The national debt has been getting more press lately as America prepares for the November election. It’s of particular concern after it swelled during the COVID-19 pandemic like an expandable water toy dropped in a bathtub. The national debt rose from $26.14 trillion in 2018 to $33.17 trillion in 2023.
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It’s become so concerning that the three major credit rating agencies downgraded the U.S. federal government’s long-term debt; the country now has a worse credit rating than Microsoft Corp. (ticker: MSFT) and Johnson & Johnson (JNJ), despite the fact that neither company can literally print its own money.
The U.S. national debt is larger than its gross domestic product, and it’s only expected to grow. Here’s how investors can address concerns raised by rising debt levels:
— Why investors should care about the national debt.
— Why is the national debt so large?
— The national debt’s impact on investments.
— Can the U.S. pay back its debt?
— Maintaining balance in the short term.
— Mitigating long-term risks.
Why Investors Should Care About the National Debt
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 could impact your daily life and investments in a painful way.
Not to be confused with the deficit, federal debt is the total amount or the collection of deficits throughout the years owed by the government. It now stands at more than $34.5 trillion, or more than $103,000 for every person in the U.S. In 2021, that number was $84,000 per person.
The deficit is the difference between the government’s revenue — which mainly comes from taxes — and its expenses, such as national defense, health care, education and other programs, for a particular period. When expenses exceed revenues, the government has a deficit.
Why Is the National Debt So Large?
The deficit and the overall national debt have risen to such heights in a short period because the economy slowed down due to the pandemic, leading to a severe flash recession. This triggered the government to increase spending by around 50% to address the fallout and speed up economic recovery.
The U.S. government is limited in the amount of money it can borrow to fund its operations. This limit is known as the debt ceiling. Congress holds the authority to raise or suspend the debt ceiling as it sees fit.
There have been many moments in history when Congress has done exactly this in order to meet budget priorities. Failing to change the debt limit would lead the U.S. government to default on its debt obligations. Congress has raised the debt ceiling, temporarily or permanently, 78 times since 1960. The most recent occurrence was in June 2023, when Congress voted to suspend the ceiling until January 2025.
“The economy is not going to implode tomorrow because of the national debt,” says David Primo, professor of political science and business administration at the University of Rochester and a senior affiliated scholar at George Mason University’s Mercatus Center. “But it is a long-run problem, and we should start making plans for addressing the massive run-in up in debt we incurred as a result of addressing the pandemic.”
The National Debt’s Impact on Investments
Investors need to be aware of what rising national debt means for the future of the economy and financial markets.
More government bonds can often lead to higher interest rates and lower stock market returns. When the U.S. government issues more Treasury securities to cover its budget deficit, the market supply of bonds increases and investors tend to demand a higher interest rate to compensate for the increased risk.
While bonds can provide investors the benefits of cash preservation and fixed income, they carry interest-rate risk. Bonds and interest rates have an inverse relationship. When interest rates rise, newly issued bonds are more attractive than existing bonds because they provide investors with higher yields. As a result, prices on old bonds paying lower interest rates tend to fall.
The Federal Reserve controls short-term interest rates through the federal funds rate, but market forces determine the rates paid on Treasury securities, which are sold at auction. The fed funds rate and Treasury rates are closely watched and related, and each rate, especially the 10-year Treasury when it comes to government debt, is a benchmark of sorts that pushes up or pulls down long-term rates consumers are offered via new mortgages or student loans.
As debt takes 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.
As far as stocks are concerned, the 10-year Treasury yield is commonly referred to as the “risk-free” rate of return: You can safely assume you can earn whatever return the 10-year is offering without the U.S. government going into default. As 10-year yields rise, more and more pressure is put on stock market valuations. Stocks are famously risky, so investors will demand the risk-free rate plus some premium in the form of a price discount in order to make stocks worth the risk.
The high cost of debt works against investors in another way: As consumers’ budgets get tighter, so do their purse strings. When people stop spending on goods and services, company revenues tend to take a hit.
Can the U.S. Pay Back Its Debt?
Higher interest rates can 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 U.S. government, which despite being recently downgraded remains one of the safest bond issuers.
As Treasury rates rise, investors tend to prefer 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.
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 government programs valued by Americans, 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, as evidenced by the recent downgrades.
Since the U.S. dollar is the world’s reserve currency, the U.S. Treasury can get away with more national debt than most. But what happens if the U.S. dollar loses reserve status?
“When interest rates were low, we were told that we didn’t need to worry about the debt because it was cheap to finance,” Primo says. But interest rates weren’t destined to be low forever.
“The high interest rate environment we are seeing now has had a dramatic effect on the budget,” he says. According to the Congressional Budget Office’s latest projections, the federal government will spend more on interest payments than on national defense in 2024.
Maintaining Balance in the Short Term
Before you start to panic, know that this is a long-running issue and one that’s unlikely to implode in the near future.
“For at least 40 years, we have been hearing how U.S. fiscal imbalances are unsustainable,” says Atul Bhatia, a fixed-income portfolio manager at RBC Wealth Management. “And for all that time those imbalances have been sustained, the U.S. economy has grown and financial markets have generated positive returns.”
He points to bond financing markets as a “clear indicator that there is no imminent concern.”
Most bonds are financed through repurchase agreements, or short-term loans with bonds as collateral. U.S. Treasurys are the preferred collateral for most lenders, Bhatia says, and as such, repo lenders have the best claim to being a canary in the coal mine for U.S. credit risk.
Right now, these lenders are “chirping happily,” he says.
Given this, Bhatia sees no reason for investors to alter their portfolios.
“History is likely to continue and positioning for a U.S. debt crisis is likely to lead to subpar returns,” he says.
Mitigating Long-Term Risks
What could be a concern is the way the debt recovery is approached. How policymakers and monetary authorities work together to address the growing national debt matters. Whether they raise taxes, cut spending or announce more quantitative easing, these different scenarios could impact stock market confidence.
If you are less optimistic than Bhatia, there are a few steps you can take to reduce the impact a ballooning national debt may have on your investments.
The first is to use real assets like commodities and real estate or Treasury inflation-protected securities, known as TIPS, to combat inflation. The reason inflation is a concern is because if the government decides to repay its debt, it could do so by printing more money. More money in circulation reduces the value of each dollar.
Municipal bonds are another investment option, as state and local governments have borrowing limits that help control their debt levels. These bonds are also generally safer than corporate bonds. They’re also exempt from federal taxes and may be exempt from state and local taxes if you buy your home state’s bonds.
You don’t have to shy away from the equity market entirely, though. The stock market tends to be a bit nearsighted. Given that the debt is a long-term concern and the market looks at short-term performance, debt levels may not be an immediate concern for the stock market.
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How the National Debt Affects Your Investments originally appeared on usnews.com
