As of June 27, 2024, theU.S. public debthas reached approximately $34.59 trillion, increasing from $31.46 trillion a year ago and reflecting a 1.72% rise from the previous quarter. Projections indicate that debt held by the public will soar to 122.4% of GDP by the end of 2034, marking the highest level ever recorded.

What are the potential implications of this continuously growing debt on stock market performance? Should investors take steps to safeguard their portfolios against a possible U.S. debt crisis? And what investment strategies could be effective in such a scenario? Here, we share our insights.

U.S. Public Debt – some facts and projections

The United States holds the world’s highest national debt, currently standing at $31.59 trillion. To put this in context, the U.S. owes as much money as the next four countries with the highest debt combined: China ($14 trillion), Japan ($10.2 trillion), France ($3.1 trillion), and Italy ($2.9 trillion).

Additionally, when considering debt sustainability, the U.S. debt-to-GDP ratio is a crucial indicator.

In CBO’s projectionspublished on June 18th 2024, the deficit totals nearly $2 trillion this year. Large deficits push federal debt held by the public to 122.4% of GDP in 2034 (this is above $50.0 trillion). Economic growth slows to 2.0% in 2024 and 1.8% in 2026 and later years.

According to theCongressional Budget Office (CBO) projections, thefederal budget deficitfor the fiscal year 2024 is expected to be $1.9 trillion. When adjusted to exclude the effects of timing shifts in certain payments, the deficit rises to $2.0 trillion in 2024 and is projected to reach $2.8 trillion by 2034. These adjustments indicate that deficits will represent 7.0% of the gross domestic product (GDP) in 2024 and 6.5% of GDP in 2025.

By 2027, as revenues increase more rapidly than expenditures, the deficit is projected to decrease to 5.5% of GDP. However, following this period, expenditures are expected to grow faster than revenues, leading to an adjusted deficit of 6.9% of GDP by 2034. This figure is notably higher than the average deficit of 3.7% of GDP over the past 50 years.

Relative to the size of the economy, the national debt is projected to swell from 2024 to 2034 due to rising interest costs and mandatory spending, which will outpace the decreases in discretionary spending and revenue growth. Publicly held debt is anticipated to increase from 99% of GDP in 2024 to 122% in 2034, surpassing the previous high of 106% of GDP.

How does the U.S. government finance its debt

The U.S. government finances its debt through a combination of methods:

Issuing Treasury Securities: The primary way is by issuing Treasury securities, such as Treasury bills (T-bills), Treasury notes, and Treasury bonds. These are debt instruments that investors purchase, effectively lending money to the government. In return, the government pays interest on these securities until they mature. Investors include individuals, institutions, and foreign governments.

Open Market Operations: The Federal Reserve (the central bank) conducts open market operations. It buys and sells Treasury securities in the open market. When the Fed buys these securities, it injects money into the economy, which indirectly helps finance the government’s debt.

Social Security Trust Fund: The U.S. government borrows from the Social Security Trust Fund. Payroll taxes collected for Social Security are invested in Treasury securities. When the government needs funds, it redeems these securities.

Intragovernmental Holdings: Various government agencies hold Treasury securities. For example, the Federal Reserve System, Medicare, and other trust funds own these securities. These holdings represent debt owed by one part of the government to another.

Domestic Investors: U.S. citizens, pension funds, mutual funds, and other institutional investors also buy Treasury securities.

Foreign Investors:

Foreign countries and investors hold a significant portion of U.S. debt. China and Japan are among the largest foreign holders of Treasury securities.

As of June 27th, 2024, the Japanese Yen has dropped to its lowest level against the U.S. Dollar since late 1986. In this context, Japan’s debt denominated in USD becomes more expensive to service. As of today, Japan holds approximately $1.12 trillion in U.S. Treasury securities. This makes Japan the largest foreign holder of U.S. debt.

Statista, estimates that Japan’s Debt-to-GDP ratio stays at 254.56% for 2024. This indicates that Japan continues to have one of the highest Debt-to-GDP ratios among developed nations. In 2022 economists predicted a public debt crisis in Japan due to an aging population and social security expenses. However, such a crisis has not materialized. However, investors should keep an eye of Japan’s sovereign debt situation because the country’s fiscal deficit continues to grow, thus reaching new highs in the coming year 2025.

Our view in regard to Japan’s sovereign debt and the recent FX move:

While the decline in the Japanese Yen and the high levels of sovereign debt pose significant risks, a sovereign debt default by Japan in 2024-2025 remains unlikely. The Japanese government and the BOJ have multiple tools at their disposal to manage these challenges. Continued economic growth, albeit moderate, and proactive fiscal and monetary policies are expected to mitigate the risks associated with debt and currency fluctuations.

However, a weakening yen may erode investor confidence in Japan’s ability to manage its debt. Investors may demand higher yields to compensate for currency risk, affecting Japan’s borrowing costs.

Notable Public Debt Crises – what the history tells

According to our research, there have been several notable public debt crises between 1900 and 2024. Below we highlight a few significant examples:

The Great Depression (1930s): Following the stock market crash of 1929, many countries experienced severe economic downturns. Public debt increased significantly as governments tried to stimulate their economies and provide relief to suffering populations.

Latin American Debt Crisis (1980s): This crisis began in August 1982 when Mexico declared it could no longer service its debt, leading to widespread defaults in the region. Countries like Brazil and Argentina were also heavily impacted, leading to a “lost decade” of economic stagnation (Source:Federal Reserve History).

Asian Financial Crisis (1997): Triggered by the collapse of the Thai baht, this crisis spread across East Asia, leading to significant increases in public debt as governments intervened to stabilize their economies (Source:Investopedia).

Global Financial Crisis (2007-2008): The subprime mortgage crisis in the United States triggered a global financial meltdown. Governments worldwide responded with massive fiscal stimulus packages, leading to substantial increases in public debt.

European Sovereign Debt Crisis (2010s): Countries like Greece, Ireland, Portugal, and Spain faced significant challenges in managing their public debt, leading to bailouts and austerity measures imposed by the European Union and the International Monetary Fund (Source:Council on Foreign Relations).

COVID-19 Pandemic (2020s): Governments around the world increased public spending dramatically to support healthcare systems and provide economic relief to individuals and businesses. This led to unprecedented levels of public debt. For example, the U.S. national debt surpassed $33.99 trillion by January 2024.

Key drivers of the U.S. Public Debt for the years 2025-2026

Demographics: The aging population contributes to rising costs for healthcare and retirement programs, which strain the federal budget.

Healthcare Costs: The inefficient U.S. healthcare system leads to high expenses without significantly better health outcomes. Healthcare spending is projected to keep rising, exacerbating the debt.

Interest Payments on Debt: As the debt accumulates, interest payments increase, adding to the fiscal burden.

Insufficient Revenue Base: Revenues are insufficient to cover the commitments made in federal spending, creating a structural mismatch.

U.S. Public Debt refinancing – understanding the inherent risks

The probability of the U.S. failing to refinance its public debt in 2025-2026 depends on several factors. Below we provide some insights:

Refinancing Activity: U.S. companies have been actively refinancing debt due in the next few years. Tight credit spreads and strong investor demand have prompted many to refinance sooner rather than wait for expected interest rate cuts in 2024.

Debt Maturities: Nearly $2 trillion of debt maturing through 2025 isspeculative grade, which carries more refinancing risk. However according toS&P Global Research, companies have time to refinance as these maturities do not peak until 2025.

Economic Outlook: Economic data remains strong, and some experts believe rate cuts may not be imminent. However, others predict a mild U.S. recession in the first half of next year, potentially affecting refinancing conditions.

If refinancing of U.S. public debt were to fail, several risks could arise:

Higher Interest Costs: The U.S. government would need to pay higher interest rates on existing debt. This would strain the budget and increase the overall debt burden.

Market Confidence: A failed refinancing could erode investor confidence in U.S. debt. Investors might demand higher yields, making it costlier for the government to borrow in the future.

Economic Impact: A debt crisis could lead to economic instability, affecting growth, employment, and consumer spending.

Downgraded Credit Rating: Rating agencies might downgrade U.S. debt, signaling increased risk and potentially triggering further negative consequences.

Crowding Out: High debt costs could crowd out other essential government spending, impacting critical programs and services.

All these factors would negatively affect the stock market.

Market conditions under which the U.S. could fail to refinance its public debt

The U.S. could face several conditions under which it might fail to refinance its public debt in the year 2025. These conditions include:

Persisting High Interest Rates: A significant factor is the remaining high interest rates. If interest rates remain elevated, the cost of borrowing are high, making it expensive for the U.S. to refinance its debt. However, we are not so much concerned with this factor because the odds that the Federal Reserve will cut interest rates starting this September are relatively high.

Increased Debt Levels: The U.S. public debt is projected to continue increasing. By the end of 2025, debt held by the public is expected to reach its highest level ever recorded, at 116% of GDP, according toCongressional Budget Office. This high level of debt could make investors wary, increasing the difficulty of refinancing.

Debt Limit Issues: If Congress does not act to raise or suspend the debt limit, the Treasury will have to rely on its existing cash and extraordinary measures. This could lead to a situation where the U.S. cannot meet its debt obligations, forcing the government to default or delay payments, as perBipartisan Policy Center.

Economic Downturn: An economic downturn could lead to reduced tax revenues and increased government spending on social safety nets. This would strain the federal budget and complicate debt refinancing efforts.

Investor Sentiment: Investor confidence plays a critical role. If investors perceive higher risks or uncertainties regarding the U.S. economy or fiscal policy, they may demand higher yields on U.S. Treasury securities, making refinancing more costly and difficult, according toS&P Global.

In our view, a combination of these factors could create a challenging environment for the U.S. to refinance its public debt in 2025.

According to the latest data of S&P Global Research, refinancing demand from the U.S. is the highest when compared to Europe and the rest of the world.

Strategies to protect investment portfolios against Debt crises

To protect their portfolios against the potential public debt crises in 2025-2026, investors can consider several strategies:

Diversify Investments: Diversification across different asset classes can mitigate risk. This includes investing in a mix of stocks, bonds, real estate, and commodities.Diversifying internationallycan also reduce exposure to country economic risks.

High-Quality Bonds: Focus on high-quality bonds rather than corporate junk bonds or emerging market bonds, which tend to be more volatile and risky during economic instability. U.S. Treasury bonds, despite the debt crisis, are still considered one of the safest investments.

Strong Cash Position: Maintaining a strong cash position can provide liquidity during market downturns and allow for investment opportunities when asset prices are low.

Gold and Precious Metals: Historically, gold and other precious metals have been safe havens during times of economic crisis and inflation. Adding a portion of these to a portfolio can provide additional security.

Investing in Low-Leveraged & Cash-Rich stock companies: Investing in low-leveraged stocks, with no debt or close to zero debt level. Investing in cash-rich stocks with stable dividend payments.

Investing in Crypto-assets:

Cryptocurrencies, such as Bitcoin (BTC) and Ethereum (ETH), can serve as an alternative store of value and a hedge against stock market crashes, inflation or FX risks. We consider it to be true due to following reasons:

Decentralization and Independence from Central Banks: Cryptocurrencies are decentralized and not controlled by any single government or central bank. This makes them less susceptible to the economic policies and inflationary pressures that can affect fiat currencies. For instance, Bitcoin and other cryptocurrencies have a limited supply, which can protect against inflation and devaluation of fiat currencies.

Global Usage: Cryptocurrencies can be used globally without the need for currency exchange, reducing the costs and risks associated with FX transactions. This can be particularly advantageous for businesses and investors operating in multiple countries, as it simplifies cross-border transactions and reduces exposure to currency fluctuations.

Hedge Against Currency Depreciation: Cryptocurrencies have shown robust stability and even growth in recent years. As some fiat currencies face depreciation due to various economic factors, cryptocurrencies can act as a store of value. For instance, during periods of extreme financial instability or hyperinflation in certain countries, cryptocurrencies have provided a more stable alternative.

Technological Advancements and Adoption: The increasing adoption and integration of cryptocurrencies into the financial systems enhance their reliability and usability. As more financial institutions and businesses start accepting and using cryptocurrencies, their role as a hedge against FX risks strengthens.

Estimating probability of the US Dollar Collapse Risk

The theoretical collapse of the US Dollar due to a U.S. public debt crisis in 2025-2028 is a topic of significant debate among economists and financial experts. Here are some key points to consider:

Debt Levels and Sustainability: The U.S. national debt is projected to rise significantly. For instance, the Congressional Budget Office (CBO) projects that federal debt will be almost $38 trillion by 2030, with some estimates adjusting for historical biases predicting a higher amount. However, theWharton Budget Modelsuggests that U.S. debt reaching about 200% of GDP could still be manageable under current favorable market conditions.

Potential Triggers for Collapse: A sudden crisis for the dollar would likely require a combination of high inflation and political instability. High inflation can erode the value of the dollar, while political instability, such as repeated conflicts over raising the debt ceiling, can undermine confidence in the U.S. government’s ability to manage its finances.

Economic Growth vs. Debt Spiral: Some economists, likePaul Krugman, argue that with current interest rates for inflation-protected U.S. bonds being relatively low, economic growth may prevent a runaway debt spiral. This suggests that while high debt levels are concerning, they might not necessarily lead to a dollar collapse if economic growth continues.

Imminence of Collapse: Despite the concerns, many analysts believe that a collapse is not imminent. The U.S. dollar remains a key reserve currency globally, and while caution is urged regarding the U.S.’s debt obligations, a complete collapse is considered unlikely in the near term.

Our view

Our analysis indicates that while the risk of a U.S. dollar collapse due to a public debt crisis cannot be entirely dismissed, it is generally considered unlikely within the 2025-2028 timeframe given the current economic conditions and the dollar’s entrenched position in the global economy. However, persistent high inflation and political instability could heighten risks and lead to significant economic challenges. The U.S. economy and the dollar are often considered Too Big To Fail. Nevertheless, history teaches us that nothing is impossible in theory.

Furthermore, the sovereign debt crisis could potentially arise from countries like Japan, which holds significant US Dollar-denominated debt. Due to a weak domestic currency, Japan may struggle to refinance this debt. The continuously growing budget deficit also requires careful examination in the context of current economic conditions and growth. The global macroeconomic situation remains challenging at present. Therefore, it is crucial for investors to remain cautious, consider inherent macroeconomic risks, and adjust their investment strategies accordingly.

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