The US debt is near its highest level in history and on track to grow from here. Neither political party currently seems intent on making it more sustainable. What risks does that present for the US economy and for investors?
The national debt has reemerged as a major market concern. While the trajectory has appeared unsustainable for quite some time, higher interest rates and a rising interest burden have brought it to the fore, prompting questions of whether it will precipitate a crisis in the medium term (Display).
We don’t know the exact tipping point that will finally elicit a reaction from the market or policymakers, but it’s safe to assume that somewhere along the inexorable upward march, the situation will come to a head. We recognize the risks to the economy and the market but are not alarmists. We believe there are still solutions and time to address the underlying issues surrounding the national debt.
The Path Forward
We foresee a combination of factors putting the debt on a sustainable path—a mix of productivity growth, moderate inflation, spending cuts, and tax hikes should be enough to avoid a major crisis.
The best way to address the debt burden would be to follow the post-WWII playbook: grow our way out of it. But how possible is that? That approach worked at the time, due to a convergence of factors that spurred significant growth in both the working-age population and labor productivity. These days, the math is more difficult. Yet if GDP can grow at a 2.2% annualized rate over the next three decades—without stoking inflation or interest rates in a material way—the debt would hover around 120% instead of 170% by 2054. That’s a dramatic shift.
Running higher inflation could also make a meaningful dent in the debt load, but it isn’t a magic wand. Instead, raising taxes and cutting spending will likely emerge as a policy combo, though there currently appears to be very little political appetite for a bipartisan coalition. Ultimately, while both parties may pay lip service to addressing the issue, a meaningful reduction does not appear imminent.
Envisioning a Crisis
What might prompt policymakers in DC to seriously address the issue? We think it would require a crisis or mini-crisis in the bond markets—similar to the early 1990s in the US or 2022 in the UK—to spur Congress into action. And while the catalyst is hard to pin down, it likely involves some collective realization that forces a rapid reassessment of the riskiness of US debt.
Where the crisis would manifest next and how far it would spread is harder to say. As in past episodes, we think it would most likely create political pressure for a course correction in fiscal policy. Assuming the fiscal response was credible, the immediate crisis should dissipate. But if left unaddressed—or if the market deemed policy moves insufficient—the impact could filter through to inflation, relative dollar weakness, or GDP as people become less willing to hold dollars or as higher interest rates take a bite out of economic growth.
An Exorbitant Privilege
It’s important to note that the US enjoys an “exorbitant privilege” as the global reserve currency and preferred destination for international savings. This gives its policymakers more flexibility than other countries would have when it comes to managing debt. Because the US issues its own currency, it does not face the same budgetary constraints as a household or firm would. However, it is still hemmed in by inflation and potential political repercussions.
Yet what happens if foreigners stop buying US bonds? Foreigners are the largest owners of US Treasuries, followed by the Federal Reserve, mutual funds and private pensions, and domestic banks (Display).
Where else could that capital flow? Looking at the relative attractiveness of the US versus other global savings destinations, we conclude that the US is likely to maintain its reserve currency status for the foreseeable future. And as a result, meaningful capital inflows are likely to continue. That should support the US’s borrowing capacity more than other economic fundamentals might suggest, for many years to come.
Asset Allocation and Planning Considerations
At the margin, this analysis makes us favor stocks and inflation-protected bonds slightly more than we would in a purely benign environment. Yet we would not tilt or overhaul allocations too dramatically. Different solutions to the debt issue carry their own implications for each asset class, making a diversified approach most effective to mitigate uncertainty (Display).
For high-net-worth investors, proper estate and tax planning plays a key role in preparing for a resolution to the debt issue. Taxes on the wealthy remain low by historical standards, and US taxes hover at the bottom end of OECD countries. Prudence suggests structuring your estate and your investments for the chance that higher tax rates may be in the offing.
Overall, don’t let the national debt derail your goals. To be sure, the debt is currently on an unsustainable path. Yet even if we don’t have the appetite to tackle it today and the clock keeps ticking, time is nowhere near running out. We’re aware of the risks and incorporate them into our allocations. Keep in mind, those who exaggerate risks win fleeting attention, but those who properly assess and mitigate risks win overall.