U.S. fiscal policy potholes

By Atul Bhatia, CFA

U.S. fiscal policy is often described as “unsustainable,” a word we’ve used ourselves and which we think is entirely appropriate. The critical failing, in our view, is the post-COVID “new normal” of running budget deficits of nearly six percent during economic expansions.

The result is that U.S. policymakers are operating as one-way Keynsians: appropriately ramping up spending during economic shocks such as a global pandemic, and then conveniently forgetting to run a budgetary surplus during good times.

But seeing that the emperor has no clothes is the easy part of U.S. budgetary analysis. The hard part is identifying how the situation resolves – in other words, what likely happens when the unsustainable can no longer be sustained?

There is no unique answer, we believe, to that question. It will depend in large part on how the global economy performs in the coming years, and in part on the “animal spirits” that drive markets. What can be said, we believe, is that investors need to be cognisant of what is – and more importantly what is not – likely as budgetary constraints eventually bind in the United States.

We think extreme outcomes are unlikely, and that for most investors the best approach to U.S. debt is a return to the basics: global diversification, frequent rebalancing, and healthy skepticism. Active positioning to exploit a U.S. debt crisis is more likely, we believe, to end in tears of sorrow rather than tears of joy.

Eventually something’s got to give

U.S. federal debt as a percentage of GDP

U.S. federal interest payments as a percentage of GDP

Source – RBC Wealth Management, White House Office of Management & Budget (OMB), Federal Reserve Bank of St. Louis, FRED database, Bloomberg; annual data through 2025

The good, the bad, and the ugly

Let’s start with what we think is unlikely to happen.

First, there’s the painless path to debt reduction. This often takes the form of a deus ex machina assertion about AI productivity gains or revenue reduction that unleashes decades of non-inflationary, above-trend growth. We think these are largely fairy tales.

While AI productivity could reduce the pain of fiscal adjustment, we think it’s unlikely to achieve the scale of gains needed to meaningfully reduce the deficit and the debt. More importantly, we see any gains likely disappearing in a wave of tax cuts, subsidies, and spending.

Next up, we have the idea of political leaders showing genuine leadership. This, we think, is even less likely. The simple reality, in our opinion, is that fixing the deficit will almost certainly be a contractionary influence on the U.S. economy and will likely lead to higher unemployment and lower stock prices. In short, it is a great way to lose an election.

As a result, single-party control is never going to address the issue, in our view. Talk about it, sure. Blame the other side, absolutely. But do something about it? Maybe next time. Divided government is unlikely to be better, given the high degree of partisan divide. The type of compromise and negotiation required to address the deficit is simply beyond the realities of today’s political conditions, in our opinion.

Safe to say, we are not optimistic of an easy budget path ahead.

But we believe the negative extreme is even less likely. We often read of analogies to the Weimar Republic and wheelbarrows of dollars to buy a loaf of bread. Both intellectual honesty and U.S. securities law compel us to recognise that this is a possible outcome, but we would emphasise that we see it as a remote outcome, to say the least.

Post-WWI German debt was crushing, and came with devastated infrastructure and massive human carnage. The U.S. just has a bit too much debt and needs to make some fiscal adjustments. There’s a point at which differences of scale are differences of kind, and the comparison between the U.S. and hyperinflation regimes is firmly in that camp, we believe.

A fistful of dollars

If the two extremes are unlikely, we’re left where we usually are in economics – the uncertain middle. Even with the lack of clarity, we think there are a few likely hallmarks of the debt adjustment process:

• Higher inflation: The U.S. has to pay back dollars. The less those dollars are worth, the less painful the repayment. The Fed may talk tough, but tolerating a bit of extra inflation helps the budget, helps home prices, and makes friends in Washington, D.C.
• Long bond pain: As we’ve said, we believe a real solution will require compromise between politicians via some good old-fashioned backroom deal making. Political realities make it impossible for politicians to kick off the process, in our opinion, but the bond market is not squeamish about making itself heard. Expect periodic flare-ups of higher yields to exert pressure on policymakers to act.
• Unnecessary economic contraction: Adding debt is borrowing future growth, and reducing it is paying back the extra fillip. By its nature, deficit and debt reductions are not going to be fun, but the costs can be minimised by timing and sequencing. We think the current environment – with solid, broad-based growth – would be perfect to start the process. In a similar vein, a well-considered plan, agreed to and implemented over decades, could be a real boon for the United States. Unfortunately, that’s unlikely, in our view. Instead, we think we’ll get an ad hoc series of measures, kicked off when the bond market forces it, with the usual stop-start approach to savings. In short, effective, but not efficient.

Investment implications

Despite our skepticism that debt reduction will be well-handled, we would be very cautious investing on that view.

One problem is timing. The budget can stay irrational much longer than any investor can stay solvent. Forecasters have been calling out U.S. debt dynamics since the Reagan administration in the 1980s. Imagine missing all those investment gains waiting for a collapse.

Another is policy response. We are very cautious on U.S. Treasury 30-year debt, for instance. But in the context of a large debt selloff, it would not be strange if the Fed stepped in to buy debt and put a ceiling on yields. While that may ultimately prove self-defeating, it would be cold comfort to investors who lost money.

The better approach, we believe, is sticking to the basics and making small adjustments. These include diversifying internationally, rebalancing between asset classes, and considering shorter Treasury maturities.

---

---