In general, we see room to run in the US equity bull market. At the same time, we believe equity investors would be well served by taking a broader view of key economic indicators. One such indicator of economic health – the debt-to-GDP ratio – provides a useful example. Comparing US government debt to GDP doesn’t give much cause for concern. Examining the underlying account composition of total US debt to GDP, however, yields a very different picture.
In the broadest sense, the ratio of debt to gross domestic product (GDP) provides an indication of economic health. A low debt-to-GDP ratio suggests that the country’s economy produces enough to service its debts without falling further into debt. A high ratio suggests that future growth prospects for the country may be compromised, as funds that could have been used for re-investment instead are allocated to debt service. Although a low debt-to-GDP ratio is generally considered desirable, the optimal level of debt to GDP depends on a plethora of complex factors, including the cost of borrowing – higher interest rates naturally make debt more expensive to service – and the country’s economic growth prospects. Where growth prospects are robust, maintaining an overly low debt-to-GDP ratio may unnecessarily cut off the opportunity to use leverage to fuel future growth.
Government debt-to-GDP versus total debt-to-GDP
There are several flavors of debt-to-GDP measures. We focus on two here: government debt-to-GDP, which provides a window into the state of the government’s finances, and total debt-to-GDP, which speaks to the financial health of the country as a whole (including corporations and private citizens). Despite a pronounced increase in US government spending since the Global Financial Crisis, comparing US government debt to GDP seems to give little cause for alarm. Indeed, the US government debt-to-GDP ratio, measured as a percentage of GDP, is comparable to that of other countries:1
But taking a more expansive view on the state of the nation’s finances reveals something quite different. Total outstanding US debt, expressed as a percentage of GDP, is currently over 250% (see Chart). The composition of that debt is also important. Since 2009, all major accounts – including money markets, asset-backed securities, federal-agency securities, municipal debt, and mortgage-related debt have declined as a percentage of GDP, while US federal debt, corporate debt, and consumer debt proportionally have grown. The biggest bingers in the post-crisis era of abundant credit are the federal government, large corporations, and consumers. As the Fed continues to gradually unwind its balance sheets, uncertainty looms: will the US government, big companies and consumers be able to service their massive debts as interest rates move upward?
Much attention has been focused on the consequences of excessive corporate borrowing in recent months. There is indeed a problem with private-sector debt; some overleveraged firms could potentially face default if economic growth prospects become bleak, or if interest rates move up too quickly. Perhaps even more worrying is the financial health of US consumers. Personal consumption has grown from 60% of US GDP in the early 1970s to nearly 70% today.2 As interest rates increase over time, consumer spending will come under greater pressure as consumers divert more of their disposable income to debt service. This, in turn, has the potential to constrain future GDP growth.
What does this mean for equity investors? Gradually rising rates and narrowing growth prospects are already contributing to increased equity-market volatility, which we believe will be persistent. This may, in turn, increase the appeal of defensive equities. Much will depend on the pace of interest-rate increases – which recent events suggest could be less predictable in the coming months than the markets have expected. One thing seems certain: the placid upward trajectory that equity investors enjoyed throughout 2017 is a thing of the past. The challenge for investors now will be to think ahead, past this record-setting global bull market, to prepare for a potentially volatile and less-abundant future.
1 The author would like to thank Tim Herlihy for his contribution to data sourcing and analysis.
2 State Street Global Advisors, Factset. As of June 30, 2018.
Bull market: A bull market is a financial market in which prices are rising or are expected to rise. A bull market is a financial market in which prices are rising or are expected to rise.
Gross Domestic Product (GDP): Gross domestic product (GDP) is a monetary measure of the value of all final goods and services produced in a period (quarterly or yearly). Nominal GDP estimates are commonly used to determine the economic performance of a whole country or region, and to make international comparisons.
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