Should investors safeguard their portfolios from surging national debt?

• Investors’ concerns about mounting federal debt are helping to push rates still higher.
• The US government's already-massive debt load may continue growing if geopolitical conflicts spur more federal outlays.
• Surging US bond issuance comes just as global demand for Treasuries seems to be cooling, which may help keep rates up.
• Some investors may be reducing over-weight stock positions to account for the risks of a higher cost of capital.

Long-term interest rates continue to rise—and it’s not just because the Federal Reserve could keep rates higher for longer.

The 10-year Treasury yield, which affects other borrowing costs such as rates on mortgages and corporate loans, has continued a monthslong ascent. Earlier this month, it hit the 5% mark for the first time in 16 years. 

According to Morgan Stanley’s Global Investment Committee (GIC), there’s one important factor driving yields higher: Investors’ growing concerns about the sustainability of the US government’s debt and the greater reward they’re demanding for purchasing this debt. This, in turn, puts upward pressure on rates, which is important because higher rates tend to weigh on bond and stock valuations alike. 

In light of these pressures—and keeping in mind that individual investors’ circumstances will vary based on their goals and risk tolerance—the GIC believes some investors may be:

• Reducing significant over-weight stock positions to account for the potential risks of rising rates.
• Adding “real” assets, such as gold, commodities, infrastructure, energy transport, and non-commercial real estate to their portfolios. These can potentially serve as a portfolio hedge for a “stagflationary” environment of weakening economic growth and accelerating inflation.

The GIC believes higher rates may create a vicious cycle for US deficits. If rates remain elevated, the US will continue paying more to finance its debt, making it ever more difficult to reduce its deficits. Here are some potential risks to be mindful of today:

1. The current federal debt pile is already massive. A recent Treasury report showed the government spent $659 billion in net interest payments during the fiscal year that ended in September—about 39% more than the same period in the previous year. The Congressional Budget Office estimates this interest expense could double in the next decade, meaning that the US government might be spending more on interest payments than on other major budget categories such as defense.
2. Supply and demand may be increasingly mismatched in the Treasury market. A recent surge in Treasury bond issuance—to help the government finance its swelling deficits—has been met with a surprising dearth of buyers. Some of the biggest buyers of Treasuries, including domestic commercial banks and foreign governments, have been reducing their purchases.
3. Geopolitical conflict in both the Middle East and Ukraine means more federal outlays may be required to aid US allies and humanitarian goals, potentially driving further government bond issuance. These developments are playing out against the backdrop of palpable dysfunction in Washington, which may further undermine investor confidence in the government and its bonds.

Growing debt, reduced demand in the Treasury market, and geopolitical conflict are all factors that could add pressure to the cost of borrowing. This  could in turn weigh on consumer and business spending, overall economic growth, and financial markets.

Investor’s whose views align with the GIC’s may be reducing significant overweight stock positions in their portfolios and adding “real” assets, such as gold, commodities, infrastructure, energy transport and non-commercial real estate.

The source of this article, Investors Eye Risks as U.S. Debt Surges, was originally published on October 25, 2023.