Rising Debt: A Looming Risk?

Source: Source: Bank for International Settlements, Amount Outstanding of Total Debt Securities in Nonfinancial Corporations Sector, All Maturities, Residence of Issuer in United States, retrieved from FRED, Federal Reserve Bank of St. Louis.

There has been no shortage of risks in the market lately, from trade wars to yield curve inversions to an escalation of geopolitical tensions with Iran. These have been countered by a healthy economy, allowing markets to climb the wall of worry. We think this investment dynamic will continue, but rising debt levels are a risk we’re watching. While it’s not an imminent threat, we think debt will play a role in economic and investment conditions longer term.

Corporate borrowing at record highs – Corporate debt levels have risen to a record $10.1 trillion, or 47% of GDP.1 We don’t think this will spark an economic downturn, but we do believe it will put additional drag on an eventual recession, as corporations are forced to pull back further to address their leverage. Rising corporate debt is not surprising or unreasonable. Further, debt as a percentage of corporate equity is roughly half its level before the financial crisis and in line with levels of the early ’90s, reflecting strong earnings and stock market values. We don’t expect corporate defaults and financial conditions to become a material headwind in 2020, but weaker GDP growth and/or rising interest rates could pose a challenge down the road.

Government debt: large but longer-term – U.S. federal debt has surpassed $23 trillion, with persistent annual budget deficits set to add to that figure. However, U.S. debt-to-GDP2 is slightly under 80% – still well below levels that portend financial stress or insolvency. Nevertheless, shifting demographics and ongoing deficits are likely to make rising government debt a more prominent risk down the road. We don’t think this will threaten the long-term opportunities in investment markets, but elevated government debt does pose a headwind to potential economic growth over time by limiting the flexibility of fiscal policy, raising government borrowing costs and, if left unchecked, crowding out private investment.

Action for Investors

Action for Investors Ensure appropriate diversification within fixed-income portfolios, with the majority allocated to investment-grade bonds. To address corporate debt risks, we favor high-quality companies with sound financial positions and stable earnings. To address long-term government debt/interest rate risks, ensure a proper allocation to global equities and domestic equities with rising dividend potential.

1 Source: Ned Davis Research, non-financial corporate debt.

2 Source: St. Louis Federal Reserve, federal debt held by the public as a percent of GDP.

Important Information:

Diversification does not guarantee a profit or protect against loss in declining markets.

Investing in equities involves risks. The value of your shares will fluctuate and you may lose principal. Special risks are inherent to international investing, including those related to currency fluctuations and foreign political and economic events.

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