Transcript
[THEME MUSIC]
Welcome to Market Perspectives, a Mercer Advisors podcast. Today is the big episode on debt and deficits, which, surprisingly, is a topic that we haven’t dug into yet in much detail. I’m Josh Zumbrun. I’m the Director of External Communications here at Mercer Advisors, and I’m joined today by Don Calcagni, our Chief Investment Officer. Don, thanks so much for being here.
Hello, Josh. Thank you. It’s great to be here again.
So we have some news on this front. In May, the rating agency Moody’s downgraded the credit rating of the United States debt. We’d been obviously AAA at one point in the past and no longer AAA rated debt, but this is also a little bit of an evergreen topic, because the federal government hasn’t had a single year of surplus since 2001.
For almost a quarter century, we’ve been spending more than we bring in at the federal level every single year, 24 years of deficits with no end in sight. So this isn’t something that’s just about what happened with Moody’s, this is a big challenge facing the nation. But let’s start off with what just happened. The rating agency Moody’s just downgraded U.S. debt. Don, tell us what just went down here.
So, Josh, there’s basically three large ratings agencies. Moody’s is one of those. The other two are Fitch and Standard and Poor’s, S&P. And Moody’s just downgraded U.S. government debt like you rightly explained is prior to Moody’s downgrade, the U.S. was AAA rated. And the way that scale works is it begins with AAA and it goes all the way down to junk status basically in default and things like that.
The U.S. is now AA1, so that’s an uppercase A, lowercase a 1, which is actually Moody’s second best rating. So just to add a little bit of context here Josh, yes, this is a downgrade. And certainly that headline is eye popping for those of us who expect the United States to be the world’s most reliable borrower.
But they weren’t downgraded to junk status. We’re not talking a B rated bond or something like that. This is the second best rating the United States still, by any objective measure, is a very reliable borrower at the moment. I know we’ll have a discussion. We’ll get into the weeds a little bit more on that, but again, just to put that in context, the U.S. now has Moody’s second best rating.
So I follow this news fairly closely, but when I saw these headlines the other week, it was a little bit of a deja vu moment. Didn’t this happen before?
Well, as a former Wall Street journalist, I’m sure you’ve even written on this in the past, right Josh? So the answer is yes. So this is not the first time. This initially began with the downgrade of U.S. government debt, in 2011 by Standard and Poor’s back then, Congress and the White House were in a bit of a standoff over around increasing the debt ceiling, the amount of capital, the amount of debt that the U.S. Treasury is permitted to issue or dollars that they are permitted to borrow.
And so that’s when the first downgrade occurred back in 2011. The second occurred when Fitch downgraded U.S. government debt in 2023, citing, and I quote, “A high and growing general government debt burden and the erosion of governance.”
And what I love about this particular quote, Josh, is I think it actually highlights what I was trying to say a moment ago in that what the United States, at least in our view, is really struggling with, is a political unwillingness to live within its means. A political unwillingness to pay our debts hence the debt ceiling debate.
We’re not talking anything about our financial ability to pay. The United States is still solvent, the United States is the world’s largest owner of land in the United States, and certainly can always increase revenues through taxation. I think Fitch did a nice job putting in there the erosion of governance. We have seen a breakdown, frankly, between the Congress and the White House when it comes to managing the fiscal affairs of the United States within our means.
And so what happened here with Moody’s was it followed the other two, and now all three of them have downgraded the U.S. How does this compare internationally? We always used to think of the U.S. as the international gold standard when it comes to creditworthiness. Where do we stack up now internationally?
That is correct. There are still several countries that have higher credit standings than the United States. That would be AAA. Australia, Germany, Singapore, Sweden, Switzerland these are countries that any investor should be happy, should be proud, should feel confident in owning their sovereign debt issued by their governments.
And within the corporate space. Just to give us a little bit of an analog, Microsoft and Johnson & Johnson are the only two companies that have AAA corporate rated debt. So I think that’s somewhat interesting. So yes, it is objectively true that, at least according to the three major ratings agencies, the United States is no longer the world’s premier borrower. There are other countries that, at least from a fiscal perspective, are arguably better borrowers than the U.S. federal government.
Where does the debt burden compare to what we see in other advanced economies?
And that’s a very important point, Josh because that’s really how we as economists and investors think about measuring the size of any country’s debt is relative to its GDP, its gross domestic product. That’s just a measure of how large their economy is.
And so when we look at the United States, our debt burden is quite large. It’s one of the very highest. There’s only three countries that have a debt to GDP ratio higher than that of the United States. And just to put this in context, we have about $36 trillion in debt outstanding, and we have about a $30 trillion economy. So if you just do the simple math on that, roughly speaking, and there’s lots of asterisks here, Josh, we have a debt to GDP ratio of about 120%.
There are three countries Japan, Greece, and Italy, that actually have a higher debt to GDP ratio than the United States. Now, with the exception of Japan, Greece and Italy are probably not the best company that you want to have when you’re thinking about the credit worthiness of your country. Those are two countries that in recent years, certainly over the past decade, that have had real challenges paying their debts. And so Japan has a very high debt to GDP ratio, but at least for the time being, has done a decent job managing that debt relative to its economy and revenues.
Now, when this downgrade happened, the market largely shrugged it off. Why do you think that is?
I think it’s important to remember as investors is that markets are very efficient when it comes to incorporating all information. So the information that Moody’s actually was analyzing to arrive at its decision to downgrade US government debt, arguably the market already knew all that information.
It’s no surprise that we’ve gotten into this situation.
No surprise.
If you’re a professional bond investor, the fact that Moody’s came out with their announcement, a professional bond investor is probably thinking, no kidding where have you been? We’ve known about this for months or years that the U.S. is credit worthiness has slowly been declining. So the market already knew this information. And that’s why I think the market largely shrugged it off. It was much ado about nothing, to be quite frank.
Now, before we dig into the debt and the nature of this challenge, I think we want to revisit something that’s been a recurring theme for us on the podcast, which is that politics and investing don’t mix. And this issue is an example of why.
We’ve seen for a quarter century we’ve had different presidents different congresses. We haven’t seen much progress. Looking back further, I was just looking through the historical record. And so we had surpluses 1998 to 2001. Before that have to go back all the way to the Eisenhower administration before you have two years in a row of surplus. So we’ve got just this extremely long, bipartisan track record of struggling to deal with this. So I wondered if you wanted to just touch on how you think about keeping the politics separate from the issues here.
Well, Josh, I think you rightly highlight why it is important to keep politics out of your portfolio. And that is, the reality is, whether you’re a Republican or a Democrat or an independent, it’s irrelevant. When you actually look at party control of government, and by that I mean both chambers of Congress and the White House, the reality is both parties have struggled perennially to deal with the deficit.
So I’m just going to be quite candid. There’s no such thing as a party of fiscal responsibility. Just look at the current budget reconciliation bill that has passed the House and is now moving to the Senate. That particular bill will actually increase the deficit over the next 10 years by anywhere from $2 to $4 trillion. That’s with a T. That’s a lot of zeros.
And regardless of who’s counting, regardless of who’s keeping score and regardless of how you keep score, that particular bill is going to make the deficit even worse. And this is a situation where we have full party control of both chambers of Congress and the White House.
And to be fair, the other party, the Democrats, have had the same struggles throughout time when they controlled both chambers of Congress and the White House. And so I think this is a political problem that frankly, neither political party has showed much interest despite the campaign rhetoric in actually solving.
And so at some point, the market will force us to solve this problem, but it is clear to me that from a political perspective at the moment neither party actually has any good answers when it comes to balancing our budget.
And so let’s talk about the drivers of federal government spending, because I think this is very revealing when it comes to this question of why has it been so hard to really make progress here and reduce these deficits.
So, Josh, if we actually look at where we’re spending our money, if we look at the federal budget, we have defense spending, which is 12% of the total budget, we have Medicare at 16%, Social Security at 22%, and Medicaid at 9%. If we add all of that up, let’s just do the arithmetic here. That puts us over half of the federal budget. Call it maybe 55% of the federal budget that is already accounted for.
And the truth is, neither political party actually wants to touch those. Although, interestingly, the bill that’s working its way through Congress does make cuts to Medicaid, and so I thought it was interesting that they actually went there.
The point is when you actually look at where the dollars are going these are painful cuts that would have to be made if — and again, back to the budget that’s working its way through Congress, they’re actually increasing defense spending, so they’re actually cutting taxes, which gets us to the other side of the equation. Where’s the money coming from?
Well, it’s coming from payroll taxes that’s 25% of all federal revenues that are collected. And then it’s coming from income taxes, which is only 37% of all the revenues that are coming in, so where is the rest coming from?
Only $0.07 of every dollar that the government spends comes from corporate taxes. So effectively speaking, the United States, we actually don’t really have corporate taxes, not like they do in other parts of the world.
Our corporate taxes, whether you agree with it or disagree with it, they are low by global standards. $0.27 of every dollar that we spend nearly $2 trillion is borrowed every single year, and the budget that’s working its way through Congress would actually make that even higher. We would actually have very high deficits for the next 10 years, frankly, we would have deficits as far as the eye can see going forward based on the current budget that’s working its way through Congress.
The current budget that’s working its way through Congress will extend and make permanent the tax cuts that were put in place in 2018. If we do that, that’s going to blow a pretty big hole in the federal budget, at least without having any offsetting cuts to government spending.
Now, I think, Josh, this is probably a place where we should make a comment about the DOGE exercise that the federal government was going through here for the past couple of months. And the reality is, even though DOGE was highly publicized and we can debate whether people liked it or not, the reality is DOGE found very little cuts in the federal government.
Some of them were highly politicized USAID and things like that, but the truth be told, when you look at this $2 trillion deficit, I think at last count, DOGE from an optimistic perspective, only cut about $160 billion from the federal budget. So less than 10% of the total deficit outstanding. So Josh, this is a very hard thing to do. These are highly cherished programs. Certainly no taxpayers want to pay more taxes, but naturally we all want lots of things from our government.
Another part of the challenge is interest rates. Currently, it’s about almost $1 trillion a year that’s spent just paying interest on the outstanding stock of debt. And this challenge is getting a little bit worse because we’re in a higher interest rate environment than we were for most of the last decade.
Absolutely. We have $36 trillion in debt.
That debt is the sum total of all prior year deficits. So prior year deficits all added up, that’s how we arrived at 36 trillion. To be fair, a majority of that has accrued over the past 10 years. Now, the political parties are going to point fingers and say, it was Trump and Trump will say it was Obama or Biden. It’s irrelevant because they’re all responsible for this increase.
Now, the challenge is to your point is prior to 2022, we were in a very low interest rate environment. So the federal government had a massive subsidy when it came to borrowing. They could borrow at interest rates that were close to 0. There’s basically no cost to issuing lots of debt.
The challenge is that all of the debt that the US government issues is interest only debt. None of it is amortizing. It’s not like your home mortgage or automobile loan, where each payment is part of it is principal and pays it down. This is interest only debt that needs to be refinanced when it comes due.
And here’s the problem, Josh, a lot of this debt is coming due. It now needs to be refinanced, and we are in a much higher interest rate environment than we were just a couple of years ago. And so the problem is the interest expense on the US federal budget has gone up dramatically.
As recently as several years ago, it was only about 250 billion annually in interest, it’s now almost $1 trillion in interest expense every year that the government now has to fork over to all of us. And many of them are our clients who own US Treasury bonds. So again, they have to refinance now into a much higher interest rate environment, whereas this was debt that was previously borrowed when rates were quite low.
You touched on it there for a second. Who actually owns this debt? I think this is a point that we sometimes see some confusion on, or maybe even a misinformation. People have these fears about what might happen if the owners of the debt all sell it, or something like that. Walk us through who actually owns US debt.
So that’s an interesting point. We often hear the Bank of China is our lender. There’s a small grain of truth to that, but when we actually look at US government debt, about 3/4 of it is actually owned by Americans. So about half of that, about 55% is owned by private investors, U.S.-based investors.
And then there’s about another 20% that’s owned by the U.S. federal government. And you may be thinking, wait a minute, why does the federal government own our debt? Well, inside of the federal government, we have the Social Security administration. I just checked this morning. They own about $3 trillion worth of US government debt. So not to be funny, but there absolutely is a Social Security Trust fund.
The trust fund.
Now, it’s eroding quickly because they’re selling off those bonds in order to meet our promises to our fellow citizens. And so the Social Security administration owns a chunk of it, and then so does the U.S. Federal Reserve.
The Federal Reserve bank of the United States back during COVID, back during the global financial crisis, one of the ways that they supported the economy and stopped it from slipping into a depression, was by buying debt of the federal government. And when they did that, they injected cash into global financial markets. So that’s who owns the majority of it.
Now, what about that other say, 25% that’s owned by other investors? Well that’s owned by non-US investors, that’s owned by other countries — investors from other countries, occasionally the governments of other countries.
Japan is actually the largest owner of U.S. government debt. It’s about I think, about $1 trillion or $1.1 trillion that’s owned by Japan. China comes in at about %750 billion. It’s been coming down a bit because China has been selling off their U.S. Treasury bond holdings, partly due to the tensions between the two countries, but also to prop up their own currency, which has come under stress here over the past couple of years.
And then, just to round out the top three, Josh is the United Kingdom. The United Kingdom is the number 3 highest largest foreign owner of US government debt. So is it true that China owns our debt? Yes. It is not true, however, that China is the largest owner of our debt. In fact, in the grand scheme of things, China only owns probably about 2.5% maybe 3% of all US government debt.
Now, to what extent, when we think about this challenge, and you touched on this earlier, to what extent is it an economic problem where this is really difficult for an economy our size to actually service the debt of this magnitude or — I think what you were saying earlier is that this is largely a political problem rather than an economic one.
It’s a political problem because the federal government could easily raise taxes. And I say easily in that they have the power to do that legally. It would not be easy politically because we have elections in this country every two years, and our politicians would have to be held accountable to the voters.
But to be fair, we’ve raised taxes before in this country. That’s not a new thing, and we’ve survived, we’re still here. I think this is more of a political problem than it is a financial problem. We have the world’s largest economy, we have the world’s most dynamic economy, or at least until last quarter, we were one of the world’s most rapidly growing economies when the rest of the world, frankly, was stagnating a bit.
So the United States is still from a financial perspective a major global powerhouse. And I have no doubt that we could handle our debts from a financial perspective. Remember too, like I said earlier, the U.S. federal government is the largest landowner in the United States. They could style off oil and gas leases, timber leases. They could style some of those holdings to private investors to raise capital. There are certainly a lot of things that the U.S. government can do in order to pay our bills.
And one last thing that I’ll mention, we often hear that the United States has what’s called an exorbitant privilege. We have a very unique global privilege. Well, what is that? You might see that term from time to time in the newspapers. It’s because the US government issues debt in the same currency that it prints.
And so, technically speaking, the U.S. government could simply go into the basement of the U.S. Treasury, fire up the printing press and send to China $750 billion worth of Ben Franklin’s and pay off any debt that we owe, for example, to China.
It might cause some inflation, but we have the power to do it.
Certainly. I’m not saying that it’s a good idea. I want to be very clear to our listeners. I’m not saying it’s a good idea. That would be inflationary. Other countries have tried that throughout human history, and it has led to inflation. As a last resort naturally, the U.S. Treasury has the ability to do that, unlike other countries that may borrow in dollars, but they operate their economies in an entirely different currency.
Look, this is a problem. The more capital that the government borrows from investors in private markets, is less capital that’s available for private businesses and consumers to borrow to fund things like business expansion or to fund consumer spending. And that’s really the workhorse of the economy.
So again, the more capital that the federal government borrows from the market, arguably there’s less available for everybody else. And so there will come a time when this really does begin to seriously drag on the U.S. economy. It’s really TBD to know exactly when we might cross that threshold point where it really begins to drag on growth.
And then one last thing, Josh, is that I think it’s quite obvious that the more debt we have and the more our interest expense rises, the less dollars that, frankly, are available for other things that are important to our citizens, whether that be education, military spending, whether that be infrastructure, maybe that’s health for our citizens and things like that. Naturally, if we spend $1 on interest that we’re sending to investors, that’s $1 that we don’t have available to invest in providing goods and services to our own people.
What should we do as investors with this knowledge? And I think the first question there is, is an alternative to the U.S. dollar — to U.S. Treasury market?
It’s a good question, Josh. We get that question a lot from our clients. And the truth is between U.S. treasuries and the U.S. dollar, those are the most widely held and highly cherished assets by investors the world over. The U.S. dollar and U.S. treasuries are the deepest asset markets in the entire world.
Frankly, there is nothing else that comes even close. So it’s just not credible when folks argue, well, maybe the Swiss Franc will become the world’s safe haven currency or maybe the Canadian dollar will become the world’s safe haven currency. Those just aren’t credible arguments. And it certainly won’t be the Chinese Yuan. It’s a highly manipulated currency, and it’s a very non-transparent economy.
The reality is, Josh, there’s nothing out there that can replace the U.S. dollar or U.S. treasuries for investors when it comes to looking for those safe haven type assets. Over 90% of global cross-border economic transactions actually occur in U.S. dollars. They’re priced in U.S. dollars. If we look at global banks central reserves, the U.S. dollar is still the world’s most highly preferred reserve currency. About 65% of all global central bank reserves are held in U.S. dollars.
And so I just don’t think it’s credible at the moment that there’s anything out there that can seriously rival the U.S. dollar or U.S. treasuries as a replacement for the world’s safe haven reserve assets.
How do we think about setting up a bond portfolio in this type of environment where there is potentially this pressure for higher interest rates over time?
Well, in any environment where you expect interest rates to be higher in the future, which you always need to be careful, that’s not always a foregone conclusion, but if you do expect interest rates to be higher in the future, you want to stay closer to home, meaning you want shorter maturities in your bond portfolio.
If you think future interest rates are going to be higher, you don’t want to buy a 30-year US Treasury bond today for example, let’s say at 4% if you think that interest rates are going to be 5% for the U.S. 30-year Treasury bond in the future.
So generally speaking, at Mercer Advisors, we like to keep our bond portfolios relatively short duration. Something south of about five or six years is where we prefer to be, but like I said, there’s no assurances that future interest rates will it be higher or lower.
I think you can actually make a case that they might be lower. The U.S. was in recession in the first quarter of this year. We had a negative GDP print of negative 0.2% for the first quarter. It is conceivable that largely due to tariffs, that the United States could slip into recession here. And if that does happen, the Federal Reserve is likely to cut interest rates. And so we could see rates perhaps decline a little bit here later this year.
But Josh, I do think longer term, as the deficit worsens, as our debt burden increases, it is logical to expect that interest rates will be higher and not lower. I can’t tell you exactly when. I can just tell you that directionally, that’s what we would expect given any deterioration in the creditworthiness of the United States.
And do you see the risks from this as part of the case for staying diversified internationally? We’ve talked a lot about the importance of that this year. Obviously, being diversified internationally has helped portfolios this year, whether some of the foibles we’ve seen in the U.S. stock market.
Absolutely right. There is absolutely no substitute for broad global diversification. Those countries we mentioned earlier, Australia, and Singapore and Switzerland owning sovereign debt issued by those countries, I think is just a good idea. It’s just good prudent investment planning.
So continuing to diversify beyond the United States, I think this year has taught many investors a painful lesson that is still a very prudent, very good approach to managing portfolios on a go forward basis, both with respect to the equity side of their portfolios, but certainly and especially relevant to this conversation on the bond side of those portfolios. So broad global international diversification combined with shorter maturities Josh, we think that’s the right way to go.
So Don, take a second to just sum this up for our listeners. What do we make of this debt challenge facing the United States? How do we go forward big picture?
I think it’s important for all of us as citizens to understand the fiscal situation that our country is confronted with. And I know it’s hard because we live in a very politicized environment that’s divided, but I think trying to look past the soundbites and try to understand where are we and what are the tough decisions that we have to make. So I think one is to contextualize and really try to understand — make an effort to understand the complexity of the US fiscal situation. That’s number 1.
As investors, it’s to keep politics out of our portfolios. Like we said earlier, Josh, neither political party has any demonstrable track record of actually balancing the budget and really bringing down the deficit, certainly not over the last 25 years. So keep politics out of our portfolio.
And then I think, with respect to the management of our portfolios, is one, remain broadly diversified both within and especially outside of the United States. What we’ve seen here thus far this year is what has been dubbed quote, “Sell America trade.” And a lot of that is in response to tariffs, it’s in response to some of the political stalemates that we have in this country.
But number 1, remain broadly diversified both across stocks and bonds. And finally, keep those maturities relatively short. We would not recommend owning 10, 15, 20 year bonds. We recommend keeping it somewhere around the five-year mark. We think that’s prudent. We think that really maintains a lot of flexibility in the portfolio for investors.
Don, thank you so much for being here today for this conversation.
Great. Well, thank you so much, Josh. It was great to be here.
If you’re already a Mercer Advisors client, feel free to reach out to your advisor and understand. Talk about how your portfolio is positioned for the scenarios we’re talking about here. And if you’re not a Mercer Advisors client, but would like more information, go to our website merceradvisors.com, set up a phone call. This has been Market Perspectives.
