Who Will Pay for the Federal Debt? Part II

This article is part 2 of a 2-part series

Scott Middleton, CFA, CIMA® and Brooks Urich

The first part of this article reviewed the long-term issues of the U.S. government’s current $27.5 trillion of debt. Potential solutions to reducing the debt include cutting spending, raising taxes, and having economic growth sizeable enough to reduce the debt as a percentage of the economy. The large government indebtedness from WWII was reduced because of a booming economy in subsequent decades. However, the future stagnant growth of the U.S. working-age population restricts the government’s ability to reduce the relative size of the debt. In light of these complexities, how should investors respond?

The government debt outlook includes two long-term threats: rising interest rates and rising inflation.

Rising Interest Rates

In March 2021 Congress passed an additional $1.9 trillion stimulus package, including funding for vaccine production and distribution, additional stimulus checks, and extended federal unemployment benefits. The additional debt from this stimulus could cause investors to further question the long-term creditworthiness of the U.S. government. Growth in this concern could cause investors to require higher yields on government debt.

In a rising interest rate environment, investors need to be especially mindful of the duration, or the interest rate sensitivity, of their portfolios. When interest rates rise, the prices of existing bonds fall because of their relative unattractiveness to new issues. In addition, the longer the remaining maturity of the bond, the greater the negative impact from rising rates.

For example, a 1% rise in interest rates would cause the total return of a two-year U.S. Treasury (UST) to drop by approximately 1.8% over a one-year period. A similar 1% rise would reduce the total return of a 30-Year UST by about 17.5% over a one-year period. In the near term, bond portfolios with shorter durations would be positioned to perform better in rising interest rate environments. However, in the long term, rising interest rates means that investors would subsequently receive higher returns from fixed income investments.

Another portfolio consideration is using active fixed income managers. Opportunistic bond managers who are permitted by prospectus to deviate from their benchmarks’ credit quality and duration have the ability to capitalize on dislocations in the bond market. For example, in first quarter of 2020, when credit spreads widened with the increasing likelihood of recession, opportunistic bond managers had the latitude to invest in below-investment-grade bonds at more attractive valuations. In the hands of proven managers, this flexibility has the potential to generate additional returns for investors in a low-return bond environment.

Rising Inflation

Rising inflation is another potential threat stemming from the U.S. government’s rapidly growing indebtedness. Falling confidence in the U.S. government’s ability to repay debt could put downward pressure on the U.S. dollar, making imported goods more expensive. In addition, inflationary pressures could build in the coming years if consumers accelerate their spending and banks lend more aggressively. The potential for rising inflation should prompt investors to re-examine their portfolios’ sensitivity to inflation.

Different asset classes offer varying levels of inflation protection with varying levels of risk. While U.S. stocks have tended to outperform inflation over very long periods of time, they have also struggled when inflation was relatively high and rising. For example, inflation was relatively high – greater than 3% – and rising over about one-fourth of the rolling 12-month periods from 1973 to 2020. In these time periods, U.S. stocks outperformed inflation only 48% of the time. In comparison, stocks outperformed inflation 90% of the time when inflation was rising, but less than 3% year-over-year (also occurring about one-fourth of the 12-month time periods measured).

The market usually discounts equities’ future dividends and earnings at a higher rate when inflation is rising. Higher discount rates applied to future growth can lead investors to pay less, as measured by the P/E ratio.

Figure 1  Lower P/Es Accompany Higher Inflation

Data from March 1973 to December 2020. Sources: Datastream Refinitiv and Schroders.

Bonds, with their fixed stream of income payments, are obvious casualties when inflation rises. Their payments become less valuable, sending yields higher and bond prices lower to compensate. As previously illustrated, short-maturity bonds tend to hold up better than long-maturity issues when inflation and rates rise.

Other Debt Instruments

While Treasury Inflation Protected Securities (TIPS) are commonly thought to be a good hedge against inflation, on average they have risen in value only 0.8% with 1.0% increases in inflation. Over time, TIPS’ inflation-fighting characteristics have been subdued by their sensitivity to changes in interest rates due to their relatively long duration. Accordingly, TIPS are not a compelling inflation hedge for most portfolios. However, below-investment-grade floating-rate corporate loans can benefit when the Federal Reserve raises interest rates to combat rising inflation. Their adjustable-rate nature makes them an effective diversifier when inflation rises, especially in a bond-heavy portfolio.

Equity Sectors

Natural resources stocks, including those in the oil, mining, and forestry industries, are often suggested  as good holdings in the event of rising inflation. Real estate investment trusts (REITs) are also frequently mentioned in that context. It is important to keep in mind that portfolios often already have exposure to stocks in these industries, especially within domestic equities. An additional factor is that natural resource stocks are exposed to stock market risk. For most investors, the best course of action is to have active equity managers decide when to overweight natural resources equities, as opposed to having a separate and overlapping allocation to those stocks.

Commodities

One of the most effective hedges in rising inflation has been commodities, which have tended to increase in value by about five percent with a one percent increase in the Consumer Price Index (CPI). Many commodities, such as oil, industrial metals, and agricultural products, are direct inputs into the production of goods reflected in the CPI. However, commodities are volatile and can undergo extended periods of poor performance. For example, for the ten years ending June 30, 2018, the Bloomberg Commodity Index lost an annualized 9.0% — an extreme test for even the most resolute investors. These disadvantages need to be carefully considered when weighing commodities’ attractive inflation-hedging characteristics.

Private Real Estate and Farmland

Directly held real assets, such real estate and farmland, are often categorized as inflation hedges. Private real estate assets can offer a partial inflation hedge through the pass-through nature of increases in rents and property prices. Because farmland income is linked to agricultural commodity price levels, its investment returns have tended to respond positively with rising inflation. Unlike commodities, farmland and real estate  can generate attractive cash flows. Because of their limited liquidity, however, these privately held assets need to be integrated as long-term portfolio positions.

Caveats

Adding exposure to inflation-fighting assets may entail greater overall portfolio volatility, as well as  reduced portfolio liquidity. More notably, the ability of each asset class to protect against rising inflation has fluctuated in the past, and should be expected to do so in the future. It is likely that the best approach to fighting inflation is to maintain allocations to a diverse selection of asset classes with attractive inflation protection, reasonable valuations, and acceptable impacts on overall portfolio liquidity and risk.

Conclusion

When considering the threats of rising interest rates and rising inflation, one of the major pitfalls for investors is making drastic portfolio changes based on a mistaken overconfidence in predicting the economy and markets. Alternatively, investors who focus on managing risk and diversification through asset allocation are best positioned to navigate volatility, including changes in interest rates and inflation, and meet long-term investment objectives.