Do you recognise the person in the background image?

Paul O’Neill was the last US Treasury Secretary to preside over a budget surplus. The year was 2001 and his boss was George W. Bush.

America has the world’s largest bond market and the yield on its 10 year Treasury bond proxies as the risk-free rate of the world. The notion of a risk-free rate is convenient as it is a main component of a discount rate used to value the cash flows or profit streams of financial assets. Without it, 160,000 CFA charter holders would struggle. It would be akin to driving a car without a steering wheel.

And yet – and here lies the problem – America’s hegemony over world politics and economic predominance looks set to weaken. The G20 meeting has two noticeable non-attendees. It is possible to be a very large nation state and officially neutral on the war in Ukraine (India). The Middle East has become a major siphon of capital, without the intermediation of London or New York. Oil can be paid for, in certain places with certain counterparties, in currencies other than the US dollar.  Whilst is convenient to characterise some nations as obvious baddies in the world (North Korea, Russia) there are many more nations who are not unhappy that the US will likely have less power to hector them in the coming decades.

This is happening at a time when the US government (the last one, this one and almost certainly the one that will follow) has abandoned fiscal probity. How might our surety regarding the risk-free rate change if it is attached to an increasingly poor risk?

Of the US$85.7tn owed collectively by world governments, US$30tn is owed by the US, US$14tn by China and US$10tn by Japan. Therefore, the US owes 50% of outstanding global debt excluding China and Japan. US debt is forecast by the Congressional Budget Office (CBO) to reach a level of 107% of GDP in 2029, a level only previously attained at the end of WWII.  The CBO forecasts suggest that this debt will reach 181% of GDP by 2053. Japan has run debt in excess of 2x its GDP since 2010 but half of this debt is owned by the Bank of Japan, creating an internal accounting puzzle with many zeros attached.

Servicing the US debt load is costing US$726bn this year and is forecast (again by the CBO) to cost US$10.6tn over the next 10 years and account for 7.2% of budget revenues at the end of that period. America has lived outside its means for the past 22 years. The last time government revenues eclipsed costs was 2001. At the beginning of that year, George W. Bush took over the Presidency from Bill Clinton, Paul O’Neill took over from Larry Summers as US Treasury Secretary and Alan Greenspan was Chair of the Federal Reserve.

This matters because neither political wing these days has an argument to mount about budget discipline and debt. The Republicans are addicted to low tax and the Democrats have not been able to roll these back. The Biden administration has been working to deliver the US-first industrial policy first trumpeted by Trump but, as it was doing, then stepped in to supply enormous support programmes to counter the economic effects of COVID-19. Those cost US$4.3tn.

Whilst Warren Buffet famously wrote “never bet against America” and has suggested that that he could not imagine the US defaulting on its debt, his suggestion as to how budget deficits could be cured is other worldly: “I could end the deficit in five minutes. You just pass a law that says that any time there’s a deficit of more than 3% of GDP, all sitting members of Congress are ineligible for re-election.”

Debt and budgets just do not feature on the election stumps. It does not achieve what political strategists term “cut-through”. In a world where popularist politics dominate, popularism is not adequately countered with probity. Probity might garner 10% or 20% support, but not a majority.

The problem with America is that its risk-free rate is anything but risk-free. This undermines the value of money and means that the traditional assumption that government debt is the least risky form of debt should be examined closely. It probably has repercussions as to where bond yields will settle and will consequently influence return assumptions from medium and longer maturities. If the world were to settle for higher yields (where the clearing price became a yield higher than the inflation rate, say) then all forms of financial assets – stocks, property, private equity – will require several years of acclimatisation. That period may include one or two recessions and equity bear markets. It is probably time to own more gold.

(Part 2 will address the problem of the US stock market)

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