Deficits boost U.S. debt but also inflate corporate profits and stocks, so reducing red ink could trigger a financial crisis, analysts warn | Fortune

"Massive budget deficits have sent U.S. debt soaring past $38 trillion, but they have also become the primary driver of corporate profits and stock valuations, according to Research Affiliates. In a recent note, Chris Brightman, who is a partner, senior advisor, and board member at the firm, and Alex Pickard, senior vice president for research, traced the historical trend between the deficit and how earnings are recycled to inflate asset prices."

"As a result, companies returned much of their capital to shareholders in the form of buybacks and dividends, which were plowed back into financial markets, often in price-insensitive passive funds that inflate valuations, the report argued. "Mandated to remain fully invested, these funds then recycle the inflows to purchase stocks in proportion to their market capitalization indifferent to valuation, thus bidding up prices without any change in fundamentals," Brightman and Pickard wrote."

U.S. federal debt has risen above $38 trillion as annual budget deficits approach $2 trillion and debt-service costs near $1 trillion. Growing deficits force increased Treasury issuance, and much of the proceeds flow into households via entitlement payments, which then support corporate revenues and profits. Intense global competition limited incentives for firms to expand domestic productive capacity, so much profit was returned to shareholders through buybacks and dividends. Those shareholder distributions were reinvested into financial markets, frequently into passive funds that are price-insensitive and thus bid up equity prices without corresponding fundamental growth.

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