The national debt may seem as far removed from your investments as your parents’ debt is from your bank account. But, like your parents’ debt, if the federal government’s budget deficit grows too large, it…
The national debt may seem as far removed from your investments as your parents’ debt is from your bank account. But, like your parents’ debt, if the federal government’s budget deficit grows too large, it will impact your daily life and investments in a painful way.
“The economy is not going to implode tomorrow because of the national debt or federal deficit,” says David Primo, a scholar at the Mercatus Center and a professor at the University of Rochester. “But it is a long run problem and the sooner we start dealing with it, the better off we’ll be as a country.”
At almost $21.5 trillion, the U.S.’s national debt is larger than GDP. It’s more than the GDP of the next three largest nations ( China, Japan and Germany) combined. And it’s only expected to grow. If current law remains unchanged, the Congressional Budget Office estimates national debt held by the public will more than triple in the next 30 years to $54 trillion in today’s dollars. By 2028, the publicly held debt-to-GDP ratio would be the largest it’s been since the end of World War II.
How does national debt impact investment decisions? Investors need to be aware of what rising national debt means for the future of our economy and financial markets. Here are some of the ways the expanding budget deficit and national debt may affect you and your investments:
More government bonds cause higher interest rates and lower stock market returns. As the U.S. government issues more Treasury securities to cover its budget deficit, the market supply of bonds increases. “When you have more of something, it gets cheaper,” says Jim Barnes, director of fixed Income at Bryn Mawr Trust. In bonds, cheaper means lower prices and higher interest rates.
For bondholders this is both a boon and a burden: New bonds will provide higher yields but the prices on old bonds will fall. For stock investors, higher rates are only a burden.
“Higher interest rates tend to lead to lower stock market returns,” says Gus Faucher, chief economist for PNC Financial Services Group. This is because higher rates increase the cost of borrowing.
While the Federal Reserve controls short-term interest rates through the federal funds rate, when the federal government raises rates on Treasury securities, it pushes up long-term rates like the one on your mortgage and student loans.
With debt taking a bigger chunk out of their budgets, investors have less income available to invest. Fewer dollars in the market means fewer opportunities for the power of compounding to work its magic.
High cost of debt works against investors in another way: As consumers’ budgets get tighter, so too do their purse strings. When people stop spending on goods and services, company revenues take a hit. And — unless you’re Tesla ( TSLA) — falling profits translate into declining stock prices.
Higher interest rates weigh on business growth and stock prices. Corporations are hit by national debt-induced rising interest rates from two sides: Not only are they getting less love from consumers, but they also have to compete with the biggest and “safest” bond issuer in the bond market: the U.S. government.
As Treasury rates rise, investors preference low-risk government bonds over riskier corporate ones. Companies must offer even higher interest rates to entice bond investors. Higher interest payments leave less money to reinvest in their businesses. And when business growth wanes, so do long-term stock prices, Faucher says.
National debt drags on economic growth. The U.S. Treasury feels a similar strain from higher interest rates. As its interest payments increase, more federal revenues must be directed toward debt repayment, leaving less money for other economically stimulating activities, Primo says.
“Once government debt reaches a certain size, it really drags on long-term [economic] growth,” he says. It can also drag on the creditworthiness of the U.S. government.
Treasury securities may no longer be risk-free. As the federal government’s debt level rises, its ability to repay its obligations may come into question.
While there’s nothing to suggest the U.S. government has reached a point of being unable to service its national debt currently, or is even near this threshold, Barnes says, other nations (Italy and Greece, for example) have indebted themselves to the breaking point.