76report

December 12, 2024

How America Can Escape the Debt Trap

The Biden administration is leaving Donald Trump a Christmas present that makes a lump of coal look like a shiny new bicycle: $36 trillion of debt that requires about $1 trillion a year in interest payments.

At least, it did come with a little bit of an apology note yesterday from Treasury Secretary Janet Yellen.

Well, I am concerned about fiscal sustainability, and I am sorry that we haven’t made more progress. I believe that the deficit needs to be brought down, especially now that we’re in an environment of higher interest rates. - Janet Yellen (12/11/2024)

Markets are unsurprisingly focused on how Trump will manage around the enormous federal government debt burden he is inheriting.

Investors have some serious concerns.

Is the U.S. dollar at risk of losing its status as the global reserve currency?

Will interest rates skyrocket?

Is more inflation inevitable?

Trump has made clear his strategy to handle the situation—cutting spending and driving economic growth.

He spoke this morning at the New York Stock Exchange and communicated his priorities for the U.S. economy, which involve making sure America dominates the industries of the future.

We’re going to do something great with crypto because we don’t want China or anybody else, not just China, but others are embracing it and we want to be the head. We’re going to be ahead of AI. We’re going to be way ahead of AI. And we’ve got to produce tremendous amounts of electricity. - Donald Trump (12/12/2024)

Investors in stocks have many good reasons to be optimistic about the implementation of Trump’s growth agenda—but America’s enormous public debt still presents meaningful risks.

These risks do not mean you should not be invested. These risks mean you need to be invested in the right places.

In the current market environment, the key investment themes to focus on are transformational technological innovation (including AI and crypto) and pro-growth policy shifts (energy and re-industrialization).

But the hard reality is that the U.S. does have enormous fixed debt obligations that will be difficult to overcome through growth alone.

There is a strong likelihood that we will see a continuation of the money printing that got the country into this mess in the first place.

Investors therefore need to focus as well on scarce real assets—assets that will appreciate, at least nominally, as the total supply of U.S. dollars continues to grow.

Investors should want to be aligned with the changes taking place in the economy.

They should also want to own supply-constrained assets that will become more valuable simply because there will be more money circulating in the economy to purchase them.

The most attractive investments may have both attributes — structural growth and asset scarcity.

WHAT TO OWN

Scarce real assets are accessible in many forms. We encourage a diversified approach.

While investors can position themselves for identifiable trends, predicting with certainty which particular assets will perform the best requires a crystal ball that nobody has.

The stock market offers a wide range of opportunities to get exposure to scarce businesses and commodities.

The key idea behind scarcity is that supply is constrained when an asset cannot be easily or cheaply replicated by would-be competitors.

Gold is the classic example of a scarce real asset. Gold is difficult and expensive to mine, which means the total supply of gold only grows about 1% to 2% per year.

But scarcity is not limited to physical commodities. Businesses with high market share and high barriers to entry typically have scarcity, which gives them pricing power.

Scarcity can also just as easily reside in intellectual property, such as technology stocks with captive customers.

Over the past 16 years or so, Bitcoin has grown from having essentially zero value to $2 trillion because it represents digital scarcity. The Bitcoin network will never exceed 21 million coins, which leaves to miners only 5% additional supply growth.

The Model Portfolio stocks we have profiled in the 76report are specifically selected because of the underlying scarcity of their operating assets and their alignment with structural trends.

Eaton (ETN) is a high market share player in key industrial niches.

ETN sells into the electrical supply chain that supports data centers as well as the electrical power networks that make them run.

Freeport-McMoRan (FCX) is one of the world’s leading copper miners.

Copper is desperately needed for the vast growth in electrical wiring the world will generate in the years ahead, yet copper, like gold, is hard to find and expensive to mine, which sets the stage for supply shortages down the road.

Vulcan Materials (VMC) has an irreplaceable network of quarries across the southern United States.

VMC produces construction aggregates that are indispensable for construction activity, which should accelerate with Trump’s reindustrialization agenda. Permitting new quarries is nearly impossible, which means VMC has continuously been able to generate pricing growth well above inflation rates for decades.

The ideas within our Model Portfolios are stocks that benefit from both scarcity and alignment with key trends.

American Resilience focuses more heavily on technology and growth opportunities.

Inflation Protection emphasizes natural resources and consumer franchises.

Income Builder leans into financials and infrastructure plays that generate relatively high cash flow streams.

As complements to broad stock market exposure and our Model Portfolio stocks, we also favor allocations to gold and Bitcoin as scarce monetary assets.

While the U.S. does have a genuine opportunity to improve its real growth trajectory through better policy, gold and Bitcoin represent attractive hedges if money supply growth ends up as a bigger part of the solution than hoped.

HAS THE U.S. BEEN HERE BEFORE?

The late 1960s provide a useful parallel to the current moment in American history.

As Trump prepares for his second inauguration next month, he returns under circumstances comparable to those that brought Richard Nixon to the White House in January 1969.

In 1968, the Democrat incumbent President Lyndon Johnson, like Joe Biden, failed to secure his party’s nomination.

The Republican nominee Nixon, like Trump, ended up with a decisive victory in the electoral college.

Many of the factors that fed into Joe Biden’s lack of popular support also dragged down Lyndon Johnson. Johnson’s term was marked by war, excessive domestic spending, inflation and debt.

Both Biden and Johnson pursued very expensive foreign and domestic policies. While Johnson had Vietnam and the Great Society, Biden had Ukraine and pandemic stimulus.

Both Biden and Johnson turned low inflation economies into high inflation economies.

In the years prior to either of them taking office, inflation rates were actually quite contained—in the vicinity of 2% and at times even lower. In both cases, heavy spending and ballooning deficits changed the inflation picture drastically.

The Johnson administration produced the first federal deficit since World War II. As Johnson left office, inflation rates were around 5.5% and rising. During Biden’s term, Consumer Price Index increases reached as high as 9% in June 2022.

The fiscal position that Nixon inherited from Johnson was so dire that, starting in 1971, the U.S. had to abandon the dollar-gold peg that was established at the tail end of World War II.

Smelling trouble and perhaps opportunity, foreign governments decided to redeem collapsing U.S. dollars for gold bars, which they were entitled to do under the Bretton Woods system.

In August 1971, France sent a naval vessel to New York City to collect its gold from the Federal Reserve Bank. Nixon was forced to close the “gold window” a few days later before all of America’s gold disappeared.

The resulting devaluation of the dollar set the stage for a truly dismal period in American history from an economic perspective.

The 1970s were a decade marked by high inflation, high interest rates, energy crises, limited innovation, and slow growth.

HOW DO WE AVOID ANOTHER LOST DECADE?

Unlike the situation in the early 1970s, the financial liabilities of the federal government today are entirely paper.

This potentially inoculates the U.S. from a sudden systemic shock like what the U.S. experienced when it abandoned the Bretton Woods gold standard.

U.S. debt is no longer backed by any asset or other currency. There is, however, much more of it than there was when Nixon took office.

As a percentage of GDP, debt levels in the U.S. have reached extreme levels not seen since World War II.

To make matters worse, as we have previously discussed, the outstanding debt obligations of the federal government are just one element of a much broader financial problem.

U.S. entitlement programs, specifically Social Security and Medicare, as currently structured, are mathematically unsustainable. Entitlements are a long-term problem that truly must be solved.

The more immediate problem, however, is the effect of higher interest rates on the federal budget.

The U.S. government’s massive debt load was created during an ultra-low interest rate environment. As these bonds mature, they are being refinanced in a much higher interest rate environment.

As rates have gone up, so have total interest payments on the public debt.

To counter inflationary pressures, the Fed started raising interest rates in March 2022. This has been necessary medicine for the economy, but higher rates have also had the unfortunate side effect of making the debt burden even more difficult to manage.

Total federal debt has recently reached $36 trillion, an approximately 50% increase over the past four years. Annual interest payments currently exceed $1.1 trillion, which represents an approximately 100% increase.

Excluding intra-governmental interest payments (such as payments to the Social Security Trust Fund) brings the annual interest obligation for 2024 closer to $900 billion. Yet this adjusted figure is still some 13% of the total federal budget and higher than the entire defense budget.

MAINTAINING BOND MARKET CONFIDENCE

When a household or business starts drowning in debt, borrowing money to meet ever growing interest payments, with no solution in sight, lenders take notice.

When it comes to the federal government, these lenders are investors in Treasury bonds, whether they are private institutions or foreign central banks.

Traders sometimes talk about the emergence of bond vigilantes.

This refers to what happens when investors in government bonds essentially refuse to buy debt instruments from governments (typically in emerging markets) that are mismanaging their financial affairs.

PIMCO is one of the largest bond managers in the world, with about $2 trillion of client assets. In a recent note, they pointed out the evolving risk that bond investors may one day turn their back on the U.S. government, notwithstanding its historical economic supremacy.

The U.S. remains in a unique position because the dollar is the global reserve currency and Treasuries are the global reserve asset. But at some point, if you borrow too much, lenders may question your ability to pay it all back. It doesn’t take a vigilante to point that out. - PIMCO (12/9/2024)

Long-term government bond yields are the barometer for perceptions of a country’s creditworthiness. The less comfortable investors are that they will get their money back, the higher interest rates go.

Yields rise as trust falls.

But if a country can print its own money without having to worry about converting it into gold or any other asset, which has been the case for the U.S. for some fifty years, this leads to a natural question.

Why do investors in U.S. Treasuries even have to worry about repayment?

The answer is inflation.

No matter how much the U.S. government borrows, it will almost certainly repay it. But the currency it uses to repay that debt may be severely debased as a result of monetary creation (or money printing).

When bond investors anticipate inflation, they require higher interest rates. They need to be compensated for the risk that they will be repaid with money that has less real value.

A country like the U.S. that operates with a fiat currency with no backing could even take it a step further.

Not only could the Fed print money to repay its loans, the Fed could go into the market (with money it creates) and buy long-term Treasury bonds in order to suppress interest rates in an artificial way.

If the U.S. is truly unable to get control over its liabilities, money printing, paired with central bank measures to bring down interest expense, is the almost inevitable result.

Economists refer to this predicament as fiscal dominance.

The central bank essentially has no choice but to inflate away the government’s fixed debts. Interest rates are kept at levels that are too low to constrain inflation, which then runs amok.

WHAT ARE BOND MARKETS NOW TELLING US?

The inflation-debt spiral has brought down many governments throughout history and is frightening even to consider.

The good news is, despite the highly concerning long-term outlook, current bond market conditions are not especially troubling.

The yield on 10-year Treasury bonds peaked in spring 2024 as inflation readings continued to come in hot. It then receded substantially towards the end of the summer as jobs reports (and associated revisions) showed significant labor market weakness.

10-Year Treasury Yields (Source: FactSet)

Bond yields bottomed in September, on the heels of the Fed’s 50 basis point rate cut, which shifted the market narrative to recession risk.

Yields began to creep up again in October and into November, however, as economic data and corporate earnings pointed to a more stable macroeconomic situation. Yields peaked in November around 4.4.%.

Since the election, yields on 10-year Treasuries have declined somewhat and now sit closer to 4.2%.

Ebbing Treasury yields are a healthy development for investors because subdued interest rates are necessary to support stock valuations and overall economic growth.

The appointment of Scott Bessent as Treasury Secretary, as we noted earlier, eased bond market concerns that the Trump growth agenda could create inflationary pressure.

The retreat in yields from 4.4% to 4.2% can be seen as a signal of confidence that Bessent, in coordination perhaps with the Musk/Ramaswamy DOGE initiative, will keep federal spending and the deficit in check.

INFLATION EXPECTATIONS ARE LOW

Thanks to the Treasury Inflation-Protected Securities (TIPS) market, we are able to infer what bond investors are pricing in with regard to future inflation expectations.

The inflation component of 10-year bond yields—in other words, the average inflation rate bond investors expect in the U.S. over the next 10 years—currently sits just below 2.3%.

The reduction of forward inflation expectations since the Bessent announcement explains most of the downward move in 10-year Treasury yields.

Inflation expectations now sit a bit higher than they were versus their lowest levels in August and September, when the market was focused on recession risk, but are materially lower than they were in the spring.

Recent economic data points support a relatively neutral view on the near-term economic outlook, and the stock market has responded positively.

The labor report issued on December 6, 2024 showed generally stable labor market conditions.

The CPI report issued on December 11, 2024 indicated 2.7% annualized inflation. This is above the Fed’s 2% target but was in line with analyst forecasts.

Right or wrong, bond investors continue to believe the Fed has room to lower rates given the trajectory of consumer prices and a somewhat cooler labor market.

A rate cut of 25 basis points at the next Fed meeting on December 18, 2024 is now priced in with near certainty.

THE SLOWING ECONOMY GIVES TRUMP BREATHING ROOM

High interest rates have been painful for American consumers and businesses but may have snuffed out the worst of the inflationary pressures that resulted from the Biden spending boom.

Notwithstanding long-term challenges, this leaves Trump in a relatively good spot as he seeks to redirect the American economy onto an enduring and elevated growth trajectory.

The U.S. debt problem does not have to be solved immediately. Bond markets appear under control.

The average American household, weakened under Biden and the high interest rate environment his fiscal policies triggered, is not generating inflationary pressure.

Softness in the economy gives Trump and his economic team a window of opportunity to restore the American economy to a more ambitious growth footing. They intend to do this through policy support for technology, energy, manufacturing and financial modernization.

Generating higher real growth through higher productivity, while cutting or at least holding back growth in government spending, is the best way for the U.S. to solve its current debt to GDP problem.

This is not the approach, incidentally, that Nixon followed. Whether or not it was the right thing to do, the Vietnam War continued until 1975, further exacerbating the fiscal situation.

Although a Republican, Nixon’s economic policies were also not focused on growth but rather statist interventions.

Nixon famously implemented wage and price controls in an attempt to constrain runaway inflation. These backfired (as they always do) and had to be abandoned.  

SCARCE REAL ASSETS OFFER PROTECTION

Trump’s policy agenda is the right one to address the heavy, but ultimately not fatal, debt burden the federal government now faces.

Realistically, however, the U.S. will also need to see sustained monetary creation to cope with its enormous debts.

Even as productivity gains flow through the economy, putting downward pressure on prices for good and services which can be produced more efficiently, the Fed will likely continue to print money at a pace that offsets deflationary impacts.

Investors should think about inflation like the Austrian economists do—as monetary debasement rather than rising prices.

Scarce real assets like stocks, commodities, gold and Bitcoin are not lifted by rising prices per se. They are lifted by money that gets printed and injected into the economy, whether or not consumer prices rise as a result (although they naturally often do).

The U.S. debt burden is widely seen as a threat to markets. To the extent it puts upward pressure on interest rates or leads to economic instability, it can be.

The biggest threat, however, is to holders of U.S. dollars in the form of cash or basically any kind of dollar-denominated bonds.

Businesses and scarce commodities have the potential to benefit from monetary debasement, while cash and bonds just get diluted.

The best way to protect one’s savings from the enormous pubic debt is to have diversified exposure to high quality real assets that will nominally rise in value as the total supply of money rises.

COULD BITCOIN BE THE SOLUTION TO THE NATIONAL DEBT?

With Bitcoin recently surpassing $100,000, there has been a lot of speculation around Bitcoin as a potential tool to address America’s fiscal challenges.

The incoming Trump administration is loaded with Bitcoin advocates, while Trump himself seems to speak favorably of Bitcoin almost daily.

We look forward to diving into Bitcoin’s relevance to Trump’s economic strategy in our next 76report.

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