional Budget Office, May 2022

⁴ Center on Budget and Policy Priorities, September 28, 2021

⁵ Ibid.

⁶ Ibid.

⁷ “Paying America’s Bills: What Investors Should Know About How the U.S. Government Manages Its Finances,” Wells Fargo Investment Institute, October 2021; “Rising Rates and the National Debt: Should We Worry?” Wells Fargo Economics, May 31, 2022

⁸ “The Budget and Economic Outlook: 2022 to 2032,” CBO, May 25, 2022

⁹ “Paying America’s Bills: What Investors Should Know About How the U.S. Government Manages Its Finances,” Wells Fargo Investment Institute, October 2021

¹⁰ “U.S.-listed Chinese Stocks Jump After China Reportedly Considers Sharing Company Audits,” CNBC, Hannah Miao, April 1, 2022

¹¹ “Navigating the Holding Foreign Companies Accountable Act – The Road to Delisting or Redemption for China-based Companies,” Akin Gump, May 16, 2022

¹² “China Faces Growing Pressure to Iron Out Audit Deal With the U.S.,” Wall Street Journal, Jing Yang and Paul Kiernan, May 24, 2022

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