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The writer is global chief investment officer at State Street Global Advisors.
Even though inflation is slowing, the global economy appears resilient and stock markets are appreciating, investors should remain on the lookout for pockets of vulnerability and risk. The combination of aggressive fiscal stimulus during the pandemic and multi-decade high interest rates has brought back a level of anxiety about debt sustainability that we have not seen globally since the crisis financial year 2008.
While we recognize that debt levels are concerning, particularly given persistently high interest rates, we do not believe debt servicing is of particular concern. The main problem, in our view, is that high levels of public debt, combined with persistently high real yields, crowd out other public spending, limit policy flexibility in the next downturn, and ultimately become a drag on growth.
Despite soaring debt levels globally, debt sustainability has important nuances. Household debt, for example, has changed dramatically since the 2008 crisis, when the American consumer was in the eye of the storm. Given a decade of steady deleveraging, U.S. household debt ratios and servicing costs (as a share of income) are manageable, falling from 10.2 percent in 2004 to 7.3 percent in 2024.
The situation is quite different on the public debt side, with the country leading the pack in public spending. U.S. government debt has skyrocketed and currently stands at $34 trillion, with gross federal debt as a percentage of gross domestic product doubling from 60.2 percent to 120.6 percent in 20 years .
The increase in public debt is important globally because it could have a major impact on economies, as three knock-on effects collide: lower future spending, increasing vulnerability to market shocks and more delicate political decisions for central bankers and governments, who will be forced to choose winners and governments. losers as the cost of debt increases.
The US economy has outperformed its developed market peers in the post-Covid recovery. The US economy is now 8.2 percent larger than it was in the fourth quarter of 2019, compared with a rise of 3.5 percent for the euro zone, 2.8 percent for Japan and 1.1 percent for the United Kingdom.
This outperformance is largely explained by a massive transfer of money from the government to consumers and businesses since the start of the pandemic. The Inflation Reduction Act (IRA) of 2022 and the Chips and Science Act have also provided notable tailwinds, directing hundreds of billions of dollars in funding toward clean energy and building capacity to United States semiconductor manufacturing. At some point, the tide will turn. How smoothly or deeply this shifts will depend on the type of political mandate that emerges from the US presidential election. But for the economy, even stagnating spending would mean that fiscal policy would become a drag on growth.
The U.S. dollar’s role as the world’s reserve currency means there is little risk that the Treasury will fail to find buyers for the debt it issues. But the question is: what price will buyers ask? At the very basic level of supply and demand, the greater the supply, the lower the price. But in this case, the fall in the price of US debt means a rise in interest rates. Benchmark Treasury yields are rising, exacerbating trade-offs in U.S. government spending.
There is another twist. American banks own a significant portion of the American public debt. As yield increases, paper losses associated with holdings multiply rapidly. A fiscal “crash” – like the UK “mini” budget that sent bond yields soaring in September 2022 – could have immediate and unforeseen ripple effects across the entire US banking and financial system. The greater these losses, the more reserves banks would have to maintain and the more limited their lending activity would be.
Rising debt levels put policymakers in a difficult situation. Outsized levels leave less financial flexibility to deal with unexpected events, making it more difficult to recover from shocks.
What are the implications for investors? It may be counterintuitive, but investors should continue to favor bonds, which appear attractively priced. We continue to favor high quality sovereign debt, notably US Treasuries. We expect vulnerability in some overleveraged sectors – notably commercial real estate –, parts of the asset-backed securities markets and lower-rated high-yield debt. A slowdown in growth rates could also derail stocks.
As public debt rises around the world, debt sustainability becomes more urgent. Politicians of the past left massive deficits for future generations to fill. The future has arrived. We live on borrowed time.
