Recently the US House of Representatives passed a bill that would greatly expand America’s outstanding debts, which had previously been forecast to reach US$59.2 trillion by 2035. (The current balance is $35 trillion).
Normally when a country announced it had embarked on an act of fiscal recklessness on such a grand scale its stock market would plunge and domestic interest rates would rise to crippling levels as foreign investors pulled their money out of the country.
But nothing of the sort has happened. Indeed the US share market has edged up 2.5% since the big spending bill passed the lower house of congress. The US 10-year bond rate has risen slightly, to 4.45%, almost as if the largest and most liquid bond market in the world shrugged its shoulders.
Many respected financial commentators and economists have warned that America’s debt binge is quickly pushing the country towards another financial crisis. But so far the crisis has been delayed or averted, although the price of both Gold and Bitcoin – hedges against US dollar collapse – have firmed to near-record levels.
I will refrain from predicting that a melt-down in US debt and equity markets is imminent. But what all investors need to bear in mind is that the vast accumulation of government and private debt in the USA is unprecedented. What is also unprecedented is the proportion of that debt that is short term in nature. A huge proportion of government and private debt has to be rolled over (refinanced) every year.
The sheer size and structure of America’s debt means that the country, while currently enjoying the fruits of unearned money, is structurally unstable. That leaves the US vulnerable to relatively small shocks, either internal or external. If foreign pension funds, for example, started selling US government bonds in large volumes the whole US economy would be plunged into a deep recession as the cost of consumer debt (which is priced relative to the US bond rate) spiralled.
While Australia’s financial position is vastly superior to that of the United States – our net debt to GDP is dramatically lower – an American crisis would quickly spread to our markets. Our bond and share markets take their pricing cues from the US. A 20 percent fall in US shares would trigger the same here. America’s profligacy is our problem.
These are anxious times for investors. Everyone has a different time horizon and a different attitude to risk so there is no “one size fits all” strategy for the current uncertainty.
For those for whom a global equity market meltdown would prove a calamity there is an argument for reducing equity exposure and increasing holdings of Australian government bonds and, perhaps, some of the higher quality gold stocks.
But such a move requires accepting lower after-tax income in the short-term. Shifting from shares to bonds means the loss of franking credits, which are vital for some. And dividends on gold shares are meagre. Someone switching from a balanced portfolio of Australian shares to a mix of 5-year bonds and gold shares would see their after-tax income yield drop from around 5-6 percent to around 2 percent.
So there are no easy choices. Lower risk will inevitably entail lower income, but the reward comes from better sleep.
Since my crystal ball was smashed some time ago I have become hopeless at forecasting short-term market movements. But I also know from four decades of working in financial markets that large structural imbalances – like the US debt and deficit problem – rarely resolve themselves nicely.
I also know that the US has been atrocious in its ability to forecast how much debt it needs to issue to keep the machine humming. The Congressional Budget Office (CBO) is an independent body which makes 10-year forecasts for US budgets and debt, using the tax and spending commitments made by Congress at a fixed point in time.
The table below shows the CBO’s forecasts for gross Federal Government debt outstanding and how they have changed over time. The most recent CBO forecast, made in January, was before Congress decided to spend a further US$2.4 trillion.
Source: Congressional Budget Office
