Many governments around the world have approved large fiscal- and monetary-aid packages designed to alleviate the economic toll of COVID-19 containment measures. Much of this spending will likely be financed through government borrowing. Some investors worry increasing government debt will stifle future economic growth or otherwise lead to market ruin. However, even as governments wade deeper into “red ink” in their effort to support families and businesses, we at Fisher Investments don’t believe that rising government debt automatically portends looming economic or market catastrophe.
This article examines how the stock market has historically responded to different government-debt levels in the US. We’ll look primarily through the lens of the United States, which serves as an insightful example since it has a large amount of outstanding government debt, is the world’s biggest stock market by market capitalization, and issues the most widely traded government-debt securities—US Treasurys.[i]
The US has large (and getting larger) debt burden, but that’s not the whole story
Congress allocated nearly $2.8 trillion in emergency aid as of mid-May and gross US federal debt that isn’t held by the government itself (i.e. net public debt) is now around $19.6 trillion.[ii] The scale of the 2020 fiscal measures—both announced and planned—is indeed significant, but how does that compare to other government responses? As of May 15, 2020, China’s fiscal response amounts to around 1.2 trillion yuan ($169 billion), while Japan added a ¥17 trillion ($157 billion) aid package to a previously approved 2020 budget. Meanwhile, the UK’s spending measures total around £175 billion ($214 billion). These amounts vary widely, but when normalized by comparing against each country’s economic output, the range varies from China’s 1.3% of gross domestic product (GDP) to the U.S.’s 13%.[iii]
In the U.S., the result is a ballooning 2020 budget deficit, which causes some investor concern. The Congressional Budget Office (CBO) released an updated 2020 budget forecast on 24 April, in which the CBO estimates the U.S. will spend about $3.7 trillion more than it receives in taxes during fiscal year 2020.[iv] That deficit is financed through U.S. Treasury debt, which adds to the U.S. net public debt load. These estimates are all subject to change and reality may differ, but if debt makes you nervous, those figures are likely anxiety-inducing.
It’s the ability to service debt, not absolute debt levels that counts
In our view, a government’s ability to make scheduled interest and principal payments—what the financial industry likes to call “servicing debt”—is the most important consideration to monitor. You’ll often see government-debt levels compared to GDP as an approximation of a country’s ability to afford its debt. The idea is to compare what a country owes to what it generates in a single year—similar to how you’d compare a household’s debt to its income. However, we think focusing on absolute debt levels compared to GDP can be misleading. A country accumulates debt over decades, but GDP is an annual flow of economic activity, making this a useful but imperfect measure of affordability.
Ultimately, governments pay their creditors with revenue generated from taxes, so we believe a better way to evaluate a country’s ability to handle its current debt load is net interest costs as a percentage of tax revenue. By historical standards, U.S. government debt today appears very affordable. In 2019, interest payments’ share of tax revenue was lower than it was during most of the 1980s and 1990s. And those were overall great periods for U.S. stocks. Even with expected debt-level increases and tax-revenue declines this year and next, we believe U.S. debt should remain affordable.
Exhibit: U.S. Federal Interest Payments as a Percentage of Tax Revenue
Lower interest rates and longer maturities take off some additional pressure
There are a number of other factors that can affect a country’s ability to afford its debt. First, there’s the debt servicing cost, which is determined by interest rates. Historically low-interest rates around the world (and governments tend to enjoy some of the lowest rates) have kept borrowing costs low for many years. Additionally, with government bond yields at historic lows (and in some regions, actually negative), newly issued debt should take advantage of these low rates and relatively cheaper debt financing.
A second factor that affects the affordability of government debt is its maturity or the length of time for which the money is being borrowed. When government debt matures and the principal amount must be repaid, many governments, including that of the U.S., issue new debt to pay off the old. Refinancing at currently low rates means older, more-expensive debt can be replaced with newer, less-expensive debt. For example, since 2009, the U.S. Treasury has increased the average maturity of outstanding U.S. debt from less than 50 months to 69.2 months, as of the end of March 2020—effectively locking in lower rates for longer.[i] Similarly, the UK government has also been actively increasing the average maturity of its debt—known as gilts—which now sits at around 15.3 years.[ii] In either case, we believe interest rates would likely have to materially rise and stay elevated for years in order to significantly increase overall debt servicing costs in the US or UK.
A few final thoughts
In our view, stock markets typically price in information relevant for how the world will look between about 3 and 30 months from the present time. The long-term nature of government-debt obligations tends to fall outside of that window, blunting the impact to markets. Plus, while recently passed spending and aid packages are big, remember that they aren’t all permanent balance-sheet entries, and they may not cost as much as originally estimated. For example, in the U.S., $454 billion of the Federal Reserve’s monetary efforts backstops loans to small businesses. To the extent these loans are repaid, that money could be recouped. The Fed will also return interest on those loans to the Treasury, as it does all of its profits, further defraying the cost. Another $211 billion relief measure is deferred—but not canceled—employer payroll taxes. Finally, this increased spending is likely a one-time splurge, not a new, permanently higher spending plateau. Following the 2008 financial crisis and subsequent stimulus and bailout efforts, the U.S. budget deficit initially soared in 2009 but then fell for six straight years. So while the amounts may boggle the mind, we don’t believe government debt is signaling stock market ruin.
[i] Source: MSCI. https://www.msci.com/documents/10199/8d97d244-4685-4200-a24c-3e2942e3adeb. Based on country weights of the MSCI ACWI as of 30/04/2020, the United States made up 57.86% of world stock markets.
[ii] Source: US Department of the Treasury, as of 27/05/2020. https://treasurydirect.gov/govt/reports/pd/pd_debttothepenny.htm
[iii] Source: IMF and OECD, as of 15/05/2020. Exchange rates from Google Finance, as of 19/05/2020 at approximately 4 p.m. Pacific Time; end-of-day prices provided by Morningstar.
[iv] Source: Congressional Budget Office, as of 22/04/2020. https://www.cbo.gov/publication/56335
[v] Source: US Department of the Treasury, as of 06/05/2020. Weighted average maturity of marketable debt outstanding, 31/03/2020. https://home.treasury.gov/system/files/221/TreasuryPresentationToTBACQ22020.pdf
[vi] Source: Her Majesty’s Treasury, “Debt Management Report 2020–21.” https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/871876/03032020_DMR_off-sen_v2_FINAL_with_jpegs_v2.pdf
Fisher Asset Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
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