U.S. debt: Changing facts, updating views

By Atul Bhatia, CFA

Our previous view, we believe, was demonstrably correct. Federal debt outstanding is at a record level in dollar terms, but U.S. equities are at or near all-time highs, and the heart of the Treasury curve – securities maturing in three to 10 years – is among the best-performing segments of the U.S. bond market. Clearly, a portfolio that positioned for a U.S. asset price collapse based on record borrowing would have performed poorly.

Why now?

Facts, however, have changed and so has our view. We no longer believe investors should completely ignore the U.S. debt when building portfolios. Instead, we think they need to consider the market implications of government borrowing at an unsustainable pace.

What remains consistent, however, is that we do not believe fiscal policy should become the sole factor in decision making, and we remain firmly convinced that any discussion of a potential U.S. debt default is wildly speculative.

In short, we think the luxury of ignoring Treasury debt is gone, but that fleeing U.S. assets blindly remains a critical mistake.

Our rising concern on the U.S. debt level is a result of the interplay between various fiscal dynamics but boils down to the magnitude of the current debt, the pace of U.S. borrowing, and a potential unfavourable shift in lender incentives. These trends are accelerating the date at which the U.S. will need to confront its debt, and the total lack of response by voters and politicians leads us to believe markets will have to play the key role in driving change.

Looked at in more detail, our key concerns are:

• Magnitude of the debt and deficit: In the years leading up to the COVID-19 pandemic, U.S. budget deficits were running between 2.6 percent and 4.7 percent of GDP and debt held by the public was less than 80 percent of GDP. Historically, if a crisis hit, the budget deficit would expand dramatically, but when the crisis passed, the deficit would drop, often to less than 2.5 percent of GDP. That was not ideal, but it was manageable. In contrast, the post-COVID, “new normal” approach of adding 6.5 percent of GDP deficits to an existing debt stock equal to or above GDP is neither ideal nor, we believe, manageable.
• Apparent inability for a political fix: No politician admits they are pro-debt funded deficits, but actions speak louder than words. Under both Democrat and Republican presidencies, with various Congressional makeups, we have seen budget-busting programs – whether infrastructure projects or unfunded tax cuts – prioritized over a return to manageable deficit levels.
• When it came to fiscal balance, the current administration arrived with two potential advantages. One was the Department of Government Efficiency (DOGE). The other was a razor-thin Congressional majority that gave significant negotiating leverage to fiscal conservatives. Despite this promising backdrop, the administration is now advancing legislation that will add trillions of dollars in debt over the next decade. We had our doubts going in, but at this point we believe it is impossible to credibly maintain that – absent external pressure – politicians will be able to achieve fiscal balance.
• External pressure may mean market pressure: External pressure, we believe, means either voters or markets. Voter pressure would be ideal – it would allow for a well-planned, multiyear approach to slowing and then reversing fiscal trends. But like most ideal solutions, we fear it may prove elusive. Instead, we think that it will ultimately be market pressure – in the form of higher bond yields, lower stock prices, and/or a weaker dollar – that leads to a reversal of current trends. For the move to matter, we think it would have to be sharp and significant.
• Fading interest means rising interest? Overseas investors own about a one-third of all Treasury debt. One consequence of lowering the U.S. trade deficit will be reducing the number of dollars that get recycled into government bonds, limiting a vital, and largely price-insensitive, buyer of Treasuries. Overseas investors may also be nervous about Section 899, a proposed change to U.S. law that would allow a president to impose tax surcharges on investors from countries with “discriminatory” tax codes. Absent a robust international borrower base, government financing costs are likely to increase, pulling forward concerns about debt sustainability. As the chart below illustrates, higher interest rates mean faster debt accumulation, as more and more debt sales are required to keep up with financing costs on previous deficits.

Put simply, the U.S. has more debt, bigger deficits, and worse fiscal prospects than it did only five or 10 years ago. Combined with an alienated lender pool and myopic politicians, we believe investors must factor in debt dynamics to their investment process.

High interest rates give the U.S. less budget flexibility

Financing costs for existing debt increasingly drive deficits

Bound to bonds

Given that backdrop, should investors flee U.S. Treasuries? Absolutely not, in our view. We still expect bonds to provide important downside protections in a recession or as the Fed cuts interest rates to stimulate economic growth. Nor do we think investors should be particularly concerned about default risk. At the end of the day, the U.S. borrows in dollars and can issue dollars at will. As a result, we think the likelihood of timely repayment of Treasuries remains incredibly high.

But we do think investors would be wise to think about how far out they go on the Treasury curve, and how much additional yield they get for volatility risk. After all, the process of markets “forcing” the government to care about debts is a potentially stomach-churning rollercoaster of price drops. A little additional yield and avoiding or reducing exposure to 30-year Treasuries could be a nice dose of preventative medicine.

Don’t run, diversify

When it comes to equities, we think the argument in favour of U.S. exposure is even more obvious. The U.S. remains a large, vibrant economy with plentiful natural resources; a creative, talented labour force; and cutting-edge technology. There is no argument we see for exiting an economy with those characteristics, particularly since most other leading economies suffer from their own debt and deficit concerns.

Remaining in U.S. equities, however, is a far cry from remaining exclusively in U.S. equities. As our other Midyear Outlook article, “A world of opportunities?”, makes clear, there are strong arguments in favour of internationally diversifying an equity portfolio. Potential debt-related volatility in U.S. assets is just another incentive.

We think it’s equally important for investors to consider how a shrinking federal budget deficit – whenever it happens – could impact U.S. stock prices. One reason for the current high level of corporate earnings is the impact of rampant government spending. A large chunk of that 6.5 percent debt-funded deficit eventually finds its way into corporate income statements. A shift toward greater fiscal balance – if it is not well-planned – could lead to earnings headwinds for some companies.

Inevitable, but perhaps not imminent

Our view is that some form of market reaction to deficits and debt is becoming, or more likely has become, inevitable. But inevitable is a far cry from imminent. Folks have been railing against the danger of U.S. debt for nearly half a century, without any investment success to date. We are extremely aware that Japan runs a debt-to-GDP ratio nearly double that of the United States, and that Treasuries are issued in U.S. currency under U.S. law – powerful advantages.

Timing the end of a dynamic that has existed for 50 years is fraught with difficulty, and it could easily be a matter of months, years, or even decades before there is any significant move by investors to push back on U.S. borrowing. We feel confident, however, saying that the longer the U.S. waits to address its debt issue, the greater the likely cost for investors and taxpayers.

Not the beginning of the end, maybe the end of the beginning?

For investors, risk typically lies on a continuum. At a certain level, a theoretical risk is largely irrelevant for price formation. At the other extreme, a negative outcome is seen as so likely that it dominates investor thinking. Between those two extremes lives the messy world of price formation.

Up until now, we’ve largely thought of the federal debt as lying at the good end of the risk spectrum – a theoretical concern with little practical implication. We now believe that we’ve entered the messier terrain of thinking about when and how the pace of debt creation in the U.S. can be brought to heel.

---

---