Contributors
Jacob Manoukian
U.S. Head of Investment Strategy
Joe Seydl
Senior Markets Economist
Chris Seter CFA
Global Investment Strategist
Samuel Zief
Global Investment Strategist
Market Update: Watching paint dry
Equity markets and bond yields both traded in a narrow band all week. Investors should enjoy the calm while it lasts. Elections in France and the United Kingdom in the coming weeks and last night’s presidential debate in the United States could spark some more pronounced market moves. But for now, we are taking the opportunity to dig into one of the most frequent questions that we get from clients: How worried should we be about the U.S. debt and deficit?
Spotlight: What risks do high debt levels and wide deficits really pose?
The U.S. fiscal trajectory has garnered significant attention since S&P Global downgraded the debt in 2011. Just last week, the Congressional Budget Office (CBO) updated its projections for the federal budget that suggest a $2 trillion deficit this year and an increase in the debt to GDP ratio to over 120% (the highest ever) by 2034.
While financial markets and presidential candidates have shown indifference, it’s crucial to understand the underlying risks associated with wide deficits and high sovereign debt levels.
The bottom line for investors is that we don’t expect meaningful improvement in the trajectory for U.S. debt or deficits in the medium term. However, multi-asset portfolios should still be able to deliver for investors. Monetary policymakers have maintained credibility, investor demand for U.S. Treasury assets is still strong and the tax base is robust.
That said, the risks are meaningful enough to consider adding non-U.S. dollar denominated assets and “real assets” such as infrastructure, gold and commodities to traditional multi-asset portfolios. A focus on tax efficiency for U.S. taxpayers could also be prudent.
In the rest of the note, we will explain the five most prevalent concerns, and will assess the impact that each might have on your portfolio.
1. High debt levels and wide deficits limit fiscal flexibility
The U.S. government’s wide deficit and elevated debt levels restrict its ability to respond effectively to future economic downturns. Historically, during recessions, governments boost spending to stimulate growth. However, the fiscal space for additional stimulus might be constrained by an already wide budget deficit. This could slow any economic recovery. That said, elevated yields provide ample monetary space to provide support should a downturn materialize.
Investment implication: Somewhat ironically, this suggests that Treasury bonds and other investment grade fixed income assets still have a critical role to play in multi-asset portfolios.
2. High debt levels and wide deficits could increase borrowing costs
As the federal deficit grows, so does the need to issue Treasury securities. While demand for Treasuries has remained robust, (at recent auctions public demand was around 2.5x greater than supply), a continued increase in supply could lead to higher yields. This scenario would increase the government's interest expenses and further exacerbating the fiscal burden. The CBO already projects that interest costs will rise to 6% of Gross Domestic Product (GDP) by 2050 (double the 3% highs recorded in the 1990s) driven by the assumption that government spending will grow at a materially faster rate than revenues.
The CBO expects total deficits to exceed 8% by 2054
CBO budget deficit outlook, percent of GDP
This chart shows the net interest outlays, primary deficit or surplus, and total deficit or surplus for the United States government from 1940 to the present and projected to 2054. In 1945, the government ran a deficit of 35%. This deficit fell following the war and the government ran a surplus of nearly 5% in 1950. By the mid-1980s, the government ran a deficit of 6%, with 3% comprising net interest outlays and 3% comprising the primary deficit. By 2000, the government ran a net surplus of 2%, while the primary surplus was 5% and the net interest outlays was 3%. By 2010, the government ran a net deficit of 10%, while the primary deficit was 8% and the net interest outlays was 2%. By 2020, the government ran a net deficit of 15%, while the primary deficit was 13% and the net interest outlays was 2%. After falling to 6% in 2024, the total deficit is projected to steadily rise in the ensuing decades until it reaches 8% in 2054. At this time, the net interest outlays are projected to reach 6% while the primary deficit is projected to reach 2%.
Source: CBO Long-Term Budget Outlook: 2024 to 2054. Data as of March 2024.
Investment implication: Potential upward pressure on bond yields emphasizes the need to add other sources of diversification against potential equity volatility, most notably real assets.
3. High debt levels and wide deficits could crowd out more productive spending
The CBO projects that by the mid 2030s, all federal revenues will be required to fund mandatory government spending alone: Largely Medicare, Medicaid, Social Security and interest on debt. At that point, the only way to finance basic functions such as defense, law enforcement, infrastructure and education would be to borrow more or to cut other discretionary spending.
This potential crowding out could impede long-term economic growth and innovation. Federal programs like the Defense Advanced Research Projects Agency (1958), the Orphan Drug Act (1983), and the National Nanotechnology Initiative (2000) have been vital to innovation in communications, computing and biotechnology.
Investment implications: While this risk is present, investors should note that the federal government is still directly investing and incentivizing investment in critical areas such as infrastructure, climate technology and manufacturing given the provisions contained in the Bipartisan Infrastructure Bill, the Inflation Reduction Act and the Creating Helpful Incentives to Produce Semiconductors (CHIPS) Act. Notably, artificial intelligence, perhaps the most important innovation for equity markets in a generation, is largely being financed by the private sector.
4. High debt levels and wide deficits will probably not lead to dollar depreciation and excess inflation
If markets begin to question the credibility of U.S. sovereign debt, the dollar could depreciate, and inflation could accelerate. Although historical data suggests this risk is low in the medium term, it cannot be entirely ruled out. For instance, the United Kingdom faced a “mini” fiscal crisis in 2022, leading to a 10% depreciation of the pound. A similar scenario in the United States could erode the dollar's purchasing power and increase import prices, contributing to inflation. However, this risk is mitigated by the credibility of U.S. monetary authorities and the dollar's status as the primary global reserve currency.
Instability and excess inflation can occur when central banks finance government spending by buying sovereign debt or keeping interest rates artificially low. While the United States was engaged in this "financial repression" during and after World War II, the Federal Reserve has decreased its holdings of government debt by $1.3 trillion over the last two years and has raised interest rates to some of the highest levels in 30 years. Inflation expectations remained well anchored during the spike of 2022 and 2023, indicating the Fed's focus on labor market and inflation outcomes.
The Fed is reducing their Treasury holdings
Fed holdings of Treasury securities, trillion dollars
This chart shows the US Treasury’s holdings of securities in trillions of US dollars from 2007 to the present and indicates periods of quantitative easing and tightening.
- In 2009, the Treasury held $0.5T in securities and began a program of quantitative easing.
- In 2010, the Treasury held $1T in securities and began another program of quantitative easing.
- In 2013, the Treasury held $1.6T in securities and began a third program of quantitative easing.
- In 2018, the Treasury held $2.5T in securities and began a program of quantitative tightening.
- In 2020, the Treasury held $2T in securities and began a program of quantitative easing in response to the COVID pandemic.
- In 2022, the Treasury held $6T in securities and began a program of quantitative tightening.
- The Treasury presently holds nearly $5T in securities.
Source: Federal Reserve, Bloomberg Finance L.P. Data as of June 19, 2024.
The U.S. dollar's status as the world's primary reserve currency provides a unique advantage. To be sure, the “BRICS+” economies are gaining geopolitical influence, and are trying to establish a rival trading and monetary system. However, the dollar still comprises around 60% of global foreign exchange reserves, is involved in 90% of global transactions and is used in over half of all global trade.
Investment implications: While this risk is low, the clear hedge against dollar depreciation is an allocation to non-USD assets and gold.
5. High debt levels and wide deficits will most likely not lead to a government default
The likelihood of the United States defaulting on its debt remains extremely low (technical defaults due to the statutory debt limit are a different story). The United States benefits from issuing debt in its own currency, which is also the global reserve currency. This unique position allows for a higher debt-carrying capacity compared to countries such as Argentina and Turkey, which issue debt in foreign currencies. Additionally, the United States has a robust tax base and the ability to raise revenues through tax reforms if necessary. Japan, with a debt-to-GDP ratio of 228%, provides a useful example of a country that has managed to avoid a fiscal crisis despite twice the indebtedness of the United States.
Because all U.S. debt is dollar denominated, there is an extremely limited likelihood that the federal government would not be able to repay. The risk is that the government does it with dollars that have lost a significant amount of value relative to other currencies or assets such as gold. The most extreme example of this for a major economy was France in the 1920s.
The U.S. dollar is the world’s dominant currency
Share of currency use, percent
This chart shows the usage of the US dollar, the Euro, the Japanese Yen, and the Chinese renminbi across multiple areas. The dollar makes up 58% of foreign exchange reserves, while the Euro makes up 20%, the yen makes up 5%, and the renminbi makes up 3%. The dollar makes up 66% of international debt while the Euro makes up 22%, the yen makes up 2%, and the renminbi makes up 1%. The dollar makes up 53% of international loans while the Euro makes up 19% and the yen makes up 2%. The dollar makes up 48% of global payment currency (SWIFT) while the Euro makes up 32%, the yen makes up 4%, and the renminbi makes up 2%. The dollar makes up 89% of foreign exchange turnover (a category which sums to 200%) while the Euro makes up 31%, the yen makes up 17%, and the renminbi makes up 7%.
Source: BIS, IMF, Society for Worldwide Interbank Financial Telecommunication (SWIFT) and ECB calculations. Data as of December 31, 2022. Notes: the latest data for foreign exchange reserves, international debt and international loans are for the fourth quarter of 2022. SWIFT data are for December 2022. Foreign exchange turnover data are as of April 2022. *Since transactions in foreign exchange markets always involve two currencies, shares add up to 200%.
Investment implications: While the fiscal outlook may appear challenging, the structural advantages of the U.S. economy and its currency provide a significant buffer against default risk.
Conclusion: Endgames for policymakers and investors
The most likely scenario for the next few years is the status quo: Deficits remain wide and debt levels continue to rise. Despite the associated risks, we believe these won't destabilize multi-asset portfolios due to the credibility of policymakers, ongoing investor demand for U.S. Treasury assets and a robust tax base.
There are methods to address the debt problem. One option is preemptive fiscal reform, which could involve altering entitlement or discretionary spending, and/or raising taxes on high-net-worth individuals or corporations. Another is higher economic growth through productivity gains. Specifically, advancements in artificial intelligence could enhance fiscal sustainability by boosting economic output without causing inflation. The CBO does not, and has not historically, forecasted these types of productivity booms.
Finally, we should note that the CBO has shown a tendency to develop overly pessimistic projections for the U.S. debt and deficits. For instance, in 2009 the CBO projected that mandatory government spending would outstrip total U.S. revenues by 2024. That intersection has been revised further into the future to 2034.
For investors, the message is clear: It is probably prudent to move beyond the traditional 60/40 portfolio. Including non-U.S. dollar assets and real assets such as infrastructure, gold and commodities in your investment portfolio can provide a hedge against potential dollar depreciation and inflation. Tax efficiency is also key. As always, understanding the risks and incorporating them into your planning process is one of the best mechanisms to achieve your financial goals.
All market and economic data as of 06/28/2024 are sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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Index definitions:
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