Debt – Does It Matter?

September 5, 2023

By Ellen Hazen, CFA®, Chief Market Strategist

August Takeaways:

  • The US economy continues to be healthy. Q2 GDP of 2.1% is broadly consistent with 2.0% in Q1 and 1% in 2022 and looks as though it may be the lowest quarter of the year. The Atlanta real-time GDPNow forecast is currently predicting that Q3 2023 GDP will be a strong 5.6%, while economist surveys are predicting 2.4%.
  • Jobs and inflation are stable. New jobs continued to grow at a healthy – although decelerating – pace, with 157,000 new jobs created in July and 187,000 new jobs created in August. The most recent unemployment rate has increased to 3.8% (which is low by historical standards), and the labor force participation rate is nearing pre-COVID levels, at 62.8%, compared to Feb 2020 at 63.3%. July CPI of 3.2% ticked up slightly from June’s 3.0%, giving the Federal Reserve (fed) an additional reason not to cut rates.
  • Jackson Hole – inflation is still the key focus. The annual global central bankers’ meeting in Jackson Hole, WY, did not result in any significant news. Fed chair Jerome Powell’s speech emphasized the Fed’s commitment to drive inflation toward its stated 2% target, and the committee’s stance that inflation is a greater risk than a slower economy. European Central Bank (ECB) president Christine Lagarde’s speech likewise emphasized that inflation remains undefeated.
  • Q2 earnings were modestly better than expected. S&P500 earnings declined by 5.5% year-over-year (Y/Y), better than negative 9%, which was the expectation as recently as two months ago. Q2 is expected to be the trough of the earnings slowdown this cycle: similar to GDP, and expectations are for Q3 to decline by only 0.5% Y/Y.
  • Equity market breadth reversed. Small- and mid-sized stocks underperformed the large-cap universe in August, after having outperformed in June and July. Small-caps declined by 4.2%, mid-caps declined by 2.9%, and the S&P500 declined by only 1.6%.
  • Fixed income yields rose. Yields rose modestly in the month, as consistently stronger than expected economic data reinforced the narrative that the Fed will keep interest rates higher for longer. Credit spreads remain fairly tight relative to history, suggesting that bond investors are not anticipating a recession.

What We Are Watching in September

  • Central banks. The Fed meets Sep 20-21 and is expected to hold rates steady. The ECB meets on September 14 and is expected to raise rates by another 0.25%.
  • Inflation is likely to remain muted but is unlikely to reach the Fed’s 2% target. CPI will be reported on September 13.
  • Jobs will be reported on October 6. After three months in a row of increasing new jobs, we will be watching to see if this trend continues. Similarly, we would like to see labor force participation continue to increase.
  • Yield curve inversion has begun to shrink, with the spread between the 2-Year Treasury and the 10-Year Treasury down to 70 basis points (bps) from 106 bps. Historically, so-called “bear steepener” markets (when rates rise, and long rates rise more than short rates) have been positive for equity markets. We will watch for further steepening in the curve or a reversal of this recent trend.

Will equity markets take their cue from slower GDP or from growing corporate profits?


By economic measures, the overheated economy of 2021 and 2022 is slowing. Jobs growth is slowing, inflation is softening, and GDP is hovering just above 2%. Against this slowing (but still solid) backdrop, corporate profit growth looks to have hit bottom in Q2 and is set to accelerate into Q3 and beyond. Will equity markets take their cue from slower GDP or from growing corporate profits?

Over the past fifteen years, equity markets have, arguably, become addicted to “easy money.” Interest rates were reduced to zero during the financial crisis of 2008 and stayed there for seven years; equity valuations, which are inversely related to rates, steadily increased, from 10x earnings in 2009 to 20x earnings by 2020. Similarly, when the Fed cut rates to zero again at the onset of the pandemic, equity markets roared back. As a result, investors have become laser-focused on the Fed and its plans for interest rates.  “Will the Fed raise rates?” or “When will the Fed cut rates?” have become questions of the day for equity investors. The idea that the equity market can remain healthy with higher rates is hard for some investors to imagine. But during the 2003-2008 period, the 10-Year Treasury yield was consistently over 3.5%, and the S&P500 returned over 12% per year. Similarly, between 1991 and 2003 – which includes the tech bubble and tech crash – the 10-year rate ranged between 3.5% and 8.5%, and the SPX returned over 10% per year.

Ultimately, stock prices are driven more by earnings than by interest rates, and companies have been able to produce decent earnings in this economy. Index performance year-to-date has been driven primarily by multiple expansion rather than earnings growth, but earnings estimates for 2023 and 2024 are now increasing, which may support current multiples.

Federal Spending and Federal Debt

When COVID-19 shut down large swaths of the US economy in early 2020, Congress acted swiftly to keep money in people’s pockets and thereby avoid a deep recession. This occurred through a variety of programs, including the so-called Trump checks, the so-called Biden checks, enhanced unemployment insurance, the Paycheck Protection Program, eviction suspension, student loan repayment suspension, and others. These were successful – after a sharp contraction in April and May of 2020, the economy strongly rebounded in the summer and has kept a steady pace since then.

What was the cost to prevent the economy from a sharp recession? In fiscal 2019 (ending September 2019), the federal fiscal deficit was $984 billion, or 4.6% of GDP. In fiscal 2020, the deficit nearly tripled to $2.7 trillion, or 14.9% of GDP. The deficit then shrank as a percent of GDP in 2021 and 2022 (partially because the economy grew quickly), declining to 5.5% of GDP by 2022. Total national debt outstanding held by the public grew from $23 trillion before the pandemic to $33 trillion this year. Treasury debt held by the public as a percent of GDP has likewise increased from 79% of GDP in 2019 to 97% of GDP today.

Source: Congressional Budget Office Historical Budget Data; CBO The 2023 Long Term Budget Outlook

In addition to elevated debt issuance by the Treasury during this period to cover the fiscal transfers, the Fed doubled the size of its balance sheet from $4 trillion to over $8 trillion by purchasing both Treasurys and mortgage-backed securities, thereby injecting an additional $4 trillion into the economy.

When interest rates were close to zero, the increased interest expense from the higher debt taken on was fairly small. Interest expense has remained in a narrow 6-8% range as a percent of annual expenditure and 1.2%-2.5% of GDP for the past few years. However, with higher interest rates, the government will have to pay higher interest expense on this debt. Currently this is projected to increase from 7.5% of annual outlays in 2022 to over 11% by 2025 and over 14% by 2030. As a percent of GDP, it is forecast to increase to over 3.5% by 2031. Whether looked at as a percent of GDP or of annual expenses, interest expense levels do not look problematic at today’s levels, but with rates higher going forward, the forecast is to reach prior highs later this decade and set new highs after 2030.

Source: Congressional Budget Office Historical Budget Data; CBO The 2023 Long Term Budget Outlook

Debt Ceilings, Government Shutdowns, and Downgrades

After resolving the debt ceiling earlier this summer, attention has turned to the possibility of a government shutdown this fall. Another government shutdown could occur sometime after the September 30 fiscal year end. Parts of the Republican party in the House are stating that they will not approve a normal spending bill unless additional funds for a border wall are included. Democrats and some Republicans are against this stance, and such a bill would be unlikely to pass in the Senate. It remains to be seen whether this is a shorter-term negotiating tactic or whether the government will be shut down.

The most recent government shutdown was from December 22, 2018, through January 25, 2019. The market was concerned about other things at the time – the Fed Funds Rate increase on December 19, 2018, was among them. The equity market seemed to take the shutdown in stride: the S&P500 had declined 17% from its peak in October 2018 until the day the government shut down, bottomed two days later, and rallied by 35% over the subsequent four months.

FitchRatings downgraded the US debt on August 1 of this year, from AAA to AA. This is twelve years after S&P downgraded the US debt rating in 2011 during the first debt ceiling standoff. Fitch’s downgrade occurred several weeks after the 2023 debt ceiling standoff was resolved but reflects concern about the same underlying cause: dysfunction in Washington. The equity market declined over 15% after the initial S&P announcement in 2011, recovering most of that by yearend. Similarly, the equity market was weak in August of 2023, possibly because of the Fitch downgrade, but has already partially reversed that decline. We believe that the downgrade formalizes what observers already know: Washington does not work smoothly or effectively when it comes to addressing longer-term fiscal issues.

Debt – Does It Matter?

US Treasury debt held by the public as a percent of GDP has been growing for many years. Some studies (such as this 2010 paper from the World Bank) have suggested that when a country’s debt-to-GDP is above 77% for prolonged periods, economic growth suffers. At the same time, it is one of many factors that drive economic growth, which also include population growth, labor productivity, inflation, and unemployment. As a percent of GDP or annual budget expense, current levels of interest expense are not troubling, although the forecast over the 5- to 10-year horizon would take the US back to prior highs on those metrics.

In the very long run, we see four possible outcomes (these are not mutually exclusive; any combination of them could occur). The government can raise taxes, cut spending, grow nominal GDP at a faster pace than debt growth (“inflate the debt away”), or default. We do not envision a default, which leaves the first three as possible outcomes. The first two require a functioning political system, which seems to be in short supply at the moment. We therefore think the most likely path forward will involve holding absolute levels of debt to a growth rate slower than that of nominal GDP.

What does this mean for investing? Given recent inflation trends, we believe that interest rates will remain higher for longer, which will increase interest expense broadly. Bonds are attractive investments in a higher rate environment, as long as that higher rate is stable. Higher interest rates should result in better allocation of equity capital, with fewer “zombie companies” able to stay alive. This in turn could boost productivity and thus GDP and equity returns. In short, while we watch debt levels, they are only one of many factors in investing.


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