The spectrum of policy uncertainty as a market driver is broadening: from a myopic focus on trade and tariffs, to a renewed focus on government spending and taxes. This is the case not just in the U.S., where the reconciliation bill was the trigger point of the “big beautiful breakup” between President Trump and Elon Musk. As we wrote last week, questions around supply and demand for Japanese government debt were the key driver behind a selloff in Japan. And as peace between Russian and Ukraine looks more elusive, questions around how much Europe invests in defense and infrastructure are top of mind. Our latest research, looking at sovereign debt sustainability as an investment megatrend, provides a strong investment-focused framework for this news flow and the investor questions it’s prompted.
The research is available here.
I want to share three takeaways from this research:
1. Debt sustainability reflects a long-standing status quo. At the highest level, major savers (many countries in Europe; Japan; China, and others), utilize Treasuries and other U.S. assets as a source of returns. The U.S., in turn, relies on these ‘imported’ savings to finance its fiscal and trade deficits. The result is a 70-year legacy supporting demand for U.S. Treasuries, influencing how ‘affordable’ interest rates are globally.
2. There are no alternatives to U.S. capital markets at scale – and this protects demand for U.S. debt. We believe the recent renaissance of global diversification from U.S. investors, as well as the re-think of U.S. exposure among global allocators, is valid – all investment ‘eggs’ need not be in the U.S. ‘basket’. But we don’t agree with views suggesting it’s the end of U.S. dominance. The two most obvious potential alternatives to Treasury debt are not yet viable at scale: European capital markets are not integrated, and therefore do not provide the depth of U.S. capital markets. There has been willingness to move further with integration, but the legal, financial, and political costs are currently prohibitive. China, which could have the capital markets scale, has explicitly chosen to keep its capital account closed, its currency managed, and its capital markets largely foreign-investor-free. Similarly to Europe, costs of liberalizing capital markets in China would be prohibitive.
3. The investment takeaways are in the journey, not the destination. Discussions around sovereign debt assume that, like a household that gets in over its head, there will be a crisis point if a country spends too much for too long. In some sense this is true: U.S. interest payments on public debt are growing too quickly, and need to be contained in the near term, otherwise they will crowd out discretionary spending, including on defense.
But countries are not households. Major economies have almost unlimited tools to ‘extend and pretend’ – their central banks and finance ministries (the Treasury department in the U.S.) can take the risk of outright external default off the table.
In the absence of a full-blown crisis (removing the “left-tail risk” of default), ongoing, long-term management of sovereign debt loads will influence asset allocation the most. Countries are starting to spend more on health, defense, critical supply chain access, and digital infrastructure. This government support for growth, shared across the U.S., Europe, and Japan, can provide long-term support for equities and risk assets. A search for higher growth implies a tolerance for inflation and moderately higher interest rates, meaning that bond prices may be pressured, but solid income generation can support total return in fixed income. Private assets will have to earn their illiquidity premium in a pro-growth environment that supports returns, meaning selection is increasingly critical. Our research concludes with a full investment playbook based different debt management paths.
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This material represents an assessment of the market environment as of a specific date and is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any investment product or any issuer or security in particular.
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