The Wall Street Journal recently featured a striking graphic headlined «Will Debt Sink the American Empire?» With the United States facing another daunting budget deficit of seven percent of GDP this year, such alarming depictions of debt are proliferating. While a US bankruptcy seems unlikely, the ramifications for investors remain severe.
Debt as a free asset?
A faction of investors and economists view these budget deficits as inconsequential, asserting that government debt, a liability, corresponds to an asset on another balance sheet, ostensibly concluding the matter. This perspective, however, is overly simplistic. The crucial question is to whom these liabilities are assigned, a factor that significantly impacts real-world outcomes.
The investor’s trinity
For prudent investors, three elements are paramount: return, risk, and diversification.
Returns: Despite recent interest rate hikes by central banks, current rates remain relatively low. With inflation likely to stabilise between two and three percent, real returns are modest. Moreover, in response to mounting deficits, central banks may resort to lowering interest rates further.
Risk: The volatility of government bonds is on the rise, not only in the US but also in France, Italy, and Japan, which collectively account for approximately 50 percent of global sovereign debt. Increased bond volatility, when compared to equities, presents a troubling scenario for mean-variance optimisation.
Diversification: Historically, the correlation between equities and bonds was negative from 1990 to 2020, offering diversification benefits. However, prior to this period, the correlation was predominantly positive, diminishing these advantages.
Given these factors, investors must critically evaluate the attractiveness of bonds, beyond the strategic motivations of countries like China, which might reduce their investments in US government bonds.
Glimpse into the future
It is evident that the US will not independently resolve its debt issues. With leadership transitions looming, the situation could deteriorate. Despite the Wall Street Journal’s foreboding headline, the US is not on the brink of bankruptcy. Instead, central banks› «patchwork model» persists, characterised by low average interest rates and higher inflation, which may extend debt sustainability. The central banks› willingness to purchase bonds will be crucial.
For other nations lacking the global reserve currency and the depth of the US bond market, the stakes are higher. The widening spreads in French bonds exemplify this sensitivity.
Jeroen Blokland, a seasoned analyst and fund manager, regularly provides insights on financial markets and macroeconomics through his newsletter, The Market Routine. His extensive experience, including his tenure as head of multi-asset at Robeco, lends authority to his analyses. This column originally appeared on InvestmentOfficer.nl.