Washington, we have a problem | The Green Line

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Articles by Gemma

Gemma Cairns-Smith

Investment Specialist

10 July 2024

“A national debt, if it is not excessive, will be to us a national blessing.” Alexander Hamilton’s mantra has been something of a guiding principle for the pullers of the United States’ purse strings, ever since the founding fathers borrowed from France and the Netherlands to pay for the War of Independence. We fear the cost of servicing debt is on track to become ‘excessive’.

This month’s chart shows the Congressional Budget Office projections for debt to GDP (shown here as the green line) and the cost of servicing that debt as a percentage of government revenue (shown as the blue line).

The US government is currently spending almost a fifth of all tax revenues to pay the interest on their borrowings. That’s already more than the entire defence budget today. Even more worryingly, the government is forecasting that interest costs will rise to 35% of total revenues by 2054.

To put this into context, this means spending on debt is predicted to exceed defence spending threefold by 2054. And whilst 35% might seem extortionate enough, this is a best case scenario. These projections are based on rosy assumptions: GDP growth of above 1.8%, ten year yields below 4%, and inflation of 2%.

So how do governments get themselves out of this unsustainable debt dynamic?

Whilst they could simply print money or raise taxes to fund their way out of this hole, neither of these would be popular at the ballot box. Instead, we are being promised either tax cuts or more spending – or even both. So the most palatable solution is financial repression. Where inflation above the level of interest rates erodes the real value of government debt over time.

Financial repression matters because it means governments are incentivised to tolerate higher inflation going forward. This is the cornerstone of our structural view; we are in a new economic regime where 2% inflation is the floor rather than the ceiling. This would be a challenging environment for asset prices – 2022 was a lesson in this. In our view, protecting portfolios against inflation risk is critical moving forward.

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For the Ruffer portfolio, such protection comes in the form of UK and US inflation-linked bonds alongside gold and other precious metals, and commodity exposure. Index-linked bond prices are driven by two factors: expectations of future interest rates and expectations of future inflation. So, investors benefit if interest rate expectations fall, and/or if inflation expectations rise. However, if neither of these come to fruition, at a minimum they will earn a decent yield. Currently the portfolio’s treasury inflation protected securities (TIPS) are guaranteed to deliver 2% plus inflation, whatever that might be, every year, if held to maturity.

Niall Ferguson boiled it down to this: “Any great power that spends more on debt service than on defence will not stay great for very long.” We agree, the official projections of the cost of servicing the US’s mammoth debt are scary, but for investors the likely outcome might be scarier still if they don’t protect portfolios against higher and more volatile inflation.

#debt, #inflation, #regime change

Articles by Gemma

Gemma Cairns-Smith

Investment Specialist

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Piers Wheeler

Director – Institutional

T +44 (0)20 7963 8258

Developing and executing asset management strategy for capital raising and strategic relationship management. Coverage includes EMEA, Asia and Australia. Piers joined Ruffer in 2021, having previously worked with asset management firms including Eastspring, AMP Capital and LEK as a strategic consultant. He holds a MA from the Bayes Business School and a BA (Hons) from the University of Oxford.

Annabel Paterson

Senior Associate – Institutional

T +44 (0)20 7963 8123

Joined Ruffer in 2021, having graduated with a first class honours degree in land economics from the University of Cambridge. After two years working with the UK Private Wealth team and completing her IMC and CFA Level I qualifications, she now supports Ruffer’s global business development and client servicing efforts.

Articles by Annabel

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‘Washington, we have a problem’