The ongoing congressional standoff over raising the debt ceiling serves as a reminder to review our investment approach. Especially in regard to holding Treasuries.
With the federal government’s revenue falling short of its spending, it’s clear that our country’s finances need attention.
Behind all the political grandstanding remains the core fact that Federal revenue is far less than current spending. Whether you favor increasing taxes, reducing spending, or combination of the two, something needs to be done.
In this post, we address two key questions related to investing in light of the debt dilemma. The viability of Treasury bills, notes, and bonds as an investment and the outlook for investing in U.S. stocks.
Investment in Treasury Bonds
Recent discussions have raised concerns about the U.S. government defaulting on its debt. As well as a potential downgrade of its credit rating.
Current United States debt credit ratings:
- S&P – AA+
- Finch – AAA
- Moody’s – Aaa
While the debt standoff and potential downgrade are serious, they do not necessarily eliminate the appeal of Treasury bonds as an investment.
Treasury bonds are backed by the “full faith and credit” of the United States. This makes it highly unlikely the government will truly default on its debt payments. Even if the debt ceiling is reached, the Treasury department will likely prioritize debt payments over non-guaranteed government obligations. Thus, the risk of (non-technical) default remains low.
There may be a delay in payment, but it’s inconceivable that investors would not be made whole.
The potential downgrade of the government’s credit rating could impact Treasury bond investors. However, the current market conditions do not support a change in approach at this point.
Despite the downgrade risk, U.S. interest rates have remained historically low. For instance, the 10-year Treasury bond yields about 3.5% (as of 5/9/23). On the high end over the past 15 years or so, but still low compared to historical averages.
Moreover, a country’s credit rating is not the sole determinant of bond value and interest rates. Japan, with a relatively low A+ S&P rating, pays a meager 0.4% on its 10-year debt. While, Australia, with the highest AAA rating, pays 3.4%.
The United States has an AA+ S&P rating. A higher rating than Japan, yet the U.S. pays ~3% more. A lower rating than Australia, but the U.S. pays about the same yield. Source.
We still believe Treasury bonds are a safe investment. Historically, investors have moved into Treasuries during times of economic stress. Thus, driving up their value and providing a nice hedge against unforeseen events.
We continue to believe Treasury bonds can play a significant role in dampening a portfolio’s volatility.
Outlook for U.S. Equities
Economic growth drives future stock market returns. Growth is measured by Gross Domestic Product (GDP). Higher projected GDP growth should lead to higher projected returns in the stock market.
It is fairly intuitive when put in simpler terms. The faster an economy grows, the more goods and services are consumed. The more revenue companies generate, the higher profits they earn. The higher the stock market goes.
A higher projected GDP growth rate usually translates to higher projected stock market returns.
Given this tight connection between GDP growth and stock market returns, one might question the impact high government debt has on GDP growth.
Unfortunately, the answer is not good.
Research conducted by the National Bureau of Economic Research indicates that once the ratio of Federal debt to GDP exceeds 90%, GDP growth tends to slow down considerably.
For developed economies, the average real GDP growth rate drops from around 3.4% to 1.7% when the debt-to-GDP ratio surpasses 90%.
The United States currently had a ratio of 120% or 129% as of the end of 2022 depending on your source. And it would be even higher if total Federal debt was included and not just “debt held by the public” with excludes intragovernmental debt.
As an investor in U.S. domestic stocks, this makes me concerned about the future returns from companies doing business in the United States.
International Investments
As high government debt dampens economic growth, investors need to broaden their horizons and consider increased international investments. Looking at both traditional developed markets and in more risky emerging markets.
For more, read: Should I Invest Internationally?
Regardless of the debt situation, most investors don’t diversify their holdings across the world and tend to overweight their home country and under-diversify globally.
One yardstick to consider is the total global market value of all public companies. Only about 40% of the total market value is from U.S. based companies. Meaning an investor could allocate well over half their equity exposure to international markets if they wanted a true globally balanced portfolio.
Of course, many other countries have as bad or worse debt-to-GDP ratios as the United States.
While concerns persist about future U.S. equity returns, it is crucial to maintain a long-term perspective and adhere to a broadly diversified investment strategy. Current events should not disrupt a well-thought-out plan.
That Being Said…
The debt dilemma and its potential consequences on government bonds and U.S. equities underscore the need for investors to be vigilant and adaptable. Despite discussions surrounding a possible default or credit rating downgrade, Treasury bonds remain a safe investment due to their backing by the United States.
However, the impact of high government debt on economic growth suggests that investors should consider diversifying their portfolios by increasing their exposure to international markets. This global diversification can help mitigate the potential risks associated with the U.S. debt situation.
Long Term Investment Focus
When constructing a well-diversified portfolio, it is important to focus on the long-term and not let current events disrupt your investment strategy. It is easy to get caught up in the headlines and make impulsive decisions based on short-term fluctuations. However, successful investing requires a disciplined approach that considers the bigger picture and aligns with your long-term goals.
One effective way to achieve global diversification is by investing in broad-based index funds or exchange-traded funds (ETFs) that cover developed international or emerging markets. These funds provide exposure to a wide range of companies across various markets, spreading the risk and potential rewards.
While the outlook for U.S. equities may be influenced by the high debt levels, it is important to remember that the stock market is a dynamic and complex system. Factors such as innovation, technological advancements, global trade, and demographic trends also play a significant role in determining stock market performance.
Rather than trying to time the market, a prudent approach is to maintain a well-diversified portfolio that includes a mix of domestic and international equities. This strategy allows you to participate in the potential growth opportunities offered by international markets. And still benefiting from the strength and stability of U.S. companies.
Additionally, it is worth noting that the debt dilemma also presents opportunities for astute investors. Market volatility resulting from uncertainty can create buying opportunities for those with a long-term perspective. Being prepared to take advantage of such opportunities can help enhance portfolio returns over time.
Stay the Course and Diversify
In conclusion, the debt dilemma facing the U.S. government serves as a reminder for investors to evaluate their investment approach.
While Treasury bonds remain a safe investment option, global diversification becomes crucial to mitigate potential risks associated with the high level of government debt.
Maintaining a long-term perspective, adhere to a well-diversified portfolio, and consider international markets. These will help investors navigate the debt dilemma and position themselves for financial success in the face of changing economic conditions.
