As we approach a rising rate environment, the scale of U.S. federal debt has some investors concerned about the sustainability of government finances in the coming years. In this bulletin we consider the most common myths about the government’s debt and discuss how investors can position their portfolios to withstand what we believe are manageable headwinds related to the federal debt burden. (This paper is an updated version of a paper with the same title, originally released in August 2015.)
MYTH 1: THE U.S. WILL DEFAULT ON ITS DEBT
Although much hype surrounds the possibility of a U.S. debt default, especially after the debt ceiling fiascos of 2011 and 2012, the likelihood is infinitesimally small. One of the reasons the U.S. has been-and continues to be-a traditional safe haven for global investors is that investors know very well that the U.S. has nearly unlimited taxing power and a huge asset base.
The total assets owned by the U.S. government are far greater than its total debt outstanding (Exhibit 1), with an approximate debt-to-assets ratio of 10%.1 This would be akin to someone with roughly $1 million of debt and a bank account with $10 million of cash or other assets. And this estimate of the U.S. government’s assets is conservative, not accounting for the significant amount of buildings owned.
In other words, the federal government could – if needed – force liquidation of these assets to pay its entire stock of debt nearly 10 times over before defaulting. This is before even considering increasing taxes on the private sector.
MYTH 2: THE U.S. DEBT IS OUT OF CONTROL
The U.S. debt is at elevated levels, but the current debt-to-GDP ratio is manageable.
In absolute terms, U.S. government debt, measured as total debt held by the public, is $13 trillion -a record high. A broader measure of U.S. debt, which includes the debt the government owes to itself, totals $19 trillion. But absolute debt levels do not tell the whole story, as it is important to consider the size of our debt in comparison to the size of the economy, which is also at a record high.
In this context, the debt-to-GDP ratio stands at approximately 77%; an elevated level, but hardly a record. For instance, the ratio reached a high of 108% in 1946, reflecting the costs of World War II (Exhibit 2). While the debt-to-GDP ratio is projected to increase, it is not expected to explode through the next decade. The Congressional Budget Office (CBO), a non-partisan government organization, projects an increase in net debt as a percentage of GDP – from 77% in 2016 to 86% in 2026 (Exhibit 2).2 Research suggests that high levels of government debt can be damaging to
long-term growth, potentially leaving an economy more susceptible to shocks.3
It is important to consider that future debt levels are not necessarily on a pre-set course. Since growth in the debt-to-GDP projections is shaped by the current paths of government revenues and outlays, if congress were to decide to address the deficit (by addressing thorny political issues such as taxes and entitlement spending) the trajectory could change.
Considering government debt from the vantage point of the annual federal budget, the U.S. fiscal situation has improved dramatically. The federal budget deficit has declined steadily from 9.8% of GDP in fiscal year 2009 to an estimated 3.2% of GDP in 2016, and it is forecasted to hover near 3% for the next few years (Exhibit 3).
MYTH 3: RISING RATES WILL EXPLODE THE DEBT
While rising rates would certainly cause the government’s net interest expense – its cost to service the debt – to increase, it will not cause it to explode.
First, rising net interest expense only becomes destabilizing if it contributes to a problematic shift in the country’s overall debt dynamics (a massive surge in debt-to-GDP, for example). But any rise in interest rates would almost assuredly be the result of a healthier economy and inflation expectations. This matters a lot, because if both GDP and the debt rise in lockstep, the debt-to-GDP ratio does not actually grow.
A closer look at this dynamic through the lens of the CBO’s forecasts posits that the yield of the 10-year U.S. Treasury will average 2.3% in 2017, 2.8% in 2018 and 3.6% in 2026 (Exhibit 3). But the forecasts also project economic growth of 2.4%, 2.2% and 1.9%, respectively. As a result, the CBO sees federal net interest payments rising slightly from 1.4% of GDP in 2017 to close to 2% in 2020 and 2.6% in 2026. Overall, net interest expenses are not set to increase as dramatically as many previously thought. This in large part is due to the view that interest rates are expected to stay lower for longer. A last important point is that much of the U.S. government debt that was issued in the past 7 years was done so at record low rates. This cheap debt has locked in coupon payments, that will not increase as interest rates rise.
If rates were to defy expectations and rise dramatically and quickly, the interest burden could indeed become a bigger problem. However, we (along with the Fed and CBO) expect that interest rates will rise slowly and steadily, given the lack of inflationary pressure in the economy.
Moreover, global demand for safety, liquidity and transparency continues to foster strong demand for U.S. Treasury debt, which may well act to insulate rates from a more dangerous spike. Overall, higher rates will not cause the debt to explode, contrary to much of the rhetoric that surrounds the issue.
MYTH 4: THE BUDGET PROBLEM CANNOT BE FIXED
The truth is that the budget problems facing our country are not difficult to solve from a mathematical perspective. The bigger challenge is finding the political will and the level of compromise and collaboration that would be required to make progress.
For example, according to a 2015 report from the Medicare Trustees, the trust fund supporting a significant part of Medicare costs is projected to be depleted by 2030. However, the present value shortfall over the next 75 years could be entirely covered if Medicare payroll taxes were increased by just 68bps, from 2.9% to 3.6%. Increasing taxes is not the only option; changes in the age of eligibility or the amount of benefits received are other feasible tweaks to handle the shortfall. There are many other pressing problems in which the solution is mathematically clear but politically difficult. Although potential budget fixes have real costs, they need not require an unreasonable amount of sacrifice.
Of course, Social Security is another issue under scrutiny; according to the Social Security Trustees 2015 Report, the trust fund backing the program would be depleted in 2035. Importantly, this does not mean that scheduled benefits would fall to zero. Rather, they would drop to 77% of their originally set levels through 2089. Clearly, this is a serious situation, and Congress will likely take action in the coming years to address the issue. But for the moment, the harsh reality is that the working age population should be planning how to use the next 20 years to prepare for the changes that are likely in the pipeline – potential shortfalls in benefits received, delayed eligibility or increased taxes to fund the currently promised level of benefits. Saving more, spending less and working with a financial advisor to build a financial plan and a diverse portfolio of investments can help an individual achieve a secure retirement.
MYTH 5: THE BIGGEST RISK TO INVESTORS IS THE FEDERAL DEBT
As the preceding arguments have made clear, the federal debt is far from the biggest risk facing investors. Nevertheless, investors should establish a plan to address a few manageable debt-related investment headwinds:
Debt-related headwinds for investors:
• Solving for growth: For investors, getting an investment portfolio to grow in an era of slower overall economic and profit growth is an important consideration. In their widely-read book, “This Time is Different,” economists Reinhart and Rogoff sparked a fierce debate about the growth implications of shouldering a heavy debt burden.
While specific debt levels and their associated costs remains a hotly contested issue amongst economists, it stands to reason that at a certain point, government spending on productive endeavors like investment spending on physical capital, R&D and education and training can be crowded out over time by increasing net interest expense. Ultimately, it could be argued that this can act to dampen overall economic growth.
• The income drought: Not directly related to the debt burden, but rather a knock-on effect from slower growth and lower inflation, is depressed interest rates. We do not expect interest rates to revert to pre-2008 levels anytime soon. One of the serious consequences of low interest rates is that the traditional sources of investment income earned by investors and retirees have all but dried up. Indeed, interest income earned from investments is now at its lowest share of income since 1978.3 For investors, it remains critically important to have a diversified approach to generating income without being overly concentrated in any single asset class.
• Taxes: As described above, one of the steps policymakers can take to help close the funding gap is to raise certain taxes. While it is impossible to know what future policy will bring, investors should work with a professional investment advisor to consider the tax implications of their investment decisions to minimize their taxable exposure.
While none of these factors would necessarily mandate a change in core asset allocation strategy, they do suggest a tilt to equities (growth-oriented, in particular), looking at alternative sources of income to counter low rates and utilizing tax-efficient strategies, where applicable. Experienced financial advisors can provide useful perspective on issues such as taxation, interest rates and growth.
There is no denying that the U.S. federal debt position is a serious problem. But the situation is manageable, particularly from the perspective of a well-diversified investor. Looking forward, fixes will be required – along with significant political compromise – to make further progress on our nation’s debt. We believe that some kind of reform of the tax code, immigration policy and entitlement spending could help.
Corporate tax reforms are needed to incentivize firms to increase investment spending and business activity in the U.S. – particularly given an environment of slower global growth and anemic trade. Immigration reform would allow the U.S. to utilize the highly skilled talent pool that wants to work in the country, an important factor against a backdrop of an aging baby boomer generation and the resulting structural decline in the labor force participation rate. Lastly, entitlement reform would strike at a core fiscal problem by creating more reasonable spending projections while bringing future costs down. Many of the programs at the center of this problem were created decades ago, and need to be updated to reflect today’s realities of longer life expectancy and changing demographics.
Ultimately, there will be no default on U.S. debt and no collapse of the U.S. currency. The U.S. boasts the deepest, widest, most liquid and transparent capital markets in the world. The full faith and credit of the U.S. government backs the country’s debt and currency, which is secured by the largest asset base on earth.
Investors should not be distracted by wild and misguided prophesies of debt Armageddon. They should instead focus on working with their advisors on topics relevant to their own financial plans, such as getting their money to grow despite a slower growth environment, or cobbling together a more diversified stream of income in a low-yield world.
Originally published by Samantha Azzarello, Global Market Strategist, J.P.Morgan
The Market Insights programme provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the programme explores the implications of current economic data and changing market conditions.
The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan)Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Korea by JPMorgan Asset Management (Korea) Company Limited; in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919); in Brazil by Banco J.P. Morgan S.A.; in Canada for institutional clients’ use only by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA/SIPC.; and J.P. Morgan Investment Management Inc.
In APAC, distribution is for Hong Kong, Taiwan, Japan and Singapore. For all other countries in APAC, to intended recipients only.
Copyright 2016 JPMorgan Chase & Co. All rights reserved.