United States Treasury yields surged to new cycle highs on the week, reversing last week’s geopolitical and Fedspeak-driven declines. Resilience in the U.S. economy again surprised the market. Retail sales data released early in the week showed a broad-based strength across categories, indicating that consumers are still healthy despite a prolonged period of restrictive monetary policy, and in fact – spending is growing at about the same rate as in 2019. The geopolitics-induced risk-off sentiment also further calmed down as investors took hope from the diplomatic efforts trying to prevent an escalation of the Israel-Hamas war. Markets responded by increasing the odds of another hike by January 2024, and reducing the number of rate cuts in 2024 from three to two. Equity prices stabilized as the market looked ahead to earnings season, which is off to a robust start.
China data also drew attention. While Q3 GDP came in above expectations, monthly data shows that growth momentum eased again in September, after recovering in August. Most headline activity numbers such as consumption, investment and production – even as they still slightly improved on year-over-year terms – were uninspiring and implied little fresh growth impulse. Looking ahead to 2024, the good news is that the Chinese economy is showing stability, and there is evidently greater determination to contain the financial spillover from housing to local government. The not so good news is that at this moment no other growth driver can manage to offset the housing slump.
Strategy Question: How serious are the U.S. fiscal woes?
Evidence of potential fiscal troubles in the United States have been accumulating for years. On August 1 this year the real wake-up call came when the ratings agency Fitch downgraded U.S. debt from AAA to AA+.1
While U.S. debt is on an unsustainable path, we do not believe that the nation will likely suffer a fiscal crisis in the years ahead.2 It’s important to keep U.S. debt in perspective: compared to most other countries, both developed and emerging, overall debt is high but far from extreme. The concern lies less with current overall debt and more on the trajectory, assuming spending on healthcare and other “entitlements” continue apace. More on that below.
Moreover, while history has rarely seen a developed country that issues its own currency suffer a sovereign debt crisis, “rare” does not mean impossible.
Last fall the British pound depreciated by 10% in a few weeks, and the U.K. had what we see as a mini-debt crisis that led to unprecedented volatility for the currency of a G7 country. Another example is in 1920s post-World War I France, when the country faced a fully-fledged fiscal disaster. The country’s solution led the franc to depreciate by about 80% relative to the U.S. dollar.3 An important lesson from both of these countries’ experiences is that, ultimately, the currency shoulders the burden of a fiscal crisis. Therefore, we think investors may want to consider adding real assets to their portfolios – just in case.
How do we reach these conclusions? Here’s we’ll set out some of our thinking.
1. The CBO has sounded the alarm—again
The Congressional Budget Office (CBO) startled many observers in June when it declared that U.S. government debt held by the public is on track to rise to its highest level ever – 116% of GDP in 2030.
This independent watchdog agency also warned that, by the mid-2030s, all federal revenues would be required to fund mandatory government spending alone: i.e., Medicare, Medicaid and Social Security, interest on debt plus other mandatory programs like unemployment insurance and veterans’ benefits.
At that point, there would be zero funds for such basic functions as defense, roadwork, the judiciary and so on—unless the federal government borrowed and went even deeper into debt. Such a spiral, if unchecked, would be dire.
The CBO assessments should be taken seriously. U.S. debt is problematic, however, we are skeptical about exactly how accurate the CBO’s deadline for a fiscal crisis will prove to be. After all, prior CBO projections proved overly pessimistic.
In 2009,4 the CBO said mandatory government spending would outstrip total U.S. revenues in 2024. Then dramatic reductions in healthcare spending (on Medicare and Medicaid) led the CBO to push back this date by a full decade – to 2034.5
2. What would a U.S. debt crisis look like?
One might argue that the U.S. is already experiencing a debt crisis of sorts. Congress’s annual showdowns over lifting the debt ceiling and adopting a budget have repeatedly damaged confidence that lawmakers can resolve fiscal issues.
However, a true debt crisis for a country like the U.S would mean that:
- Tax revenue could no longer finance the fiscal deficit, or at least keep it from spiraling higher.
- Investor demand for Treasury securities would deteriorate dramatically.
- The Treasury would be forced to ask the central bank to finance the deficit directly, in a way that supersedes the central bank’s inflation objective.
This scenario is not playing out now—nor do we believe it is likely to in the future. One reason for our confidence is that the debt-carrying capacity can be mind-bogglingly high for countries like the U.S., which issues nearly all sovereign debt in domestic currency. Just consider that a debt crisis still hasn’t arisen in Japan (which issues its debt almost entirely in yen), even with a sovereign debt-to-GDP ratio of more than 200% currently – more than twice that of the United States.6
Indeed, the U.S. and Japan can never technically default, as they can always print domestic currency to pay their debts.
Still, the U.S. could quasi-default. The government could be forced one day to borrow money from the central bank to fund public spending, causing a dramatic depreciation of the dollar and/or spiraling inflation.
That said, right now, the Federal Reserve is doing the exact opposite. The Fed has been reducing the size of its balance sheet to counter high inflation.
3. Tough battles are ahead over taxes and spending
The U.S. democratic process will decide what budgetary changes, if any, will be made to improve the nation’s fiscal sustainability. We make no recommendations and have no preferences. We can, though, observe facts that will underlie discussions about how to stave off a potential quasi-default.
First, it is unlikely the problem will be solved by potential savings from increased means-testing for entitlement programs.7 There is also a firm bipartisan consensus against more sizable cuts to these programs.8
In addition, it’s not obvious that the U.S. government has a spending problem in its other mandatory categories such as unemployment compensation, the nutrition assistance programs, veterans’ benefits etc.. This component of spending surged during the pandemic. However, it is expected to drop back to its historical average (relative to GDP) over the next decade.
This brings us to taxes. U.S. tax revenue is low relative to the U.S.’s own history, and it is especially low relative to the tax share of GDP in other wealthy countries.9
That could mean that in the next ten years lawmakers could try to raise tax revenue.10
What can an investor do?
While the politicians battle it out in Washington, what action might you take as an investor? We recommend these steps:
Stay aware. The sovereign debt-to-GDP ratio cannot spiral into disaster so long as the interest rate on newly issued debt (R) is below the economy’s structural growth rate (G).11 Therefore, watch for how much AI truly contributes to the economy. Innovations in healthcare have dramatically reduced government spending on Medicaid/Medicare in the past, and AI-enabled innovations have the potential to further reduce the healthcare bill and raise the economy’s structural growth rate.
Consider adding real assets to your portfolio. Given that real assets have historically done well when the USD depreciates, this might be a smart move if U.S. economic growth fails to pull the government out of the hole. Political gridlock prevents necessary changes to government revenue/spending, and recently-passed legislation ends up being more costly than assumed.
Consider adding allocation to gold. Gold has been incredibly resilient over the past two years on the back of higher real rates, thanks to active buying by global central banks. The metal’s safe haven characteristics are also still intact – gold prices spiked during the regional bank crisis and debt ceiling chaos earlier this year.
1The last time such bad news was delivered was in 2011. Back then, Standard & Poor's was the messenger.
2Here we mean the economic sense of the term fiscal crisis: when funding pressures are so great that they can’t be financed domestically with tax collections, forcing the central bank to directly finance the shortfall in a way that supercedes the central bank’s inflation objective.
3From 1919 through 1926.
42009 was the first year the CBO started providing longer-term budgetary projections.
5In 2009 the CBO was projecting healthcare spending at 12.2% of GDP in 2050. Now, the CBO projects healthcare will be just 7% of GDP in 2050.
6This is the Bank for International Settlements’s 2022 estimate of the debt-GDP ratio for Japan. The BIS attempts to remove inter-governmental debt issuance, to avoid double counting. Including inter-governmental debt issuance, Japan’s debt-to-GDP ratio was 259% in 2022.
7For example, according to a CBO study in December 2022, means testing that reduces benefits only for top-quintile earners would reduce Social Security outlays by a total of $40 billion by 2032. However, $40 billion is miniscule compared to total Social Security expenditures of $2.27 trillion by 2032, in the CBO baseline projection. Reduce Social Security Benefits for High Earners,” The Congressional Budget Office, December 7, 2022.
8See, for example: “Few Americans support cuts to most government programs, including Medicaid,” Pew Research Center, May 26, 2017; “Public Wants Changes in Entitlements, Not Changes in Benefits,” Pew Research Center, July 7, 2011; “How Americans evaluate Social Security, Medicare, and six other entitlement programs,” YouGov, February 8, 2023.
9European Commission AMECO database, Haver Analytics. Data as of August 9, 2023.
10For how, exactly, the lawmakers might do that, see: “What options would increase federal revenues?” Tax Policy Center Briefing Book, May 2020.
11In a given year, the percentage point change in the debt-GDP ratio is equal to the primary deficit (i.e., the deficit excluding interest rate payments) plus R-G multiplied by the debt to GDP ratio. It can thus be seen that if R is less than G, the debt ratio cannot rise in a multiplicative manner; if R is less than G, a widening in the primary deficit (say, due to an exogenous shock like a pandemic) will cause the debt-GDP ratio to rise, but it will rise concavely not convexly, ultimately settling at a higher but stable level in equilibrium.
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