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Weekly Market Analysis - Will Debt and Deficits Derail the U.S. Recovery?
Posted on3 Things to Know
Debt and Deficits are Unlikely to Derail the US Recovery
Is the pace of US Federal borrowing long-run sustainable? No. But will the US have an economic crisis in the next decade because of Federal borrowing? We think it’s unlikely.
This dual view doesn’t mean debt and government spending is “insignificant.” How resources are used is an important driver of the economy. That doesn’t mean the US Treasury will be unable to refinance and grow its borrowing or that real interest rates will surge.
Global Confidence in US Bonds Remains High
Many long-run Federal debt metrics looked worse in 2020 when short-run US borrowing was also at its peak pace. Rates plummeted to record lows despite this. Then and now, the US dollar was strong and foreign confidence in US bonds high.
Do Not Wait for Household Debt to Scuttle this Recovery
Debt crises are far more common for private borrowers unable to repay debts. This was the case in 2007-2008.
While components of US household debt have surged, broad private debt and household debt have been restrained, falling relative to GDP in recent years. Those looking for an economy-wide debt crisis may be distracted and waiting in vain.
Summary
Long before there were concerns about climate change, pollution or even nuclear proliferation, debt has served as a singular worry to scuttle attention from other economic issues. Employment and profits may be growing, but “what about the debt?!” This is the question that can’t be answered succinctly with any satisfaction.
Future debts are important to economic performance because Federal borrowing to pay for retiree healthcare and other costs compete for scarce savings. Yet given the critical role the US plays in world finance, it allows the US government to grow debt further and shift the burden of financing to future generations of taxpayers. The cost of the debt in the coming decade is not likely to rise to extreme levels unless another, more credible borrower or borrowers competes more successfully for US and global savings.
The Fed is also a potent source of US credibility as evidenced by the US dollar’s enduring strength. Many other government borrowers would likely default before the US does. While all events and risks can’t be anticipated far into the future, we believe a US government debt crisis is unlikely in the coming decade.
Portfolio considerations
For those looking to stabilize portfolios, hedging costs in equity and credit markets remain historically inexpensive. For those that are underexposed to equity and bond market investments, we’d look for pullbacks to add to reasonably-priced growth and income opportunities highlighted in our asset allocation.
Source: Bloomberg, Feb 14, 2024.
Rising U.S Debt is Unlikely to Cause a Crisis
Debt crises do occur. For government borrowers, there have been many sovereign defaults, generally among smaller economies borrowing in foreign currencies they don’t control (most often the US dollar). In the US itself, the events of 2008 were undoubtedly a debt crisis. However, this was driven by very poor lending standards for home mortgage borrowers unable to repay shaky housing investments.
US government debt since 2008 has been rising rapidly on a bi-partisan basis. The US Treasury, however, sits in an unusual place ahead of the world’s other borrowers in accessing credit from domestic (77%) and international lenders (23%) to be the world’s largest debtor.
Unlike other developed economies, the bulk of government support for healthcare spending is age-triggered rather than birth triggered. Driven by the world’s most expensive healthcare costs per unit (according to The Organization for Economic Cooperation and Development data), and limited direct revenue collections for Medicare spending, an aging population has a larger impact on US debt creation than other economies which generally cover or insure healthcare spending from birth. How the US Congress determines to spend, tax, and borrow in the future is an open question. Current law would leave a trajectory of rising spending and deficits relative to GDP in the decade ahead. However, US budget projections that embed long-term interest rate expectations quite close to current levels seem entirely plausible.
Another unique feature of US borrowing is the existence of a statutory “debt ceiling.” Enacted at the time of World War I, Congress must ratify its borrowing plans – including servicing existing debt – after making decisions to tax and spend. On occasion, a few US policymakers have threatened intentional default rather than raise the debt ceiling which has increased almost annually since the early 20th century. The threat of intentional default is political rather than a result of market forces. As such, it should be considered a relatively remote risk to the world economy and financial markets.
Global Confidence in US Bonds Remains High
But what determines the US’s cost and ability to borrow now? The periods of the largest immediate debt issuance – to support economic stabilization – generally occur during recessions. Therefore, short-term and even long-term interest rates are negatively correlated with US budget deficits. Periods of economic weakness tend to be times when savers are risk averse and gladly add to low-risk fixed income holdings rather than allocate more to risk assets, pushing down yields.
In 2020, when U.S. borrowing rose a record $4.3 trillion, US 10-year Treasury yields fell to a record low 0.5%. As the economy recovered, net borrowing fell to $2.4 trillion last year, while 10-year US Treasury yields rising to about 4% at year-end. One of the Dollar’s great strengths is the Federal Reserve’s commitment to low inflation. Many have been shocked by the U.S. central bank raising interest rates so high that it has forced up government borrowing costs while marking down the value of the Fed’s own bond portfolio. History, however, suggests that the Fed is actually limiting future borrowing costs for the US Treasury by maintaining the dollar’s credibility.
Do Not Wait for Household Debt to Scuttle this Recovery
While the U.S. government fiscal situation may be unsustainable over the long run, the consumer balance sheet is fundamentally healthier post pandemic than it was before. Post housing crisis consumers have retrenched significantly and, with high inflation deflating debts, a generationally important reset of debt levels has occurred.
The reality - in aggregate and from a balance sheet perspective - is that the pandemic, massive government cash infusions, and inflation were a gift to consumers balance sheets. High inflation and a stalled housing market and consumers’ tendency to hold floating assets but fixed interest debts have driven up their net worth while driving debt to income ratios to the lowest level in 20 years.
