Rising federal budget deficits and national debt could eat into stock market returns.

By Paulina Likos and Coryanne Hicks USNEWS Jan. 25, 2021

How the National Debt Affects Investors

The rising U.S. federal debt is now larger than the country’s gross domestic product.

THE NATIONAL DEBT MAY seem as far removed from your investments as your parents’ debt is from your bank account. But like your parents’ debt, if the federal government’s budget deficit grows too large, it could impact your daily life and investments in a painful way.

Not to be confused with the deficit, federal debt is the total amount or the collection of deficits throughout the years owed by the government. It now stands at more than $27 trillion, or more than $84,000 for every person in the U.S.

The deficit is the difference between the government’s revenues – which mainly come from taxes – and its expenses, such as national defense, health care, education and other programs, for a particular period. When expenses exceed revenues, the government has a deficit.

The Congressional Budget Office estimated the federal government to run a $3.3 trillion deficit for the 2020 fiscal year in a September 2020 report.

The 2020 deficit and the overall national debt have risen to such heights in a short period because the economy slowed down due to the pandemic, leading to a recession. This triggered the government to increase spending to address the fallout and speed up economic recovery.

The U.S. government is limited in the amount of money it can borrow to fund its operations. This limit is known as the debt ceiling. Congress holds the authority to raise or suspend the debt ceiling as it sees fit.

There have been many moments in history when Congress has done so to meet budget priorities. Failing to change the debt limit would lead the U.S. government to default on its debt obligations. In August 2019, former President Donald Trump signed a budget deal suspending the debt ceiling until July 2021.

“The economy is not going to implode tomorrow because of the national debt,” says David Primo, a professor of political science and business administration at the University of Rochester and a senior affiliated scholar at George Mason University’s Mercatus Center. “But it is a long-run problem and we should start making plans for addressing the massive run-in up in debt we incurred as a result of addressing the pandemic.”

At more than $27 trillion, the U.S. national debt is larger than its gross domestic product, and it’s only expected to grow. If current law remains unchanged, the CBO’s September report estimates national debt held by the public will reach $33.5 trillion over the next decade. This means that by 2030, the publicly held debt-to-GDP ratio would be 109%.

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Here’s how investors can address concerns raised by rising debt levels:

  • The national debt’s impact on investments.
  • Can the U.S. pay back its debt?
  • Mitigating short-term and long-term risks.

Investors need to be aware of what rising national debt means for the future of our economy and financial markets.

More government bonds cause higher interest rates and lower stock market returns. As the U.S. government issues more Treasury securities to cover its budget deficit, the market supply of bonds increases and the existing bonds earn fewer profits at their fixed-interest rate. This makes the bonds less appealing.

“When you have more of something, it gets cheaper,” says Jim Barnes, director of fixed income at Bryn Mawr Trust.

While bonds can provide investors the benefits of cash preservation and fixed income, they carry interest-rate risk. Bonds and interest rates have an inverse relationship. When interest rates rise, newly issued bonds are more attractive than existing bonds because they provide investors with higher yields. As a result, prices on old bonds tend to fall.

“Higher interest rates tend to lead to lower stock market returns,” says Gus Faucher, chief economist for PNC Financial Services Group. This is because higher rates increase the cost of borrowing for companies.

While the Federal Reserve controls short-term interest rates through the federal funds rate, when the federal government raises rates on Treasury securities, it pushes up long-term rates like the one on taking out a new mortgage or student loan.

With debt taking a bigger chunk out of their budgets, investors have less income available to invest. Fewer dollars in the market means fewer opportunities for the power of compounding to work its magic.

The high cost of debt works against investors in another way: As consumers’ budgets get tighter, so do their purse strings. When people stop spending on goods and services, company revenues take a hit. And unless you’re Tesla (ticker: TSLA), falling profits translate into declining stock prices.

Can the U.S. Pay Back Its Debt?

Higher interest rates can weigh on business growth and stock prices. Corporations are hit by national debt-induced rising interest rates from two sides. Not only are they getting less love from consumers, but they also have to compete with the biggest and “safest” bond issuer in the bond market: the U.S. government.

As Treasury rates rise, investors tend to prefer low-risk government bonds over riskier corporate ones. Companies must offer even higher interest rates to entice bond investors. Higher interest payments leave less money to reinvest in their businesses. And when business growth wanes, so do long-term stock prices, Faucher says.

The U.S. Treasury feels a similar strain from higher interest rates. As its interest payments increase, more federal revenues must be directed toward debt repayment, leaving less money for other economically stimulating activities, Primo says.

“Once government debt reaches a certain size, it really drags on long-term (economic) growth,” he says. It can also drag on the creditworthiness of the U.S. government.

As the federal government’s debt level rises, its ability to repay its obligations may come into question and Treasury securities may no longer be risk-free.

While there’s nothing to suggest the U.S. government has reached a point of being unable to service its national debt, or is even near this threshold, Barnes says, other nations such as Italy and Greece have indebted themselves to the breaking point.

Since the U.S. dollar is the world’s reserve currency, the U.S. Treasury can get away with more national debt than most. But what happens if we lose that coveted status?

“Interest rates are very low right now, but when that changes, the U.S. will be in a very different fiscal position as federal debt servicing costs will skyrocket. If we ignore this issue, there’s a real risk investors will no longer view the dollar as a safe haven,” Primo says.

Mitigating Short-Term and Long-Term Risks

Rhea Thomas, senior economist at Wilmington Trust in Wilmington, Delaware, says investors should care about the debt because it has impacts on economic growth and could impact investments over time.

“In the future, countries will be forced to pay debt either through raising taxes or by printing more money to pay for that debt, which could end up slowing growth or risking higher inflation. Both of those things can impact equity and bond markets,” she says.

Although the federal stimulus has been supporting equity markets in the short-term while increasing the overall national debt, rising debt levels may not be an immediate concern – but there are some long-term risks the economy could face. Some argue that we don’t have to worry about high debt levels because the Fed’s commitment to keeping interest rates lower in the long term will support economic recovery.

But Thomas says low interest rates are something we can’t count on forever, and interest rates can go higher. Pent-up consumer demand could lead to higher prices of goods and services, which has the potential for runaway inflation.

“If we have inflation running hotter, the Fed might have to hike interest rates higher than expected,” Thomas explains.

In the long term, if interest-rate risk and inflation risk were to come into play, fixed income and equities could come under pressure if debt dynamics deteriorate, Thomas says. To mitigate these risks, she says investors can look to real assets like commodities and real estate or Treasury inflation-protected securities (TIPs).

But investors shouldn’t shy away from the market yet.

“In the near-term, 12-month horizon, the current situation supports being invested in equities,” Thomas adds.

Given that the debt is a long-term concern and the markets are looking at short-term performance, debt levels may not be an immediate concern for the stock market.

On the fixed-income front, Thomas sees value in municipal bonds. “Municipal debt levels have remained steadier because state and local governments, unlike the federal government, have borrowing limits and that helps to control debt,” she says.

What could be a concern is the way the debt recovery is approached. It would depend on how policymakers and monetary authorities work together to address the growing national debt. Whether they raise taxes, cut spending or announce more quantitative easing, these different scenarios could impact stock market confidence.