Concerns about the gross national debt, perennially in the background, have taken on a new urgency recently. Since the outbreak of the Covid-19 pandemic in 2020, total federal debt levels in the United States have been rising rapidly and are on track to exceed a record $35 trillion by the end of this year. This represents about 122% of Gross Domestic Product (GDP), a ratio that is itself near a record high and close to the peak we experienced just after World War II.
Rising debt levels are a direct function of ongoing budget deficits, basically the difference between government spending and tax receipts. Today’s annual budget deficit is around 6% of GDP, driven by higher spending related to foreign military aid, Medicare and Medicaid costs, student loan debt relief, and higher interest costs on US Treasurys. (Typical budget deficits are closer to 3-4%, a level that allows for a stable debt-to-GDP ratio as long as nominal GDP grows by at least 3-4% annually.)
While these statistics have alarmed citizens and investors alike, the outlook they imply for inflation and market returns isn’t clear. Let’s take a look at Japan as an example.
While debt levels in the US are at historically high levels today, they are nowhere near Japan’s debt burden. The chart below compares debt-to-GDP ratios for Japan and the US. At 255% of GDP, Japan ranks as one of the most highly indebted nations on earth, shouldering a debt load more than double that of the United States:
You may be surprised to learn that despite these debt levels, Japan has experienced almost no inflation in the past 20 years. In fact, until quite recently, Japan has been much more concerned with deflation as annual consumer price changes hovered between -1% and +1% for most of the past decade.
In addition to tame inflation, Japanese equity returns have been strong. The MSCI Japan index is up 90% in the past ten years and 20% in just the last 12 months. As impressive as these returns are, a Japanese investor that diversified globally would have fared even better. Imagine an investor in Japan that held half their investments in Japanese stocks and the other half in US stocks. This simple 50/50 diversified portfolio would have earned more than 32% in the last 12 months, due to US stock performance (+27%) plus exchange rate changes between the US dollar and the Japanese Yen.
While Japanese equities have performed well, their local currency has not. The Yen has fallen 40% against the Euro in the past 5 years and 45% against the US dollar. Imports are more expensive now in Japan and inflation, while still below 3% annually, has started to turn up. Note that economists believe that the weaker Yen is primarily a result of interest rate differences between countries, not high debt levels in Japan.
What does this mean for investors concerned about high debt levels in the US? It’s only one example, but the evidence from Japan suggests that equity markets can remain resilient, and inflation can stay under control even at very high levels of government debt. This is believed to be generally true for sovereign nations that issue and borrow in their own currencies.
It’s also possible that we are near peak ratios of debt-to-GDP in the US already, and economic growth will be sufficient to bring it down over time. If not, at some point, the US Federal Reserve may be forced to intervene in the Treasury market to reduce—or even cap—interest rates on government debt, a tool that the Japanese central bank employs regularly, and one that we used in the post WWII period. A weaker US dollar might result from those actions, but globally diversified equity investors are likely well hedged against that possibility.