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Investment Strategy

How worried should you be about the U.S. debt and deficit?

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 impacts 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, further exacerbating the fiscal burden. The CBO already projects that interest costs will rise to 6% of 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, % of GDP

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 such as 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 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 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, $ trillions

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 be 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, %

Sources: 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 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 the best way to achieve your financial goals.

All market and economic data as of June 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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We break down common concerns, share possible scenarios, and discuss how policymakers and investors might respond.

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