Introduction

The U.S. Treasury market is by far the biggest pool of safe assets in the world, backed by the full faith and credit of the U.S. government.

Its status as a safe haven has been driven in large part by the strength of the dollar, which influences almost every entity that imports or exports goods in the global markets.

In 2016 the Bank of International Settlements, a global nonprofit organization run by central banks, reported that the dollar represents 88% of daily foreign currency trades in the $5 trillion market.[1] Trading dollars is less costly and more convenient than other currencies due to the benefits of easy liquidity and an efficient banking system. As such, it has become the main reserve currency held by central banks worldwide, according to Bloomberg L.P. An attractive yield relative to other safe haven assets like the German bund and Japanese yen has also encouraged steady inflows. A Bloomberg index that tracks negative-yielding debt reached its highest point since September 2017, with $10 trillion in 10-year bunds trading in negative territory as of May 2019, and 40% of global bonds now yielding less than 1%. Many investors have been quite comfortable investing their dollars in Treasuries to earn some yield, with Japan one of the top foreign holders at $1.12 trillion as of August 2019.[2] There is incentive abroad to keep the Treasury market stable since a sharp sell-off would likely hurt large holders of the dollar and American debt in China, Europe, and Japan.[3]

Most Traded Currencies by Value (as of 12/2018)

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Sentiment has also been helped because the government controls its currency and can meet its liabilities in the dollar with minimal risk of default. This is in contrast to Italy, which adheres to the euro rather than issuing its own currency. During the euro debt crisis of 2009, interest on Italian bonds surged above 7% as Italy’s economy struggled. Japan has experienced similar financial problems but has been able to maintain extensive debt due to control over its currency and an easy accommodative monetary policy.[4]

Despite the global appeal of Treasuries, there seems to be a mounting concern the United States will reach a tipping point in which the risk of holding substantial debt may become too great, causing yields to surge as demand declines. Our view is that while less borrowing would be preferable in any circumstance, the risks at this time are relatively small. The United States has a robust asset base, the dollar remains the leading foreign currency reserve, and the government has nearly unlimited taxing power. If the fiscal situation were to deteriorate, the Treasury could raise funds by drawing down its assets or increasing taxes on the private sector. With debt representing 10% of the country’s total assets, according to the U.S. Treasury’s financial report, it could pay off the debt in full and still be quite solvent. These assets include national parks and buildings, patents, digital access rights, and mining rights. Further, few debt crises have occurred in countries that borrow in their own currencies and can print money. In Japan, where the debt has exceeded 100% of GDP for almost two decades and is currently more than 200%, real rates on debt are negative. Even real rates in Italy are less than 2% despite a sizable debt, bloated budget, and a high risk for default, according to the Federal Reserve Bank of St. Louis.

Investments for Future Growth

Economists and policy makers have debated the implications for long-term GDP growth and performance in the equity markets for some time. This has been a tricky area in which to draw firm conclusions given the lack of evidence that a true correlation exists between debt levels and future growth. Several researchers have found tenuous connections at best, and we can only make broad inferences based on data from past debt cycles.[5] What is clear to us, however, is that there is currently a trickledown effect in the federal budget, including the “crowding out” of discretionary spending on the U.S. Office of Scientific Research and Development, Department of Health and Human Services, Department of Housing and Urban Development, and other federal agencies. These programs are crucial to providing opportunities for career and skills training, affordable housing, educational grants, and other assistance services.[6]

There has also been a drop in support for such priorities as the environment, infrastructure, and private capital investment. The nonpartisan Congressional Budget Office (CBO) has noted that each year the deficit diverts public funds that could be stimulating business growth, the labor market, and scientific and technological breakthroughs. Indirectly, this may result in a bump to tax rates as revenues fall, further dampening investment and the motivation to enter the workforce. A drop in revenues may also act as a restraint on public investment as the government attempts to control deficit spending.

Lawmakers established the CBO under the Congressional Budget Act of 1974 to provide objective and nonpartisan data that would support Congress in its effort to make effective budget and economic policy decisions. 

To maintain its standing as a leader in the global markets, many economists assert that the United States will need to attract and retain innovative and profitable companies and a steady flow of foreign investment. We believe Congress needs to support legislation that encourages firms to increase private capital investment and business activity. While it’s true that investment is critical to supporting strength in GDP, it’s hard to prove without a doubt that debt in itself is a risk to future growth given the number of factors involved in driving an expansion.[7] Further, relative to other advanced nations like Japan, France, and Singapore, the amount of borrowing does not appear to be excessive and the United States is in a better financial position. Borrowing costs are cheap, the stock market is healthy, and major multinational companies are holding large cash levels.

Public Debt by Country as a Percentage of GDP, 2017

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The impact to the equity markets has been a related topic of discussion given that stability in GDP and earnings growth is central to supporting strong company fundamentals. Some economists have argued the United States may reach a threshold in its debt exposure that puts earnings at risk by driving up the cost of financing. 

Additionally, some companies may become hesitant to fund share buybacks and dividends as margins are pinched due to higher debt service burdens. These strategies have been two important sources of total return for investors in recent years as it becomes harder to move the needle in a late-stage bull market. Many large multinational companies had been “hoarding” cash abroad the past few years given the 35% federal tax on foreign sourced income. The 2017 tax reforms made it financially more palatable to repatriate profits back to the United States, leaving successful companies like Microsoft Corp., Apple Inc., Alphabet Inc., Cisco Systems, Inc., and Amazon.com, Inc. flush with cash. Dividends and buybacks have become a popular strategy to deploy cash and boost equity returns, with buybacks in particular on track to outpace 2018’s record of $1.08 trillion.[8]

While we believe these risks are valid, it is difficult to say with certainty that the federal debt will detract from the long-term equity returns, especially given the two factors have historically had a low correlation.

For example, between 1982 and 2016, debt moved from 32% to 105% of GDP while the S&P 500® gained an average of 11.7% on an annualized basis. The two biggest year-over-year increases in the debt to GDP ratio occurred in 1983 and 2009 (up 20%), and both times they were followed by the longest bull markets in America’s history. The only time the ratio has been negative was at the start of the 2000 bear market, and it began rising as the markets recovered (7.8% year over year), according to data from the Federal Bank of St. Louis.

Sustainability of the Safety Net

As the interest burden grows and tax revenues drop, concerns have emerged regarding the sustainability of the Social Security and Medicare programs. Lower rates of fertility and improved longevity have helped boost the number of people who will require government benefits in the future amid a narrowing tax base. According to the Social Security Administration’s (SSA) recent fact sheet, those over 65 years old rose from 35 million in 2000 to 49 million in 2018, and that number is expected to reach more than 79 million by 2035. The SSA further reports that the trusts created to meet these costs will likely be depleted in the next 20 years, presenting a risk to the 80% of seniors with income at or below the federal poverty level ($29,425). Both Social Security and Medicare have their own “trust,” which is a federal vehicle to account for the taxes paid into the programs and the cash distributed to beneficiaries. In 2018 the board of trustees for the Social Security and Medicare programs reaffirmed their projections that the trusts will not meet their total commitments due to the widening gap between the retired and working age populations. In simpler terms, the government has promised to pay benefits in the future that exceed the revenues the current tax code can support.[9]

Social Security provides assistance to 63 million Americans through Old Age and Survivors Insurance and Disability Insurance. The SSA expects the two trusts for these programs combined to be exhausted by 2035 after meeting 80% of their obligations (SS benefits will drop below 100% of expected benefits before 2035). This does not mean scheduled benefits will fall to zero but that will drop to 80% of their original set levels. 

Expenses in 2018 exceeded total income in the trusts for the first time since 1982, and in 2020 the program must start drawing down its assets, which currently total $2.9 trillion, to pay out promised benefits. In its most recent fact sheet, the SSA forecasts Social Security to grow from 4.9% of GDP in 2019 to 5.9% of GDP by 2039, with the ratio of workers to each program participant declining from 2.8 to 2.2.

Medicare delivers health care to more than 51.2 million people ages 65 and older, and the Centers for Medicare & Medicaid Services (CMS) forecasts costs will rise from 3.7% of GDP in 2018 to 6.5% by 2038.[10] The Medicare Hospital Insurance Trust Fund (HI), commonly known as Part A, is Medicare’s largest component and insures inpatient hospital visits and care at nursing facilities. The number of workers contributing taxes for each HI beneficiary (the numbers of supporting workers differ between the SS and HI systems because the expenses are different) is projected to fall from four in 1980 to two in 2030, and its trust will be drained by 2026[11]. The CMS trustees have emphasized the urgency to address shortfalls in both Social Security and Medicare now so that reforms can be phased in gradually, thus affording people time to adapt to any changes to their long-term benefits. In the future, social net and tax reform could create more reasonable spending projections and bring budget expenses down.

Conclusion

As we discussed in our paper Federal Debt and the U.S. Economy: Why the Federal Debt Matters, we anticipate the federal deficit will continue to widen in the coming decade due to shifting demographic and economic dynamics that have made it increasingly difficult for Congress to balance the federal budget. With the potential for rising rates in a late-stage expansion, the scale of the federal debt has some investors uneasy about the sustainability of government finances. Many economists believe deficit spending is a sign of fiscal irresponsibility that prompts higher interest rates, reduces public and private investment for future growth, and leaves a country more vulnerable in the face of a major shock to the financial markets, such as a recession or international crisis. The Treasury Department’s flexibility to borrow is particularly crucial during a downturn, helping to offset a decline in consumer spending and business activity through fiscal stimulus efforts and tax cuts.

However, we firmly believe the risks will be manageable in the near to midterm given the strength of the U.S. economy and robust demand for its debt.

Treasuries remain a popular safe-haven asset worldwide due to the dominance of the dollar in global trade, a relatively attractive yield, and a deep asset base to secure its liabilities in the unlikely event it becomes necessary to raise funds. It is also important to remember that the outlook for the budget is not set in stone, and Congress has the ability to make modifications to current law to set the country on a more balanced fiscal path. Nonetheless, we are quite aware of the potential challenges to investors and will communicate any new developments that may change our long-term view.

 

TEXT VERSION OF CHARTS

Most Traded Currencies by Value (as of 12/2018)

Currency Daily Share
U.S. Dollar 87.6%
Euro 31.3%
Japanese Yen 21.6%
British Pound 12.8%
Australian Dollar 6.9%
Canadian Dollar 5.1%
Swiss Franc 4.8%
Chinese Yuan 4.0%
Mexican Peso 2.2%
Swedish Krona 2.2%
New Zealand Dollar 2.1%
Singapor Dollar 1.8%
Hong Kong Dollar 1.7%
Norwegian Krone  1.7%
South Korean Won 1.6%
Turkish Lira 1.4%
Indian Rupee 1.1%
Russian Ruble 1.1%
Brazilian Real 1.0%
South African Rand 1.0%


Public Debt by Country as a Percentage of GDP, 2017

Country Public Debt in Relation to the GDP
Japan 236.4
Greece 181.9
Italy 131.5
Portugal 125.6
Spain 98.4
France 97.0
Canada 89.7
United Kingdom 87.0
European Union 86.8
United States 82.3