The National Debt and How it Affects Investors

Investors should be aware how the rise of the national debt will impact the assets in their portfolio.
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The national debt is projected to be on track to widen to more than 100% of national GDP by the end of the year, which would exceed the record set after World War II.

The U.S. national debt is over $25 trillion, equating to $76,665 per citizen and $203,712 per taxpayer. The federal deficit is over $1.9 trillion through April and the Congressional Budget Office projects it will rise exponentially to $3.7 trillion by Sept. 30, the end of the fiscal year.

The national debt is tracked by USDebtClock.org and maintains the debt levels in real time. (It's truly worth a look.)

“All of this continues to draw the eventual day of reckoning closer and more pressing,” said Mark Hamrick, senior economic analyst for Bankrate.

“The fear is that investors could eventually demand higher rates if they view the federal government’s position as increasingly precarious,” he said.

Short-Term Impact of Government Debt

The U.S. government had to lower interest rates and provide liquidity to the market, said Brian Rehling, head of global fixed income strategy at Wells Fargo Investment Institute, a division that supports wealth and investment management of Wells Fargo  (WFC) - Get Report.

“There's not a lot of short-term impact and there is not much risk by adding additional debt to the government’s balance sheet,” he said.

The Federal Reserve, the central bankers, have “aggressively” expanded its balance sheet, in part, to purchase bonds used to finance the deficit, Hamrick said. The annual deficit is now forecast to reach about $3.7 trillion this year, almost four times the remarkably high $1 trillion that was a concern before the coronavirus.

“The sobering truth about the current dual COVID-19 related crises is that massive federal spending is necessary to avert a lasting depression with the hope that the current unprecedented downturn will not persist,” Hamrick said.

The short-term impact from the rapidly rising national debt and federal deficit are not immediately obvious to most Americans and seemingly forgotten by elected officials in Washington, Hamrick said.

“Their inattention to the problem has been a feature of the political atmosphere for the past decade or so,” he said. “This is akin to an individual who continues to pile on credit card debt without considering the short-term or long-term risks. In both cases, the behavior is not sustainable.”

The short-term impact is net positive because the economy and the financial markets almost certainly required, and likely continue to require, a “material fiscal response to support their functioning and keep the U.S. from entering into a deep spiral towards a depression,” said Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley  (MS) - Get Report business.

Since the U.S. dollar is a reserve currency and the federal government can print an unlimited amount of money, there aren’t any obvious materially immediate consequences of rising debt. The Fed can buy the debt, keeping down interest rates, she said.

The Fed has been clear that they will use any tools they have and have suggested they have many options to support the markets. In the short term, it’s less likely that increasing the U.S. debt becomes an issue, said Daren Blonski, managing principal of Sonoma Wealth Advisors in California. On a recent CBS "60 Minutes" show, Fed Chairman Jerome Powell reiterated this strategy and said, “there is really no limit to what we [Fed] can do with these lending programs that we have.”

“As the old saying goes, ‘don’t fight the Fed,’” he said.

Longer-Term Impact to the Economy

Once businesses start to reopen and growth returns at lower levels, the likelihood of tax increases on both the federal and state levels is high, Rehling said.

Higher debt levels tend to be a drag on growth and lead to the likelihood of lower investment returns, but also lower inflation.

“Expect to see a continuation of the trends we saw in the last decade during 2008 to 2009, but this time the magnitude is greater,” he said. “The same trends will continue - low interest rates, low growth levels, low inflation and lower investment returns, but higher taxes.”

The reality is it’s difficult to make the case that printing and flooding the system with trillions of U.S dollars won’t have some sort of an impact, Blonski said.

“The question remains what the actual impact will be,” he said. “This is certainly a foray into modern monetary theory and a grand experiment.”

There is no guarantee that the fiscal policies enacted will be successful and push the economy on a long term path to growth, said Gunzberg.

The narrative and the politics may switch to reigning in the deficit and this change in policy could have massive implications for government spending, especially in areas like pension and medical spending as the U.S. economy ages.

“The path of inflation will likely have an effect not only on the price of the services the government supports but also on cost to service the debt,” she said. “The world’s faith in the U.S. dollar as the reserve currency could come under pressure as our debt/GDP explodes. That can cause interest rates to rise, hampering the ability of governments to support their debt and consumers to borrow at low rates–essentially crowding out private debt.”

How Investors Are Impacted

As economic conditions shift, investors need to remain nimble. People who are seeking higher returns will need to look in places like the equity markets, Blonski said.

“As Congress continues to roll-out aid packages this will bring more cash to the markets and likely drive markets further,” he said.

The stimulus bill passed by Congress sent a lifeboat out to businesses and Americans. In turn, the U.S. national debt level, which was already extremely high, skyrocketed. Taking on additional debt is not necessarily a bad thing, but it’s similar to consumer budgets - this means we’re spending more than we’re taking in, said Mike Loewengart, managing director, investment strategy at E-Trade  (ETFC) - Get Report , an Arlington, Virginia-based brokerage company.

Spending now helps bolster the economy in the short term and can help stimulate growth for the long term. The overarching concern with this level of stimulus is the rise of inflation as the U.S. works on a path toward recovery.

“This will have to be closely addressed through fiscal and monetary policy so we don’t swing too far to the other side of the pendulum,” Loewengart said. “Further, if we fail to spur enough economic growth to sustain and service our current debt load, then investors could begin to question the creditworthiness of the U.S. and look to be compensated in the form of higher interest rates.”

In the current economic environment, investors are on the hunt for quality, and while Treasurys could fit the bill, bond yields have come under pressure, leaving investors to look for other dividend-yielding opportunities.

“Don’t write off Treasurys as part of your portfolio strategy,” Loewengart said. “Although yields may come under pressure, fixed income holdings can still provide critical ballast to a diversified portfolio. The best course of action for most investors is to hold tight and stay committed to your long-term goals.”

Riskier assets such as equities, high yield fixed income and preferred stock could have decent returns, but growth remains low as investors search for higher returns, Rehling said.

With the increase in government debt, the fixed income benchmarks will get bloated with government securities. In the future, investors should check that a fixed-income index fund or ETF does not only own Treasurys because yields will remain low.

“It’s probably not a good return-maximizing strategy,” he said. “Investors should maybe own corporate or mortgages with higher yields and be more active in choosing investments.”

Instead of relying on passive index funds, since the market conditions are rapidly changing, investors might find it makes sense to “lean into” the more professionally-managed mutual funds, Blonski said.

“An active mutual fund can target specific parts of the market that offer more yield,” he said.

One thing that hasn’t changed is that the need remains for investors of all kinds, individuals and institutions, to have fixed-income exposure and U.S. Treasurys remain a prime option in this regard, Hamrick said.

“Even as the nation’s debt and deficits have mushroomed, the urgency of the current crisis has underscored the demand for so-called safe haven assets, including U.S. Treasurys,” he said.

Municipal bonds are credit instruments and vary widely, so it’s difficult to measure the impact in aggregate, Gunzberg said. The fiscal future for many issuers of municipal bonds are “dire, so it is imperative to understand the credit risks behind any purchase of muni bonds and rely on that analysis to make decisions,” she said.

It may make sense to own assets that attempt to hold their value when currencies are debased, like gold, Gunzberg said.

“Never in history has there been a monetization of debt the way that’s occurring now,” she said. “In order to measure the impact of taxation and expenditures on the budget in the future, accounting and reporting metrics may need to be modified. There exists an opportunity now to revisit policies and programs that affect the fiscal imbalance, and to address savings and productivity that may grow the economy.”