Why the U.S Debt Matters When it Comes to Investing

 

The federal government’s total debt now stands at more than $34 trillion, roughly double what it had been a decade ago. While some of this debt expansion is due to the Covid 19 pandemic, much of it stems from the aging U.S. population and a dramatic increase in the number of people qualifying for government-sponsored healthcare.

 

Because of the rising debt burden and tighter monetary policy, the interest cost to service the debt ballooned to $659 billion in the 2023 fiscal year. That figure is up 39% from 2022’s figure of $475 billion. While the amount of debt the U.S. should maintain has been debated for years, the sheer volume of debt and the diverting tax revenue to pay interest leaves less money available for other programs. Additionally, as the government issues more debt, it crowds out available resources for private capital.

How did we get here?

The U.S. Government has run deficits on and off (mostly on) for decades. One of the few exceptions was during the Clinton Administration because of solid tax receipts, higher tax rates, and controlled spending, including somewhat of a “peace dividend” after the Cold War defense spending. However, the annual deficit and total debt took off during the Great Financial Crisis. The Federal Government poured vast sums of money into the U.S. economy to stave off a total meltdown. Entitlement spending and tax revenues have been at a structural imbalance for years with few, if any, signs of change as more Baby Boomers retire each year.

 

Also, the U.S. has issued more debt, creating a snowball-like effect where more deficit spending is needed to cover outlays and rising interest costs. The U.S.’s political leaders have been spending more recently, while tax cuts have contributed to the problem in recent years. Traditional buyers like the Fed, Japan, and China are buying less U.S. debt, which is pushing interest rates higher and increasing the cost of the government's borrowing.

 

Recently, the government issued more 30-Year U.S. Treasury bonds. Due to slack in demand, the bonds were awarded more than five basis points higher than the previous issuance. Reports noted it was the most expensive 30-year auction tail going back to Aug. 2011. around the time the S&P downgraded the U.S.’s credit rating from AAA to AA+. (An auction tail is the difference between the yield awarded at the auction and the yield during pre-auction trading. A larger tail can indicate a weak auction.) About a year ago, Fitch Ratings downgraded the U.S. from its triple-A credit rating to AA. Even though a bipartisan group agreed to suspend the debt ceiling until next year, Fitch sees serious problems.

 

“In Fitch's view, there has been a steady deterioration in governance standards over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025,” the rating agency said in a release. “The repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” Several months later, Moody’s downgraded its outlook on the U.S. debt, citing political polarization and the rapidly increasing cost of financing it.

 

For the Federal Government’s most recently completed fiscal year:

 

The largest receipts for 2023 include:

• Individual Income Taxes: $2.2 trillion (49% of total receipts)
• Social Insurance and Retirement: $1.6 trillion (36%)
• Corporate Income Taxes: $420 billion (10%)

 

The remaining revenue streams account for just $229 billion (5%).

 

The largest expenses for 2023 include: 

• Health and Human Services: $1.7 trillion (27.7% of total outlays)
• Social Security Administration: $1.4 trillion (23.1%)
• Dept. of the Treasury: $1.1 trillion (17.9%; note: This includes interest on public debt)
• Dept. of Defense: $776 billion (12.6%)

 

The four largest expenses are viewed as government obligations, (non-discretionary spending) and cannot be reduced quickly, or without serious future reforms.

 

The government's net interest expense, which is part of the Department of Treasury outlays, totaled $659 billion. It is possible that interest expense could top $1 trillion in the coming years and become one of the three largest expenditures. When the government pays more in interest expenses, there is less financial flexibility and potentially less funding for other priorities.

 

The Congressional Budget Office recently announced that it expects fiscal year 2024’s budget deficit to reach $1.9 trillion—up almost 12% from last year.

Impact on the U.S. economy.

It should be noted that the amount of government debt and interest on the debt has so far had a relatively small impact on the U.S. economy, which has surprised some economists. Many market participants had expected a shallow recession, which would blunt some of the criticism of runaway deficit spending. However, the economy has held up surprisingly well. One contributing factor is the relatively low level of debt held by consumers. Recent estimates suggest about 60% of home mortgage holders have rates at 4% or lower, which has damped the effect of higher interest rates elsewhere in the economy.

 

That doesn’t mean the debt and deficit spending won’t harm economic growth going forward. As stated earlier, larger deficits imply less financial flexibility, so think reduced funding for other priorities such as infrastructure or education.

 

It is generally accepted that a country will accrue additional debt to keep various programs functioning in economic downturns. In our case the U.S. economy has been expanding, making the spending and interest costs even more precarious. However, when the U.S. economy eventually contracts (a safe assumption), the debt could look even worse since tax receipts fall during soft economic activity.

Impact on investing.

While the U.S. economy has surprised to the upside, there are cautionary notes with all the debt. Many of the issues appear in the fixed-income universe and include:

• The more debt an entity has, the higher the likelihood it will be unable to repay it. There is increased default risk, and, if there is a greater risk of default, investors will demand higher yields. This is why rating agencies (S&P and Fitch) have downgraded U.S. debt. However, this is still an incredibly minor risk associated with U.S. Treasury obligations.
• When an entity issues more debt, there needs to be buyers and holders of that debt to match the increased supply. To match supply, the price must go down (or fixed income yields must go up). This is another supply/demand characteristic.
• Higher yields can be a vicious cycle. One option is to issue more debt to pay the higher interest on previously spent money.

 

Within the equities, some of the impacts are related to fixed income and include:

• Debt can push up treasury rates, making them more attractive than equities and encouraging investors to invest more heavily in fixed income than stocks. However, this has not occurred.
• Debt often means that the U.S. Government is spending money in certain areas, which can impact equity sectors positively or negatively.
• Debt also often means reduced revenue through tax cuts. Companies and equities enjoy paying fewer taxes since they can affect the bottom line.

 

Within the alternative investment universe, most private debt, for example, comes with a floating rate. Borrowers in the private debt may pay higher interest rates as more government debt is issued.

Why it matters.

The nation’s interest expense and deficit spending could harm the U.S.’s status as the world’s reserve currency.

 

In short, countries hold U.S. currency for transactions with other countries because they see the U.S. dollar as stable and safe. When foreign countries conduct transactions with one another, they typically do so with the U.S. dollar. Many foreign currencies are also pegged to the dollar, which is one of the nation’s strengths.

 

If the U.S. were to lose its status as the world’s reserve currency, it would likely have less access to capital and incur higher borrowing costs. This could adversely impact stock market valuations as well.  America’s status as a reserve currency has allowed the nation to, in part, run deficits. If foreign countries no longer want to hold the dollar, it could force some unpleasant belt-tightening. The counterargument is that even though the U.S.’s trajectory is troubling; no clear rival exists. However, with the implementation of digital currencies, strong foreign competition, and domestic discord, another currency may become more attractive.

 

Also, the debt will restrict growth. The CBO projects that the weight of the debt will slow income growth by 12% over the next 30 years since debt payments will crowd out other investment opportunities.

 

If there is a positive aspect, the U.S. is the most resourceful, innovative, and economically successful country in history. The country’s ingenuity and determination are incredibly valuable traits. Righting the ship will take the brightest minds and the most determined people available, and the U.S. has those people. Also, some leaders in the U.S. historically wait until the last minute to address and deal with a problem. We are not at that point yet, but it is undoubtedly getting closer and leaders in Washington, D.C need to address the issue.