Guy: Welcome everyone to the “MIM Cuts to the Chase” podcast series. I'm your host, Guy Haselmann, and today we will discuss and unravel the US Treasury Bond market – which I often refer to as “the most important market in the world”. In light of the record-breaking U.S. Treasury issuance and looming large fiscal deficits, I think our discussion here couldn't be timelier. I’m joined by two of my esteemed colleagues, Tom Smith, a highly experienced and insightful Emerging Markets Portfolio Manager, and Shan Ahmed, a key part of MIM’s Global Economic and Market Strategy team. Gentlemen, it's wonderful to have you here today.
Shan: Thanks Guy.
Tom: Thanks for having us.
Guy: Before we dive in, I thought it would make sense to set the stage for our listeners, particularly since it seems that the frequency of conversations pertaining to debt levels – and debt levels of all kinds – is on the rise. And rightly so, as global indebtedness has increased by multiples after more than a decade of near zero interest rates. Free money, no doubt, can have that effect. But with the Federal Reserve hiking interests so quickly to above 5%, it creates a whole set of new dynamics, notably servicing costs, especially as the debt rolls over into new issuance. It also has a material impact on valuations, simply through the “time value of money” function. With all that in mind, let me come in through the side door and start with Tom. As primarily an emerging market sovereign investor, could you enlighten us about why the current US debt situation is something of particular interest to you?
Tom: Sure. Thanks, Guy. And I've been looking forward to this chat. I'm glad you made that point. I am focused primarily on emerging markets sovereign debt, and as such, I'm not really an expert per se, on US debt. Although as a fixed income investor, I do watch the US Treasury market very closely. It is a key variable in our space that I have to be constantly aware of. Now, to your question. There have been discussions about US debt for decades, right? We all hear about it. The Debt Clock, the political drama that tends to resurface every time there's a vote to increase the debt ceiling. So, we know there's some issues, but how bad is it? It's bad enough that two rating agencies took action on U.S. credit ratings over the past year, during the summer of 23, Fitch downgraded the US rating from triple A to double A plus. Then later in November, Moody's put its AAA rating on negative outlook. At that point, we decided to do a debt sustainability analysis on US sovereign credit. And for reference, a debt sustainability analysis, which we call a DSA is a really important tool that our sovereign team uses in credit assessments. We feed it with assumptions like growth, fiscal balances, and interest rates, and the output helps us predict a country's debt trajectory.
Guy: Well that makes sense that you’d want to do that type of analysis given how much debt levels have exploded, and it is quite a shift in thinking on US and sovereigns. Shan, from your perspective, why now? In other words, what separates the current debt situation apart from past worries?
Shan: Yeah, sure. So, one critical aspect that sets this particular situation apart is the dramatic surge in US publicly held debt to GDP. I mean, it's soared from 50% in 2009, to almost 100%, today. And the crux of this issue lies in the fact that costs continue to go up, but revenues have largely remained stable over time. And that imbalance will naturally lead to a rising deficit, which in turn leads to increasing debt levels. I mean, it's kind of worrying that the recent second estimate for 2023 full year GDP was 2.5%, and that exceeded many people's expectations, and yet, at the same time, the total deficit was still over 6% for fiscal year 2023, and that number is going to increase if the US enters a recession.
Guy: Well, that is, indeed some sobering figures that you point out, deficits should be lower certainly well below 3% when growth is strong, so 6% - with reasonable GDP growth - is certainly worrying. Shan given the current trajectory, what are your projections and are there feasible ways to evade that deteriorating path?
Shan: Unfortunately, in my view, the options are extremely limited. I mean, with the current debt situation we're looking at a net Treasury issuance that's approximately quadruple the pre-pandemic average. And that translates to effectively over $2 trillion in annual net issuance. And that's a huge increase from the pre pandemic long-term average of just around $500 billion. Now, in our baseline scenario, we first see public debt-to-GDP escalating to nearly 125% by 2029, from just about 100% today, as I mentioned before, and those figures just don't align with other AA-rated country sovereign debt. To stabilize that trend, we think the deficit reduction of at least 3% or 4% of GDP is needed, whether through some combination of increasing revenues or decreasing cost. But, making such a significant adjustment is hard, particularly in the current political climate. On top of that, the trajectory could actually worsen over time due to the relatively inflexible spending on Social Security and Medicare, which we know will continue to exert upward pressure on costs. Based on our calculations and the Congressional Budget Office guidance. We anticipate that a fiscal adjustment of roughly 1% of GDP would be necessary by 2030 to offset the increase from Social Security and the major health care programs expenditures.
Guy: Sounds to me like you're painting an awfully gloomy story that ends in permanently higher annual deficits and unsustainable debt levels. Is that right?
Shan: Well, without measures such as inflating away the debt or implementing significant fiscal reforms, there just doesn't seem to be a practical way to change the current trajectory. The deficit has been amplified since the great financial crisis in 2008 and COVID exacerbated the situation even more. So historical CBO data shows that the average total deficit since 2008 was around 6%. And that's double the average of 3% that it was from 1940 to 2007. Compounding the issue is the new debt, which according to our estimates results in a net Treasury issuance ofapproximately 4X the pre-pandemic average, as I mentioned, and at notably at higher prevailing rates. So, this scenario is also unfolding at a time when the Fed and its effort to reduce its balance sheet size is no longer a net buyer of securities anymore.
Guy: It's also clear to me that the US isn't an isolated case when it comes to debt challenges. Tom, let's turn to you, how does the US situation compare to other high debt countries?
Tom: Guy, it doesn't look good. And to be fair, we need to set the right comparables, I like to compare the US to its other higher quality developed market triple A, double A peers. This includes countries like the UK, Canada, Germany and France. However, because the US debt load is already high and projected to rise, it's also worth looking further down in quality to find countries that are more notoriously debt heavy, like Japan, which is a single A, and even some developed market triple Bs like Italy, Greece, Portugal and Spain. Shan alluded to the debt to GDP measure. This is the most traditional leverage metric. And it's a good barometer of overall debt levels. The global average and the debt-to-GDP metric is about 40 to 60%. And it tends to vary by rating where higher debt leads to lower ratings. At the end of 2023, only nine countries in the world had a debt-to-GDP ratio higher than 100%. And the US, when we include unfunded liabilities, has a debt-to-GDP ratio of 120%. This number ranks fourth in the world behind Japan at 230. Greece in Italy in the 140 area, and then France and UK around 110 to 120.
Guy: Tom, let me interrupt you there. I've heard of other debt measures and what do they indicate?
Tom: Yeah, good question. Debt-to-GDP metric is good, but it's a stock measure and doesn't really tell the whole story. I think it's helpful to look at other debt metrics that are flow measures. And unfortunately, these tell a very similar story regarding US credit. The first is a debt-to-revenues ratio, which compares leveraged to cash flows, like a debt-to-EBITDA ratio of a corporate. So, the debt-to-revenue ratio for the US is 390%. It's second in the world only to Japan, and noticeably higher than Greece and the average of EM single-B's. There's another ratio I'd like to comment on, it's the interest-to-revenues ratio. And this is the best cash flow measure as it explains how much of fiscal revenue is allocated to interest on the debt stock. And the US ratio is 10%. And that's equivalent to the emerging market BB sovereign median, and not far from where it is for single B's. Meanwhile, other developed market peers, even those with higher debt, like Japan, dedicating much lower portion of the revenues to paying interest in the US does.
Guy: Tom, I can't help but put you on the record here and try to get you to commit. Are you saying that the US debt is rated too high, and you think that it risks a downgrade?
Tom: Well, let's first state the obvious. The US stands somewhat on its own, given the size and depth of the economy, the global demand for treasuries as a risk-free asset, and the dollars, reserve currency status. These are all very important factors. But that doesn't mean that debt deterioration will go unnoticed. And what we've learned from the Japanese experience, for instance, is that high debt levels are manageable, as long as the debt trajectory is stable, ordeclining, and the cost of debt is low. Unfortunately, and the US case, the United States has none of these factors going for it. In fact, the United States is the only one of its peers projected to grow its debt in a meaningful way, as Shan has mentioned before, and this is because its primary deficit, which is fiscal revenues, less all expenditures before paying interest is very high, at around 4% of GDP. At the end of last year, it was the largest in its peer group. And As Shan mentioned, it's going to be hard to bring this down.
Guy: I think your perspective as an emerging market analyst and portfolio manager gives this some particularly interesting insights. And I think, Shan over here, I bet you're itching to add a few comments to this.
Shan: Yeah, so overall, I agree with Tom. There are many countries that are more indebted than the US, but they don't receive the leniency that the US does. But at the same time, it is plausible that the US will start seeing the typical consequences of ever-increasing debt. Meaning, as the US issues more debt, yields will be pressured to rise. And that's going to lead to cost implications. This is already evident as older debt issued in the past decade is now being refinanced at today's higher rates. Adding to those concerns is the maturity profile of the debt. So as of the beginning of 2024, 35%, of US debt is set to mature by the end of this year, with an additional 20%, maturing over 2025 and 2026. So basically, about 55% of US debt is going to mature in the next three years. And that wasn't an issue when interest rates were near zero, but at current higher rates, it's going to amplify the fiscal impact and increase the cost of US debt. And this situation is unique to the US because other developed or emerging market countries don't necessarily have such a concentrated debt maturity.
Guy: I assume this all has the potential to create even more, dare I say, political tensions?
Shan: Oh, absolutely. There's a significant political aspect to consider. Tom was talking about the interest-to-revenue ratio, and as the interest-revenue ratio worsens in the US, the government is going to need to allocate an increasing portion of its budget just to interest payments. And that's going to further politicize the issue. The situation may worsen even more after the Social Security trust funds run out of money, which is predicted to happen early in the next decade. Our model predicts that by 2030, 17% of government rent revenue could go directly towards interest payments. Given that, I believe there's a reasonable chance that we do see a decline in US credit ratings as rating agencies scrutinize the processes more thoroughly. So, if the fiscal situation continues to deteriorate, or if political gridlock leads to more budget impasses and government shutdowns, you know, fiscal processes being ineffective, we may witness more outlook revisions or downgrades. That could mean further downgrades by Fitch, a downgrade by Moody's, which, by the way, is the last agency to give us a AAA-rating, or even just further outlook revisions.
Guy: And that's a really crucial point. Tom, given these complex dynamics as a portfolio manager, what are you particularly being vigilant about?
Tom: Well Guy, as an investor, if this was any other country, we'd probably underweight Treasuries in our portfolios due to these concerning debt trends. But the US does receive some of those special considerations that I mentioned earlier.
Guy: The political aspect and ratings uncertainty certainly complicates matters as we've been discussing, but hopefully they will also draw some attention to them as well. Hopefully they can get addressed in some manner. I don't know how. I can't see how that's going to happen but I'm hopeful. Tom you up in mentioned how you tried to think about how things will ultimately play out. So as a portfolio manager, again, were in that hat. What final thoughts? Could you leave our listeners with?
Tom: Sure. So, in the work I do on EM debt, both fundamental and technical factors matter a lot. So, let's think about the technical factors at play here for US debt. And Shan mentioned earlier, the $2 trillion in annual issuance going forward versus the $500 billion pre pandemic. It's hard for me to imagine that there wouldn't be any market impact from this $1.5 trillion in annual issuance. It's a lot of supply. And I wonder where the demand will come from, with the Fed, and China, one of the biggest buyers of the past few decades reducing its US Treasury holdings in recent years. So, this puts a lot of pressure on other investors like banks, asset managers, and others who will eventually buy treasuries. I mean, after all, it is the global risk-free asset. But the question is at what price? And my hunch is that over the next few years, we could see rates pushing higher than where they otherwise would be in the cycle and could potentially affect the curve shape as well.
Guy: Well, thank you for that perspective. I think this is an excellent place to stop for today. I'd add though that at MIM I know we have a very strong focus in 2024, on what we refer to as a “world in debt”. And we have and will continue to analyze these for treasuries, other sovereigns and all other types of debt markets throughout the year. And what we hope to put out will be a series of future content. So Shan, and Tom, thank you for your valuable insights, and expert analysis. I do believe this is a critically important topic now that debt is back. And it will undoubtedly warrant careful attention and vigilance in 2024 and beyond. Thanks for being here.
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