We have received several client questions in recent weeks about the perilous trajectory of our federal debt. It is an important question, and it is one that we have spent a good deal of time thinking about. And though we don’t have all the answers, we hope our thoughts below will help frame the debate.
Federal Reserve Chairman Jerome Powell has repeatedly stated, most recently in his summer Humphrey-Hawkins testimony before Congress, that the current fiscal trajectory is “unsustainable.” Federal debt continues to grow faster than the economy even as economic growth appears to be accelerating and as long as debt grows faster than GDP, the ratio of debt to GDP will continue to climb. The question is, at what point does this matter? It clearly didn’t matter too much as the ratio of gross federal debt to GDP rose from around 31% in 1980 to its current level of about 105%. How do we know? Because borrowing costs trended lower over this same time frame. The yield on the 10-year Treasury note dropped from a high of almost 16% in late 1981 to a low of 1.36% in mid-2016. Usually when the demand for something goes up (i.e., the US Treasury’s demand for money), the price tends to go up. In this case, though, the growth in the supply of money available to the US Treasury outstripped the growth in demand, and interest rates fell
Source: Federal Reserve Bank of St. Louis
Looking to the future, the Congressional Budget Office is now projecting that federal debt held by the public (that is, federal debt excluding that held by other federal agencies) will increase 83% over the next decade to $28.7 trillion. By 2028, the CBO expects that the ratio of federal debt held by the public to GDP will be over 96% compared to about 76.5% in 2017. Daunting numbers, indeed. (For our purposes here, it is important to distinguish between gross federal debt, which is used for the chart above, and debt held by the public. The fact that the Treasury will no longer be able to raid the cookie jar [borrow from the Social Security trust] means that it will need to find a much larger investor base to absorb the massive amounts of Treasury issuance needed to fund the government in the years to come. Therefore, debt held by the public is expected to grow at a much faster pace than gross federal debt over the next decade.)
With that as background, let’s move to the threat that our profligate spending may pose. First I’ll say that the situation may not be as dire at it may first appear. Because we are in a period of very low interest rates, the percentage of the economy devoted to servicing the federal debt, while perhaps not low, is currently manageable when placed into an historical context. As you can see in the chart below, the interest payments on the debt, in terms of GDP, in recent years have been close to historical norms at a little less than 1.5%. From the early 80s to late 90s, on the other hand, the federal government spent over 2% of the GDP on interest payments, and the percentage topped out at over 3% during the recession of the early 90s. This time period was characterized by not only rapid growth in federal government debt, but also relatively high interest rates. The fact that interest rates are now low is our primary line of defense against a fiscal catastrophe.
Source: Federal Reserve Bank of St. Louis
All is not completely rosy, however, as the current trends are toward both rising interest rates and rising deficits. To make matters worse, the Treasury has shown a perplexing propensity to issue shorter-term bonds rather than locking in low interest rates for a longer time period. Generally speaking, if rates are trending downwards, an issuer would want to finance using shorter-term bonds, allowing for the possibility of refinancing at lower rates when the term expires. And generally the converse is true – if rates are rising, lock in the lowest rate for the longest term. This is Corporate Finance 101, and it applies to the federal government as well. The feds have failed.
So how much of a threat are rising interest rates? The answers cannot be known, but the CBO estimates that the rate on the 3-month Treasury bill will rise from a little over 2% today to 3.2% in 2021. Over the same time frame, the yield on the 10-year Treasury bond is expected to rise from about 2.9% today to about 4.0% by 2021. Based on those interest-rate projections, the CBO expects interest expense as a percentage of GDP to rise from about 1.6% in 2018 to 2.5% in 2021 – still well below the peak of over 3% we experienced during the recession of 1990-1991 (see the second chart above). However, if we go further out, the CBO does expect to hit those heights again by the year 2028. So there’s time. Though the increasing debt-service burden over the coming years will almost certainly be a drag on economic growth, it does not appear as though rising interest rates, if maintained at a moderate pace, will cause any kind of fiscal calamity for the government.
Another important point to stress is that the US Treasury has the power to print an unlimited amount of money, if need be, so that it can pay off its debts. While this would not be received positively by our creditors (whom we depend on to finance our profligate spending) and would certainly cause inflation, this option is always available to us (unlike individual European countries that have a common currency and therefore can’t inflate their way out of debt by printing more money). Furthermore, the dollar’s status as the reserve currency for the world means that the market for our debt is the deepest and most liquid, and this will be the case until an alternative currency (or a crypto-currency like Bitcoin) poses a threat to the dollar. Dick Cheney famously said, “deficits don’t matter.” The reason he said that is because of the dollar’s status as reserve currency, and to a certain extent he is right. We have continued to run up bigger and bigger debts with no repercussions – until very recently, interest rates stayed on a downward trajectory for over 30 years.
The reality is that our high deficits, debt, and dire fiscal outlook (which is largely the result of an expected ramp in entitlement spending due to aging boomers) will not be a problem until suddenly it is. If our creditors decide at some point that our deficits have gotten out of control, they can revolt by selling their Treasuries or refusing to buy more. (Russia is currently displaying its displeasure with the US by selling almost all of their Treasury holdings in retaliation for economic sanctions). However, for our biggest creditors, they would be shooting themselves in the foot if they aggressively sold their Treasuries because the value of their remaining holdings would plummet. Moreover, they would need to have an alternative currency for their reserves.
We have consistently talked about the risks of so much debt over the past many years. But we have also said that we have the capability to almost instantly improve the budget outlook by enacting entitlement reform. If we raised the retirement age for Social Security (which only makes sense due to longer life spans) and means-test Medicare, we would instantly have more flexibility to invest in areas (like education, training, infrastructure, and new industries Artificial Intelligence, biotech, green energy, etc.) that improve productivity and therefore accelerate economic growth. Because economic growth is simply the sum of productivity growth and labor growth, the investments in productivity would ultimately generate higher rates of GDP growth through faster productivity growth. It should also be said that our economic growth outlook might be further improved if efforts to dramatically scale back immigration were abandoned. In any case, almost everyone would agree that faster and more sustainable rates economic growth are the best way to deal with the problem of too much debt. If the economy is growing faster, tax receipts will rise and transfer payments will fall, improving the fiscal outlook.
The issue, of course, is that there is no political will to cut entitlement spending. It’s basically political suicide. We probably won’t end up doing it until it is forced upon us. Still, that lever is there, and as long as it is there I think the threats of bond vigilantes and hyperinflation as a result of money-printing are limited. In any event, we are unlikely to reach the crisis stage in the next few years. Our debt service ratio is far too low right now to become a problem, and the dollar’s status as reserve currency is as yet unchallenged.
What are the investment implications of carrying so much federal debt? First we’d say that many an investor have been frustrated over the past many years at the inability to get a reasonable yield on their deposits and/or bonds. The Fed’s aggressive monetary policy had the unfortunately consequence of punishing savers, bailing out reckless actors, and forcing investors into assets that carry more risk than they are comfortable with. Where is a safe place to invest when government borrowing seems out of control (largely a result of quantitative easing) and stock valuations appear full? This is a big problem for our country, in particular, because the large majority of our people have under-saved for retirement. High current valuations for both stocks and bonds mean that returns will be lower, perhaps much lower, in the future. Those who are behind will have to set aside even more money due to those lower return expectations. And unfortunately, from a macro standpoint, the need to save more will be a drag on economic growth.
In our view, the best alternative is high-quality, blue-chip stocks with high dividend yields that will continue to grow. These types of stocks have reasonable valuations, offer some protection against inflation, generate a lot of cash and have defensive balance sheets. It is true that you may be sacrificing some current performance so that you will be better positioned if and when inflation and interest-rates begin to increase at a faster pace. But that is a choice every investor must make. Do you dance while the music is playing (as former CEO of Citibank from Chuck Prince famously said), or do you position yourself to withstand turbulence? For us the choice is clear.