America’s Growing Debt Problem

Lawrence Gillum:

With election season in full swing, investors may be concerned about how either a Kamala Harris or a Donald Trump presidential term will impact their portfolios. However, for the long-term investor, political opinions are best expressed at the polls and not in portfolios. Markets care more about policy than politics. But, with neither party frankly concerned about funding policy goals, we would expect government spending to continue mostly unabated regardless of who wins in November. So in this Street View video, we take a look at what could be the biggest loser during this election cycle, the federal deficit. While there are still several months until the election is decided, the expectation is that regardless of who ultimately becomes our 47 president, the biggest loser could be the fiscal deficit. Per the Congressional Budget Office, the U.S. government is expected to run sizable deficits over the next decade to the tune of five to 7% of gross domestic product each year.

Lawrence Gillum:

The deficit is expected to increase significantly in relation to GDP over the next 30 years, reaching 8.5% of GDP in 2054. Now, those projections assume the Trump tax cuts will expire at the end of 2025. So deficits are likely going to be even higher, assuming Harris or Trump will extend most, if not all of the tax cuts. If Trump's tax cuts are fully extended, budget deficits are expected to be in the seven to 8% range of GDP over the next decade. But ultimately, deficits will remain elevated regardless of who's in the White House in 2025, even without new spending or tax cuts due to higher spending on Medicare and Social Security, plus the growing interest expense on the growing debt pile. So with budget deficits expected into the foreseeable future, the Treasury Department will need to increase Treasury issuance to fund those deficits.

Lawrence Gillum:

More debt added to an already growing debt load. In early August, total outstanding Treasury debt eclipsed $35 trillion, which is up from the $31.5 trillion in June 2023, right before Congress gave the Treasury Department unfettered borrowing capacity until January 2025. Now, to be fair, only around $28 trillion of that is held by the public with the rest held within the U.S. government. Now, while certainly large numbers, absolute numbers like $28 trillion, however, failed to provide the necessary context, particularly for a growing economy framed against economic growth, total debt held by the public is currently a manageable 99% of GDP. Debt held by the public, though is expected to eclipse its highest level ever in 2029, measured as a percentage of GDP and then continue to grow, reaching 166% of GDP in 2054 and remaining on track to increase thereafter. Perhaps a very small sense of comfort at large debt loads can be found when looking at the current debt to GDP ratios of other developed countries. By far, the most indebted country is Japan, with debt to GDP ratios over 250% with Singapore, Italy, and Greece, all with debt to GDP ratios above those of the U.S.

Lawrence Gillum:

However, that comfort goes away rather quickly when you consider that the U.S. is expected to increase its debt load significantly quicker than those other developed countries over the next few decades. Is there a glimmer of hope? Interest payments as a share of federal expenditures have foreshadowed previous periods of fiscal consolidation. Currently, interest payments account for close to 14% of total U.S. expenditures and are rising. Now, there is historical precedent with Congress making necessary changes to federal budgets. Previous episodes when interest payments reached similar levels were followed by fiscal consolidation after World War II under Ronald Reagan in the late 1980s and under Bill Clinton in the 1990s. Now we'll see if current and future lawmakers have the intestinal fortitude to make the tough choices as interest payments continue to increase. So where does that leave us? Despite the mountain of debt and growing interest payments, the U.S. government is not at risk of financial collapse, nor are there concerns of such.

Lawrence Gillum:

As long as Treasuries are considered risk-free securities, there will always be buyers of Treasuries and Treasury can fund its deficits. Full stop. The question though, remains price. At what price would it take for these non-traditional buyers to get interested? So far, we haven't seen a tremendous drop off in demand during these treasury auctions, but there could be an eventual fatigue, which means yields would need to increase to attract that additional demand. So as issuance increases, that may mean investors will start to demand more compensation, higher yields, for holding larger and larger amounts of debt. So what does this mean for investors? Amid elevated debt and deficits? We expect more market volatility ahead as financial markets become more sensitive to fiscal and political shocks. The volatility in the UK after budgetary concerns cause a government bond buyer strike in 2022 and a similar episode in France this year come to mind as possible or even plausible reactions here in the U.S. eventually as well.

Lawrence Gillum:

But even with potential pressures on longer maturity yields with the Fed set to cut interest rates this year and into 2025, we're likely going to see shorter maturity Treasury yields fall more than longer maturity yields. The treasury yield curve is still inverted, so until the curve writes itself, longer maturity yields are likely stuck at or around current levels. Now, this limits the potential for price appreciation, but income opportunities are more enduring. And one such income opportunity that could benefit savers is TIPS. Tips are Treasury securities whose principle and interest payments are adjusted for inflation. Unlike other Treasury securities where the principle is fixed, the principle of TIPS can go up or down over its term. So when TIPS matures, if the principle is higher than the original amount, you get that increased amount. If the principle is equal to or lower than the original amount, you get the original amount.

Lawrence Gillum:

Now, since these securities are government-guaranteed, TIPS investors who hold the individual bonds to maturity receive at a minimum the original investment back plus coupons, which are paid semi-annually, but could get more than the original investment if inflation surprises to the upside, which we think is possible given the ongoing fiscal spending. Now, one of the key metrics we examined to determine if when it makes sense to own tips versus just owning comparable maturity, nominal treasuries, is the break even rate between these two securities. That is the difference in yields between the two securities, which is also the market's best guess about what inflation will average over the maturity of those securities. Now, currently, breakevens remain relatively contained, so the bar to invest in TIPS, particularly relative to nominal treasuries remains fairly low. As such, depending on your inflation expectations going forward, it may make sense to allocate a small portion of your bond portfolio to TIPS. The next few months are likely going to be noisy with all the election rhetoric, but for long-term investors, political opinions are best expressed at the polls and not in portfolios. Investors are likely better served by staying invested in markets. Regardless of which party claims the presidential office. It doesn't mean there won't be volatility. There likely will be, especially as the rhetoric increase is going into election day. However, research has shown that regardless of the winner, markets tend to go up and the best strategy tends to be the simplest. Stay invested. Thanks for listening.