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 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.

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.

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 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). TheUnited 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, theUnited 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.

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.

DISCLOSURES

The information presented is not intended to be making value judgments on the preferred outcome of any government decision or political election.

Index definitions:

The Russell 3000 Index is a capitalization-weighted stock market index that seeks to be a benchmark of the entire U.S. stock market. It measures the performance of the largest 3,000 U.S. companies representing approximately 96% of the investable U.S. equity market.

The S&P 500 Equal Weight Index is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight of the index total at each quarterly rebalance.

The Bloomberg U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

The S&P 500 Equal Weighted Index is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight – or 0.2% of the index total at each quarterly rebalance.

The Magnificent Seven stocks are a group of influential companies in the U.S. stock market: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.

The Magnificent 7 Index is an equal-dollar weighted equity benchmark consisting of a fixed basket of 7 widely-traded companies (Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta, Tesla) classified in the United States and representing the Communications, Consumer Discretionary and Technology sectors as defined by Bloomberg Industry Classification System (BICS).

The S&P Midcap 400 Index is a capitalization-weighted index which measures the performance of the mid-range sector of the U.S. stock market.

The S&P 500 index is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

Bonds are subject to interest rate risk, credit, call, liquidity and default risk of the issuer. Bond prices generally fall when interest rates rise.

The price of equity securities may rise or fall due to the changes in the broad market or changes in a company's financial condition, sometimes rapidly or unpredictably. Equity securities are subject to "stock market risk" meaning that stock prices in general may decline over short or extended periods of time.

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

The Bloomberg Eco Surprise Index shows the degree to which economic analysts under- or over-estimate the trends in the business cycle. The surprise element is defined as the percentage difference between analyst forecasts and the published value of economic data releases.

The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance.

The NASDAQ 100 Index is a basket of the 100 largest, most actively traded U.S companies listed on the NASDAQ stock exchange. The index includes companies from various industries except for the financial industry, like commercial and investment banks. These non-financial sectors include retail, biotechnology, industrial, technology, health care, and others.

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How Worried Should You Be About The U.S. Debt And Deficit? | J.P. Morgan (2024)