How serious are U.S. fiscal woes – and how can investors protect themselves?

In the United States, evidence of potential fiscal troubles has been accumulating for years. Then, on August 1, the rating agency Fitch issued a wake-up call: It downgraded U.S. debt from AAA to AA+.¹

While U.S. debt is on an unsustainable path, we do not think the nation will suffer a fiscal crisis in the years ahead.²

Still, taxpayers should beware: One way the government is likely to help the nation avoid this fate would be by raising taxes to increase revenues. Therefore, in the coming decade, investors may want to consider making it a priority to enhance their tax efficiency.

Moreover, while history has rarely seen a developed country that issues its own currency suffer a sovereign debt crisis, “rare” does not mean impossible.

• Last fall, the UK had what we see as a mini-debt crisis that led to unprecedented volatility for the currency of a G7 country: The pound depreciated by 10% in a few weeks
  
• In the 1920s, post-World War I France faced a full-fledged fiscal disaster. The country’s solution led the franc to depreciate by about 80% relative to the U.S. dollar³

An important lesson from both these countries’ experiences is that, ultimately, the currency shoulders the burden of a fiscal crisis. Therefore, you might want to consider adding real assets to your portfolios—just in case.

How do we reach these conclusions? Here’s some of our thinking. (For a more in-depth version of this article, click here.)

 1. The CBO has sounded the alarm—again

The Congressional Budget Office (CBO) startled many observers in June when it declared that U.S. government debt held by the public is on track to rise to its highest level ever: 116% of GDP in 2030.

This independent watchdog agency also warned that, by the mid-2030s, all federal revenues would be required to fund mandatory government spending alone: i.e., Medicare, Medicaid and Social Security, interest on debt plus other mandatory programs like unemployment insurance and veterans’ benefits.

At that point, there would be zero funds for such basic functions as defense, roadwork, the judiciary and so on—unless the federal government borrows and goes even deeper into debt. Such a spiral, if unchecked, would be dire.

The CBO assessments should be taken seriously. U.S. debt is problematic. However, we are skeptical about exactly how accurate the CBO’s deadline for a fiscal crisis will prove to be. After all, prior CBO projections proved overly pessimistic.

In 2009,⁴ the CBO said mandatory government spending would outstrip total U.S. revenues in 2024. Then dramatic reductions in healthcare spending (on Medicare and Medicaid) led the CBO to push back this date by a full decade—to 2034.⁵

2. What would U.S. debt crisis look like?

One might argue that the U.S. is already experiencing a debt crisis of sorts. Congress’s annual showdowns over lifting the debt ceiling and adopting a budget have repeatedly damaged confidence that lawmakers can resolve fiscal issues.

However, a true debt crisis for a country like the U.S would mean that:

1. Tax revenue could no longer finance the fiscal deficit, or at least keep it from spiraling higher.
   
2. Investor demand for Treasury securities would deteriorate dramatically.
   
3. The Treasury would be forced to ask the central bank to finance the deficit directly, in a way that supersedes the central bank’s inflation objective.

This scenario is not playing out now—nor do we believe is it likely to in the future. One reason for our confidence is that the debt-carrying capacity can be mind-bogglingly high for countries like the U.S. that issue nearly all sovereign debt in domestic currency. Just consider that a debt crisis still hasn’t arisen in Japan (which issues its debt almost entirely in yen), even with a sovereign debt-to-GDP ratio of 228% currently, more than twice the U.S.’s.⁶

Indeed, the U.S. and Japan can never technically default, as they can always print domestic currency to pay their debts.

Still, the U.S. could quasi-default: The government could be forced one day to borrow money from the central bank to fund public spending, causing a dramatic depreciation of the dollar and/or spiraling inflation.

That said, right now, the Federal Reserve is doing the exact opposite. The Fed has been reducing the size of its balance sheet to counter high inflation.

3. Tough battles ahead over taxes, spending

The U.S. democratic process will decide what budgetary changes, if any, will be made to improve the nation’s fiscal sustainability. We make no recommendations and have no preferences. We can, though, observe facts that will underlie discussions about how to stave off a potential quasi-default.

First, it is unlikely the problem will be solved by potential savings from increased means-testing for entitlement programs.⁷ And there is a firm bipartisan consensus against more sizable cuts to these programs.⁸

Also, it’s not obvious that the U.S. government has a spending problem in its other mandatory categories (unemployment compensation, the nutrition assistance programs, veterans’ benefits, etc.). This component of spending surged during the pandemic. However, it is expected to drop back to its historical average (relative to GDP) over the next decade.

Which brings us to taxes. U.S. tax revenue is low relative to the U.S.’s own history, and it is especially low relative to the tax share of GDP in other wealthy countries.⁹

That could mean, in the next 10 years, lawmakers will try to raise tax revenue.¹⁰

What’s an investor to do?

While the politicians battle it out in Washington, what action might you take as an investor? We recommend these steps:

1. Stay aware. The sovereign debt-to-GDP ratio cannot spiral into disaster so long as the interest rate on newly issued debt (R) is below the economy’s structural growth rate (G)¹¹ Therefore, watch for how much AI truly contributes to the economy. Innovations in healthcare have dramatically reduced government spending on Medicaid/Medicare in the past. AI-enabled innovations have the potential to further reduce the healthcare bill, and raise the economy’s structural growth rate.
2. Consider making your portfolio more tax efficient. Tax-loss harvesting strategies can be rewarding. Separately managed accounts (SMAs) can offer significant tax advantages over exchange traded funds (ETFs). You also should make sure to match asset type and account type for the greatest tax benefits.
   
3. Consider adding real assets to your portfolio. Given that real assets have historically done well when the USD depreciates, this might be a smart move if U.S. economic growth fails to pull the government out of the hole, political gridlock prevents necessary changes to government revenue/spending, and recently passed legislation ends up being more costly than assumed.

We can help

Speak with your J.P. Morgan team about all the ways you might make your portfolio more tax efficient. Your team also can help you evaluate whether adding real assets would support all your long-term financial goals.

To continue reading about this topic, click here.

¹The last time such bad news was delivered was in 2011. Back then, Standard & Poor's was the messenger.

²Here we mean the economic sense of the term fiscal crisis: when funding pressures are so great that they can’t be financed domestically with tax collections, forcing the central bank to directly finance the shortfall in a way that supercedes the central bank’s inflation objective.

³From 1919 through 1926.

⁴2009 was the first year the CBO started providing longer-term budgetary projections.

⁵In 2009 the CBO was projecting healthcare spending at 12.2% of GDP in 2050. Now, the CBO projects healthcare will be just 7% of GDP in 2050.

⁶This is the Bank for International Settlements’s 2022 estimate of the debt-GDP ratio for Japan. The BIS attempts to remove inter-governmental debt issuance, to avoid double counting. Including inter-governmental debt issuance, Japan’s debt-to-GDP ratio was 259% in 2022.

⁷For example, according to a CBO study in December 2022, means testing that reduces benefits only for top-quintile earners would reduce Social Security outlays by a total of $40 billion by 2032.[7] However, $40 billion is miniscule compared to total Social Security expenditures of $2.27 trillion by 2032, in the CBO baseline projection. Reduce Social Security Benefits for High Earners,” The Congressional Budget Office, December 7, 2022.

⁸See, for example: “Few Americans support cuts to most government programs, including Medicaid,” Pew Research Center, May 26, 2017; “Public Wants Changes in Entitlements, Not Changes in Benefits,” Pew Research Center, July 7, 2011; “How Americans evaluate Social Security, Medicare, and six other entitlement programs,” YouGov, February 8, 2023.

⁹European Commission AMECO database, Haver Analytics. Data as of August 9, 2023.

¹⁰For how, exactly, the lawmakers might do that, see: “What options would increase federal revenues?” Tax Policy Center Briefing Book, May 2020.

¹¹In a given year, the percentage point change in the debt-GDP ratio is equal to the primary deficit (i.e., the deficit excluding interest rate payments) plus R-G multiplied by the debt to GDP ratio. It can thus be seen that if R is less than G, the debt ratio cannot rise in a multiplicative manner; if R is less than G, a widening in the primary deficit (say, due to an exogenous shock like a pandemic) will cause the debt-GDP ratio to rise, but it will rise concavely not convexly, ultimately settling at a higher but stable level in equilibrium.