Since March, debt levels have skyrocketed and have exceeded post- World War II levels with no expectations to reverse this rising trend. Concerns over the level of debt accumulation have emerged, including whether these debt levels will restrict or delay the modernization of key infrastructure and the economy. It has also lead to questions pertaining to what the future will look like for the major economies, the financial markets, and taxpayers.    

According to the International Monetary Fund (IMF), public debt levels of advanced economies have increased by almost 27% since January 2020. That brings public debt levels to greater than 120% of GDP. In comparison, global debt levels sit at 102% of GDP. While global debt levels are not as high, they are still at record highs. Still, these figures fail to consider off-balance-sheet government obligations such as pension and healthcare expenditures that must be paid in the future. As such, according to the group, Truth in Accounting, if all the off-balance-sheet items for the next 75 years were included, debt levels would increase from the current $27 trillion to $137 trillion.

It may not be surprising that the level of debt is at unprecedented highs. The COVID-19 induced economic shutdowns resulted in significant business and personal losses. To ensure that individuals remained employed and businesses survived, it was necessary for governments to stimulate the economy with the help of public debt.

Although high levels of public debt may sound alarming, it does not necessarily mean that there is heightened systemic risk. For some countries, the household debt burden is a greater concern relative to public debt levels. As it pertains to the US, following the 2008 Financial Crisis, US household debt obligations actually dropped from 100% of GDP to 75% of GDP. On the other hand, publicly held federal debt increased from 50% of GDP to 80% of GDP. (see chart below) This increase in federal debt may seem unfavourable, however the shift yields a better result in the interest of systemic risk. This is because the federal government, through its ability to print money and engage in other fiscal and monetary policies, is better capable of addressing debt compared to individuals and households.

Another concern involves the debt servicing costs associated with this debt. Despite higher debt levels, current borrowing costs for governments are actually quite low due to low-interest rates. Existing government bond issues with high coupon rates are being re-financed at ultralow rates. Hence, this has allowed interest expenses to decrease, despite the rise in debt levels. With this in mind, RBC Wealth Management does not anticipate a large increase in the share of GDP that will be spent on interest payments. Looking a decade into the future, they estimate the cost could gradually move to 2.5 percent of GDP, which is not much more than the last two decades where it averaged 1.5 percent of GDP. Moreover, 2.5% is ‘cheaper’ compared to the 1980s and the first half of the 1990s, when more than three percent of GDP was spent on debt servicing. With debt servicing costs unlikely to increase significantly, the likelihood of a default from the G20 nations also declines.

So, what is the overall result of debt accumulation?  We believe there are three notable implications. First, high debt levels will eventually restrict the flexibility of a government’s budget and most likely point towards higher tax rates. Hence, for investors, the idea of raising capital gain inclusions and tax rates will likely be an ongoing discussion, potentially encouraging investors to rebalance portfolios.  Second, despite low-interest rates, economic growth may be restricted. The Congressional Budget Office (CBO) forecasts US GDP to grow between 4 to 4.5%, which is slower than the decade following the financial crisis of 5 to 5.5%. Hence, portfolios should be populated with stocks where one has a high conviction that sales, earnings, and dividends will grow faster than the economy. Finally, a high debt load is a powerful incentive for policymakers to further suppress interest rates for a longer period than one might think is reasonable. This will cause a burden for savers and fixed-income investors who will be encouraged to engage in strategies that balance safety, liquidity, and income generation. This is a task that undoubtedly requires more attention.

Governments, taxpayers, and investors are all entering unchartered territory. Reviewing one’s portfolio strategy should go beyond a post-pandemic environment, but to further consider an era of investing under the weight of unprecedented public debt.