Should Investors Fear Rising National Debt?

U.S. National Debt continues to rise and many investors are afraid. This fear is nothing new; it has been around for decades.

Is it rational for equity investors to fear rising debt levels? Let’s take a look.

First, some background.

Since 1966, the U.S. National Debt has risen in each and every calendar year. Through Democrat and Republican administrations – the one constant has been more debt – from $320 billion in 1966 to nearly $20 trillion today. With a current budget deficit north of $600 billion, the national debt clock continues to tick higher.

National Debt as a percentage of GDP is moving higher as well, most recently coming in at 104%. Just 10 years ago this ratio stood at 62%. You have to go back to 1995-2000 to find a period where the ratio was trending lower for any sustained period of time.

Why is the ratio moving consistently higher? For the last 16 years, National Debt growth has outpaced Nominal GDP growth in every single quarter (on a year-over-year basis). This has been true during both recessionary and expansionary environments, and both Democratic and Republican administrations.

So, were equity investors justified in being concerned with rising National Debt over the years?

Not exactly. U.S. National Debt has increased by 8.4% per year since 1966 and over that time the S&P 500 has advanced 9.7% per year. Clearly, rising debt levels by themselves are not an impediment to equity returns.

What about rising Debt as a percentage of GDP?

Again, not exactly. From 1982 to 2016 this ratio moved from 32% to 105%. Over this time period, the S&P 500 gained 11.7% per year.

What about large spikes in the debt level. Is that a bearish omen?

Not exactly. The two largest year-over-year increases in National Debt occurred in early 1983 and early 2009 (both >20% increases). Two of the strongest and longest bull markets in history followed.

Interestingly, the National Debt has gone negative year-over-year in only one quarter since 1966. That was in the 3^rd quarter of 2000, near the start of the 2000-02 bear market. By the time the bear market ended in the 3^rd quarter of 2002, National Debt was once again on the rise (up 7.8% year-over-year).

But isn’t there a breaking point at which National Debt could be a problem for stocks?

Yes, if the National Debt reached a level at which default risk was a real concern, that would be worrisome as it would likely coincide with severe economic weakness. The only problem is no one knows what that level is or when it will occur. We just know we haven’t yet come close to reaching that “breaking point” in the United States.

In 2015, Moody’s developed a “Fiscal Space” metric which attempts to measure the “difference between a nation’s sovereign debt-to-GDP ratio and the limit beyond which the nation will default unless policymakers take unprecedented steps.”

If you trust their analysis, the U.S. is still in the “safe zone” and far from any significant risk of default.

Japan, on the other hand, is in Moody’s “grave risk” zone. With an astronomical Debt-to-GDP ratio of over 250%, this isn’t exactly surprising.

What may be surprising, though, is that Japanese stocks (EWJ ETF, total return) recently hit a 21-year high.

And at the same time, Japanese yields remain near all-time lows. Even at 250% of GDP, Japan’s National Debt still seems to be below its “breaking point.”

Japan may be a unique situation but it’s an instructive one, nonetheless. There are no hard and fast rules regarding stock market performance and National Debt. In fact, the two variables have had literally zero correlation historically in the United States. National Debt is likely to continue to rise in the foreseeable future and at some point stocks will go down, but that doesn’t mean stocks will be going down because of National Debt. Don’t confuse short-term correlation with causation.

If you are worried about rising National Debt, that may or may not be a valid concern as it pertains to the economy (many have argued that higher debt levels will impede future growth), but when it comes to the stock market and investing in general such fears do not seem warranted. The stock market is not the economy and it certainly isn’t the national debt. Your best protection against the risk of a debt crisis in the future? Diversification, diversification, diversification.