Rising public debt could put investors on defensive

The International Monetary Fund warned that global government debt is projected to grow by 1% per year and reach nearly 100% of GDP by the end of the decade, potentially putting the squeeze on investors' fixed-income portfolios.

"Government debt ratios declined in 2021 and 2022," said Vitor Gaspar, the former finance minister of Portugal and director of the fiscal affairs department at the IMF, in its latest Fiscal Monitor Report issued on Oct. 11. However, these will "turn back up in 2023. Going forward global public debt is not only higher, but also projected to grow faster than foreseen before the pandemic."

Among the major countries, the ratio of public debt to GDP varies widely. For example, in Germany, the ratio is relatively modest, having edged up to 47% in 2022 from 42% in 2018, according to IMF data. But in Japan, the ratio moved up to 218% from 194% over the same time frame. The corresponding figures for the U.S. are 89% and 114%, respectively.

This looming debt crisis will not only force individual governments to boost their balance sheets by increasing revenues and cutting spending, but it will also likely impact the way asset managers run their portfolios, some experts said.

Richard Weiss, senior vice president and chief investment officer of multiasset strategies at American Century Investments, said spiraling debt will penalize debt-holders.

"Equities, real assets, and possibly even gold should benefit," he said.

In a climate of rising public debt, asset managers may have to migrate away from U.S. Treasuries and other fixed interest investments to non-dollar assets, "along with shortening durations to avoid the potential for credit downgrades and further bond losses," Weiss stated.

"The U.S. is in a unique position as the global reserve currency. Our current federal budget deficit and historically high public debt levels threaten to motivate more transactions outside the U.S. dollar and reduce global investment and reliance on Treasury securities," he said. "Currencies such as the Japanese yen or Swiss franc may benefit at the margin as Treasury securities may be downgraded further as rates and inflation continue to rise.”

American Century Investments has more than $200 billion in assets under management.

As asset managers are often faced with strict mandates about how they allocate portfolios. Phillip Toews, CEO and portfolio manager at Toews Asset Management, with $1.7 billion in assets under management and administration, recommended that asset owners should address the reality of high debt by building a contingency plan to protect portfolios from both financial crises and high or even hyperinflation.

“That means hedging equities portfolios with well-thought-out strategies and holding adaptive fixed-income strategies that can migrate to short- or long-term positions, TIPS (Treasury inflation-protected securities), or high yield based on evolving trends,” he added.

Stocks, Toews added, are “natural inflation hedges,” as companies can increase prices as inflation increases, helping them to rise along with inflation. “However, the history of inflation shows that during the transition from benign to high inflation, stocks can fall significantly,” he noted.

“Also, data shows that as sovereign debt increases beyond 90% of GDP, both the probabilities and severity of financial crises increases. For that reason, hedged equity funds that have built-in ways to address a shock for a portion of investors’ portfolios or institutions’ portfolios can be attractive,” Toews added.

John Vail, chief global strategist and managing director at Nikko Asset Management, said growing concerns about government deficits and associated higher interest rates makes some investments in fixed income more attractive, “with some bias towards the short end of the curve.”

“The unsustainability of debt is far from reality now, but if somehow deemed (to be) so, it certainly should cause a shift to the shorter end of the interest rate curve and to some inflation-hedged assets like TIPS,” Vail added.

Nikko has $219.2 billion in AUM.

Josh Jamner, investment strategy analyst at ClearBridge Investments, said rising government debt burdens could push interest rates even higher in the coming years.

“As yields rise, investors can find more attractive yields in fixed income, which can diminish the appeal of defensive equities, which typically pay higher dividends, relative to cyclicals,” he said. “Similarly, growth stocks tend to have a greater emphasis on cash flows further in the future, meaning they can come under additional pressure when interest rates rise and the value of their future cash flows is reduced.”

By contrast, Jamner noted, value stocks “tend to be priced to a greater degree on cash flows occurring in the next few years, making them relatively less susceptible to changes in the discount rate.”

ClearBridge has AUM of $155.2 billion.

David Bahnsen, founder, managing partner and chief investment officer of The Bahnsen Group, with more than $4.5 billion in assets, said that rising public debt will lead to downward pressure on bond yields as central banks have to intervene to facilitate the debt burden.

“This is the model of Japan and we have watched it in real time for 30-plus years,” Bahnsen said.

In this climate, Bahnsen suggested that investors should avoid anything speculative or momentum- driven and focus on stocks trading at reasonable valuations, or attractive-yielding fixed income, and non-correlated alternatives.

Weiss of American Century Investments said there are various ways that global governments can reduce debt, including: restrict or tighten budgetary spending; raise taxes to increase revenues; and prompt the central bank to lower interest rates or print money in an effort to spur economic growth.

But Weiss admits some of these steps might not be popular with the public.

Bahnsen suggests that governments should target a spending-to-GDP or debt-to-GDP ratio that, when breached, allows for significant discretionary spending cuts and even burdensome limits to the legislators that approve spending.

Toews said spending reductions in the U.S. would likely mean making cuts in Social Security, Medicare and defense. “However, reducing current annual fiscal deficits does not address the challenge of reducing total government debt unless governments are able to produce surpluses or grow their economies significantly,” he elaborated.

Kaspar Hense, London-based BlueBay senior portfolio manager at RBC Global Asset Management, pointed out that not all governments are in bad shape.

“Scandinavian countries do not really have much government debt at all,” he said.

Hense offered Sweden, which had a public debt/GDP ratio of about 37% in 2022, as an example of what governments can do to reduce their public debt. In the 1990s, Sweden suffered a housing crisis as well as an unsustainable social security system, he noted. The Stockholm government took “hard measures at that point in time to bring government debt down from 70% to 40% in a rather short period of time,” he said. “If you want to reduce debt, you need to either increase taxes or reduce expenditures,” Hense said. RBC has about $419 billion in AUM.

Another potential victim of spiraling public debt would likely be the efforts of global governments to battle climate change by reaching carbon neutrality at some future date.

“There is little question that any and all fiscal, monetary and/or geopolitical problems will likely take precedence over longer-term environmental issues,” Weiss said.

Large fiscal deficits impede wealthy nations’ willingness to contribute to poorer nations’ efforts to become carbon neutral, observed Toews.
“If attempts to become carbon neutral are reframed as pathways to economic improvement or competitiveness, this could potentially offset the challenge,” he said.