Do we need to be worried about the U.S. fiscal deficit?

To mitigate the impacts of the Covid-19 pandemic, governments worldwide injected significant liquidity into markets to ensure their stability, support businesses, and provide households with income. While this intervention was necessary at the time, it has left a lasting impact on the public purse. Government debt levels have reached all-time highs, and with elevated borrowing costs due to high interest rates, the expense of servicing these deficits has increased substantially.

When considering the key risks to systemic stability, many investors point to the US fiscal deficit. Whilst other developed nations (such France, Italy, and the U.K.) are running elevated fiscal deficits, there seems to be little appetite in the U.S. to tighten the fiscal stance. U.S. debt levels are at record highs and are projected to continue rising. Regardless of whether a Democrat or Republican wins the U.S. Presidential election in November, one outcome is almost certain: increased spending and running a large deficit.

‍Why we should not be worried about the US fiscal deficit?

The U.S. fiscal deficit is something that investors clearly need to be aware of as it has macroeconomic and geopolitical implications. Furthermore, if U.S. growth slows and/or interest rates remain high, the risks surrounding larger deficits rise. While market participants may demand to be compensated for such fiscal irresponsibility, via higher interest rates, we do not envisage a Liz Truss type scenario (partly because this was an idiosyncratic event). So why should we not be worried about the U.S. fiscal deficit, at least in the short-medium term?

• Firstly, the Congressional Budget Office (CBO) has been predicting that the US fiscal deficit will increase for several years, so such an event is not a surprise. For instance, a report from one of our research providers recently highlighted how the CBO forecasted in 2017 that the budget deficit will rise to almost 6%, from 3%, by 2027. The budget deficit now stands at circa 6%, which, despite COVID-19 which can be classed as a black swan event, is not far off earlier forecasts.
• Secondly, demand for US Treasuries remains robust globally. Auctions for US bonds are consistently oversubscribed, and Treasuries are considered "safe haven" assets. This connects to the US dollar’s status as the global reserve currency being undiminished. While trade in dollars is slowly decreasing, financial transactions remain heavily reliant on the dollar.
• The ‘primary balance’, which is fiscal spending excluding interest costs, is set to decrease in real terms (see below) which is implies that Congress is clearly aware of the need for fiscal prudence. While this is not downplaying the issue of interest expenses increasing, it is important to remember that the government can finance additional interest payments by issuing more debt. The government is also supported by the Federal Reserve who can act to alleviate fiscal pressures through financing government spending.

We are often also asked what the likelihood is of the U.S. government defaulting. On this point, it is important to note that for a country who has their own central bank, defaulting is essentially a choice, as the central bank can print money to cover debt obligations. A recent example is Greece whose deficit burden was largely owed to foreign creditors. In this case, as their central bank was ‘outsourced’ to the ECB, they were not able to immediately print money to cover their debt obligations once foreign creditors decided to stop buying Greek debt.

So, the extent that U.S. debt is held by foreign creditors (circa 25% owned by foreign entities) is less of a tail risk than for other nations. Nearly 80% of U.S. debt is held by the public and of that two-thirds is held by domestic investors, with the Federal Reserve owning about a third of this domestically held debt. Although the portion of U.S. debt held by foreign lenders has increased over the past few decades, the majority of the government debt burden remains a domestic issue. This domestic ownership translates to fewer interest payments abroad and greater control over the nation's markets.

‍The Bottom Line

In conclusion, significant changes to fiscal policy are unlikely before the November election. We have previously noted how politics and markets are interrelated, so as the election approaches further discussions about fiscal spending and polling results will likely influence bond and currency markets. However, addressing the challenge of stabilising the U.S. fiscal deficit remains primarily a long-term issue. Investors need not fear a U.S. debt default but should be prepared for potential market volatility due to the fiscal and political uncertainties. The strength of the majority in November’s election will determine how much the fiscal deficit may rise, i.e. how much flexibility the new US President will have to increase spending.

Given these risks, diversifying portfolios is a prudent strategy. In the LGT WM MPS, we maintain exposure to "real assets" such as infrastructure, gold, and commodities through thematic funds and absolute return strategies. We also own a combination of sovereign bonds, gilts, and U.S. treasuries. However, arguably the best protection against a US fiscal tail risk scenario is investing in quality businesses. We consistently emphasise that quality businesses are robust, resilient, and capable of protecting investors through economic cycles and unforeseen geopolitical events. While we do not anticipate such a systemic crisis, our focus is on building resilient portfolios that can withstand unforeseen challenges. In this context, quality businesses represent the next safe haven asset.

Important information

This article was originally published by LGT Wealth and has been republished here with permission.

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