Unlock the Editor’s Digest for free
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is global chief investment officer at State Street Global Advisors
Even as inflation eases, the global economy appears resilient and equity markets grind higher, investors need to remain on the lookout for pockets of vulnerability and risk. The combination of aggressive fiscal stimulus during the pandemic alongside multi-decade highs in interest rates have brought back a degree of anxiety about debt sustainability that we have not seen globally since the 2008 financial crisis.
While we agree that debt levels are worrying, particularly given persistently higher rates, we do not think debt servicing is a particular cause for concern. The primary problem, we believe, is that high levels of government debt coupled with persistently high real yields crowd out other government spending, limit policy flexibility when the next downturn comes and ultimately become a drag on growth.
Despite soaring debt levels globally, there are important nuances in debt sustainability. Household debt, for example, has changed drastically since the 2008 crisis when the US consumer was at the eye of the storm. Given a decade of steady deleveraging, American household debt ratios and service costs (as a share of income) are manageable, decreasing from 10.2 per cent in 2004 to 7.3 per cent in 2024.
The story is starkly different on the public debt side, with the country leading the pack on government spending. US government debt has rocketed and at present stands at $34tn, with gross federal debt as a percentage of gross domestic product having doubled from 60.2 per cent to 120.6 per cent over 20 years.
The rise in government debt globally matters because it could have a major impact on economies as three knock-on effects collide: lower future spending, rising vulnerability to market shocks and trickier policy decisions for central bankers and governments which will be forced to choose winners and losers as the cost of debt rises.
The US economy has outperformed developed-market peers in the post-Covid recovery. The US economy is now 8.2 per cent larger than it was in the fourth quarter of 2019, against the eurozone’s 3.5 per cent gain, Japan’s 2.8 per cent and the UK’s 1.1 per cent.
This outperformance has been largely driven by a massive transfer of money from government to consumers and businesses since early in the pandemic. The 2022 Inflation Reduction Act (IRA) and the Chips and Science Act also provided notable tailwinds, directing hundreds of billions of dollars in funding to clean energy and to bolster US semiconductor manufacturing capacity. At some point, the tide will turn. How gently or how dramatically this occurs will depend on what type of political mandate emerges out of the US presidential election. But for the economy, even flatline spending would mean fiscal policy becomes a headwind to growth.
The US dollar’s role as global reserve currency means there is little danger that the Treasury would fail to find buyers for the debt it issues. But the question is, what price will buyers demand? On a very basic supply and demand level, the more supply, the lower the price. But in this case, the lower the price of US debt means a higher interest rate. Yields on benchmark Treasuries rise, exacerbating the US government’s spending trade-offs.
There is another twist. American banks own a significant amount of US government debt. As the yield on that rises, the paper losses associated with the holdings rapidly multiply. A fiscal “accident” — such as the UK’s “mini” Budget which sent bond yields soaring in September 2022 — could have immediate unforeseen ripple effects throughout the US banking and financial system. The more substantial these losses, the more reserves banks would need to keep and the more constrained their lending activity would be.
Growing debt levels put policymakers in a tight spot. Outsized levels leave less financial flexibility to deal with unexpected events, making it more difficult to recover from shocks.
What are the implications for investors? Perhaps counter-intuitively, investors should continue to embrace bonds, which look attractively priced. We continue to favour high-quality sovereign debt, including US Treasuries. We expect vulnerability in some overleveraged sectors — particularly commercial real estate — some parts of the asset-backed securities markets and lower-rated high-yield debt. Slowing growth rates could also derail equities.
As public debt mounts worldwide, debt sustainability has become more urgent. Past politicians have left massive deficits for future generations to fix. The future has arrived. We are living on borrowed time.
